Chapter 3
AN INTRODUCTION TO CONSOLIDATED FINANCIAL
STATEMENTS
Comprehensive Chapter Outline
A BUSINESS COMBINATION IS CONSUMMATED WHEN ONE CORPORATION
ACQUIRES OVER 50% OF THE OUTSTANDING VOTING STOCK OF ANOTHER
CORPORATION.
A
A corporation that holds a majority interest (over 50%) of the voting stock of another
corporation is referred to as the parent company.
B
The interest not held by the parent company is referred to as the minority interest or the
non-controlling interest.
C
A corporation whose outstanding voting stock is over 50% owned by another corporation
is a subsidiary of that corporation.
D
Once a parent company-subsidiary relationship exists, the purchase of additional shares of
stock is accounted for by the purchase method, but the purchase is not a business
combination.
E
The parent company and subsidiary exist as separate legal entities and maintain separate
accounting records, but each reporting period their separate accounting records are
combined into consolidated financial statements for reporting the financial position and
results of operations of a consolidated reporting entity.
1
Consolidated financial statements are prepared for all the companies under the
control of a single management team to reflect a single reporting entity with
multiple divisions.
2
The consolidated statements are primarily for the stockholders and creditors of
the parent company.
3
The subsidiary will continue to report the results of its separate operations to its
minority stockholders.
4
The consolidated entity (the reporting entity) has no transactions and it does not
maintain a ledger. The financial statements of the separate legal entities are
combined only for external reporting purposes.
CONSOLIDATION POLICY
A
Under the provisions of FASB Statement No. 94, "Consolidation of All Majority owned
Subsidiaries," consolidation is required for all corporations that are over 50% owned
except:
1
Where control is likely to be temporary or
2
Where control does not rest with the majority ownership, such as when a
subsidiary is in bankruptcy or operates under foreign exchange restrictions,
controls, or other governmentally imposed uncertainties so severe that they cast
doubt on the parent’s ability to control the subsidiary.
PARENT AND SUBSIDIARY WITH DIFFERENT FISCAL PERIODS: Consolidated
statements are prepared for and as of the end of the parent company’s fiscal period.
A SET OF CONSOLIDATED FINANCIAL STATEMENTS INCLUDES A
CONSOLIDATED BALANCE SHEET, A CONSOLIDATED INCOME AND
RETAINED EARNINGS STATEMENT, AND A CONSOLIDATED STATEMENT OF
CASH FLOWS.
A
The consolidated balance sheet, income statement, and retained earnings statement are
prepared by combining the separate financial statements of the parent company and the
subsidiary.
B
The consolidated cash flow statement, however, is prepared from the consolidated
financial statements for two consecutive years.
THE CONSOLIDATED BALANCE SHEET:
A
The investment in subsidiary account on the parent company balance sheet and the
stockholders’ equity accounts on the subsidiary’s balance sheet are reciprocal, both
representing the net assets of the subsidiary.
1
2
B
The reciprocal investment in subsidiary and subsidiary stockholders’ equity
accounts are eliminated in consolidation.
Non-reciprocal accounts are combined.
The capital stock and retained earnings amounts that appear in the consolidated balance
sheet are those of the parent company.
C
Unamortized cost-book value differentials are added to (or subtracted from) the asset
and liability accounts that will appear in the consolidated balance sheet. Goodwill from
the investment, which does not appear in the separate company statements, is added to
the asset listing.
D
Intercompany balances are eliminated.
E
100% of the assets and liabilities of the parent company and subsidiary are shown in the
consolidated balance sheet, and any minority interest in the subsidiary’s net assets is
reported separately in the liability or the stockholders’ equity section.
1
Minority interest is computed as the minority interest ownership percentage
times the subsidiary equity at the balance sheet date.
2
Classification of minority interest:
a
In practice, minority interest is usually shown as a separate item in the
liability section of a consolidated balance sheet.
b
Conceptually, minority interest should appear as a separate component of
stockholders’ equity because it represents an equity investment in the
consolidated net assets.
WORKING PAPERS PROVIDE A CONVENIENT WAY TO ORGANIZE THE
INFORMATION NEEDED TO PREPARE CONSOLIDATED FINANCIAL
STATEMENTS.
A
Working paper adjusting and eliminating entries are not recorded in the ledgers of either
the parent company or subsidiary.
B
Cost-book value differentials are not recorded on the books of the parent company or its
subsidiary, and therefore they must be entered in the working papers to adjust the
subsidiary’s book values to the new cost basis for consolidated statement purposes.
1
The amounts assigned to identifiable assets and liabilities are for the majority
interest’s share of the fair value and book value difference because the price paid
by the parent company/investor is for only a percentage of the net assets.
2
The minority interest's share of the subsidiary’s assets and liabilities is not
revalued under current GAAP.
3
The asset and liability amounts that appear in the consolidated balance sheet are
determined by combining the separate parent company and subsidiary statement
amounts with the debit and credit amounts entered in the adjustment and
elimination columns.
4
If several asset and liability accounts are affected by cost-book value
differentials, the use of an “unamortized excess” account simplifies the process
of entering the cost-book value differentials in the working papers. The
unamortized excess account does not affect the consolidated financial statements
because it has equal debit and credit entries in the adjustment and elimination
columns.
COMPARISON OF SEPARATE COMPANY AND CONSOLIDATED INCOME
STATEMENTS:
A
Under the equity method, parent company net income and consolidated net income are
the same.
B
The parent company’s income statement shows revenues and expenses of the parent
company and investment income from the subsidiary.
C
The consolidated income statement shows the total revenues and expenses of the parent
company and subsidiary (adjusted for amortization of the cost-book value differentials)
and a deduction for minority interest income. Investment income from the subsidiary is
excluded.
D
The objective of a consolidated income statement is to show the income of a parent
company and its subsidiaries as if there were only one legal and accounting entity.
PUSH DOWN ACCOUNTING IS BASED ON THE ASSUMPTION THAT THE
PURCHASE OF THE VOTING STOCK OF ANOTHER COMPANY CREATES A
NEW COST BASIS FOR THE ASSETS AND LIABILITIES OF THAT COMPANY.
A
Push down accounting affects the subsidiary’s separate books and financial statements,
but it does not affect consolidated financial statement amounts.
1
Cost-book value differentials are recorded on the books of the subsidiary (i.e.,
pushed down to the subsidiary’s accounts). At the acquisition date:
a
The parent company records its investment as usual.
b
The subsidiary makes an entry on its own books to record the new asset
bases, including goodwill, and reclassifies retained earnings to push
down capital.
2
B
The balance sheets of the parent company and subsidiary are consolidated by
eliminating the investment in subsidiary account against the subsidiary’s capital
stock and push down capital.
The SEC requires push down accounting for SEC filings when a subsidiary is
substantially wholly owned and has no public debt or preferred stock outstanding.