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ISBN: 0078025648
Author: Baker
Title: Essentials of Advanced Financial Accounting 1e
Front endsheets
Color: 4c
Pages: 2,3
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ISBN: 0078025648
Author: Baker
Title: Essentials of Advanced Financial Accounting 1e
Front endsheets
Color: 4c
Pages: 4, Insert
Confirming Pages
Essentials of
Advanced
Financial
Accounting
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Essentials of
Advanced Financial
Accounting
Richard E. Baker
Northern Illinois University
Theodore E. Christensen
Brigham Young University
David M. Cottrell
Brigham Young University
With contributions from:
Valdean C. Lembke
Professor Emeritus
University of Iowa
Thomas E. King
Professor Emeritus
Southern Illinois University, Edwardsville
Cynthia G. Jeffrey
Iowa State University
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ESSENTIALS OF ADVANCED FINANCIAL ACCOUNTING
Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue
of the Americas, New York, NY, 10020. Copyright © 2012 by The McGraw-Hill Companies, Inc. All
rights reserved. No part of this publication may be reproduced or distributed in any form or by any
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Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission,
or broadcast for distance learning.
Some ancillaries, including electronic and print components, may not be available to customers outside
the United States.
This book is printed on acid-free paper.
1 2 3 4 5 6 7 8 9 0 QDB/QDB 1 0 9 8 7 6 5 4 3 2 1
ISBN 978-0-07-802564-8
MHID 0-07-802564-8
Vice president and editor-in-chief: Brent Gordon
Editorial director: Stewart Mattson
Publisher: Tim Vertovec
Senior sponsoring editor: Dana L. Woo
Executive director of development: Ann Torbert
Development editor II: Katie Jones
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Library of Congress Cataloging-in-Publication Data
Baker, Richard E.
Essentials of advanced financial accounting / Richard E. Baker, Theodore E. Christensen,
David M. Cottrell; with contributions from Valdean C. Lembke, Thomas E. King, Cynthia
G. Jeffrey.—1st ed.
p. cm.
Includes index.
ISBN-13: 978-0-07-802564-8 (alk. paper)
ISBN-10: 0-07-802564-8 (alk. paper)
1. Accounting. I. Christensen, Theodore E. II. Cottrell, David M. III. Title.
HF5636.B35 2012
657’.046—dc22
2010053791
www.mhhe.com
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About the Authors
Richard E. Baker
Richard E. Baker was a member of the faculty of Northern Illinois University for
26 years. His academic recognitions include having been named the Ernst & Young Distinguished Professor of Accountancy at Northern Illinois University. In addition, he has
been recognized as an inaugural University Presidential Teaching Professor, the highest
teaching recognition of his university. He received his B.S. degree from the University
of Wisconsin at River Falls and his MBA and Ph.D. from the University of Wisconsin
at Madison. His activities in the American Accounting Association have been continuous over many years and include service on the AAA’s Executive Committee as the
Director of Education of the AAA; as a member of the AAA’s Council; as the Chair
of the Teaching and Curriculum Section; and as the President of the Midwest Region.
His lengthy service to the Federation of Schools of Accountancy (FSA) includes the
offices of the President, the Vice President, and the Secretary. Many of his extensive
professional and academic organization committee service efforts have involved research
in assessing teaching and learning outcomes, designing innovative curriculum models,
developing meaningful measurement criteria for evaluating accounting programs, and
continually integrating new electronic technology into the accounting classroom. Professor Baker has received numerous teaching awards at both the undergraduate and graduate
levels and has been selected as the Illinois CPA Society’s Outstanding Accounting Educator. His most recent published research studies have concentrated on ways to make the
learning/teaching experience as effective as possible.
Theodore E. Christensen
Ted Christensen has been a faculty member at Brigham Young University since 2000.
Prior to coming to BYU, he was on the faculty at Case Western Reserve University
for five years. He received a B.S. degree in accounting at San Jose State University,
a M.Acc. degree in tax at Brigham Young University, and a Ph.D. in accounting from
the University of Georgia. Professor Christensen has authored and coauthored articles
published in many journals including The Accounting Review, the Journal of Accounting and Economics, Accounting Organizations and Society, Review of Accounting Studies, the Journal of Business Finance & Accounting, Accounting Horizons, and Issues in
Accounting Education. Professor Christensen has taught financial accounting at all levels, financial statement analysis, both introductory and intermediate managerial accounting, and corporate taxation. He is the recipient of numerous awards for both teaching and
research. He has been active in serving on various committees of the American Accounting Association and is a CPA.
David M. Cottrell
Professor Cottrell joined the faculty at Brigham Young University in 1991. He currently
serves as the Associate Director of the School of Accountancy. Prior to coming to BYU
he spent five years at The Ohio State University, where he earned his Ph.D. Before pursuing a career in academics he worked as an auditor and consultant for the firm of Ernst
& Young in their San Francisco office. At BYU, Professor Cottrell has developed and
taught a case-based accounting and auditing research course in the graduate program,
and also has taught financial accounting and corporate financial reporting courses in
the School of Accountancy, the MBA program, and the Finance program. He has won
numerous awards from the alumni and faculty for his teaching and curriculum development. He has received the Outstanding Professor Award in the college of business as
selected by the students in the Finance Society; he has received the Outstanding Teaching Award as selected by the Marriott School of Management; and he is a four-time
winner of the collegewide Teaching Excellence Award for Management Skills, which is
v
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vi About the Authors
selected by the Alumni Board of the Marriott School of Management at BYU. In 2005
he was named as a University Faculty Fellow for Teaching and Learning with Technology. Professor Cottrell also has authored many articles about accounting and auditing
issues. His articles have been published in Issues in Accounting Education, The Journal
of Accounting Case Research, The Quarterly Review of Distance Education, Journal of
Accountancy, The CPA Journal, Internal Auditor, The Tax Executive, and The Journal of
International Taxation, among others.
NOTE FROM THE AUTHORS
Our objective in creating the “Essentials of Advanced Accounting” text was to give an
additional option to instructors and students who have only one term or one semester to
devote to advanced accounting topics. We have received several requests from Instructors and students for a resource which will help them cover in a single term or semester
the core elements of the advanced accounting material that is most frequently represented
on the CPA exam. Hence this text contains the essential information on consolidations,
multinational entities, partnerships, and governmental and not-for-profit entities.
The subject matter of advanced accounting is expanding at an unprecedented rate.
New topics are being added, and traditional topics require more extensive coverage. Most
one-term courses are unable to cover all the topics included in a traditional comprehensive advanced accounting text. In recognition of time constraints, this text is structured
to provide the most efficient use of the time available, while maintaining all the learning
support and ancillary materials that cover these essential topics. For students and instructors who would like to cover a wider set of topics, we invite you to examine our comprehensive text, Advanced Accounting, which is now in its ninth edition.
The new authors, Ted Christensen and David Cottrell, are excited to be involved with
this book and express their gratitude to Val Lembke, Tom King, and Cindy Jeffrey for
their many years of hard work to the previous editions of the comprehensive text.
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Preface
Essentials of Advanced Financial Accounting is an up-to-date, comprehensive, and
highly illustrated presentation of the accounting and reporting principles and procedures
used in a variety of business entities. Every day, the business press carries stories about
the merger and acquisition mania, the complexities of modern business entities, new
organizational structures for conducting business, accounting scandals related to complex business transactions, the foreign activities of multinational firms, the operations of
governmental and not-for-profit entities, bankruptcies of major firms, and other topics
typically included in advanced accounting. Accountants must understand and know how
to deal with the accounting and reporting ramifications of these issues.
OVERVIEW
Essentials of Advanced Financial Accounting provides strong coverage of advanced
accounting topics, with clarity of presentation and integrated coverage based on continuous
case examples. The text is highly illustrated with complete presentations of worksheets,
schedules, and financial statements so that students can see the development of each topic.
Inclusion of all recent FASB and GASB pronouncements and the continuing deliberations
of the authoritative bodies provide a current and contemporary text for students preparing
for the CPA examination and current practice. This has become especially important given
the recent rapid pace of the authoritative bodies in dealing with major issues having farreaching implications. An overview of the contents and organization is illustrated below.
Multi-Corporate Entities
Business Combinations
1
Intercorporate Acquisitions and Investments in Other Entities
Consolidation Concepts and Procedures
2
3
4
5
Reporting Intercorporate Investments and Consolidation of Wholly Owned with
No Differential
The Reporting Entity and Consolidation of Less-than-Wholly-Owned with No Differential
Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than
Book Value
Intercompany Transfers
6
7
Intercompany Inventory Transactions
Intercompany Transfers of Services and Noncurrent Assets
Multinational Entities
Foreign Currency Transactions
8
Multinational Accounting: Foreign Currency Transactions and Financial Instruments
Translation of Foreign Statements
9
Multinational Accounting: Issues in Financial Reporting and Translation of Foreign
Entity Statements
Partnerships
Formation, Operation, Changes
10
Partnerships: Formation, Operation, and Changes in Membership
Liquidation
11
Partnerships: Liquidation
Governmental and Not-for-Profit Entities
Governmental Entities
12
Governmental Entities: Introduction and General Fund Accounting
Special Funds
13
Governmental Entities: Special Funds and Government-wide Financial Statements
vii
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viii Preface
KEY FEATURES OF ESSENTIALS OF ADVANCED FINANCIAL ACCOUNTING
• Introductory vignettes. Each chapter begins with a brief story of a well-known company to illustrate why topics covered in that chapter are relevant in current practice.
Short descriptions of the vignettes and the featured companies are featured in the
Chapter-by-Chapter Changes section on page xvi.
• A building-block approach to consolidation. Virtually all advanced financial
accounting classes cover consolidation topics. While this topic is perhaps the most
important to instructors, students frequently struggle to gain a firm grasp of consolidation principles. Baker/Christensen/Cottrell 1e provides students with a learningfriendly framework to consolidations by introducing consolidation concepts and
procedures more gradually. This is accomplished by a building-block approach that
introduces consolidations earlier than in previous editions by beginning the consolidation discussion earlier in Chapters 2 and 3. The building-block approach can be summarized as follows:
• Chapter 2 begins with the most basic consolidation situation: the consolidation of
a wholly owned subsidiary that is either created or purchased at an amount equal to
the book value of net assets. Thus, students practice basic consolidation procedures
without having to worry about the complications associated with a differential or
noncontrolling shareholders.
• Chapter 3 introduces the notion of partial ownership of a subsidiary that is created
or acquired at an amount equal to the book value of net assets. In this way students
are exposed to the nuances associated with the existence of noncontrolling shareholders, but without the details associated with a differential.
• Chapter 4 exposes students to the intricacies of consolidation when the subsidiary
is acquired for an amount that exceeds the book value of net assets. In order to
isolate the new concepts and procedures that accompany the consolidation of a
subsidiary with a differential, this chapter focuses on wholly owned subsidiaries.
• Chapter 5 finally brings students full circle to the point where they are ready to
tackle more realistic situations where the parent company purchases a controlling interest in a subsidiary (but not 100% ownership) and the acquisition price
exceeds the book value of net assets. Thus, students learn how to simultaneously handle all of the details associated with a differential and noncontrolling
shareholders.
The overall coverage of the consolidation process by chapter is illustrated below:
Wholly owned
subsidiary
Partially owned
subsidiary
Investment = Book value
Chapter 2
Chapter 3
No
differential
Investment > Book value
Chapter 4
Chapter 5
Differential
No NCI
shareholders
NCI
shareholders
• Reorganization of consolidation elimination entries. Consistent with the buildingblock approach to consolidation, the text includes a slight reorganization of the elimination entries used in consolidation to facilitate the elimination of the investment
in a subsidiary in two steps: (1) first the book value portion of the investment and
income from the subsidiary are eliminated and (2) then the differential portion of the
investment and income from the subsidiary are eliminated with separate entries. This
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Preface
•
•
•
•
•
ix
approach facilitates the building-block approach in Chapters 2–5. The text also uses
frequent illustrations to help students visualize the steps in the elimination process.
Presentation of intercompany transactions. Intercompany inventory transfers
are presented before fixed-asset transfers. Inventory transfers are (1) far more common than fixed-asset transfers and (2) easier for students to understand. The fully
adjusted equity method is presented in Chapters 6 and 7. This method links back to the
building-block approach in Chapters 2–5.
New FASB codification. All authoritative citations to U.S. GAAP include secondary
citations to the new FASB codification. We also maintain the authoritative citations
for clarity during this period of transition.
IFRS comparisons. As the FASB and IASB work toward convergence to a single
set of global accounting standards, the SEC is debating the wholesale introduction of
international financial reporting standards (IFRS). The text summarizes key differences between current U.S. GAAP and IFRS to make students aware of changes that
will likely occur if the SEC adopts IFRS in the near future.
AdvancedStudyGuide.com. See page xv for details.
The use of a continuous case for each major subject-matter area. This textbook
presents the complete story of a company, Peerless Products Corporation, from its
beginning, through its growth to a multinational consolidated entity, and finally to its
end. At each stage of the entity’s development, including the acquisition of a subsidiary, Special Foods Inc., the text presents comprehensive examples and discussions of
the accounting and financial reporting issues that accountants face. The discussions
tied to the Peerless Products continuous case are easily identified by the company
logos in the margin:
The comprehensive case of Peerless Products Corporation and its subsidiary, Special
Foods Inc., is used throughout the for-profit chapters. For the governmental chapters,
the Sol City case has been used to facilitate the development of governmental accounting and reporting concepts and procedures. Using a continuous case provides several
benefits. First, students need only become familiar with one set of data and can then
move more quickly through the subsequent discussion and illustrations without having to absorb a new set of data. Second, the case adds realism to the study of advanced
accounting and permits students to see the effects of each successive step on the
financial reports of an entity. Finally, comparing and contrasting alternative methods
using a continuous case allows students to evaluate different methods and outcomes
more readily.
• Extensive illustrations of key concepts. The book is heavily illustrated with complete, not partial, workpapers, financial statements, and other computations and comparisons useful for demonstrating each topic. The illustrations are cross-referenced to
the relevant text discussion. In the consolidations portion of the text, the focus is on
the fully adjusted equity method of accounting for an investment in a subsidiary, but
two other methods—the cost method and the modified equity method—are also discussed and illustrated in chapter appendices.
• Comprehensive coverage with significant flexibility. The self-contained units of
subject matter allow for substantial flexibility in sequencing the course materials.
In addition, individual chapters are organized to allow for going into greater depth
on some topics through the use of the “Additional Considerations” sections. Several
chapters include appendices containing discussions of alternative accounting procedures or illustrations of procedures or concepts that are of a supplemental nature.
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x
Preface
• Contemporary topical coverage. The dynamic business environment requires
accountants to continually learn about new types of transactions, new technologies
available to the profession, and new requirements and standards for accounting and
financial reporting. This textbook integrates the most recent professional standards
and includes cases and examples from current practice. For example, the importance
in recent years of topics such as the Sarbanes-Oxley Act, special-purpose entities
(SPEs), variable interest entities (VIEs), derivatives, fair value reporting, and international financial reporting standards (IFRS) has led to significant coverage of these
topics in the current and recent editions of the text. The GASB’s recent focus on
enhanced financial statement disclosures for governmental entities is discussed and
illustrated. Students are presented with an abundance of current information and learning opportunities to see that the topics in their advanced financial accounting courses
are a significant part of today’s profession of accountancy.
• Extensive end-of-chapter materials. A large number of questions, cases, exercises,
and problems at the end of each chapter provide the opportunity to solidify understanding of the chapter material and assess mastery of the subject matter. The end-ofchapter materials progress from simple focused exercises to more complex integrated
problems. Cases provide opportunities for extending thought, gaining exposure to
different sources of accounting-related information, and applying the course material to real-world situations. These cases include research cases where students are
referred to authoritative pronouncements, and Kaplan CPA Review simulations. The
American Institute of CPAs has identified five skills to be examined as part of the
CPA exam: (a) analysis, (b) judgment, (c) communication, (d) research, and (e) understanding. The end-of-chapter materials provide abundant opportunities for students to
enhance those skills with realistic and real-world applications of advanced financial
accounting topics. Cases and exercises identified with a world globe icon provide special opportunities for students to access real-world data by using electronic databases,
Internet search engines, or other inquiry processes to answer the questions presented
on the topics in the chapters.
MCGRAW-HILL’S CONNECT ™ ACCOUNTING
Less Managing. More Teaching. Greater Learning.
McGraw-Hill’s Connect™ Accounting is an online assignment and assessment solution
that connects students with the tools and resources they’ll need to achieve success.
McGraw-Hill’s Connect™ Accounting helps prepare students for their future by
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McGraw-Hill’s Connect™ Accounting Features
McGraw-Hill’s Connect™ Accounting offers a number of powerful tools and features
to make managing assignments easier, so faculty can spend more time teaching. With
McGraw-Hill’s Connect™ Accounting, students can engage with their coursework anytime and anywhere, making the learning process more accessible and efficient. McGrawHill’s Connect™ Accounting offers you the features described below.
Simple Assignment Management
With McGraw-Hill’s Connect™ Accounting, creating assignments is easier than ever, so
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• Go paperless with the eBook and online submission and grading of student assignments.
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xi
Smart Grading
When it comes to studying, time is precious. McGraw-Hill’s Connect™ Accounting
helps students learn more efficiently by providing feedback and practice material when
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The McGraw-Hill’s Connect™ Accounting Instructor Library is your repository for additional resources to improve student engagement in and out of class. You can select and
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Increase the attention paid to lecture discussion by decreasing the attention paid to note
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McGraw-Hill’s Connect™ Plus Accounting
McGraw-Hill reinvents the textbook learning experience for the modern student
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xii Preface
eBook and McGraw-Hill’s Connect™ Accounting, McGraw-Hill’s Connect™ Plus
Accounting provides all of the McGraw-Hill’s Connect™ Accounting features plus
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In short, McGraw-Hill’s Connect™ Accounting offers you and your students powerful tools and features that optimize your time and energies, enabling you to focus on
course content, teaching, and student learning. McGraw-Hill’s Connect™ Accounting
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For more information about McGraw-Hill’s Connect™ Accounting, go to www
.mcgrawhillconnect.com, or contact your local McGraw-Hill sales representative.
TEGRITY CAMPUS: LECTURES 24/7
Tegrity Campus is a service that makes class time available 24/7 by automatically capturing every lecture. With a simple one-click start-and-stop
process, you capture all computer screens and corresponding audio in a
format that is easily searchable, frame by frame. Students can replay any
part of any class with easy-to-use browser-based viewing on a PC or Mac, an iPod, or
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Educators know that the more students can see, hear, and experience class resources,
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To learn more about Tegrity, watch a two-minute Flash demo at http://tegritycampus
.mhhe.com.
COURSESMART.COM
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MCGRAW-HILL/IRWIN CUSTOMER CARE
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Preface
xiii
MCGRAW-HILL HIGHER EDUCATION AND BLACKBOARD HAVE
TEAMED UP. WHAT DOES THIS MEAN FOR YOU?
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SUPPLEMENTS FOR INSTRUCTORS
• Online Learning Center (OLC). We offer an Online Learning Center (OLC) that follows Essentials of Advanced Financial Accounting chapter by chapter. It doesn’t
require any building or maintenance on your part. It’s ready to go the moment you and
your students type in the URL: www.mhhe.com/baker1e.
The OLC includes
•
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Interactive chapter quizzes
PowerPoint® presentations
Excel worksheets
Check figures
Supplemental chapters
Supplemental problems
• Instructor PowerPoints. The authors have developed a comprehensive set of
PowerPoint slides designed to accompany the text. These slides do much more than
simply summarize the topics in each chapter. They illustrate key concepts but also
include group exercises and practice quiz questions to give students hands-on practice in class to better prepare them for future homework and assessment experiences.
Instructors benefit from proven interactive class discussions and exercises fully
annotated by the authors.
• Solutions Manual. Created by the authors, solutions are provided for all questions,
cases, exercises, and problems in the text. Solutions are carefully explained and logically presented. Answers for many of the multiple-choice questions include computations and explanations.
• Test Bank. Prepared by the authors, this comprehensive collection of both conceptual and procedural test items is organized by chapter and includes a large variety
of multiple-choice questions, exercises, and problems that can be used to measure
student achievement in the topics in each chapter. The test items are closely coordinated with the text to ensure consistency.
• Instructors’ Resource Manual. The Instructor’s Resource Manual includes chapter outlines, additional examples, teaching suggestions, and other materials to assist
instructors in making the most effective use of the text.
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Preface
• Supplemental Problems. Downloadable additional exercises and problems are provided for a number of chapters. Instructors can assign these additional exercises and
problems to broaden their students’ understanding of the topics in the chapters. The
instructor side of the OLC includes downloadable solutions to those supplemental
exercises and problems.
• Supplemental Chapters. Two chapters are available online: (a) accounting for home
office and branch operations and (b) accounting and reporting for estates and trusts.
Cases, exercises, and problems are also available for these two chapters and the
Instructor Edition includes solutions to those end-of-chapter items.
• Instructor Updates. Contains timely discussions and illustrations of major accounting
or financial reporting issues under deliberation by standard-setting bodies. Instructors
can choose to share them with their students.
ASSURANCE OF LEARNING READY
Many educational institutions today are focused on the notion of assurance of learning,
an important element of some accreditation standards. Essentials of Advanced Financial
Accounting is designed specifically to support your assurance of learning initiatives with
a simple, yet powerful solution.
Each test bank question for Essentials of Advanced Financial Accounting maps to a
specific chapter learning outcome/objective listed in the text. You can use our test bank
software, EZ Test and EZ Test Online, or in McGraw-Hill’s Connect™ Accounting to
easily query for learning outcomes/objectives that directly relate to the learning objectives for your course. You can then use the reporting features of EZ Test to aggregate
student results in a similar fashion, making the collection and presentation of assurance
of learning data simple and easy.
AACSB STATEMENT
The McGraw-Hill Companies is a proud corporate member of AACSB International.
Understanding the importance and value of AACSB accreditation, Essentials of Advanced
Financial Accounting recognizes the curricula guidelines detailed in the AACSB standards for business accreditation by connecting selected questions in the text and the test
bank to the six general knowledge and skill guidelines in the AACSB standards.
The statements contained in Essentials of Advanced Financial Accounting are provided only as a guide for the users of this textbook. The AACSB leaves content coverage
and assessment within the purview of individual schools, the mission of the school, and
the faculty. While Essentials of Advanced Financial Accounting and the teaching package make no claim of any specific AACSB qualification or evaluation, we have within
Essentials of Advanced Financial Accounting labeled selected questions according to the
six general knowledge and skills areas.
SUPPLEMENTS FOR STUDENTS
accounting
• McGraw-Hill’s Connect™ Plus Accounting
This integrates all of the text’s multimedia resources. Students can obtain state-of-theart study aids, including an online version of the text.
• McGraw-Hill’s Connect™ Accounting
This Web-based software duplicates problem structures directly from the end-ofchapter material in the textbook. It shows students where they made errors. All applicable exercises and problems are available with McGraw-Hill’s Connect™ Accounting.
Available on the Online Learning Center at www.mhhe.com/baker9e
• Online Quizzes. Interactive quizzes give students a variety of multiple-choice and
true/false questions related to the text for self-evaluation.
• Excel Worksheets. These worksheets for use with Excel are provided to facilitate completion of problems requiring numerous mechanical computations.
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xv
• Check Figures. Prepared by the text authors, a list of answers is provided separately
for many of the end-of-chapter materials in the text.
• Microsoft PowerPoint Slides®. Available by chapter to facilitate note taking and review.
• Supplemental Problems. Additional problem materials for a number of the chapters are
available online to enhance students’ learning of the topics in the chapters. These supplemental problems tend to be longer problems that present a more comprehensive fact
situation and can extend understanding of the topics in the chapters to a broader scope.
• Supplemental Chapters. Two chapters are available online for those persons wishing extended learning: (a) accounting for home office and branch operations and
(b) accounting and reporting for estates and trusts. Cases, exercises, and problems are
also available for these two chapters.
HIGH TECH: ESSENTIALS OF ADVANCED FINANCIAL ACCOUNTING HAS KEY
TECHNOLOGY RESOURCES TO BENEFIT BOTH STUDENTS AND INSTRUCTORS
Essentials of Advanced Financial Accounting introduces the most cutting-edge technology supplement ever delivered in the advanced accounting market. AdvancedStudyGuide.com is a product created exclusively by the authors of the text that represents a
new generation in study resources available to students as well as a new direction and
options in the resources instructors can use to help their students and elevate their classroom experiences.
Traditional study guides offer students a resource similar to the text itself. That is
more discussion like the text accompanied by more problems and exercises like the ones
in the text, all of this at a fairly costly price to just give students the same type of materials that they already received with the text.
At its core AdvancedStudyGuide.com (ASG) offers materials that go beyond
what a printed text can possibly deliver. The ASG contains dozens of narrated, animated discussions and explanations of materials aligned to key points in the chapter.
Not only that, the ASG also contains animated problems just like key problems in the
exercises and problems at the end of each chapter. For the student who would like a
little help with Essentials of Advanced Financial Accounting, the ASG is like having
private tutoring sessions from the authors who wrote the book (not a class TA) any
time, day or night. This also can provide tremendous benefits for instructors, as outlined below.
For Students:
The Questions
• Have you ever had to miss a class and were then confused about what the book was
trying to say about a topic?
• Even when you were in class, do things sometimes not make as much sense when you
are reviewing on your own?
• Do you ever feel stuck when it comes to doing homework problems, even though you
read the chapter?
• When the exam is a few weeks after you covered the material in class, do you ever
wish someone could walk you through a few examples as you review for the exam?
• Have you ever purchased a study guide for a text and found it was very expensive and
did not give the additional study help you needed?
The ASG Answer
• The Answer, at least in part, is the ASG: a new type of study guide designed for the
way you like to study and the way that you learn best.
• It is our attempt as authors to really discuss the material in a way that a text-only
approach cannot do.
• AND we can discuss your questions with you 24/7, anytime—day or night, at times
when your regular instructor is not around.
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xvi Preface
• Through the ASG, we will bring you streaming media discussions where the authors
of the book (not a class TA) explain key points of each chapter.
• The ASG will also show, explain, and illustrate for you the approach to solving key
homework problems in the text. These explanations are Like Problems; that is, they
are problems “just like” some in the text that you were assigned for homework.
The ASG Benefit
AdvancedStudyGuide.com brings you discussion and examples worked out in streaming
video. While traditional study guides can Tell you what to do, the ASG will Show You
What to Do AND HOW to Do It.
See the student page at AdvancedStudyGuide.com.
For Instructors:
The Questions
• Have you ever had a student miss class and then come to your office and ask you to go
over the topics that were discussed in class the day the student was absent?
• Even when a student is in class, does he or she sometimes come to your office and ask
you to repeat the discussion?
• Even when you have discussed the chapter concepts, do you have students who still
get stuck when it comes to doing homework problems?
• When exams are approaching, do students sometimes ask you to go back over material
you taught days or weeks before?
• Would it be helpful to you if, on occasion, the authors of the text offered to hold
“office hours” with your students for you?
The ASG Answer
• The Answer, at least in part, is the ASG: the authors’ attempt to partner with you in
helping to better serve students’ needs in some of the common situations where questions arise, without using more of your scarce time.
• The ASG will allow you to refer to streaming media discussions where the authors
explain key points of each chapter.
• The ASG will show, explain, and illustrate for students the approach to solving key
homework problems in the text. These explanations are Like Problems; that is they are
problems “just like” some in the text that you can assign for homework.
The ASG Benefit
AdvancedStudyGuide.com (ASG) is a great tool to let the authors of the text partner
with you, the instructor, in helping students learn Essentials of Advanced Financial
Accounting. The ASG will (1) help your students learn more effectively, (2) improve
your class discussions, and (3) make your student contact hours more efficient.
See the instructor page at AdvancedStudyGuide.com.
CHAPTER-BY-CHAPTER COVERAGE
• Chapter 1 emphasizes the importance of business acquisitions and combinations based
on the January 2010 acquisition of Cadbury PLC by Kraft Foods, Inc. The business
world is complex, and frequent business combinations will continue to increase the
complex nature of the business environment in the future. An understanding of the
accounting treatment of mergers, acquisitions, and other intercorporate investments is
an invaluable asset in our ever-changing markets.
• Chapter 2 summarizes the different types of intercorporate investments based on
the 2009 investment portfolio of Berkshire Hathaway. This vignette also discusses issues such as ownership and control that are related to the accounting for
investments.
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xvii
• Chapter 3 introduces the notion of special-purpose entities and accounting standards
related to variable interest entities by discussing the well-known collapse of Enron
Corporation. New accounting rules for determining when a business entity must be
consolidated resulted from this and other scandals. We also explore how the basic
consolidation process differs when a subsidiary is only partially owned.
• Chapter 4 gives a “behind the scenes” look at the work that goes into the consolidation process based on Disney Corporation. We learn about value-added activities
during the consolidation process. In addition, we introduce issues such as when a differential occurs when the acquiring company pays more than the book value of the
acquired company’s net assets.
• Chapter 5 discusses majority ownership of subsidiaries based on the 80 percent acquisition of Nuova Systems by Cisco Systems, Inc. in 2006. We further the discussion
of acquisitions with a differential with the added complexity of noncontrolling interest
shareholders when they purchase less than 100 percent of the outstanding common
stock.
CISCO
NCI
20%
80%
NuOVA
S Y S T E M S
• Chapter 6 introduces intercompany inventory transfers based on Toys R Us and
its 100 percent owned subsidiary Toysrus.com. Transactions between the two are
related-party transactions; therefore, the profit from intercompany inventory transfers
is eliminated in preparing consolidated finanial statements. This elimination process
can become complicated. Therefore, this chapter examines intercompany inventory
transactions and the consolidated procedures associated with them.
100%
49%
51%
• Chapter 7 presents a real fixed-asset transfer that took place in 2009 between two of
Mircon subsidiaries. This chapter explores the accounting for both depreciable and
nondepreciable asset transfers among affiliated companies.
100%
Asset
$
• Chapter 8 discusses the accounting issues affecting companies like Microsoft that
have international operations. Specifically, we discuss foreign currency transactions,
financial instruments, and the effects that changes in exchange rates can have on
reported results.
R
• Chapter 9 resumes the discussion of international accounting by looking at
McDonald’s global empire and how differences in accounting standards across countries and jurisdictions can cause significant difficulties for multinational firms. This
chapter summarizes current efforts to develop a global set of high-quality accounting
standards and explores the translation of financial statements of a foreign business
entity into U.S. dollars.
• Chapter 10 summarizes the evolution of the large accounting firms with an emphasis on partnerships. This chapter focuses on the formation and operation of partnerships, including accounting for the addition of new partners and the retirement of a
present partner.
LAVENTHOL & HORWATH
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• Chapter 11 illustrates the dissolution of partnerships with the example of Laventhol
& Horwath, the seventh largest accounting firm in 1990. We present the concepts that
accountants must know if they offer professional services to partnerships undergoing
liquidation.
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xviii Preface
City of
• Chapter 12 introduces the topic of accounting for government entities by examining the complexity of the operations of San Diego, California. The chapter has
two parts: the accounting and reporting requirements for state and local governmental units and a comprehensive illustration of accounting for the general fund
of a city.
San Diego
• Chapter 13 resumes the discussion of accounting for governmental entities by specifically examining special funds and government-wide financial statements using the
example of the state of Maryland. We present the accounting and financial reporting
requirements for four remaining governmental fund types, two proprietary fund types,
and the four fiduciary fund types.
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Acknowledgments
This text includes the thoughts and contributions of many individuals, and we wish to
express our sincere appreciation to them. First and foremost, we thank all the students in
our advanced accounting classes, from whom we have learned so much. In many respects,
this text is an outcome of the learning experiences we have shared with our students. Second, we wish to thank the many outstanding teachers we have had in our own educational
programs, from whom we learned the joy of learning. We are indebted to our colleagues
in advanced accounting for helping us reach our goal of writing the best possible essentials of advanced financial accounting text. We appreciate the many valuable comments
and suggestions from the faculty who used recent editions of the text. Their comments
and suggestions have contributed to making this text a more effective learning tool. We
especially wish to thank Jane Ou from Santa Clara University, Mallory McWilliams from
San Jose State University, Mary Callegari from San Jose State University, Pam Smith
from Northern Illinois University, Larry Walther from Utah State University, and Han
Stice, Cameron Flanders, and Melissa Larson, all from Brigham Young University.
We express our sincere thanks to the following individuals who provided reviews on
the full version of the text:
Alexander K. Buchholz
Brooklyn College of the City University
of New York
Mary Burnell
Fairmont State University
Steve Fabian
New Jersey City University
Earl Godfrey
Gardner-Webb University
Joshua Herbold
University of Montana
Mallory McWilliams
San Jose State University/University of
California, Santa Cruz
Abe Qastin
Lakeland College
Chantal Rowat
Bentley University
Margaret Shelton
University of Houston, Downtown
Frank Shuman
Utah State University
Nathan Slavin
Hofstra University
James Yang
Montclair State University
Jian Zhou
Binghamton University
We are grateful for the assistance and direction of the McGraw-Hill/Irwin team:
Stewart Mattson, Tim Vertovec, Dana Woo, Katie Jones, Alice Harra, Pat Frederickson, Michelle Gardner, Dean Karampelas, Matt Baldwin, Greg Bates, Carol Bielski, and
Suresh Babu, who all worked hard to champion our book through the production process.
Permission has been received from the Institute of Certified Management Accountants of
the Institute of Management Accountants to use questions and/or unofficial answers from
past CMA examinations. We appreciate the cooperation of the American Institute of Certified Public Accountants for providing permission to adapt and use materials from past
Uniform CPA Examinations. And we thank Kaplan CPA Review for providing their online
framework for Essentials of Advanced Financial Accounting students to gain important
experience with the types of simulations that are included on the Uniform CPA Examination.
Above all, we extend our deepest appreciation to our families who continue to provide
the encouragement and support necessary for this project.
Richard E. Baker
Theodore E. Christensen
David M. Cottrell
xix
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Brief Table of Contents
PREFACE vii
8
Multinational Accounting: Foreign
Currency Transactions and Financial
Instruments 373
Multinational Accounting: Issues in
Financial Reporting and Translation of
Foreign Entity Statements 444
1
Intercorporate Acquisitions and
Investments in Other Entities 1
2
Reporting Intercorporate Investments
and Consolidation of Wholly Owned
Subsidiaries with No Differential 53
9
3
The Reporting Entity and Consolidation of
Less-than-Wholly-Owned Subsidiaries with
No Differential 107
10 Partnerships: Formation, Operation, and
Changes in Membership 506
11 Partnerships: Liquidation
4
Consolidation of Wholly Owned Subsidiaries
Acquired at More than Book Value 157
561
12 Governmental Entities: Introduction and
General Fund Accounting 599
5
Consolidation of Less-than-WhollyOwned Subsidiaries Acquired at More
than Book Value 206
13 Governmental Entities: Special Funds
and Government-wide Financial
Statements 658
6
Intercompany Inventory Transactions 254
Intercompany Transfers of Services and
Noncurrent Assets 306
INDEX 727
7
xxi
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Table of Contents
ABOUT THE AUTHORS v
Questions 28
Cases 29
Exercises 32
Problems 43
PREFACE vii
Chapter 1
Intercorporate Acquisitions and Investments
in Other Entities 1
Kraft’s Acquisition of Cadbury 1
A Brief Introduction 2
The Development of Complex Business Structures 4
Enterprise Expansion 5
Organizational Structure and Business Objectives 5
Organizational Structure, Acquisitions, and Ethical
Considerations 6
Business Expansion and Forms of Organizational
Structure 6
Internal Expansion 6
External Expansion through Business Combinations 7
Frequency of Business Combinations 8
Complex Organizational Structures 9
Organizational Structure and Financial Reporting 10
Creating Business Entities 10
Business Combinations 12
Forms of Business Combinations 12
Methods of Effecting Business Combinations
Valuation of Business Entities 14
Accounting for Business Combinations
Acquisition Accounting 16
12
15
Fair Value Measurements 16
Applying the Acquisition Method 16
Goodwill 17
Combination Effected through the Acquisition of Net Assets 18
Combination Effected through Acquisition of Stock 22
Financial Reporting Subsequent to a Business
Combination 23
Disclosure Requirements 24
Additional Considerations in Accounting for Business
Combinations 24
Uncertainty in Business Combinations 24
In-Process Research and Development 26
Noncontrolling Equity Held Prior to Combination
Acquisitions by Contract Alone 26
Summary of Key Concepts 26
Key Terms 27
APPENDIX 1A
Methods of Accounting for Business
Combinations 27
Chapter 2
Reporting Intercorporate Investments and
Consolidation of Wholly Owned Subsidiaries
with No Differential 53
Berkshire Hathaway’s Many Investments 53
Accounting for Investments in Common Stock
Reasons for Investing in Common Stock 56
The Cost Method 57
Accounting Procedures under the Cost Method 57
Declaration of Dividends in Excess of Earnings since
Acquisition 57
Acquisition at Interim Date 59
Changes in the Number of Shares Held 59
The Equity Method
59
Use of the Equity Method 60
Investor’s Equity in the Investee 60
Recognition of Income 60
Recognition of Dividends 61
Comparison of the Carrying Amount of the Investment
under the Cost and Equity Methods 62
Acquisition at Interim Date 62
Changes in the Number of Shares Held 63
Comparison of the Cost and Equity Methods 65
The Fair Value Option 66
Overview of the Consolidation Process 66
Consolidation Procedures for Wholly Owned
Subsidiaries That Are Created or Purchased at Book
Value 67
Consolidation Worksheets 67
Worksheet Format 67
Nature of Eliminating Entries
69
Consolidated Balance Sheet with Wholly Owned
Subsidiary 69
100 Percent Ownership Acquired at Book Value
Consolidation Subsequent to Acquisition
26
54
Consolidated Net Income 74
Consolidated Retained Earnings
70
73
75
Consolidated Financial Statements—100 Percent
Ownership, Created or Acquired at Book Value 76
Initial Year of Ownership 77
Second and Subsequent Years of Ownership 81
Consolidated Net Income and Retained Earnings
Summary of Key Concepts
83
84
xxiii
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xxiv Table of Contents
Key Terms 134
APPENDIX 3A
Consolidation of Variable Interest Entities
Questions 135
Cases 136
Exercises 139
Problems 147
Key Terms 85
APPENDIX 2A
Additional Considerations Relating to the
Equity Method 85
APPENDIX 2B
Consolidation and the Cost Method 88
Questions 90
Cases 92
Exercises 94
Problems 100
Chapter 3
The Reporting Entity and Consolidation of
Less-than-Wholly-Owned Subsidiaries with
No Differential 107
The Collapse of Enron and the Birth of a New
Paradigm 107
The Usefulness of Consolidated Financial
Statements 109
Limitations of Consolidated Financial Statements 109
Subsidiary Financial Statements 110
Consolidated Financial Statements: Concepts and
Standards 110
Traditional View of Control 110
Indirect Control 111
Ability to Exercise Control 111
Differences in Fiscal Periods 112
Changing Concept of the Reporting Entity
113
116
Computation of Noncontrolling Interest 116
Presentation of Noncontrolling Interest 116
Combined Financial Statements 118
Additional Considerations—Different Approaches to
Consolidation 119
Consolidated Net Income 122
Consolidated Retained Earnings
Worksheet Format 124
122
123
Consolidated Balance Sheet with a Less-than-WhollyOwned Subsidiary 124
80 Percent Ownership Acquired at Book Value
125
Consolidation Subsequent to Acquisition—80 Percent
Ownership Acquired at Book Value 127
Initial Year of Ownership 127
Second and Subsequent Years of Ownership
Summary of Key Concepts
bak25648_fm_i-xxviii.indd xxiv
133
The Difference between Acquisition Price and
Underlying Book Value 159
Consolidation Procedures for Wholly Owned
Subsidiaries Acquired at More than Book Value 162
Treatment of a Positive Differential 165
Illustration of Treatment of a Complex Differential 166
100 Percent Ownership Acquired at Less than Fair
Value of Net Assets 169
Illustration of Treatment of Bargain-Purchase
Differential 169
Intercompany Receivables and Payables 180
Push-Down Accounting 180
Summary of Key Concepts 181
Key Terms 181
APPENDIX 4A
Push-Down Accounting Illustrated 181
Questions 184
Cases 184
Exercises 186
Problems 197
Chapter 5
Consolidation of Less-than-Wholly-Owned
Subsidiaries Acquired at More than Book
Value 206
119
The Effect of a Noncontrolling Interest
How Much Work Does It Really Take to Consolidate?
Ask the People Who Do It at Disney 157
Dealing with the Differential 158
Initial Year of Ownership 171
Second Year of Ownership 176
112
Off-Balance Sheet Financing 113
Variable Interest Entities 114
IFRS Differences in Determining Control of VIEs
and SPEs 116
Theories of Consolidation 119
Comparison of Alternative Theories
Current Practice 122
Chapter 4
Consolidation of Wholly Owned Subsidiaries
Acquired at More than Book Value 157
Consolidated Financial Statements—100 Percent
Ownership Acquired at More than Book Value 171
Special-Purpose and Variable Interest Entities
Noncontrolling Interest
134
131
Cisco Acquires a Controlling Interest in Nuova 206
A Noncontrolling Interest in Conjunction with
a Differential 207
Consolidated Balance Sheet with Majority-Owned
Subsidiary 207
Consolidated Financial Statements with a
Majority-Owned Subsidiary 210
Initial Year of Ownership 210
Second Year of Ownership 214
Discontinuance of Consolidation
217
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Treatment of Other Comprehensive Income
220
Modification of the Consolidation Worksheet 220
Adjusting Entry Recorded by Subsidiary 220
Adjusting Entry Recorded by Parent Company 220
Consolidation Worksheet—Second Year Following
Combination 221
Consolidation Procedures 221
Consolidation Worksheet—Comprehensive Income
in Subsequent Years 224
Additional Considerations
224
Subsidiary Valuation Accounts at Acquisition 224
Negative Retained Earnings of Subsidiary at
Acquisition 225
Other Stockholders’ Equity Accounts 225
Subsidiary’s Disposal of Differential-Related Assets 225
Summary of Key Concepts
Key Terms 227
Questions 227
Cases 228
Exercises 229
Problems 239
227
254
Inventory Transfers at Toys R Us 254
Overview of the Consolidated Entity and
Intercompany Transactions 255
Elimination of Intercompany Transfers 256
Elimination of Unrealized Profits and Losses 256
Inventory Transactions 256
Transfers at Cost 257
Transfers at a Profit or Loss 257
Effect of Type of Inventory System 257
Downstream Sale of Inventory
258
Resale in Period of Intercorporate Transfer 259
Resale in Period following Intercorporate Transfer 260
Inventory Held for Two or More Periods 266
267
Equity-Method Entries—20X1 267
Consolidation Worksheet—20X1 268
Consolidated Net Income—20X1 269
Equity-Method Entries—20X2 270
Consolidation Worksheet—20X2 270
Consolidated Net Income—20X2 272
Additional Considerations
272
Sale from One Subsidiary to Another 272
Costs Associated with Transfers 273
Lower of Cost or Market 273
Sales and Purchases before Affiliation 273
Summary of Key Concepts 274
Key Terms 274
APPENDIX 6A
Intercompany Inventory Transactions—Modified
Equity Method and Cost Method 274
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Chapter 7
Intercompany Transfers of Services and
Noncurrent Assets 306
Micron’s Intercompany Fixed Asset Sale 306
Intercompany Long-Term Asset Transfers 307
Intercompany Transfers of Services 309
Intercompany Land Transfers 309
Overview of the Profit Elimination Process 309
Assignment of Unrealized Profit Elimination 311
Downstream Sale of Land 313
Upstream Sale of Land 317
Eliminating the Unrealized Gain after the
First Year 321
Subsequent Disposition of the Asset 321
Intercompany Transfers of Depreciable
Assets 323
Chapter 6
Intercompany Inventory Transactions
Upstream Sale of Inventory
Questions 281
Cases 282
Exercises 284
Problems 292
Downstream Sale 323
Change in Estimated Life of Asset upon Transfer
Upstream Sale 331
Asset Transfers before Year-End 341
331
Intercompany Transfers of Amortizable
Assets 341
Summary of Key Concepts 341
Key Terms 341
APPENDIX 7A
Intercompany Noncurrent Asset Transactions—
Modified Equity Method and Cost Method 342
Questions 349
Cases 350
Exercises 352
Problems 360
Chapter 8
Multinational Accounting: Foreign
Currency Transactions and Financial
Instruments 373
Microsoft’s Multinational Business 373
Doing Business in a Global Market 374
The Accounting Issues 375
Foreign Currency Exchange Rates 376
The Determination of Exchange Rates 376
Direct versus Indirect Exchange Rates 376
Changes in Exchange Rates 378
Spot Rates versus Current Rates 381
Forward Exchange Rates 381
Foreign Currency Transactions
381
Foreign Currency Import and Export
Transactions 383
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xxvi Table of Contents
Managing International Currency Risk with
Foreign Currency Forward Exchange Financial
Instruments 386
Derivatives Designated as Hedges 387
Forward Exchange Contracts 389
Case 1: Managing an Exposed Foreign Currency Net
Asset or Liability Position: Not a Designated
Hedging Instrument 391
Case 2: Hedging an Unrecognized Foreign Currency
Firm Commitment: A Foreign Currency Fair Value
Hedge 396
Case 3: Hedging a Forecasted Foreign Currency
Transaction: A Foreign Currency Cash Flow
Hedge 399
Case 4: Speculation in Foreign Currency
Markets 403
Foreign Exchange Matrix 405
Additional Considerations
405
A Note on Measuring Hedge Effectiveness 405
Interperiod Tax Allocation for Foreign Currency
Gains (Losses) 406
Hedges of a Net Investment in a Foreign Entity 406
Summary of Key Concepts 406
Key Terms 406
APPENDIX 8A
Illustration of Valuing Forward Exchange
Contracts with Recognition for the Time Value
of Money 407
APPENDIX 8B
Use of Other Financial Instruments by
Multinational Companies 410
Questions 422
Cases 423
Exercises 425
Problems 436
Chapter 9
Multinational Accounting: Issues in
Financial Reporting and Translation of
Foreign Entity Statements 444
McDonald’s—The World’s Fast Food
Favorite 444
Differences in Accounting Principles 446
Determining the Functional Currency 449
Functional Currency Designation in Highly
Inflationary Economies 451
Translation versus Remeasurement of Foreign
Financial Statements 451
Translation of Functional Currency Statements into
the Reporting Currency of the U.S. Company 453
Financial Statement Presentation of Translation
Adjustment 454
bak25648_fm_i-xxviii.indd xxvi
Illustration of Translation and Consolidation of a
Foreign Subsidiary 455
Noncontrolling Interest of a Foreign
Subsidiary 464
Remeasurement of the Books of Record into the
Functional Currency 466
Statement Presentation of Remeasurement Gain
or Loss 467
Illustration of Remeasurement of a Foreign
Subsidiary 468
Proof of Remeasurement Exchange Gain 469
Remeasurement Case: Subsequent Consolidation
Worksheet 470
Summary of Translation versus
Remeasurement 473
Additional Considerations in Accounting for Foreign
Operations and Entities 473
Foreign Investments and Unconsolidated
Subsidiaries 474
Liquidation of a Foreign Investment
474
Hedge of a Net Investment in a Foreign
Subsidiary 475
Disclosure Requirements 476
Statement of Cash Flows 476
Lower-of-Cost-or-Market Inventory Valuation
under Remeasurement 477
Intercompany Transactions 477
Income Taxes 479
Translation When a Third Currency Is the Functional
Currency 479
Summary of Key Concepts
Key Terms 480
Questions 480
Cases 481
Exercises 485
Problems 494
479
Chapter 10
Partnerships: Formation, Operation, and
Changes in Membership 506
The Evolution of PricewaterhouseCoopers
(PwC) 506
The Nature of the Partnership Entity 507
Legal Regulation of Partnerships 507
Definition of a Partnership 508
Formation of a Partnership 508
Other Major Characteristics of Partnerships 509
Accounting and Financial Reporting Requirements
for Partnerships 511
International Financial Reporting Standards for
Small and Medium-Sized Entities and Joint
Ventures 512
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Table of Contents xxvii
Accounting for the Formation of a Partnership
512
Illustration of Accounting for Partnership
Formation 513
Accounting for the Operations of a
Partnership 514
Partners’ Accounts
Accounting for the Bustling City of San Diego 599
Differences between Governmental and Private Sector
Accounting 600
History of Governmental Accounting 601
Major Concepts of Governmental Accounting 602
514
Allocating Profit or Loss to Partners
515
Illustrations of Profit Allocation 516
Multiple Bases of Profit Allocation 519
Special Profit Allocation Methods 520
Partnership Financial Statements
Changes in Membership 521
520
General Concepts to Account for a Change in
Membership in the Partnership 521
New Partner Purchases an Interest 523
New Partner Invests in Partnership 525
Determining a New Partner’s Investment Cost 538
Dissociation of a Partner from the Partnership 538
Additional Considerations
570
576
576
Summary of Key Concepts 577
Key Terms 578
APPENDIX 11A
Partners’ Personal Financial Statements
Questions 581
Cases 582
Exercises 584
Problems 593
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Interfund Activities
625
(1) Interfund Loans 625
(2) Interfund Services Provided and Used
(3) Interfund Transfers 626
(4) Interfund Reimbursements 627
626
Overview of Accounting and Financial Reporting for
the General Fund 627
Comprehensive Illustration of Accounting for the
General Fund 628
564
569
Incorporation of a Partnership
614
615
The Expenditure Process 615
Classification of Expenditure Transactions and
Accounts 617
Outstanding Encumbrances at the End of the Fiscal
Period 617
Expenditures for Inventory 621
Accounting for Fixed Assets 623
Long-Term Debt and Capital Leases 624
Investments 624
564
Illustration of Installment Liquidation
Cash Distribution Plan 573
Measurement Focus and Basis of Accounting
(MFBA) 609
Recording the Operating Budget
Dissociation, Dissolution, Winding Up, and Liquidation
of a Partnership 562
Installment Liquidations
605
Fund-Based Financial Statements: Governmental
Funds 606
Accounting for Expenditures
561
Realization of Assets 564
Expenses of Liquidation 564
Illustration of Lump-Sum Liquidation
Financial Reporting of Governmental Entities
Budgetary Aspects of Governmental
Operations 614
The Demise of Laventhol & Horwath 561
Overview of Partnership Liquidations 562
Lump-Sum Liquidations
Elements of Financial Statements 602
Expendability of Resources versus Capital Maintenance
Objectives 603
Definitions and Types of Funds 603
Basis of Accounting—Governmental Funds 610
Basis of Accounting—Proprietary Funds 613
Basis of Accounting—Fiduciary Funds 613
Summary of Key Concepts 541
Key Terms 541
APPENDIX 10A
Tax Aspects of a Partnership 541
APPENDIX 10B
Joint Ventures 543
Questions 545
Cases 545
Exercises 548
Problems 554
Chapter 11
Partnerships: Liquidation
Chapter 12
Governmental Entities: Introduction and
General Fund Accounting 599
578
Adoption of the Budget 628
Property Tax Levy and Collection 630
Other Revenue 631
Expenditures 632
Acquisition of Capital Asset 632
Interfund Activities 633
Adjusting Entries 633
Closing Entries 634
General Fund Financial Statement Information
Summary of Key Concepts
635
638
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Table of Contents
Key Terms 638
Questions 639
Cases 639
Exercises 642
Problems 650
Trust Funds
Agency Funds
Illustration of Transactions in an Agency Fund
Additional Considerations
Illustration of Transactions 665
Financial Statement Information for the Capital
Projects Fund 668
668
671
671
Governmental Funds Financial Statements
Enterprise Funds 675
672
Illustration of Transactions 676
Financial Statements for the Proprietary Funds
Internal Service Funds
bak25648_fm_i-xxviii.indd xxviii
678
680
Illustration of Transactions 681
Financial Statements for Internal Service Funds
697
Special-Purpose Governmental Entities 697
Financial Reporting for Pensions and OPEB Plans
Illustration of Transactions 669
Financial Statement Information for the Debt Service
Fund 671
Illustration of Transactions
686
686
Four Major Issues 686
Government Financial Reports 688
Government-wide Financial Statements 689
Reconciliation Schedules 691
Budgetary Comparison Schedule 693
Management’s Discussion and Analysis 695
Notes to the Government-wide Financial Statements 695
Other Financial Report Items 696
Interim Reporting 696
Auditing Governmental Entities 696
Governmental Accounting in Maryland 658
Summary of Governmental Fund Types 660
Governmental Funds Worksheets 661
Special Revenue Funds 661
Capital Projects Funds 665
Permanent Funds
684
685
The Government Reporting Model
Chapter 13
Governmental Entities: Special Funds
and Government-wide Financial
Statements 658
Debt Service Funds
683
Illustration of Private-Purpose Trust Fund
698
Summary of Key Concepts 699
Key Terms 700
APPENDIX 13A
Other Governmental Entities—Public School
Systems and the Federal Government 700
Questions 702
Cases 702
Exercises 704
Problems 715
INDEX 727
683
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Chapter One
Intercorporate
Acquisitions and
Investments in Other
Entities
Multi-Corporate
Entities
Business
Combinations
Consolidation
Concepts and Procedures
Intercompany Transfers
Multinational
Entities
Partnerships
Governmental
Entities
KRAFT’S ACQUISITION OF CADBURY
In recent years as well as during the past several decades, the business world has witnessed many corporate acquisitions and combinations, often involving some of the
world’s largest and best-known companies. Some of these combinations have captured
public attention because of the personalities involved, the daring strategies employed,
and the huge sums of money at stake. In January 2010 Kraft Foods Inc. finalized a deal
to acquire Cadbury PLC for $19.4 billion to form the second-largest confectionery, food,
and beverage company in the world. At the time of the acquisition, Cadbury’s net assets
were only worth around $5 billion. During the three months preceding Kraft’s final bid,
rumors circulated of a potential counterbid by Hershey. While a bidding war seemed
likely, Hershey decided not to counterbid when Kraft produced a “winning” offer. This
highly visible transaction was really the next step in more than a century of regular
acquisitions.
In 1896, inspired in part by his time in the Kellogg brothers’ Battle Creek Sanitarium,
C.W. Post founded Postum Cereal Company, Ltd. The following year he introduced
Grape-Nuts brand cereal. Within five years, Postum employed 2,500 people and its Battle
Creek facility was the largest of its kind in the world.
In 1903, James L. Kraft started selling cheese door to door from the back of a horsedrawn wagon. Although not immediately successful, he continued operations and was
eventually joined by four of his brothers in 1909. By 1914 Kraft & Bros. Company (later
Kraft Foods Inc.) had opened its first cheese manufacturing plant and in 1916 patented a
new process for pasteurizing cheese, making the cheese resistant to spoilage and allowing it to be transported over long distances.
These two start-up companies (Kraft and Postum) continued to grow independently.
Postum went public in 1922, followed by Kraft in 1924. In 1925 Postum acquired Jell-O
Company and in 1928 Maxwell House Coffee. That same year (1928) Kraft merged with
Phenix Cheese, maker of Philadelphia Brand cream cheese.
In 1929, Postum changed its name to General Foods Corporation and in 1930 Kraft was
acquired by National Dairy Products. In 1937 Kraft launched its well-known macaroni
and cheese dinners. By 1953 business was booming for General Foods and they acquired
Perkins Products, maker of Kool-Aid. In 1981 General Foods made another acquisition,
this time acquiring Oscar Mayer & Co.
Philip Morris acquired General Foods in 1985 and Kraft in 1988. A year later General
Foods and Kraft were combined to form Kraft General Foods Inc., which was renamed
1
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Kraft Foods Inc. in 1995. In 2000, Philip Morris acquired Nabisco Holdings and began
integrating Nabisco and Kraft. The story does not end here. In August 2008 the Post
Cereal portion of Kraft was spun off and merged with Ralcorp Holdings. The remaining portion of Kraft Foods Inc. is the company that took part in the 2010 acquisition of
Cadbury PLC.
Of course, this is only half of the story. Cadbury took its own journey. It took
104 years and dozens of mergers and acquisitions to finally end up with the companies
that took part in the 2010 acquisition. The business world is complex and frequent
business combinations will continue to increase the complex nature of the business
environment in the future. An understanding of the accounting treatment of mergers,
acquisitions, and other intercorporate investments is an invaluable asset in our everchanging markets. This chapter introduces the key concepts associated with business
combinations.
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO1
Understand and explain different methods of business expansion, types of
organizational structures, and types of acquisitions.
LO2
Make calculations and prepare journal entries for the creation and purchase of
a business entity.
LO3
Understand and explain the differences between different forms of business
combinations.
LO4
Make calculations and prepare journal entries for different types of business
combinations through the acquisition of stock or assets.
LO5
Make calculations and business combination journal entries in the presence of
a differential, goodwill, or a bargain purchase element.
LO6
Understand additional considerations associated with business combinations.
A BRIEF INTRODUCTION
Before launching into our discussion of business combinations, we pause to provide
a brief overview of the text. First, we note that the book’s title does not necessarily
describe the level of difficulty of topics covered in the text. The concepts covered here
are not necessarily harder to grasp than those covered in your intermediate-level financial accounting courses. This course introduces financial accounting topics associated
with many different topics that are typically not covered in intermediate-level texts.
It may be more accurate to simply say that the term “advanced” means that the text
covers topics that are more appropriately introduced after you’ve established a solid
foundation in your intermediate courses. While the topics covered here will probably
not be more difficult than those covered in previous courses, they have been saved to
help you to build on what you’ve learned in prior courses. They will certainly help you
transition from simple, contrived accounting examples to more realistic settings found
in real-world situations.
Figure 1–1 summarizes the six major sections of this text. Chapters 1–7 comprise
the first major section of the text on multi-corporate entities. In this chapter, we introduce major topics related to business combinations, as illustrated with the Kraft-Cadbury
example. Chapters 2–5 explain the basic concepts and procedures for preparing consolidated financial statements, the required financial reporting method of affiliated corporate
groups. Chapters 6–7 describe the intricacies of preparing consolidated financial statements in the presence of intercompany asset or debt transfers within a controlled group
of companies. This major portion of the book on multi-corporate entities comprises the
first half of the text.
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Governmental Entities
Partnerships
Multinational Entities
Multi-Corporate Entities
Section
Special Funds
Governmental Entities
Liquidation
Formation, Operation, Changes
Translation of Foreign Statements
Foreign Currency Transactions
Intercompany Transfers
Consolidation Concepts
and Procedures
Business Combinations
Major Topic
FIGURE 1–1 Topical Overview
13
12
11
10
9
8
6
7
3
4
5
2
1
Governmental Entities: Special Funds and Government-Wide Financial Statements
Governmental Entities: Introduction and General Fund Accounting
Partnerships: Liquidation
Partnerships: Formation, Operation, and Changes in Membership
Multinational Accounting: Issues in Financial Reporting and Translation of Foreign Entity Statements
Multinational Accounting: Foreign Currency Transactions and Financial Instruments
Intercompany Inventory Transactions
Intercompany Transfers of Services and Noncurrent Assets
Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with
No Differential
The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
Intercorporate Acquisitions and Investments in Other Entities
Chapter # Chapter Title
Advanced Financial Accounting Overview
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3
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
The next major section of the text on multinational entities introduces two
main topics. Chapter 8 explains the accounting for foreign currency transactions,
which are increasingly becoming more common in today’s global economy. Then,
Chapter 9 explains the translation of financial statements of foreign entities into
U.S. dollars.
The subsequent major section of this text introduces the accounting for partnerships.
In particular, Chapter 10 covers the accounting for the formation and normal operation of
a partnership as well as the nuances of accounting for changes in ownership. Chapter 11
explores the winding-up process of partnership liquidation.
The next major section of the text provides a brief overview of accounting for
governmental entities. In particular, Chapter 12 introduces basic concepts related
to governmental accounting and the notion of fund accounting. Chapter 12 uses the
general fund to illustrate these basic accounting principles. Chapter 13 concludes
the discussion of governmental accounting by explaining the accounting for special
funds.
The locator bar at the beginning of each chapter will remind you of where you are relative to the topical overview illustrated in Figure 1–1.
THE DEVELOPMENT OF COMPLEX BUSINESS STRUCTURES
LO1
Understand and explain
different methods of business expansion, types of
organizational structures,
and types of acquisitions.
bak25648_ch01_001-052.indd 4
The business environment in the United States is perhaps the most dynamic and vibrant
in the world. Each day, new companies and new products enter the marketplace, and
others are forced to leave or to change substantially in order to survive. In this setting,
existing companies often find it necessary to combine their operations with those of other
companies or to establish new operating units in emerging areas of business activity.
Recent business practice has also experienced the creation of numerous less traditional
types of enterprise structures and new, sometimes novel, entities for carrying out the
enterprise’s operating and financing activities. The creation of new structures and special
entities is often a response to today’s current operating environment, with its abundant
operating risks, global considerations, and tax complexities. In some cases, however,
as evidenced by numerous lawsuits, criminal investigations, congressional actions, and
corporate bankruptcies, the legitimacy of the use of some of these structures and special
entities has been questioned. The adequacy of some of the accounting methods has also
been questioned.
Overall, today’s business environment is one of the most exciting and challenging
in history, characterized by rapid change and exceptional complexity. In this environment, regulators such as the Securities and Exchange Commission (SEC), the
Financial Accounting Standards Board (FASB), and the Public Company Accounting
Oversight Board (PCAOB) are scrambling to respond to the rapid-paced changes in
a manner that ensures the continued usefulness of accounting reports to reflect economic reality.
A number of accounting and reporting issues arise when two or more companies
join under common ownership or a company creates a complex organizational structure involving any of a variety of forms of new financing or operating entities. The
first seven chapters of this text focus on a number of these issues. Chapter 1 lays
the foundation by describing some of the factors that have led to corporate expansion and some of the types of complex organizational structures and relationships
that have evolved. Then, it describes the accounting and reporting issues related
to formal business combinations. Chapter 2 focuses on investments in the common
stock of other companies and on selected other types of investments in and relationships with other entities. Moreover, it introduces basic concepts associated with
the preparation of consolidated financial statements that portray the related companies as if they were actually a single company. The next six chapters systematically
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 5
explain additional details related to the preparation and use of consolidated financial
statements.
Today’s business environment is complex. This complexity arises when companies
do business across state and national boundaries. Each state and country has its own set
of laws, tax provisions, and risks. Moreover, each jurisdiction has a myriad of different
types of common business transactions and financial instruments, and various other factors that require unique managerial expertise. The simple business setting in which one
company has two or three manufacturing plants and produces products for a local or
regional market is much less common now than it was several decades ago. As companies grow in size and respond to their unique business environment, they often develop
complex organizational and ownership structures.
Enterprise Expansion
Most business enterprises seek to expand over time in order to survive and become profitable. Both the owners and managers of a business enterprise have an interest in seeing a
company grow in size. Increased size often allows economies of scale in both production
and distribution. By expanding into new markets or acquiring other companies already in
those markets, companies can develop new earning potential and those in cyclical industries can add greater stability to earnings through diversification. For example, in 1997,
Boeing, a company very strong in commercial aviation, acquired McDonnell Douglas,
a company weak in commercial aviation but very strong in military aviation and other
defense and space applications. When orders for commercial airliners plummeted following a precipitous decline in air travel, increased defense spending, partially related to the
war in Iraq, helped level out Boeing’s earnings.
Corporate managers are often rewarded with higher salaries as their companies
increase in size. In addition, prestige frequently increases with the size of a company
and with a reputation for the successful acquisition of other companies. As a result,
corporate managers often find it personally advantageous to increase company size.
For instance, Bernard Ebbers started his telecommunications career as the head of a
small discount long-distance telephone service company and built it into one of the
world’s largest corporations, WorldCom. In the process, Ebbers became well known
for his acquisition prowess and grew tremendously wealthy—until WorldCom was
racked by accounting scandals and declared bankruptcy and Ebbers was sentenced to
prison in 2003.
Organizational Structure and Business Objectives
Complex organizational structures often evolve to help achieve a business’s objectives, such as increasing profitability or reducing risk. For example, many companies
establish subsidiaries to conduct certain business activities. A subsidiary is a corporation that is controlled by another corporation, referred to as a parent company,
usually through majority ownership of its common stock. Because a subsidiary is a
separate legal entity, the parent’s risk associated with the subsidiary’s activities is
limited. There are many reasons for creating or acquiring a subsidiary. For example,
companies often transfer their receivables to subsidiaries or special-purpose entities
that use the receivables as collateral for bonds issued to other entities (securitization).
External parties may hold partial or complete ownership of those entities, allowing
the transferring company to share its risk associated with the receivables. In some
situations, companies can realize tax benefits by conducting certain activities through
a separate entity. Bank of America, for example, established a subsidiary to which
it transferred bank-originated loans and was able to save $418 million in quarterly
taxes.1
1
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“PNC Shakes Up Banking Sector; Investors Exit,” The Wall Street Journal, January 30, 2002, p. C2.
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Organizational Structure, Acquisitions, and Ethical Considerations
Acquisitions and complex organizational structures have sometimes been used to manipulate financial reporting with the aim of enhancing or enriching managers. Many major
corporations, taking advantage of loopholes or laxness in financial reporting requirements, have used subsidiaries or other entities to borrow large amounts of money without
reporting the debt on their balance sheets. Some companies have created special entities
that have then been used to manipulate profits.
The term special-purpose entity has become well known in recent years because of the
egregious abuse of these entities by companies such as Enron. A special-purpose entity
(SPE) is, in general, a financing vehicle that is not a substantive operating entity, usually
one created for a single specified purpose. An SPE may be in the form of a corporation,
trust, or partnership. Enron Corp., one of the world’s largest companies prior to its collapse in 2001, established many SPEs, at least some of which were intended to manipulate financial reporting. Some of Enron’s SPEs apparently were created primarily to
hide debt while others were used to create fictional transactions or to convert borrowings
into reported revenues.
Accounting for mergers and acquisitions also is an area that can lend itself to manipulation. Arthur Levitt, former chairman of the SEC, referred to some of the accounting
practices that have been used in accounting for mergers and acquisitions as “creative acquisition accounting” or “merger magic.” For example, a previously widely used method of
accounting for business combinations, pooling-of-interests, sometimes created earnings
and, in the view of many, provided misleading financial reporting subsequent to a combination. WorldCom was a company built through acquisitions, many of which were accounted
for using the pooling-of-interests method. Another approach used by many companies in
accounting for their acquisitions was to assign a large portion of the purchase price of an
acquired company to its in-process research and development, immediately expensing the
full amount and freeing financial reporting in future periods from the burden of those costs.
These practices have since been eliminated by the FASB. However, the frequency and
size of business combinations, the complexity of acquisition accounting, and the potential impact on financial statements of the accounting methods employed mean that the
issues surrounding the accounting for business combinations are of critical importance.
The scandals and massive accounting failures at companies such as Enron, WorldCom,
and Tyco, leading to heavy losses suffered by creditors, investors, employees, and others,
focused considerable attention on weaknesses in accounting and the accounting profession. In the past several years, Congress, the SEC, and the FASB have taken actions to
strengthen the financial reporting process and to clarify the accounting rules relating to
special entities and to acquisitions.
BUSINESS EXPANSION AND FORMS OF ORGANIZATIONAL STRUCTURE
Historically, businesses have expanded by internal growth through new product development and expansion of existing product lines into new markets. In recent decades,
however, many companies have chosen to expand by combining with or acquiring other
companies. Either approach may lead to a change in organizational structure.
Internal Expansion
As companies expand from within, they often find it advantageous to conduct their
expanded operations through new subsidiaries or other entities such as partnerships, joint
ventures, or special entities. In most of these situations, an identifiable segment of the
company’s existing assets is transferred to the new entity, and, in exchange, the transferring company receives equity ownership (as illustrated in the diagram on the next page).
Companies may be motivated to establish new subsidiaries or other entities for a variety of reasons. Broadly diversified companies may place unrelated operations in separate
subsidiaries to establish clear lines of control and facilitate the evaluation of operating
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 7
P
Internal
expansion
S Stock Assets
S
results. In some cases, an entity that specializes in a particular type of activity or has its
operations in a particular country may qualify for special tax incentives. Of particular
importance in some industries is the fact that a separate legal entity may be permitted
to operate in a regulatory environment without subjecting the entire entity to regulatory
control. Also, by creating a separate legal entity, a parent company may be able to protect
itself from exposing the entire company’s assets to legal liability that may stem from a
new product line or entry into a higher-risk form of business activity.
Companies also might establish new subsidiaries or other entities, not as a means of
expansion, but as a means of disposing of a portion of their existing operations through
outright sale or a transfer of ownership to existing shareholders or others. In some cases,
companies have used this approach in disposing of a segment of operations that no longer fits well with the overall mission of the company. In other cases, this approach has
been used as a means of disposing of unprofitable operations or to gain regulatory or
shareholder approval of a proposed merger with another company. A spin-off occurs
when the ownership of a newly created or existing subsidiary is distributed to the parent’s stockholders without the stockholders surrendering any of their stock in the parent
company. Thus, the company divests itself of the subsidiary since it is owned by the company’s shareholders after the spin-off. A split-off occurs when the subsidiary’s shares
are exchanged for shares of the parent, thereby leading to a reduction in the outstanding
shares of the parent company. While the two divestiture types are similar, the split-off
could result in one set of the former parent shareholders exchanging their shares for those
of the divested subsidiary. Although a transfer of ownership to one or more unrelated
parties normally results in a taxable transaction, properly designed transfers of ownership
to existing shareholders generally qualify as nontaxable exchanges.
External Expansion through Business Combinations
Many times companies find that entry into new product areas or geographic regions is
more easily accomplished by acquiring or combining with other companies than through
internal expansion. For example, SBC Communications, a major telecommunications
company and one of the “Baby Bells,” significantly increased its service area by combining with Pacific Telesis and Ameritech, later acquiring AT&T (and adopting its name), and
subsequently combining with BellSouth. Similarly, since the state of Florida has traditionally been very reluctant to issue new bank charters, bank corporations wishing to establish
operations in Florida have had to acquire an existing bank to obtain a charter in the state.
A business combination occurs when “. . . an acquirer obtains control of one or more
businesses.”2 The diagram on the next page illustrates a typical acquisition. The concept of control relates to the ability to direct policies and management. Traditionally,
control over a company has been gained by acquiring a majority of the company’s common stock. However, the diversity of financial and operating arrangements employed in
recent years also raises the possibility of gaining control with less than majority ownership or, in some cases, with no ownership at all through other contractual arrangements.
The types of business combinations found in today’s business environment and the
terms of the combination agreements are as diverse as the firms involved. Companies
2
Financial Accounting Standards Board Statement No. 141 (revised 2007), “Business Combinations,”
December 2007, para. 3e. (ASC 805-10-65-1)
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
$
P
External
expansion
S Shareholders
S Stock
S
enter into various types of formal and informal arrangements that may have at least some
of the characteristics of a business combination. Most companies tend to avoid recording
informal agreements on their books because of the potential difficulty of enforcing them.
In fact, some types of informal arrangements, such as those aimed at fixing prices or
apportioning potential customers, are illegal. Formal agreements generally are enforceable and are more likely to be recognized on the books of the participants.
Informal Arrangements
Informal arrangements take many different forms. A simple gentlemen’s agreement may
be all that is needed to establish an amiable long-term relationship in a joint business venture. In other cases, companies with complementary products or services develop implicit
working relationships. For example, a building contractor might always use a particular
electrical or plumbing subcontractor. Some companies form strategic alliances for working
together on a somewhat more formal basis. For example, Washington Mutual, the country’s largest thrift organization, formed a strategic alliance with SAFECO Corporation to
distribute SAFECO annuities through Washington Mutual’s multistate branch network.
Many airlines, such as American with Qantas and Delta with Air France-KLM, routinely
enter into route-sharing or code-sharing agreements with one another, and many other
well-known companies have entered into strategic agreements, such as Microsoft with Sun
Microsystems, Microsoft with Nortel, eBay with VeriSign, Boeing with IBM, and AOL
with Google. Companies that partially depend on each other may use interlocking directorates, in which one or more members serve on the boards of directors of both companies, as a
means of providing a degree of mutual direction without taking formal steps to join together.
The informality and freedom that make informal arrangements workable also are
strong factors against combining financial statements and treating the companies as if
they were a single entity. Another key factor in most informal arrangements is the continuing s…
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