Advanced financial accounting by baker chapter 03

Consolidated Financial Statements• Consolidated financial statements present the financial position and results of operations for a parent controlling entity and one or more subsidiarie

The Reporting Entity and Consolidated Financial Statements

3

Consolidated Financial Statements

• Consolidated financial statements present the financial position and results of

operations for a parent (controlling entity) and one or more subsidiaries (controlled

entities) as if the individual entities actually were a single company or entity.

Consolidated Financial Statements

• Consolidation is required when a corporation owns a

majority of another corporation’s outstanding common

stock and occasionally under other circumstances.

• Two companies are considered to be related when one

controls the other or both are under the common control

of another entity.

• The same accounting principles should be applied in

preparing consolidated financial statements as in

preparing separate-company financial statements.

• More useful than the separate financial statements of the individual companies when the companies are related

Benefits of Consolidated Financial

Statements

• Presented primarily for those parties having a

long-run interest in the parent company, including its

management, shareholders, long-term creditors or

other resource providers.

• Often provide the only means of obtaining a clear

picture of the total resources of the combined entity that are under the parent's control.

Limitations of Consolidated Financial

Statements

• Results of individual companies included in the consolidation are not disclosed, thereby hiding poor performance

• Not all the consolidated retained earnings

balance is necessarily available for

dividends of the parent.

• Financial ratios are not necessarily

representative of any single company in the consolidation.

Limitations of Consolidated Financial

Statements

• Similar accounts of different companies that are combined in the consolidation may not

be entirely comparable.

• Additional information about companies

may be needed for a fair presentation, thus requiring voluminous footnotes.

• Information is lost any time data sets are

aggregated.

Subsidiary Financial Statements

• Creditors, preferred stockholders, and

noncontrolling common stockholders of

subsidiaries are most interested in the separate financial statements of the subsidiaries in which they have an interest

• Because subsidiaries are legally separate from

their parents, the creditors and stockholders of

a subsidiary generally have no claim on the

parent, and the stockholders of the subsidiary do not share in the profits of the parent

Concepts and Standards

• Professional guidance is provided in ARB 51,

FASB 94, and FASB 160.

• Traditional view of control

– ARB 51 indicates that consolidated financial

statements normally are appropriate for a group of

companies when one company “has a controlling

financial interest in the other companies.”

– FASB 94 requires consolidation of all majority-owned

subsidiaries unless the parent is unable to exercise

control.

Concepts and Standards

• Less Than Majority Ownership

– A company may be able to direct the operating and

financing policies of another with less than majority

ownership.

– FASB 94 does not preclude consolidation with less

than majority ownership, but such consolidations have seldom been found in practice

– FASB 141R indicates that control can be obtained

without majority ownership of a company’s common

stock.

Concepts and Standards

• Traditional view of control includes:

– Direct control that occurs when one

company owns a majority of another

company’s common stock

– Indirect control or pyramiding that occurs

when a company’s common stock is owned

by one or more other companies that are all

under common control

Concepts and Standards

• Ability to Exercise Control

– Sometimes, majority stockholders may not be

able to exercise control even though they hold

more than 50 percent of outstanding voting stock

• Subsidiary is in legal reorganization or bankruptcy

• Foreign country restricts remittance of subsidiary profits to domestic parent company

– The unconsolidated subsidiary is reported as an intercorporate investment.

Concepts and Standards

• Differences in Fiscal Periods

– Difference in the fiscal periods of a parent and subsidiary should not preclude consolidation

– Often the fiscal period of the subsidiary is

changed to coincide with that of the parent

– Another alternative is to adjust the financial

statement data of the subsidiary each period

to place the data on a basis consistent with

the fiscal period of the parent

Concepts and Standards

• Changing Concept of the Reporting Entity

– FASB 94, requiring consolidation of all

majority-owned subsidiaries, was issued to eliminate the

inconsistencies found in practice until a more

comprehensive standard could be issued

– Completion of the FASB’s consolidation project

has been hampered by, among other things,

issues related to:

• Control

• Reporting entity

Concepts and Standards

• FASB has been attempting to move toward a consolidation requirement for entities under

effective control

– Ability to direct the policies of another entity even

though majority ownership is lacking.

– Even though FASB 141R indicates that control can

be achieved without majority ownership, a

comprehensive consolidation policy has yet to be

achieved.

Concepts and Standards

• Defining the accounting entity would help

resolve the issue of when to prepare

consolidated financial statements and what

entities should be included

• FASB 160 deals only with selected issues

related to consolidated financial statements,

leaving a comprehensive consolidation policy

until a later time

Consolidation Process- Overview

• Starting point: Separate financial statements of

the companies involved

• Separate statements are added together, after

some adjustments and eliminations, to generate consolidated statements

– Adjustments and eliminations relate

to intercompany transactions and

holdings.

Parent

Subsidiary

Consolidation Process

• Intercorporate Stockholdings

– Common stock of the parent is held by

those outside the consolidated entity and

is viewed as the common stock

of the entire entity.

– Common stock of the subsidiary is held entirely

within the consolidated entity and is not stock

outstanding from a consolidated viewpoint.

– Note: A company cannot report in its financial

Consolidation Process

• Intercorporate Stockholdings

– Parent’s retained earnings (less the

unrealized intercompany profit) remains

as the only retained earnings figure

in the consolidated balance sheet.

Parent

Subsidiary

Subsidiary’s common stock

Parent’s common stock

Consolidation Process

• Intercompany Receivables and Payables

– A single company cannot owe itself money,

that is, a company cannot report (in its

financial statements) a receivable to itself and

a payable to itself

– Therefore, an intercompany

receivable/payable is eliminated

from both receivables and

payables in preparing the

consolidated balance sheet

Parent

Subsidiary

Intercompany receivable/ payable

Consolidation Process

• Intercompany Sales

– The sale should be removed from the

combined revenues because it does not

represent a sale to an external party

• Remaining inventory must be restated to its original cost to the consolidated

entity (transferring affiliate).

Parent

Cost of goods

Sales

Consolidation Process

• Difference between Fair Value and Book Value

– Fair value of the consideration given usually

reflects the fair value of the acquired company

and differs from its book value

– An acquiree’s assets and liabilities must be

valued based on their acquisition-date fair values, and any excess of the consideration given over

the fair values of the net assets is considered

goodwill.

Consolidation Process

– To understand the adjustments needed, one

should focus on:

1 identifying the treatment accorded a particular

item by each of the separate companies and

2 identifying the amount that would appear in the

financial statements with respect to that item if the consolidated entity were actually a single company.

Mechanics of the Consolidation

Process

• A worksheet is used to facilitate the process of

combining and adjusting the account balances

involved in a consolidation

• While the parent company and the subsidiary

each maintain their own books, there are no

books for the consolidated entity

• The balances of the accounts are taken at the

end of each period from the books of the parent

and the subsidiary and entered in the

consolidation workpaper

Mechanics of the Consolidation

Process

• Where the simple adding of the amounts from

the two companies leads to a consolidated figure different from the amount that would appear if

the two companies were actually one, the

combined amount must be adjusted to the

desired figure

• This is done through the preparation of

eliminating entries.

Noncontrolling Interest

• For the parent to consolidate the subsidiary,

only a controlling interest is needed—not 100% interest

• Those shareholders of the subsidiary other than the parent are referred to as “noncontrolling” or

“minority” shareholders

• Noncontrolling interest or minority interest refers

to the claim of these shareholders on the income and net assets of the subsidiary

Noncontrolling Interest

• Computation of income to the noncontrolling

interest: In uncomplicated situations, it is a

simple proportionate share of the subsidiary’s

net income

• Presentation: FASB 160 requires that the term

“consolidated net income” be applied to the

income available to all stockholders, with the

allocation of that income between the controlling and noncontrolling stockholders shown

Noncontrolling Interest

• The noncontrolling interest’s claim on the net

assets of the subsidiary was previously shown

between liabilities and stockholders’ equity in the consolidated balance sheet

– Some firms reported minority interest as a liability,

although it did not meet the definition of a liability.

• FASB 160 makes clear that the noncontrolling

interest’s claim on net assets is an element of

equity, not a liability

Combined Financial Statements

• Financial statements are also prepared for a group of companies when no one company in the group owns a majority of the common

stock of any other company in the group.

• Combined financial statements are those that include a group of related companies without including the parent company or other owner.

– Procedures are essentially the same as those used in preparing consolidated financial statements.

Special Purpose Entities

• Corporations, trusts, or partnerships created for a single specified purpose

• Usually have no substantive operations and

are used only for financing purposes

• Used for several decades for asset

securitization, risk sharing, and taking

advantage of tax statutes.

Special Purpose Entities

• Qualifying SPEs

– Types of SPEs widely used for servicing

financial assets and meet very restrictive

conditions established by FASB 140

– Conditions generally require that the SPE be

“demonstrably distinct from the transferor,” its activities be significantly limited, and it hold

only certain types of financial assets

Variable Interest Entities

• A legal structure used for business

purposes, usually a corporation, trust, or

partnership, that either:

– Does not have equity investors that have

voting rights and share in all profits and

losses of the entity

– Has equity investors that do not provide

sufficient financial resources to support the

entity’s activities

Variable Interest Entities

• FIN 46 (an interpretation of ARB 51) uses the

term variable interest entities to encompass

SPEs and other entities falling within its

conditions

– Does not apply to entities that are considered SPEs

under FASB 140.

• FIN 46R defines a variable interest in a VIE as a

contractual, ownership (with or without voting

rights), or other money-related interest in an

entity that changes with changes in the fair value

of the entity’s net assets exclusive of variable

interests

Different Approaches to

Consolidation

• Theories that might serve as a basis for

preparing consolidated financial statements:

– Proprietary theory

– Parent company theory

– Entity theory

• With the issuance of FASB 141R, the

FASB’s approach to consolidation has moved very much toward the entity theory.

Recognition of Subsidiary Income

Proprietary Theory

• Views the firm as an extension of its owners.

• Assets and liabilities of the firm are

considered to be those of the owners.

• Results in a pro rata consolidation where the parent consolidates only its proportionate

share of a less-than-wholly owned

subsidiary’s assets, liabilities, revenues and

expenses.

Parent Company Theory

• Recognizes that though the parent does not

have direct ownership or responsibility, it has the ability to exercise effective control over all

of the subsidiary’s assets and liabilities, not

simply a proportionate share.

• Separate recognition is given, in the

consolidated financial statements, to the

assets and earnings of the subsidiary.

Entity Theory

• Focuses on the firm as a separate

economic entity, rather than on the

ownership rights of the shareholders.

• Emphasis is on the consolidated entity

itself, with the controlling and

noncontrolling shareholders viewed as two separate groups, each having an equity in the consolidated entity.

Current Practice

• FASB 141R has significantly changed the

preparation of consolidated financial

statements subsequent to the acquisition

of less-than-wholly owned subsidiaries.

– Under FASB 141R consolidation follows

largely an entity-theory approach

– Accordingly, the full entity fair value increment and the full amount of goodwill are

recognized

Current Practice

• Current approach clearly follows the entity theory with minor modifications aimed at

the practical reality that consolidated

financial statements are used primarily by those having a long-run interest in the

parent company.