**Consolidated Financial Statements – Mergers, Acquisitions, and Equity Method

Consolidated financial statements present the financial position and operating results of a parent company and its subsidiaries as if they were a single economic entity. This requires consolidating the assets, liabilities, revenues, and expenses of the parent and its controlled subsidiaries. Control is generally defined as owning more than 50% of the subsidiary's voting rights, although control can exist even with less than 50% ownership if other factors indicate control (e.g., contractual agreements). The primary purpose is to provide a comprehensive view of the entire group's performance. The parent company and subsidiaries will each prepare their own financial statements. However, these will then be aggregated using various adjustments and eliminations.

Example: Imagine Company A owns 80% of Company B. Both prepare their own income statements. In the consolidated income statement, Company A will include 100% of Company B's revenues, expenses, assets, and liabilities. However, the 20% ownership that Company A does not control must be accounted for by the Non-Controlling Interest (NCI) section. NCI represents the portion of the subsidiary's equity that the parent company does not own, and it appears on the consolidated balance sheet and income statement (for net income).

The acquisition method is the primary method for accounting for business combinations (mergers and acquisitions). This is the only method used under IFRS and US GAAP standards. Under this method, the acquirer recognizes the identifiable assets acquired and liabilities assumed at their fair values at the acquisition date. Any excess of the consideration transferred over the net fair value of identifiable assets and liabilities is recognized as goodwill. If the consideration transferred is less than the fair value of net assets acquired, the acquirer recognizes a gain on the bargain purchase. The acquired company's financial statements are then consolidated with the parent's starting from the acquisition date.

Calculation steps:
1. Determine the Fair Value of the Acquired Company: This includes the purchase price paid (cash, stock, other assets), and any consideration.
2. Identify and Measure Identifiable Assets and Liabilities at Fair Value: Perform an independent valuation.
3. Calculate Goodwill: Purchase Price - Net Asset Fair Value.
4. Consolidate: Combine the financials of the acquirer and acquiree after all necessary adjustments (fair value adjustments and elimination of intercompany transactions).

Example: Company X acquires Company Y for $10 million in cash. Company Y has net identifiable assets with a fair value of $8 million. Goodwill is therefore $2 million. In the consolidated financial statements, Company X will include all the assets and liabilities of Company Y at their fair values, adding goodwill of $2 million to its balance sheet. Further, Company X will reflect the net income or loss of Company Y, with the appropriate adjustments to reflect NCI.

The equity method is used to account for investments in associates, which are companies where the investor has significant influence but not control (typically 20-50% ownership of voting rights). Under the equity method, the investment is initially recorded at cost. The investor then recognizes its share of the associate's profit or loss in its income statement (Equity in Earnings/Loss). The investment balance is increased by the investor's share of the associate's profits and decreased by dividends received from the associate. This reflects the economic reality that the investor is essentially earning its share of the associate's profits. This method provides a more accurate view than simply recording dividends received as revenue.

Key principles:
1. Initial Investment: Recorded at cost.
2. Share of Profit/Loss: Investor's share is recognized in the income statement (Equity in Earnings/Loss).
3. Dividends: Dividends received reduce the investment balance.
4. Adjustments for Fair Value Differences: Any difference between the carrying value of the associate's assets/liabilities and their fair value must be amortized over the asset's useful life, impacting the investor's share of profit.

Example: Company Z owns 30% of Company W. Company Z initially invests $5 million. Company W reports net income of $2 million, and declares dividends of $500,000 during the year. Company Z will recognize equity in earnings of $600,000 (30% * $2 million), increasing its investment balance. Company Z also recognises dividends received of $150,000 (30% * $500,000), reducing the investment balance. The income statement will reflect Equity in Earnings of $600,000.

A crucial part of consolidation is eliminating intercompany transactions to avoid double-counting. This covers transactions between the parent and its subsidiaries or between the subsidiaries themselves. These include:

• Intercompany Sales and Purchases: Eliminate intercompany revenue and cost of goods sold. Any unrealized profit (inventory sold internally but not to an outside party) must be deferred.
• Intercompany Loans: Eliminate intercompany interest income and expense. Similarly, you must eliminate intercompany payables and receivables.
• Intercompany Dividends: These dividends are eliminated in consolidation, as they represent a transfer within the group.
• Elimination of Investments in Subsidiaries: The parent's investment in its subsidiary is eliminated against the subsidiary's equity (primarily common stock and retained earnings) at the acquisition date.

Example: Company A sells inventory to its subsidiary, Company B, for $100,000, with a profit of $20,000. Company B still has this inventory on hand at year-end. In the consolidated statements, the $100,000 of intercompany sales and cost of goods sold need to be eliminated. Further, the $20,000 of unrealized profit in inventory needs to be deferred by decreasing ending inventory (reducing assets) and reducing consolidated retained earnings (reducing equity), thereby cancelling out the impact of the profit from the intercompany transaction until the inventory is sold to an outside party.