Problem 4-20

Pcost Company purchased 85% of the common stock of Scost Company on April 1, Year 1. The fair value of the consideration transferred consisted of a cash payment of $536,692 and contingent consideration as described in the earnout agreement below. Under the agreement, Pcost Company agrees to pay an earn-out (contingent consideration) to the stockholders of Scost 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 contingent consideration to be $52,868. Acquisition-related costs of $20,000 are included in other expenses. Scost will become a reportable segment for consolidated purposes. No control premium was included in the offer price. Both companies have a December 31 year-end. Trial balances for Pcost and Scost on April 1, Year 1 were:

		At April 1, Year 1
		Pcost		Scost
Cash		$28,200		$10,800
Accounts Receivables		124,800		121,300
Inventory		229,200		116,900
Treasury Stock at Cost, 500 Shares		0		48,100
Investment in Scost Company		589,560		0
Property and Equipment (net)		856,100		458,300
Cost of Goods Sold		382,400		187,700
Selling, General, & Administration		79,100		39,800
Other Expenses		24,100		22,300
Dividends Declared		0		0
Total		$2,313,460		$1,005,200
Accounts Payable		$214,000		$156,600
Contingent Consideration		52,868
Dividends Payable		0		0
Common Stock, $5 par value		273,400		40,000
Other Contributed Capital		884,900		247,300
Retained Earnings, 1/1		348,100		236,800
Sales		540,192		324,500
Dividend Income		0		0
Total		$2,313,460		$1,005,200

On the acquisition date, the book values and fair values of Scosts assets and liabilities were equal with the following exceptions.

		Book Value		Fair Value
Inventory		116,900		147,200
Property and Equipment		458,300		500,700

The increase in Property and Equipment will be depreciated over seven years. All fair value estimates will be considered final (no measurement period adjustments). Earnout (Contingent Consideration) AgreementPcost and Scost Company April 1, Year 1 The agreed-upon earn-out has three components. If the yearly revenue of Scost exceeds a target level at the end of years 1, 2, and 3, Pcost will pay the shareholders of Scost an amount equal to 50% of the excess, up to $84,100 per year for a maximum earn out payment of $252,300 in total. The initial target revenue level for year 1 is $1,310,000 and increases in amount by 5% per year. Target levels in years 2 and 3 will be $1,375,500 and $1,444,275. Pcost estimates the fair value of the earn-out using the present value of expected payments and its incremental borrowing rate adjusted for risk of 20%. The fair value of the three earn-outs was estimated to be $52,868 on the date of acquisition, computed as follows: Fair Value of Contingent Consideration

		Year 1		Year 2		Year 3		Total
Estimated Revenues of Scost		$1,310,000		$1,422,700		$1,566,175
Target level Revenues		1,310,000		1,375,500		1,444,275
Estimated excess		0		47,200		121,900
Reduced by 50%		0.50		0.50		0.50
Potential payout		0		23,600		60,950
Present value factor		0.876		0.719		0.589
Fair value of earn-out		0		16,968		35,900		$52,868

Changes in fair value and interest charges are included in other expense (income) on the income statement.

(a)

Prepare a consolidated balance sheet workpaper on the date of acquisition. You can assume that Scost closes its books on this date to facilitate consolidation.