FINANCIAL ACCOUNTING
THEORY AND ANALYSIS:
TEXT AND CASES
11TH EDITION
RICHARD G.
SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY
CHAPTER 16
ACCOUNTING FOR
MULTIPLE ENTITIES
Introduction


Businesses find it useful to combine
operations for efficiencies of scale
Accounting issues for
multiple entities:



Business combinations
Consolidations and segment reporting
Foreign currency translation
Business Combinations
Wyatt’s classifications

1.
2.
3.
Classical era
Second wave
Third era
Why do businesses combine?

1.
2.
3.
4.
5.
Tax consequences
Growth and diversification
Financial considerations
Competitive pressure
Profit and retirement
Business Combinations
Two methods of acquisition

1.
2.
Cash
Exchange of stock
Accounting Method
Accounting Treatment
Purchase
Fair Market Value
& Goodwill
Pooling of Interests
Book Value
Criticisms of the Pooling of
Interests Method

Accounting is distorted



Investment is not disclosed
Assets undervalued
Income overstated in
subsequent years

FASB decision


Economic consequences
arguments
2001: SFAS 141 (FASB ASC
805) abolished further use
The Fresh Start Method


Some combinations are a merger of
equals in which none of the combined
companies survive
Revalue all assets as if it were a newly
formed entity
The Purchase Method

Must be used




When one company acquires the net assets of a business
And also obtains control over that business
SFAS No. 141 applies to both
incorporated and
unincorporated businesses
2007: Revised standard
SFAS No. 141(R) (FASB ASC 805)
The Acquisition Method
SFAS No. 141(R): broadened scope of purchases
Changed name to acquisition method
When a business combination is created by an
exchange of stock, requires that the following
“pertinent facts and circumstances” be taken into
consideration (FASB ASC 805-10-55-12) :



a.
b.
c.
d.
e.

The relative voting rights
The existence of a large minority voting interest
The composition of the governing body
The composition of senior management
The terms of exchange of equity securities.
Subsequently allocate cost to all
identifiable assets with remainder to
goodwill
Steps in The Acquisition Method
Identify acquiring entity
Determine cost of acquisition




Historical cost prior to SFAS No. 141
Revised standard: acquirer must recognize all
assets acquired, liabilities assumed, and any
noncontrolling interest at fair value (exit value)
Business Combinations II

FASB – IASB project on business combinations



Phase 1- Valuation of intangibles (IFRS No. 3 and
SFAS No. 141)
Phase 2 – Develop a common set of principles
intended to improve the completeness, relevance and
comparability of financial information about business
combinations.
2007: FASB determined business combinations
should be recorded at fair value as defined is
SFAS ASC 820

Now used under guidelines in FASB ASC 805
Consolidation



When one business organization has control over
another they should report as a unified whole
Now required by FASB ASC 810-10-25
ARB No. 51 criteria






Parent-subsidiary relationship
Control
Maintenance of control
Operate as integrated unit
Approximate fiscal years
Principles


Cannot own or owe itself
Cannot make a profit by selling to itself
The Concept of Control

The power of one entity to direct or cause the direction of the
management and operating and financing policies of another
entity
Should control be presumed in
cases of less than 50% ownership?

Control is presumed when the parent
 Owns the majority of the subsidiary’s outstanding common
stock
 Has the ability to dominate the subsidiary’s board of directors
 Has the ability to dissolve the entity
The Modified Approach
to Control
FASB Exposure Draft
Asks the question:
Is consolidation required?


Is the entity a special purpose entity and is it a
transferor or its affiliate?
1.

Are the permitted activities and powers of the entity significantly
linked?
2.

If not the presumption of control exists
Are powers limited? Can the party change the entity’s purpose?
3.


4.
(Use SFAS No 140 – see FASB ASC 860 – criteria)
If so consolidate
Also consolidate if no new cash outlay or benefits exceed new cash
outlay
If step 3 does not require consolidation, assess whether variable
interests are significant
Theories of Consolidation
Entity theory
Emphasis is on control of a
group of legal entities operating
as a single unit
Parent company
theory
Purpose of consolidated
statements is to provide
information for parent company
stockholders
Noncontrolling Interest


Definition
Placement




Liability
Separately presented
Stockholder equity
Noncontrolling interest and theories of
consolidation



Doesn’t meet SFAC definition of liability
FASB ED suggests “non-controlling interest in
subsidiaries”
Report as separate component of stockholders’ equity
Additional Issues

Proportionate consolidation


Ignore minority interest
Goodwill
Should it be attributed to
minority interest?

Drawbacks to consolidation

Loss of information
Special Purpose Entities




Partnership, corporation, trust, or joint
venture
 Created for a limited purpose
 Limited life and limited activities
 Designed to benefit a single company
Primary motive for most SPEs
 Off-balance sheet financing
 Often to avoid reporting capital leases under SFAS No. 13
(See FASB ASC 840)
Companies are able to avoid consolidation of SPEs in which
they do not have a majority voting interest
SPE is created by an asset transfer
 The assets are sold to the SPE
 To achieve off-balance sheet treatment
 Minimum (previously 3%, now 10%) investment from an
independent third party investor is required
Special Purpose Entities

SFAS No. 140, “Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities”
Outlines requirements to qualify an SPE for non-consolidation


Transferor company, has surrendered control over the transferred
assets (and thus has a sale) when all of the following conditions are
met:
The transferred assets have been put beyond the reach of the transferor
and its creditors
Each transferee (SPE) has the right to pledge or exchange the assets and
no conditions constrain the transferee from taking advantage of its right to
pledge or exchange
The transferor does not maintain effective control over
the transferred assets through either
a.
b.
c.
1.
2.
An agreement that entitles and obligates the transferor to
repurchase or redeem the transferred assets before
maturity or
The ability to unilaterally cause the holder to return
specific assets, other than through a cleanup call
Special Purpose Entities
FIN No. 46, 2003, “Consolidation of Certain Special
Purpose Entities”


Later amended by FIN 46R
Company may have controlling financial interest but
no voting interest


Variable interest entities (VIEs)
Intent: require consolidation only if VIE did not effectively
disperse risks and benefits
SFAS No. 167, Dec. 2009, “Amendments fo FASB
Interpretation No. 46(R)




Required analysis of controlling financial interest in VIE
Assess whether a company has implicit financial responsibility
Segmental Reporting


Required under SFAS No. 131 (FASB ASC 280)
How it became a factor



Why important?



SEC line-of-business reporting
NYSE recommendations
Various operations may have differing prospects for growth
rate of profitability and degrees of risk
Assessment of decentralized management
What to disclose



Operations in different industries
Foreign operations
Major customers
SFAS No 14 (1976, since superseded) Criteria

Definition





Identity segment
Reportable segment
Revenue
Operating profit or
loss
Identifiable assets

Reporting guidelines



Reportable segments
Information to be
disclosed
Where to disclose
SFAS No. 131(FASB ASC 280-10-50-20 to 25)



Operating segment
Report balance sheet
and income statement information
about each operating segment
Include other specified information



If it is included in the measurement of segment profit
Include other geographic information
Include reliance on major customers
FASB ASC 280



Goal: use enterprise’s internal organization so
reportable operating segments will be readily
evident
Definition of operating segment
Major problems:



Determination of reportable segments
Allocation of joint costs
Transfer pricing
Reportable Segments

Meet any of following quantitative thresholds
1.
2.
3.


Reported revenue is >= 10% of combined revenue
Reported profit (loss) >= 10% of combined profit (loss)
Assets >= 10% of combined assets
Some segments can be aggregated
FASB ASC 280-10-50 requires
specific disclosures
Foreign Currency Translation



Foreign currency translation issues
 Increase of foreign operations
 Allowing dollar to float on world market
Necessary to state financial statements in a
common measuring unit
Problems:



When do you measure difference?
How do you translate specific assets and liabilities
Methods of translation




Current – Noncurrent
Monetary – Nonmonetary
Current Rate Method
Temporal Method
FASB and Foreign Currency Translation

SFAS No. 8 (since superseded)







Closely follows the temporal method
Measure in conformity with US GAAP
Record transactions at initial exchange rate
Use balance sheet date or measurement date as
basis for translation of balance sheet items
Use transaction date for revenues and expenses
Exchange gains and losses in income
Gains and losses from foreign exchange contracts in
income
FASB and Foreign Currency Translation

SFAS No. 52 (FASB ASC 830)







SFAS No. 8 produced distortions
SFAS No. 52 adopted functional currency
approach
Record transactions in functional currency
Adjust, if necessary to comply with GAAP
Translate into currency of reporting
company
Transaction gains and losses reported in
OCI
If local currency is not functional currency
- gains and losses in income
Foreign Currency Translation – Additional Issues

Translation vs. Remeasurement



Translation – expressing amounts denominated
or measured in a different currency
Remeasurement – measuring transactions
originally denominated in a different unit of
currency (use temporal method
Foreign currency hedges



Fair value hedge
Cash flow hedge
Hedge of net investment in foreign operations
International Accounting Standards

The IASC has issued standards dealing with the
following issues:
Revised IAS No. 27 (2008): Consolidated Financial
Statements and Accounting for Investments in
Subsidiaries


More in line with U. S. GAAP
Standard to be applied
1.
2.

For group of entities under control of a parent, and
Accounting for investments when entity presents separate financial
statements
Consolidation required




Ownership of > 50% of voting rights
Ability to govern
Ability to appoint or remove majority of board of directors
Ability to cast majority votes at board of directors meetings
IAS No. 27: Consolidated Financial Statements and
Accounting for Investments in Subsidiaries

Parent companies should present
consolidated financial statements
 When it has the ability to control its subsidiaries
Major Revisions to IAS No. 27
IAS No. 27 permits wholly
owned (and virtually
wholly-owned)
subsidiaries to be
excluded from
consolidation
If the exemption is
applied, an entity should
disclose:
1.
2.
a.
b.
The reason for not
publishing consolidated
financial statements
The name of the parent
that publishes
consolidated financial
statements that comply
with IFRS.
3.
4.
Minority interests should
be presented in equity,
separately from parent
shareholders' equity.
The exemptions from
consolidation are
tightened
IAS No 21: The Effects of Changes in
Foreign Exchange Rates


Initially record transactions at historical cost
Use monetary - nonmonetary method for subsequent transactions
 Translate monetary items at current rate
 Translate nonmonetary items at either historical or current rate
depending upon when they were measured
 Exchange gains and losses reported as a component of stockholders’
equity
IFRS No 3: Business Combinations

Requires all business combinations to be accounted
for using the purchase method


The pooling of interests method is prohibited
Acquirer must be
identified for all
business
combinations
IFRS No 3: Business Combinations

The acquirer measures the cost of
a business combination

At the sum of the fair values,
at the date of exchange, of



Assets given,
Liabilities incurred or assumed,
And equity instruments issued
by the acquirer

The acquirer recognizes
separately, at the acquisition date,
 The acquiree's identifiable

Assets,
 Liabilities
 And contingent liabilities
 That satisfy specified recognition
criteria
ISRS No. 8: Operating Segments


Adopts requirements of IFRS
No. 131 except for some
terminology
“Management Approach”

Operating segments become
reportable based on threshold
tests related to




Revenues
Results
Assets
Requires disclosure of
“measure” of profit or loss and
total assets
New Developments

New pronouncements dealing with multiple entities:
ISRS No. 10: Consolidated Financial Statements




Outlines requirements for preparation and presentation of
consolidated financial statements
Requires entities to consolidate entities it controls.
Requires a parent entity (an entity that controls one or more
other entities) to present consolidated financial statements
Objective: Establish principles for presentation and
preparation of consolidated financial statements. It:





Defines the principle of control and establishes control as the
basis for consolidation
Sets out how to apply the principle of control to identify whether
an investor controls an investee and therefore must consolidate
the investee
Sets out the accounting requirements for the preparation of
consolidated financial statements
Defines an investment entity and sets out an exception to
consolidating particular subsidiaries of an investment entity
Contains special accounting requirements for investment
entities.
ISRS No. 10: Consolidated Financial Statements


An investor determines whether it is a parent by
assessing whether it controls one or more
investees.
An investor controls an investee if the investor has
all of the following elements:



Power over the investee—i.e., the investor has existing
rights that give it the ability to direct the relevant activities
(the activities that significantly affect the investee’s
returns)
Exposure, or rights, to variable returns from its
involvement with the investee
The ability to use its power over the investee to affect the
amount of the investor’s returns
ISRS No. 10: Consolidated Financial Statements

However, a parent need not present consolidated financial
statements if it meets all of the following conditions:




It is a wholly owned subsidiary or is a partially owned subsidiary
of another entity, and its other owners, including those not
otherwise entitled to vote, have been informed about, and do not
object to, the parent not presenting consolidated financial
statements.
Its debt or equity instruments are not traded in a public market).
It did not file, nor is it in the process of filing, its financial
statements with a securities commission or other regulatory
organization for the purpose of issuing any class of instruments
in a public market.
Its ultimate or any intermediate parent of the parent produces
consolidated financial statements available for public use that
comply with IFRSs
ISRS No. 10: Consolidated Financial Statements

The following principles apply when preparing
consolidated financial statements:



Combine like items of assets, liabilities, equity, income,
expenses, and cash flows of the parent with those of its
subsidiaries.
Offset (eliminate) the carrying amount of the parent’s
investment in each subsidiary and the parent’s portion of
equity of each subsidiary.
Eliminate in full intragroup assets and liabilities, equity,
income, expenses, and cash flows relating to transactions
between entities of the group (profits or losses resulting
from intragroup transactions that are recognized in
assets, such as inventory and fixed assets, are eliminated
in full).
ISRS No. 10: Consolidated Financial Statements




A parent presents noncontrolling interests in its consolidated
statement of financial position within equity separately from
the equity of the owners of the parent.
A reporting entity attributes the profit or loss and each
component of other comprehensive income to the owners of
the parent and to the noncontrolling interests.
The proportion allocated to the parent and noncontrolling
interests are determined on the basis of present ownership
interests.
The reporting entity also attributes total comprehensive
income to the owners of the parent and to the noncontrolling
interests even if this results in the noncontrolling interests
having a deficit balance.
ISRS No. 10: Consolidated Financial Statements

If a parent loses control of a subsidiary, the parent:




Derecognizes the assets and liabilities of the former subsidiary
from the consolidated statement of financial position
Recognizes any investment retained in the former subsidiary at
its fair value when control is lost and subsequently accounts for
it and for any amounts owed by or to the former subsidiary in
accordance with relevant IFRSs.
That fair value is regarded as the fair value on initial recognition
of a financial asset in accordance with IFRS No. 9 or, when
appropriate, the cost on initial recognition of an investment in an
associate or joint venture
Recognizes the gain or loss associated with the loss of control
attributable to the former controlling interest
ISRS No. 10: Consolidated Financial Statements



IFRS N0. 10 contains special accounting requirements for
investment entities.
Where an entity meets the definition of an investment entity,
it does not consolidate its subsidiaries or apply IFRS No. 3
when it obtains control of another entity.
IFRS No. 10 provides that an investment entity should have
the following typical characteristics:





It has more than one investment.
It has more than one investor.
It has investors that are not related parties of the entity.
It has ownership interests in the form of equity or similar
interests.
An investment entity is required to measure an investment in
a subsidiary at fair value in accordance with IFRS No. 9 or
IAS No. 39.
ISRS No. 11: Joint Arrangements


Outlines accounting by entities that
jointly control an arrangement.
Basic principle:


A party to a joint arrangement determines
type of joint arrangement by assessing
rights and obligations.
Party accounts for rights and obligations in
accordance with that type of joint
arrangement.
ISRS No. 11: Joint Arrangements

A joint arrangement is an arrangement of which two or
more parties have joint control. A joint arrangement has
the following characteristics:





The parties are bound by a contractual arrangement.
The contractual arrangement gives two or more of those
parties joint control of the arrangement.
Joint arrangements are either joint operations or joint
ventures:
A joint operation is a joint arrangement whereby the parties
that have joint control of the arrangement have rights to
the assets, and obligations for the liabilities, relating to the
arrangement.
A joint venture is a joint arrangement whereby the parties
that have joint control of the arrangement have rights to
the net assets of the arrangement
ISRS No. 11: Joint Arrangements

A joint operator recognizes in relation to its interest
in a joint operation:






Its assets, including its share of any assets held jointly
Its liabilities, including its share of any liabilities incurred
jointly
Its revenue from the sale of its share of the output of the
joint operation
Its share of the revenue from the sale of the output by the
joint operation
Its expenses, including its share of any expenses incurred
jointly
A joint operator accounts for the assets, liabilities,
revenues and expenses relating to its involvement
in a joint operation in accordance with the relevant
IFRSs.
ISRS No. 11: Joint Arrangements



A joint venturer recognizes its interest in a joint venture as an
investment and shall account for that investment using the equity
method in accordance with IAS No. 28
A party that participates in, but does not have joint control of, a
joint venture usually accounts for its interest in the arrangement
in accordance with IFRS No. 9.
The accounting for joint arrangements in an entity’s separate
financial statements depends on the involvement of the entity in
that joint arrangement and the type of the joint arrangement:


If the entity is a joint operator or joint venturer it shall account for its
interest as a joint operation
If the entity is a party that participates in, but does not have joint
control of, a joint arrangement it shall account for its interest:


As a joint operation
As a joint venture in accordance with IFRS No. 9
IFRS No. 12: Disclosure of Interests in Other Entities

Consolidated disclosure standard


Requires wide range of disclosures about an
entity’s interests in subsidiaries and other
entities
Objective: Require disclosure of
information that enables users of
financial statements to evaluate:


Nature of interests in other entities
Effects of interests on financial performance
IFRS No. 12: Disclosure of Interests in Other Entities

An entity discloses information about
significant judgments and assumptions it
has made in determining:



That it controls another entity
That it has joint control of an arrangement or
significant influence over another entity
The type of joint arrangement when the
arrangement has been structured through a
separate vehicle
IFRS No. 12: Disclosure of Interests in Other Entities

An entity shall disclose information that enables
users of its consolidated financial statements to:






Understand the composition of the group
Understand the interest that noncontrolling interests have in the
group’s activities and cash flows
Evaluate the nature and extent of significant restrictions on its
ability to access or use assets, and settle liabilities, of the group
Evaluate the nature of, and changes in, the risks associated with
its interests in consolidated structured entities
Evaluate the consequences of changes in its ownership interest in
a subsidiary that do not result in a loss of control
Evaluate the consequences of losing control of a subsidiary
during the reporting period
End of Chapter 16
Prepared by Kathryn Yarbrough, MBA
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