HW$-7$ & $8$ Comprehensive Problem $($I use P and S to refer to the parent and subsidiary$)$

Pequity Company purchased $85\%$ of the common stock of Sequity Company on April $1,$ Year

$1.$ The fair value of the consideration transferred consisted of a cash payment of $$545,000$ and

contingent consideration as described in the earnout agreement below. Under the agreement, $545000$

Pequity Company agrees to pay an earn$-$out $($contingent consideration$)$ to the stockholders of

Sequity as part of the consideration for their shares. The Company has the option of paying any

earn$-$out in cash and$/$or shares of its common stock and has estimated the fair value of the con$-$

tingent consideration to be $$50,000.$ Acquisition$-$related costs of $$20,000$ are included in other

expenses. Sequity will become a reportable segment for consolidated purposes. No control premium

was included in the offer price.

On the acquisition date, the book values and fair values of Sequity$$s assets and liabilities were equal

with the following exceptions:

Book Value Fair Value

Inventory $116,000146,00030,000$

Property & Equipment $465,000507,00042,000$

The increase in Property & Equipment will be depreciated over seven years. The Company uses

the full year convention for depreciation $($a full year's depreciation in the first year$).$

All fair value estimates were considered final $($no measurement period adjustments$).$

All inventory acquired was sold by year$-$end.

Earnout $($ContingentConsideration$)$ Agreement $$ Pequity and Sequity Company

April $1,$ Year $1$

The agreed$-$upon earn$-$out has three components. If the yearly revenue of Sequity exceeds a

target level at the end of years $1,2,$ and $3,$ Pequity will pay the shareholders of Sequity an

amount equal to $50\%$ of the excess, up to $$85,000$ per year for a maximum earn$-$out payment of

$$255,000$ in total.

The initial target revenue level for year $1$ is $$1,300,000$ and increases in amount by $5\%$ per

year. Target levels in years $2$ and $3$ will be $$1,365,000$ and $$1,433,250.$ Pequity estimates the

fair value of the earn$-$out using the present value of expected payments and its incremental bor$-$

rowing rate adjusted for risk of $20\%.$ The fair value of the three earn$-$outs was estimated to be

$$50,000$ on the date of acquisition, computed as follows:

Fair Value of Contingent Consideration

Year $1$ Year $2$ Year $3$ Total

Estimated Revenues of Sequity $$1,300,000$ $$1,415,600$ $$1,541,250$

Target level Revenues $1,300,0001,365,0001,433,250$

Estimated Excess $050,600108,000$

Reduced by $50\%0\mathrm{.}50\mathrm{.}50\mathrm{.}5$

Potential Payout $025,30054,000$

Present Value Factor $0\mathrm{.}8760\mathrm{.}7190\mathrm{.}589$

Fair value of Earn$-$Out $018,18031,820$ $$50,000$

Changes in fair value and interest charges are included in $$other expense $($income$)$

on the income statement.

Balance Sheet

Beginning of Year $1($January $1)$

Pequity Sequity

Cash $$100,000$ $$15,000$ $$115,0007000($$$108,000)$

Accounts Receivables $170,000115,000$ $$285,000308000$ $$23,000$

Inventory $220,000122,000$ $$342,000392000$ $$50,000$

Property and Equipment $850,000450,000$ $$1,300,0001497000$ $$197,000$

Total $$1,340,000$ $$702,000$ $$2,042,000$ $$2,204,000$ $$162,000$

Accounts and Notes Payable $$65,000$ $$169,000$ $$234,000384500($$$150,500)$

Dividends Payable $-50,000$ $$50,0002000$ $$48,000$

Capital Stock, $$5$ par value $220,00040,000$ $$260,000270000($$$10,000)$

Other Contributed Capital $700,000250,000$ $$950,000900000$ $$50,000$

Retained Earnings $355,000241,000$ $$596,000647500($$$51,500)$

Treasury Stock $(48,000)($$$48,000)0($$$48,000)$

Total $$1,340,000$ $$702,000$ $$2,042,000$ $$2,204,000($$$162,000)$

Sequity Company

Trial Balance on

April $1,$ Year $1$ April $1,$ Year $1$

Sequity

Cash $$11,000$

Accounts Receivables $121,000$

Inventory $116,000$

Property and Equipment $465,000$

Cost of goods sold $188,500$

Selling, General, & Administration $40,000$

Other expenses $22,500$

Treasury Stock $48,000$

Total $$1,012,000$

Accounts and Notes Payable $$156,000$

Dividends Payable $-$

Capital Stock, $$5$ par value $40,000$

Other Contributed Capital $250,000$

Retained Earnings $1/1/$Yr $1241,000$ NI

Sales $325,000114,000$

Total $$1,012,000$