CPA FAR I-75 CH 16

Question 1

3 types of business combinations

Answer 1

1. legal merger
2. legal consolidation
3. legal acquisition

Question 2

legal merger

Answer 2

Companies A and B combine, and only A survives

The assets and liabilities of B are recorded on the books of A

Company B ceases to exist

NO consolidated financial statements

Question 3

legal consolidation

Answer 3

Companies A and B combine, and company C is formed

The assets and liabilities of A and B are recorded on the books of new company C

Companies A and B cease to exist

NO consolidated financial statements

Question 4

Legal acquisition

Answer 4

A acquires controlling interest in B, over 50%

Both A and B continue to exist as separate legal entities

No entity ceases to exist

In an acquisition, the assets and liabilities of the acquired entity B remain on B’s books

Legal acquisition requires consolidated financial statements

Consolidated financial statements required by SEC!

Question 5

Companies A and B combine to form Company C, Both A & B cease to exist. What type of business consolidation is this?
1. merger
2. consolidation
3. acquisition
4. all of the above

Answer 5

Legal consolidation

Stock of A and B are both cancelled as these entities cease to exist

New stock is issued for Company C, the newly formed company

Question 6

Companies A and B combine, and Company B ceases to exist.
What type of business consolidation is this?
1. merger
2. consolidation
3. acquisition
4. all of the above

Answer 6

Legal merger

Stock of company B is cancelled, and their assets and liabilities are transferred to A’s balance sheet

Since the entities are combined on the date of acquisition, post combination consolidation is not necessary because all the assets and liabilities are already recorded on the acquirer’s books

Question 7

A corp acquires B corp in a business combination involving two public entities.
Consolidated financial statements would be required if the business combination were:
1. legal merger
2. legal consolidation
3. legal acquisition

Answer 7

Legal acquisition because they remain separate legal entities, and the SEC will require consolidated financial statement filing.

Question 8

Any need for consolidated financial statements?
1. legal merger
2. legal consolidation

Answer 8

Legal merger and legal consolidation = assets and liabilities of the acquiree are recorded on the books of the acquirer along with goodwill or gain directly on the acquirer’s books.

No need for consolidated financial statements.

Question 9

Need for consolidated financial statements: legal acquisition

Answer 9

A corp gains control of B corp without purchasing all the assets and liabilities of B corp. B corp continues to exist and has its own financial statements.

They need to file consolidated financial statements with SEC because they are two companies under common ownership.

In all other cases, they will maintain separate financial statements.

Question 10

In which of the following legal forms of business combinations are the assets and liabilities of an acquired entity recorded on the books of the acquiring entity?
1. legal merger
2. legal acquisition

Answer 10

Legal merger

Assets and liabilities of companies A and B are combined on A’s books and B ceases to exist

Question 11

A bargain purchase gain would be recorded on the separate books of the acquirer if the transaction was a
1. legal merger or consolidation
2. legal acquisition

Answer 11

Both 1 and 2

All bargain purchase gains are recorded in the acquirer’s books (impacts I/S)

Question 12

A corp acquired controlling interest in B corp in a legal acquisition. Which of the following would not be part of the journal entry on the separate books of A Corp?

Answer 12

NOT: Debit to goodwill

Journal entry company A:
DR Investment in company B
CR Cash or CS/APIC

There could be a bargain purchase gain on I/S. Goodwill is not recorded at the time of acquisition on the parent’s separate books. Goodwill might be recognized on the consolidate financial statements of a parent and subsidiary.

Legal acquisition, parent’s separate books, I/S gain cannot have goodwill on separate books of parent.

Question 13

If the purchase price is more than fair value of the net assets acquired, goodwill would be recorded on the separate books of the acquirer if the transaction was:
1. legal merger or consolidation
2. legal acquisition

Answer 13

1. legal merger or consolidation

NOT recorded legal acquisition

Question 14

A corp acquires all the assets and liabilities of B corp in a business combination qualifying as a legal merger. Goodwill will be recognized on A corp’s books if:

Answer 14

fair value of the net assets acquired by A corp are less than the cost of the investment

Question 15

In a legal merger, which of the following is NOT recognized on the books of the acquiring entity when recording the business combination?
1. AP
2. Bonds payable
3. Investment in acquiree corp
4. AR

Answer 15

3. Investment in acquiree corp

In a legal merger, the acquirer recognizes on acquirers’ books almost all the assets and liabilities of the acquiree. The reason why there is no account called Investment in acquiree is because in a legal merger the acquiree ceases to exist.

Question 16

business combinations and consolidated financial statements

Answer 16

With regard to business combinations, when would you have consolidated financial statement requirements?

In an acquisition when A controls B over 50% but B still exists, the SEC requires that A and B file consolidated financial statements when reporting their earnings under 1934 Act reporting requirements.

All other times, A and B still have their own separate financial statements and have no requirement to file consolidated unless they are reporting to the SEC.

Question 17

Which of the following would lead to filing of consolidated financial statements to satisfy SEC reporting?
1. legal merger
2. legal consolidation
3. legal acquisition

Answer 17

Correct: 3. legal acquisition = parent and subsidiary each maintain separate financial statements and would be required by the SEC to file consolidated financial statements

Question 18

The acquiring entity

Answer 18

In an acquisition, we need to know who the acquirer is. Generally, to be an acquirer, an entity must own, directly or indirectly, more than 50% of voting stock in the other company

Question 19

In which case is company A considered acquirer of company B in a business combination?

Answer 19

more than 50% voting stock

company A owns 35% company B voting stock and 60% of company C voting stock which owns 20% of company B voting stock

To be an acquirer, an entity must own, directly or indirectly, more than 50% of voting stock in the other company:
Company A owns 35% of company B directly and another 20% indirectly (owns 60% of company C which owns 20% of company B) = 55%

Question 20

acquisition date

Answer 20

The date which the acquiring entity obtains control of the other entity which is the closing date.

Deal may be announced March 1 but not close until July 31. The acquisition date would be July 31 as that is the date the parent company obtained control.

Question 21

Thorn Corp is acquiring Marble Corp in an acquisition. What date should be used as the acquisition date for the transaction?

Answer 21

The date Thorn Corp obtains control of Marble Corp= acquisition date

Question 22

Journal entry on acquisition date:
Paren company announces Feb 1 that it is purchasing Sub company for 1M shares CS with par value $1. In Feb 1, the market price of CS $9. Transaction closes May 5 and 1M shares are issued when the stock is worth $12/share.

Answer 22

DR Investment in Subsidiary $12,000,000
CR Common stock $1,000,000
CR APIC CS $11,000,000

Question 23

Paren company announces Feb 1 that it is purchasing Sub company for 1M shares CS with par value $1. In Feb 1, the market price of CS $9. Transaction closes May 5 and 1M shares are issued when the stock is worth $7/share. Stock price falls at close.

Answer 23

DR Investment in Subsidiary $7,000,000
CR Common stock $1,000,000
CR APIC CS $6,000,000

Question 24

Certain direct costs and general expenses related to the acquisition are expensed and not capitalized such as finder’s fees and legal fees

Answer 24

DR Investment in subsidiary $2,000,000
CR Cash $2,000,000

DR Legal fees $30,000
CR Cash $30,000

Direct out of pocket costs are expensed like finder’s fees and legal fees= not capitalized to investment in sub

Question 25

Which of the following is correct regarding business combination accounted for as an acquisition?
1. acquisition date must be determined
2. acquirer must be determined
3. the costs and general expenses of the acquisition are capitalized

Answer 25

1 and 2 are correct

3. is incorrect as costs and general expenses of the acquisition are expensed not capitalized

Question 26

registration and issuance costs

Answer 26

if the parent buys the subsidiary for stock instead of cash, stock registration and issue costs like SEC filing fees are a direct reduction of the value of the stock = reduce APIC.

DR APIC (for stock registration and SEC fees) *not an expense

Question 27

A business combination is accounted for as an acquisition. Which of the following costs related to the business combination should be included, in total, in the determination of net income of the combined corp for the period in which the expenses are incurred?
1. fees of finders and consultants
2. registration fees for equity securities issued

Answer 27

1 only is correct

reg fees = reduction to APIC

Question 28

In a business combo accounted for properly as an acquisition, which of the following costs should be expensed in the period incurred?
1. registration and issuance costs
2. consulting fees

Answer 28

2. consulting fees = expensed (direct costs of acquisition)

registration and issuance costs = reduction APIC

Question 29

determining the cost of the acquisition

Answer 29

cash + stock issued + contingent consideration

Question 30

Liabilities and determining cost of acquisition

Answer 30

most consideration transferred to effect a business combination is measured at fair value including if there were any liabilities incurred, they would have been included at fair value in determining the cost of the acquisition

Question 31

Which of the following is correct regarding the Acquistion of a business in a business combo?
1. Contingent consideration should be included in the cost of an acquired business at fair value existing on acquisition date.
2. Most consideration transferred to effect a business combo should be measured at fair value.

Answer 31

Both!

Question 32

Which of the following incurred by an acquiring entity in carrying out a business combo would NOT be included in the cost of an acquired entity?
1. cash paid to acquire entity
2. fair value of liabilities incurred in the combination
3. fair value of contingent consideration
4. SEC fees to issue stock certificates

Answer 32

Correct:
4. SEC fees to issue stock certificates = not included

also not included are legal costs= they are expensed
filing fees= reduction of APIC

Question 33

Noncontractual contingency

Answer 33

a noncontractual liability such as a lawsuit pending against the subsidiary that has a greater than 50% chance to meet the definition of a liability= should be recorded at acquisition date at fair value

once meets threshold of more likely than not = should be recognized

Question 34

Which of the following contingencies that exist on acquisition date should be recognized in a business combo?
1. A contractual contingency to provide warranty service to prior customers of the acquiree.
2. An outstanding lawsuit against acquiree for which the attorney believes there is a 35% probability that the suit will be successful.

Answer 34

Correct 1. Yes, contractual is recognized

NO, 2. Not more likely than not yet

Question 35

Which of the following items acquired in a business combo are measured at fair value?
1. identifiable assets acquired
2. liabilities assumed

Answer 35

Both

Question 36

Acquisition- assets and liabilities

Answer 36

subsidiary assets and liabilities are recognized at fair value

Question 37

Pace company acquired all of the outstanding common stock of company Silo in exchange for cash. The acquisition price exceeds the fair value of net assets acquired. How should company Pace determine amounts to be reported for the inventory and LT debt acquired from company Silo?

Answer 37

LT debt = fair value
Inventory = fair value

Question 38

Intangible assets acquired in a business combo

Answer 38

In a business combo, the acquirer will recognize intangible assets that were not previously recognized by the acquiree due to GAAP rules that say internally generated patents are expensed as R&D.

This technology may have led to the decision to purchase the acquired entity. Look out for patents, in-process research and development measured at fair value even though it is not currently on the books of the acquiree.

When the acquiree gets acquired, those patents are measured at fair value and are included on the books of the consolidated entity

Question 39

Which of the following items acquired in a business combo are measured at fair value?
1. in-process R&D
2. an internally generated patent not currently on the books of the acquiree

Answer 39

Both!

Question 40

Which of the following items acquired in a business combo are measured at fair value and recognized at the time of acquisition?
1. identifiable assets such as equipment and inventory
2. liabilities assumed such as warranty liabilities
3. intangibles not currently being recognized by the acquiree

Answer 40

All of the above

Question 41

Intangible assets that are already recognized

Answer 41

Intangible assets that are already recognized: franchise agreement, trademark, copyright that arise from contractual legal rights

These represent future benefits that derive from legal rights and will be measured at fair value at the date of business combo provided that they are capable of being sold, transferred, licensed, rented.

The only tangible that will NOT be recognized by the acquiring entity is old goodwill on the books of the acquired entity from some legal merger or legal consolidation that they previously made.

Question 42

Which of the following assets on the books of an acquired entity immediately before a business combo would be recognized by the acquiring entity on the consolidated balance sheet?
1. future benefits that can separately be sold such as a copyright or franchise agreement
2. goodwill from a previous agreement

Answer 42

1. YES
2. goodwill from previous acquisition = NO

Question 43

Goodwill and noncontrolling interest

Answer 43

In an acquisition, we calculate goodwill and report it on the consolidated B/S, but it is not amortized. It is tested for impairment annually (at least).

If you purchase 100% of the subsidiary, goodwill is the excess of the price paid over the fair value of the net assets acquired

Question 44

Noncontrolling interest and goodwill

Answer 44

If the acquirer does not purchase 100% of the stock, noncontrolling interest, then it is more difficult to calculate goodwill.

The shares of the acquiree that were NOT purchased by the acquirer= shares owned by third parties.

CPA exam: if the acquiree’s stock is traded in an active market, exam will give quoted price and will determine the fair value of noncontrolling interest.

Question 45

fair value of assets not known

Answer 45

if information regarding fair value of assets of subsidiary is incomplete at acquisition date, the assets should be reported at a provisional amount measure date of acquisition.

There is a year to change the provisional amount = measurement period.

Ex. Excess of cost over book value should be allocated 60% inventory and 40% goodwill provisionally

Question 46

Question: July 1 YR 1, Duffy Corp acquires Krohn Corp in a transaction properly accounted for as business acquisition
At the time of acquisition, some info for valuing Krohn’s assets was incomplete
How should Duffy account for incomplete info in prep of financial statements?

Answer 46

Record the uncertain items at a provisional amount measured at the date of acquisition

*One year to revise

Question 47

Consolidated financial statements

Answer 47

Important elements for CPA exam:
-eliminating journal entry on date of acquisition
-consolidated net income

Question 48

Why consolidated financial statements- what is the objective?

Answer 48

the objective of consolidated financial statements is to present the financial statements of entities under common control as if one entity

legal control = parent has greater than 50% ownership of another entity’s voting stock

result: economic substance over economic legal form (separate legal entities)

consolidated: B/S, I/S, statement of SE and statement of CF

Question 49

consolidated income statement

Answer 49

parent’s income and expenses for the entire year plus subsidiary (rev + exp) from date of acquisition to the end of the year

Question 50

Parent purchased 51% of sub stock July 1, Yr 20. If both parent and sub are calendar year entities, the consolidated financial statements dated July 1 YR 20 immediately after acquisition would include:
1. B/S parent only
2. B/S of parent Corp and Sub Corp and income statement of parent only.
3. B/S of both and I/S of both
4. B/S and I/S of parent ONLY

Answer 50

Correct: 2. B/S of parent Corp and Sub Corp and income statement of parent only.

Question 51

Eliminate Common Stock APIC and Retained Earnings of Subsidiary

Answer 51

immediately following an acquisition, consolidated equity will be equal to the parent company’s equity balance plus any noncontrolling interest (if the parent does not own 100%)

**sub’s equity does not make it onto the consolidated B/S =eliminated via journal entry (debit all equity accounts)

Question 52

Goodwill impairment- new for 2020 (test for impairment)

Answer 52

once goodwill is recognized in a business combo, it is not amortized, but instead, tested for impairment at least annually

the test for goodwill impairment has gotten easier 2020: If the fair value of the subsidiary slips below carrying amt of subsidiary, goodwill is impaired, and the loss is booked on I/S

fair value of <carrying amt sub = goodwill impairment

Question 53

Intercompany sales of equipment

Answer 53

when parent sells depreciable assets to the sub (or sub sold to parent)

there is an intercompany profit

elimination entries

Question 54

VIE: variable interest entity

Answer 54

is a company in which an investor holds controlling interest that is not based on the majority of voting rights but rather is based on contractual agreements

this was developed in response to corporate scandals like Enron where corps used special purpose entities to hide debt and inflate profits

The VIE model applies when the investing company’s interest in the VIE meets the criteria for being the “primary beneficiary”

Question 55

VIE, variable interest entity

Answer 55

Under FASB (Financial Accounting Standards Board) guidelines, a company that has controlling interest in a VIE is required to consolidate the VIE’s financial statements with its own.

This means the parent company must report VIE’s assets, liabilities, income, and expenses as if they were its own which can reveal obligations that might otherwise be hidden off B/S entities.

Question 56

VIE, controlling interest and reporting

Answer 56

The VIE model depends on companies correctly identifying and reporting their controlling interests in VIEs. In some cases, companies may be able to structure their relationships with VIEs to avoid consolidation. For example, they might spread the risk among several investors so that no one investor has a controlling financial interest

Question 57

VIE

Answer 57

variable interest entity is a company in which control is established and exercised not through voting rights (as is the case with a traditional subsidiary), but through other means such as contractual arrangements.

This could include agreements that give one entity the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance

Question 58

primary beneficiary

Answer 58

the primary beneficiary of a VIE is the entity that has a majority of the risk of loss from the VIE’s activities, or the right to receive a majority of the VIE’s residual returns after costs and liabilities have been met.

In other words, the primary beneficiary is the entity that is exposed to a majority of the economic risks and rewards associated with the VIE

not necessarily the largest stockholder

Question 59

Example: primary beneficiary

Answer 59

For example, if a parent company sets up a VIE for specific project and agrees to absorb any losses from the project, it could be seen as the primary beneficiary because it is absorbing the majority of the expected losses.

Similarly, if the agreement states that the parent company will receive the majority of any profits after costs have been paid, it would also be considered the primary beneficiary due to majority of expected returns

Question 60

How consolidation applied to VIE

Answer 60

the primary beneficiary is required to consolidate the VIE’s financial statements with its own.

This means the primary beneficiary must report the VIE’s assets, liabilities, income and expenses as if they were its own which can reveal obligations that might otherwise be hidden in off balance sheet entities

Question 61

Identifying the primary beneficiary

Answer 61

identifying the primary beneficiary requires significant judgment as it involves assessing expected losses and residual returns which are forward looking and uncertain

Therefore, the process usually involves a thorough analysis of the terms and conditions of the arrangements between entities involved

Question 62

A VIE, Variable Interest Entity, is characterized by:

Answer 62

a company in which an investor holds a controlling interest not based on the majority of voting rights

It is based on contractual agreements

Question 63

What is the reason behind the introduction of the VIE concept:

Answer 63

to prevent companies from hiding liabilities in off balance sheet entities

it was brought to light after the Enron scandals in the early 2000s

not recognized by IFRS

Question 64

What is true regarding primary beneficiary:

Answer 64

the primary beneficiary of the VIE is the party that absorbs a majority of the risk/expected losses and receives a majority of the expected residual returns, or BOTH

Question 65

What does consolidation of a VIE involve?

Answer 65

combining the financial statements of the VIE with the primary beneficiary

Question 66

Why create a VIE?

Answer 66

It is not typically created to gain voting control over another company

It is generally established for business purposes such as securitizing assets, financing large projects or leasing assets

Creating a VIE allows a company to undertake a large, potentially risky project, with the VIE absorbing the majority of the project’s risk and thereby reducing risk to the parent company

Companies often establish VIEs to engage in LT leasing arrangements without including the leased assets or associated liabilities directly on their B/S

Question 67

Securitizing assets

Answer 67

Liquidity
risk transfer
off B/S financing
funding source

Question 68

Securitizing assets: Liquidity

Answer 68

securitization allows a company to convert liquid assets (like loans or receivables) into cash, enhancing the company’s liquidity by selling off these assets in the form of securities

This allows the company to reinvest the capital in other parts of their business

Question 69

Securitizing assets: risk transfer

Answer 69

By securitizing assets, a company can transfer the risk associated with those assets to the investors who purchase the securities. This can be especially beneficial for assets like loans and mortgages which carry the risk of default

Question 70

Securitizing assets: off B/S financing

Answer 70

securitized assets are often moved to a separate legal entity effectively removing them from the company’s B/S

This can make the company’s financial position look stronger as it reduces the company’s apparent debt and asset levels

This can improve the company’s financial ratios and potentially its credit rating

Question 71

Securitizing assets: finding source

Answer 71

For financial institutions, securitization provides an additional source of funding

By selling off assets in the form of securities, they can raise capital

Question 72

A company has decided to create a VIE to securitize assets. What is likely the main benefit the company is seeking?

Answer 72

enhanced liquidity = convert illiquid assets into cash by selling off those assets in the form of securities (reduce debt levels, improve financial ratios, and enhance liquidity)

Question 73

Which is NOT a reason for creating VIE?
1. to securitize assets and remove them from B/S
2. to finance large project without putting the entire company at risk
3. to lease assets on a LT basis
4. to gain voting control over another company

Answer 73

Correct: 4. to gain voting control over another company

Question 74

Which is a common reason to create a VIE, variable interest entity?
1. gain voting control over another entity
2. to securitize assets and remove them from the B/S
3. to increase company’s total assets
4. to increase profitability

Answer 74

Correct: 2. to securitize assets and remove them from the B/S

this allows the company to reduce apparent risk and debt levels, improve financial ratios and enhance liquidity

Question 75

Which of the following scenarios is most likely to lead to the creation of VIE?
1. a company wants to finance a large project without putting the entire company at risk
2. a company wants to acquire a competitor to increase market share
3. a company wants to expand its operations in another country
4. a company wants to increase its voting rights in another company

Answer 75

Correct: 1. a company wants to finance a large project without putting the entire company at risk

VIE absorbs the majority of the project’s risk and reduces risk for the parent company

Question 76

What can be sign that a company is a primary beneficiary of a VIE?
1. company owns more than 50% VIE’s voting rights
2. company has minority interest in VIE
3. the company absorbs a majority of the VIE’s expected losses or receives a majority of its expected residual returns
4. all of these

Answer 76

Correct: 3. the company absorbs a majority of the VIE’s expected losses or receives a majority of its expected residual returns

auditor examines primary beneficiary- assessing contracts, agreements and other evidence of decision-making authority over VIE’s activities (who has power to direct the activities that most significantly impact the VIE’s economic performance)