 Hello, and welcome to the session in which we would look at consolidation of financial statements, specifically balance sheet elimination entry. And to be more specific, we're going to focus on the elimination of the investment in the subsidy area account, which is it's a lot to know. Also, we would look at how to create intangibles and talk about the measurement period. In the next session, after we after we create the intangible, we're going to look at impairing those intangibles. Now, as always, I'm going to mention this. This review session is designed specifically for CPA candidate. What does that mean? Why am I saying this? I'm saying this because I may not go over in depth as much as a typical advanced accounting students would need to. If you need to go more in depth about this topic, please go to my advanced accounting course where you will have where you will have more detailed explanation, more detailed explanation. So this session is a review, although I will explain the concept, but not as much as in depth. I would have done it if it's an advanced accounting course. If you need to, if you have access to my far hat lectures, you will have access to that plus additional exercises. Let's go ahead and get started. In a business combination accounted for using the acquisition, the acquirer, which is the parent company and the inquiry continue to exist as two separate legal entities. Simply put, we have a parent and we have a sub and each one of them will keep their books separately. Only the acquirer or the parent company prepare the consolidated financial statement. So when the parent company prepared the consolidated financial statement, they will include the parent plus the sub. And the combined financial statement would include 100% of the assets, 100% of the liabilities of both parent and the sub. After we process the elimination of intercompany transaction, which will work a separate session on this. Now bear in mind, if we are compiling, if we are buying the sub and we are combining the parent plus the sub, the sub, the sub equity will have to be gone. Why? Because we purchase the sub. If we purchase the sub, it means we purchase their equity. Let me show you what I mean. If when we buy an asset, not if, when we buy, when we buy a company, when we buy a company, we would look at their assets, we would look at their assets and assets equal to liabilities plus equity. Simply put, if we rearrange equity equal assets minus liabilities, asset minus liabilities equal equity. In business combination, we call equity net asset. So this is the same thing as net asset, which is assets minus liability. So what we do is we buy their net asset. Well, if we're buying their net assets, in other words, we're buying their equity. Therefore, we cannot buy their assets and keep their equity on the books. Therefore, the equity has to be gone. So you have to understand why we eliminate the equity, why we eliminate the equity, because we already purchase the company's assets and liabilities. And companies assets and liabilities would include their equity. So that's why the first thing, the equity will be gone. And I'm going to show you this entry maybe a couple times in this recording, but it's something that has to stick in your mind. Because when you're doing the consolidation, if they're asking you to do so, don't show any equity of the sub on the consolidated balance sheet. Now, so let's start. So what are the elimination entries? To eliminate the investment in the sub, you should always keep in mind the following. Because when we consolidate, we cannot keep the investment, because this investment, it's in the sub. Well, if we're adding the sub assets and liabilities, we cannot add the assets and liabilities and keep the investment, because the investment was paid for to buy those assets and liabilities. So the sub equity should be fully eliminated. So the first thing we have to do is eliminate their equity. What does that mean? It means common stock will have to be debited of the sub. Additional paid in capital will have to be debited. Retained earnings of the sub will have to be debited. And what do we do is we credit the investment. Because what we paid for the investment is to buy those trades. So when we consolidate, we remove the investment and we remove those three. The parent company investment in the sub should also be eliminated. I just showed you, we credit the investment. Whenever the acquisition is less than 100%, we have to add an NCI, NCI. We have to add an NCI to account for those minority or what we called non controlling interest share. And that will be a separate line in the consolidated financial statement. Now, sometimes what happened is we pay an access of the subsidiaries net asset over the book value. So what do we have to do? Well, if we pay exactly the book value, well, if we pay, let's assume a company is worth, we have a company, let's use some numbers here, their assets equal to 100, their liabilities equal to 40, the equity is 60. If we pay 60, that's easy. What's going to happen is we eliminate their assets and we for 60, we eliminate the investment for 60, all is good. Now, let's assume we have a company with with assets equal to 100 liabilities equal to 40, so they're not asset equal to 60. Now we went ahead and we paid, rather than 60, we paid $80. So we paid $80 and access of 60. It means we paid an additional $60. Well, I understand 60 is to pay their equity. What happened to the remaining $20 that we paid extra? Why did we pay extra? Well, many reasons why you would pay extra for the company. You like the company, maybe some of their assets are undervalued. They have a good potential. There are many reasons, endless reasons. So what do you have to do with this extra $20? Here's what you have to do. First, you have to adjust any asset, any tangible asset acquired over their book value. Maybe they have some assets, maybe have to have a piece of land on the books. It's worth $10, but the fair value equal to 12. You buy everything at fair value. In other words, this $20, $2 of it goes toward the land. We increase the land by $2. If we have other tangible asset that we can identify and they are they are undervalued, we report them, we increase this. Now, we still have $18 to go. Then once you adjust all the tangible assets, notice here the word tangible, it means assets that we can see like equipment, land, furniture, so on and so forth. Recognition of identifiable intangible asset at their fair value. Now, the company might have an intangible asset. Okay, it may be on the books or it may not be on the books. What does that mean? It means they might have an intangible asset that they created themselves because they created themselves. It doesn't show. You cannot record it on the books, but since you bought the company, now you would, you will identify it. You will, you would say you have this intangible asset. It's not on your books, but I, as the purchaser, I can now identify it because I bought it. I did not create it. Let's assume this intangible asset is worth, I don't know, $10. Now, of the 20, I gave two to the land or two to the tangible asset, 10 to the intangible asset, or I might have an intangible asset that's also undervalued regardless, whether it's undervalued or it does not exist. Well, I still have $10. Any remaining, which is $8, I paid above and beyond, tangibles and intangible assets, which is $8, this is going to be my goodwill. So, this is how I would allocate this. So, I paid $20 extra. I need to allocate this $20 extra. Let's assume there is no land, there is no intangible, then the whole $20 will be goodwill. Okay? If the balance was negative, the difference will be a negative goodwill and there's no such thing as negative goodwill, it's recorded as a gain. It's considered a bargain purchase. In other words, goodwill is computed as the access of the purchase price of the consideration paid over the fair value of the subsidiary's net asset. But first, we have to allocate that extra value to tangible and intangible asset if they exist. If not, everything is fair, everything is goodwill. So, let's take a look at the journal entry. What do we do when we eliminate the investment? We have to eliminate all the subs. This is all the sub equity. We have to debit sub equity, sub equity, sub equity, and credit the investment. And we credit the investment. Now, if we paid exactly $60, that will be the entry. If we paid $60 for this company, those in total will equal to $60. We credit the investment $60 and we're done. Assuming we also purchased 100%. If we did not pay 100%, well, we have to create the non-controlling interest if we did not pay 100% of the company. Then we create an uncontrolling interest. Now, let's assume we paid more. So, what do we do when we paid more? First, we debit any balance sheet account adjustment, like land, if we need to adjust the land, if we need to adjust the equipment account. Well, if that's not enough, we need to debit any intangibles, any intangible. Remember the $10, we debit any intangibles for the difference. Well, if we have anything remaining, we debit goodwill or we credit goodwill depending on whatever we have a negative balance or not, we assume we have a debit in goodwill. So, this is the elimination entry. Obviously, we're going to work an example with numbers, but I just wanted to show you from a theoretical perspective. Now, remember we have we debited intangibles. Now, we need to know a little bit more about intangibles because intangibles, they could be tricky. We have different type of intangibles. You have to know what to do with the intangibles. Identified intangibles are subject to impairment tests as follow. So, once we have an intangible, we have to determine, we have two types of intangibles. One and two. We have intangibles with finite life. What does that mean? Finite life means the intangible can serve the company for seven years or for eight years or for ten years. Those intangibles, because they have a finite life, a limited life, we amortize them over the useful life and we always test for impairment, which will see the testing for impairment in the next session. If the intangible will have an indefinite life, certain intangibles, once you purchase them, you could use them forever and they can benefit the company forever, they are not amortized. Well, why cannot be amortized? Because they have an indefinite life. To amortize something, you have to have a limited life for it. Limited life means you have to amortize it over a certain period of time. I'm telling you, this asset does not have a limited life, so you cannot amortize it, so it's subject to the two-step impairment test. Now, the other thing that you have to be aware of when you buy a company, that purchase, that company that you purchased might have R&D, research and development costs. Now, generally, not generally speaking, what do you need to know about research and development costs? When the company incurred research and development costs, research and development cost is expensed as incurred for the company. Now, what happens if you buy a company and they have in-process research and development cost? Now, they're not done with it, they're in process, but it's research and development and you purchase this company. Now, we're dealing about an acquisition, acquisition, in-process, in-process R&D. That is not written off immediately. So, what's going to happen is this, you're going to buy the company, they have something going on, maybe a cure for COVID, okay? Since we're talking about since COVID is a popular thing. So, they're doing R&D for COVID. What you do is this, you would recognize this in-process R&D first as intangible. You're going to say this is an intangible asset because possibly they're going to generate future economic benefit. Maybe that's why you bought the company. Therefore, you are buying an asset, could have a potential future benefit. You are paying for it. Now, you will wait. If the project succeeds, excellent, then you will capitalize in-process R&D and you will amortize it over its useful life. Actually, it's already capitalized. You would amortize it. If the FDA said, guess what? Your cure for COVID is not a fly. It's going to fail. It's not acceptable. Then, what you do, you will impair and write off. Simply put, you will expense, which what you should have, what should have the company did, but since you bought the company. So, be careful if you are buying a company and they have R&D. First, you will treat it as an intangible asset and you will wait. If it succeeds, you amortize. You amortize that cost. You amortize that intangible. If not, you will write off. It's assuming that this intangible will have a limited life. It's and, you know, pharmaceutical, they will have a definite life. It's also important to know that goodwill created in an acquisition is not amortized. So, when you have a goodwill, that's not amortized. It's tested for impairment. Now, for the private companies, we'll see if it's for smaller companies, they can amortize it, but generally speaking, it's not amortized. Measurement period. Remember, when you buy the company, you're buying their assets and liabilities, when do you measure their assets and liabilities? When do you measure them? When do you find the fair value? Usually, in on the exam, in your classes, usually it's valued on January 1st when you buy the company, but that's not really, that's not what happened in the real world. On the acquisition date, the value of the asset and the liabilities acquired by the parent company are not always precisely determinable, so you cannot find everything that day. Therefore, these values may be re-measured during a specific period of time called the measurement period, but how long the measurement period? How long can you wait? Well, the measurement period should not extend beyond one year starting from the acquisition date, and they should any time the company has improved information about the value of the asset and the liabilities. So, you have one year. Now, if there's any adjustments, if there's any, there was changes in the adjustment, what do you change if the adjustment relate to events that occur after the acquisition date? They should not be included. Now, if it's after the acquisition date, this is new information. It has, you bought the company, you have to look at your value before the acquisition date. If there's any adjustments before, you will offset the value of goodwill or gains previously recorded. So, if you have any goodwill, you will adjust the value for that. The best way to illustrate this is to work an example. On February 2nd, year one company X announced its decision to acquire 90% of the common stock of company Y. 90% did not buy the whole thing. By issuance, 20,000 shares of its $15 par value common stock that's trading at 40. The acquisition took place March 15th, year two. Well, guess what? I don't care about what happened on the announcement date. I'm going to be looking at March 15th. When the fair value of company X stock was $45. Well, I paid $45, not $20. So, if I issued 20,000 shares times $45, it means I paid 900,000 for this company. In addition, company X incurred and paid in cash all the following cost. We paid legal cost of 75,000. Remember, legal cost is expense. We're going to expense legal cost. Stock issuance cost for 6,000 and registration fees for 48. What did we do with those stock issuance cost and registration fees? We are going to reduce additional paid in capital, which I showed you the details in the prior session. I will go over it briefly here. Moreover, company X agreed to pay $30,000 in company's Y-former shareholders on March 15th if the average net income over year three and four exceeds 275 under the 30% probability this could happen. This is, remember, this is called the contingent consideration 30,000 times 30%. In other words, we're going to have to add 9,000 to the investment. So, the investment in the subsidiaries is 909 and we're going to credit the contingent liability for contingent consideration 9,000. So, we accounted for the legal expense. We debited the investment. Now, we have to credit the common stock of the other company. So, we're going to credit common stock 300,000, cash we paid 179, cash we paid 179, and additional paid in capital is 496. Why additional paid in capital is 496? Here's why. When we issued the shares, the shares were issued at $45. Simply put, we debited investment 900,000. We credit common stock for 300,000. Why 300,000? 300,000 is the number of shares that we issued times the par value and anything remaining, anything remaining, which will be 600,000, should go to additional paid in capital. Now, why additional paid in capital is 496 is because we incurred 60,000 in issuing costs and 44 in registration costs, which is minus 104, which is going to give us the 496. I did this in the prior session. It's okay to do it again, but we created the investment. Let's add additional information to this example to make it more interesting and to illustrate the points that we're trying to make. On the acquisition date, the book value of Y company was $575,000. All right, that's fine. Book value equal to $575,000. While the fair value amounted to $710,000, the fair value of their assets amounted to $710,000. Well, if we find the difference between those two, it appears it's $135,000. Okay, so let me just use a calculator and if we take $710,000 minus $575,000 equal to $135,000. So that's the difference between their assets and their liabilities. Now, obviously they have to tell us if there's an explanation for this difference. The only difference between the two is that, and it retains, it tells us here, the only difference between the book value and the fair value relate to an equipment that has a remaining useful life of five years. So this $135,000 has to do with the equipment. That's fine. The equity section of the common stock, of the subsidiaries, common stock is $300,000, additional paid in capital is $200,000, and retained earning is $75,000. What do we need to do with those three balances? We need to debit them, get rid of them. In addition, company Y had an unpatentant technology, had a fair value of $175,000. So they told us now, they also have another asset, which is not on the books. It's not patented. It's not on the books because they created the intangible internally. They cannot record it, and they did not even they did not even register. It's not unpatented. But now since we bought the company, we can recognize this asset. Now, the fair value of the company amounted to $710,000, so we accounted for that. How much did we pay for the company? So what's the total fair value of the company? We paid for the company. We as investors paid for the company $909. We paid for the company $909. Remember, this $909 only represented 90% of the company. We did not buy the full company. We only paid $909 and we purchased it. We purchased 90%. By doing so, we can find out what is the total fair value of the company. Well, if we take $909 divided by $0.9, which we did this in the prior session, the fair value of the company is what we the fair value of the company is one fully for the company is $1,010,000. Okay, that's fine. So the fair value is $1,010,000. The book value is $575,000. Let's again find the total difference. The total difference. So $1,010,000 minus $575,000. What is the total difference between the two? Okay, so let's do this. Minus $575,000. That's equal to $435,000. $435,000. We know from the $435,000, you already know the reason the reason it's valued for more because there's a piece of equipment that's worth $135,000. If we take $435,000 minus $135,000, that's going to keep us with $300,000 difference because we allocated of the $435,000. We know $135,000 goes to the piece of equipment. We already also know that we have a piece, we have not piece, we have an unpatented technology that's worth $175,000. Again, we're going to allocate $175,000 minus, let me change this in a different color, minus $175,000 to that unpatented technology. Well again, if I allocated $125,000 to the unpatented technology, I have $125,000 to allocate. Well, I don't see anything else. I'm not told anything else. Well, if I'm not told anything else, the remaining $125,000 must be good. Well, so notice how we did this. We went from the total fair value. What's the total fair value of the company? Well, we did not pay 100%. We have to find 100% of the fair value, which is what we paid divided by 90%. We'll give us the total fair value. Then this total fair value, the difference between that and the book value equal to $435,000. We already know immediately $135 goes to the equipment, which means we have to increase the value of the equipment. We have to debit the asset and we have to create goodwill. Now, obviously the difference between $1,010,000 and $909,000 is the non-controlling interest, which we computed in the prior session. So here's what we have to do. The equity of the subsidiary should be eliminated. So we're going to have to debit common stock. We have to debit common stock 300, APEC 200, and additional paid in capital 75, which is we're going to have a debit of $575,000. The investment in the subsidiary $909,000 will have to be eliminated. We will do that. The non-controlling interest, which is $101,000 computed in the prior session will have to be created. Then we have to allocate the remaining, which is the $575,000, remaining of the extra fair value, the difference, which is, I'm sorry, it is the extra $435,000 as follow. $135,000 goes to the equipment, $175,000 to the intangibles, and the remaining $125,000 after we allocated, you know, $1,010,000 minus $575,000 book value, minus the tangible asset, minus the intangible asset, what's left is $125,000 for the good will. So you see how we allocated this. So make sure you understand how we do this. And let's look at the journal entry. Here's the journal entry. Debit the sub, credit the investment, debit the equipment, increase the value of the equipment, put the technology that, that unpatented technology on the book, debit the good will and create non-controlling interest, create the non-controlling interest. Now let's assume that the fair value of why company's asset was provisional. It means it was an estimate at the beginning on the acquisition date. Remember acquisition date was March 15th, year two, and the fair value is now known by July, basically, April, May, June, after three and a half months. We find out that the fair value should be 685, not 710. Okay, calculate the necessary adjustment to good will. We're going to adjust the good will, knowing that the change relate to the equipment. Remember the equipment, we thought it was worth, I believe, the equipment was worth 135 above fair value, 135. Now what we find out, it's not worth 135 above fair value. Now we need to prepare the adjustment necessary. Well, the adjustment needed to the recorded good will is an increase of 20, 25. So what's going to happen is this, we are going to make the adjustment to good will and reduce the land. Any subsequent adjustment will be made to good will. So simply put, we're going to increase good will by 25, okay, and we have to reduce the equipment by 25. Therefore we reduce the equipment, we credit the equipment 25, and we debit good will. Remember, we don't touch the investment. Now any adjustment goes to good will, any adjustment goes to good will, because we made them, not we made a mistake, it was a provisional estimate. The land is worth the, was it the land or a piece of equipment was worth $25,000 less. Given the change in fair value, we adjust good will. Now, impairment of intangible asset. Remember we have an intangible on the box, now we have to impair it. What I'm going to do, I'm going to cover this, the impairment of intangible asset as a separate recording, because I believe it requires separate recording. Now what should you do? Go to farhatlectures.com, if you are not a subscriber, subscribe, work multiple choice questions and exercises. This topic is important on the CPA exam. Yes, you have a CPA review course, try to supplement with my material, it will help you. Invest in yourself, good luck, study hard, and of course stay safe.