CONSOLIDATED FINANCIAL STATEMENTS:
THEORY AND UTILITY
by
JAMES WILSON PATTILLO, B.S. in C.
A THESIS
IN
ACCOUNTINa
Submitted to the Graduate Faculty
of Texas Technological College
in Partial Fulfillment of
the Requirements of
the Degree of
MASTER OP BUSINESS AMINISTRATION
August, 1959
VV-.
I am deeply indebted to Professor Reginald Rushing
for his direction of this thesis and to the other members of ray committee. Professors P. W, Norwood, and
W, G. Cain, and to Professor A. T. Roberts, for their
guidance and helpful criticism.
TABLE OP CONTENTS
I*
INTRODUCTION
6
General Observations . . • . . • • • • • • •
Group Financial Statements
10
Statement of the Problem
13
Scope of the Study
ll}.
Limitations
• .
Basic Premises and Assumptions
Terminology and Concepts • •
16
19
23
2l\.
2l\.
25
Consolidation
Merger
Amalgamation • , •
•...••
Combination
Parent, Subsidiary, and Control . . . .
Affiliated Company
INSTITUTIONAL BACKGROUND OF CONSOLIDATED
STATEMENTS
Historical Background of the Holding
26
26
2?
2?
27
26
38
Company in the United States
Histoid of the Consolidated Statement
15
15
Essential Business Entity of the
Holding Company Group
The Auxiliary Nature of Consolidated
Statements • • *
• •
The Primacy of Proper Asset Valuation •
Adherence to the Concept of a Going
Concern
The Desirability of Consistency . • . ,
II.
6
38
...
l\.l
Quantitative Importance of the Holding
Company in the United States
III.
CONDITIONS UNDERLYING CONSOLIDATION
Percentage of Stock Ownership and Control
as a Standard
-3,
l\.7
50
52
k
IV,
similarity of Operations as a Standard . . .
60
National Concentration as a Standard . . . .
63
Consistency of Treatment as a Standard . . .
77
Necessity for Disclosure of Basis of
Incltxsion or Exclusion • . • • » • • • •
STANDARDS UNDERLYING INTERCOMPANY OPERATING
TRANSACTIONS
•
8l
85
A Characteristic Feature of
Consolidation—Elimination
85
Transactions Involving the Debtor-Creditor
Relationship
• • . * .
87
Intercompany Receivables and Payables .
Long-term Loans Among Affiliates • . , .
Long-term Bonds Among Affiliates . . • .
Holdings of Preferred Stocks by
iiX X Xx3>a bes . • • • • • • • • • • « «
Transactions Involving Intercompany
Merchandising or Accommodating
Activities
Intercompany Sales and Purchases of
Goods
Fixed Assets Bought and Sold Among
Affiliates
Other Intercompany Transactions and
Considerations
88
89
90
y(
99
99
120
122
Reciprocal Revenue and Expense Accounts. 123
Contingent Liabilities for Debts of
Affiliates
125
Intercompany Bad Debts . ,
127
V.
STANDARDS UNDERLYING INTERCOMPAl^ FINANCIAL
TRANSACTIONS
129
Investments in Affiliates on Owner's Books . 129
Methods of Carrying the Investment:
Arguments of Each
Treatment of Changes in Equity Due to
Subsidiary's Actions
I30
lb,l
5
Treatment of Changes in Equity Due to
Parent's Actions
ll).9
Intercompany Shareholdings--Eliminations . . 15kVI.
MINORITY INTERESTS AND CONSOLIDATED SURPLUS . .
Minority Interests
....
Allocation of Consolidated Profit
or Loss
Allocation of Consolidated Capital . . .
Consolidated Surplus
VII.
VIII.
163
163
166
168
, 169
CONSOLIDATED STATEMENTS' UTILITY PROIi VARIED
VIEWPOINTS
172
From the Viewpoint of the Accoimtant . . . .
172
From the Viewpoint of Management
176
From the Viewpoint of the Investors
....
179
From the Viewpoint of the Creditors
....
I83
SUMr4ARY AND CONCLUSIONS
I87
Siaramary
I87
Conclusions
195
BIBLIOGRAPHY
199
CHAPTER I
INTRODUCTION
General Observations
In an address that was delivered before the Rutgers
University Graduate Seminar in S.E.C, Accounting in 19i|.l,
William W. Wemtz, then Chief Accountant of the Securities
and Exchange Commission, spoke on the subject of consolidated statements in part as followsj
Consolidation accounting is one of the areas in
which recognized principles are few, divergent
principles many, and underdeveloped sectors large.
This kind of accounting and this kind of statement
are discussed in nearly all textbooks; certain elements are the subject of rules by governmental
bodies and the New York Stock Exchange; a few articles have been written, and the professional societies have sponsored a few principles. But for the
most part, these writings stick to a pretty well
beaten path and rarely discuss more than a handful
of questions. Published financial statements likewise scarcely ever disclose any difficult problems
which frequently, if not customarily, arise in
their preparations. . . .
The available discussions of general principles,
the landmarks, are seldom sufficiently detailed to
enable one to determine with reasonable assurance
which of several possible„solutions would be consistent with the premise.
1
See William Herbert Childs, Consolidated Financial
Statements! Principles and Procedures, Cornell University
i-ress Uthaca, New York, 19i4-9;, p. vll. Hereafter cited as
Childs, Consolidated Statements.
2
Childs, Consolidated Statements, footnote No. 1 on
page vii reads as followsz "Wemtz, William W., 'Consolidated and Combined Statements,' an address delivered before
the Rutgers University Graduate Seminar in S.E.C. Accountin;^,
October 5, 191+1 (unpublished), p. 1."
^
Along the same lines, Maurice Moonitz stated in 19i|i4.:
Ttie recent. . .interest in consolidated statements
has emphasized anew the lack of a firm theoretical
foundation on which to build satisfactory multicompany reports. The confusing array of alternative
and sometimes contradictory procedures found in
accounting literature is one Important manifestation of the absence of a generally accepted explanation of the nature, purpose, and limitations
of consolidated statements.-^
Although these statements were made more than fifteen
years ago, they largely hold true today.
There has been no
thorough exploration in the field of consolidation accounting
and consolidated statements as there has been in other fields,
such as cost accounting,
©lis lack of exploration may ac-
count for the absence of generally accepted principles.
As
Mr, Wemtz states, this kind of accounting and this kind of
statement are discussed in nearly all textbooks, and a few
books appear which exclusively treat the subject.
However,
the stress is not on the theory underlying the subject;
-_
rather the emphasis is on the mechanical aspects involved.
Articles have appeared in accounting and other business
Journals; but, here again, the treatment is upon the mechanical phases, or upon isolated problems, with the result that
the theory is either neglected or ciirsorily treated in the
process.
It is generally true, as Mr. Wemtz states, that
3
Maurice Moonitz, Ttie Entity Theory of Consolidated
Statements, The Foundation Press, Inc. (Brooklyn, 1951)>
p. V, Hereafter cited as Moonitz, Entity Theory.
8
"• . .for the most part, these writings stick to a pretty
well beaten path and rarely discuss more than a handful of
questions.**
Recognizing the lack of and need for generally accepted standards underlying the presentation of consolidated
statements, the American Accounting Association has sponsored
research upon the subject, and in 1951^-* the Committee on
Accounting Concepts and Standards published its Supplementary
5
Statement No, 7, entitled "Consolidated Financial Statements."
Also, the American Institute of Certified Public Accountants
is currently considering in its Committee on Accounting Procedure the desirability of a bulletin on consolidation prac6
tices.
When one considers the nature of the subject itself,
it is somewhat understandable that generally accepted principles have not been formulated.
Consolidation accounting is
a complex subject; its principles are formulated only with
great difficulty.
The principal reason for this difficulty
See the quotation by Mr. Wemtz on page 6.
5
American Accounting Association--Committee on Accounting Concepts and Standards, "Consolidated Financial
Statements" (Supplementary Statement No. 7), Accounting and
^epor'ting Standards for Corporate Financial Statements and
i>^^PP4-e^^ents, American Accountinp; Association (Columbus, Ohio,
iVi?Y), pp. 42-14.5. Hereafter cited as American Accounting
Association, "Consolidated Financial Statements."
6
This is the gist of a parenthetical note appearing
after a related article in the The Journal of Accountancy,
August, 1957. p. 36.
9
is that the formulation of principles entails going beyond
the accountant's concepts of legal equities in the assets of
a single corporation to determine the proper allocation of
constructive equities in the combined assets of a multicorporate enterprise.
Frequently that enterprise is inexactly
termed an "economic entity."
However, the accountant's idea
of an economic entity is usually in terms of his concepts of
the "legal entity."
Thus, the accoimtant is prone to hold
the position of the parent company as a legal entity while he
reaches out to bring in such group data as he can fit into
the pattern of the individual accounts of the parent.
This
idea of legal entity occurs despite the consolidated statement usually being purported to be an exhibit, without regard
for legal boundaries, of the financial and operational data
of a group of affiliated companies.
Therefore, consolidated
statements are frequently devised as expansions of the parent
company data, rather than in accordance with the concept that
the consolidated acco^lnts are those of different business
units; in other words, are frequently?- devised as a legal
entity rather than an economic entity.
As a consequence, once the accountant has formulated
his "principles" of consolidated statements, whether they be
in accordance with the legal or economic entity concept, he is
likely to be hesitant (or even prejudiced) to consider the
other point of view.
In addition to this undesirable condi-
tion, the accountant must submit reports and statements which
10
meet the requirements of various regulatory agencies.
Such
regulatory rules are usually followed blindly, with few
searching questions concerning their theoretical rightness
being introduced.
7
But to say that there are few questions
does not mean that the policies are not sound.
Backing the
soundness of the rules of the Securities and Exchange Commission, Victor H, Stempf writess
While the requirements of the commission concerning consolidated statements are exacting, and may be
thought by some to exceed reasonable limits in the
volume of data required, the underlying principles
are indisputably sound and provide adequately for
Judgement and flexibility in the presentation of g
material facts as they appear in individual cases.
Nevertheless, such apparent rigidity seems to be unfortunate in any field since progress depends upon the
willingness of the members of the profession to objectively
consider different concepts.
Group Financial Statements
"A group financial statement is an acco\mting device
for presenting in a single report the combined financial
position or the combined operating results of affiliated
7
Childs, Consolidated Statements, pp. vli-ix.
Victor H. Stempf, "Consolidated Financial Statements, " ^_2ie_J[oumal_£f_Ac£^
LXII (November, 1936),
p. 375.
11
9
companies."
It must be remembered that the object of accounts
is to show facts, and that any form of statement which discloses all material facts is equally permissible and proper;
the precise form is largely a matter of circumstances and
10
preference,
A legal entity the structure of which has
branches or divisions or departments must include in its reports the operations of all its constituent parts; the individual accounts of a department or division would be inadequate to give a complete view of the position and operations
of the enterprise.
On the other hand, there is a similar
need for an over-all view when the branches or divisions or
departments are part of the combination of corporations
which are legal entities in themselves.
Group financial
statements provide to interested parties a better view of
theraulticompanystructiire as a whole.
Combined accounts may be presented in one of three
methods:
the combined statement, the consolidating statement,
or the consolidated statement.
A combined statement is a financial statement which is
prepared from the reports of affiliates that are of a different order than that of the controlling company, or are under
9
Childs, Consolidated Statements, p. 1.
Arthur Lowes Dickinson, "Accounting Practice and
Procedure," in Selected Readings in Accounting and Auditing,
Mary E. Murphy, ed., Prentice-Hall, Inc. (New York, 1952),
pp, 172-173.
12
different conditions.
The combined statement is used in
situations where more and better information could be had by
consolidated statements.
For example, a number of foreign
subsidiaries would issue a combined statement which would be
presented as a supplement to the consolidated statement of
the parent company and its domestic subsidiaries.
The consolidating statement is merely a financial
statement in worksheet form and displays the details that go
into the making of consolidated statements.
This consoli-
dating statement ties together book figures with the published
financial statements, and is occasionally furnished along with
the more foaroial consolidated statements in order to supply
information about the sources of various consolidated items.
"The essential purpose of consolidated statements is
to display the income record and financial position of two or
more associated, but legally separated, companies SLS ±£ they
11
represented a single enterprise."
Through such statements
legal lines are disregarded or at least minimized, and managerial unity is stressed; a picture is drawn of the affiliation—the family of companies--in its over-all relation to
12
the external business community.
In essence, the
11
William A. Paton, and William A. Paton, Jr.,
Corporation Accounts and Statements, Macraillan Company
(New York, 1955), p. 573. Hereafter cited as Pat^n and
Paton, Corporation Accounts.
12
Paton and Paton, Corporation Accounts, p. "73
13
distinguishing characteristic of the consolidated statement
is the presentation, in a single financial report, of the
combined operations and position of the controlling and the
controlled companies.
However, each company must be regarded
13
as a legal entity in itself.
Group statements have a number of common characteristics.
There must be a single control over the policies and
operations of the included companies; moreover, that control
must be exercised, and not merely be potential.
There must
be an economic relation; that is, the companies' operations
must be similar, auxiliary, or complementary in character.
Ownership is also a criterion for combination, as is the
ownership form.
Most significant, however, is that a group
statement does not pretend to present the data as they appear
in the books of account of any individual company.
In this
sense, a group statement is frequently referred to, with substantial basis, as an "artificial" report.
The consolidated statement is the most-used of the
group account forms, and is the subject of this work.
Statement of the Problem
This study will be concerned with the problem of
determining the validity of the following assumptions:
13
Childs, Consolidated Statements, p. 2,
^ Childs, Consolidated Statements, pp. 1-2.
Ill
(1) that consolidated statements are based on the hypothesis
that underlying legal entities do not exist, and in that
sense, the statements are "artificial"; (2) that the circumstances of presentation and the standards and principles
underlying their preparation are numerous, complex, and sometimes conflicting; (3) that the purposes for which they are
published are few; and (ij.) that an evaluation is needed of
the extent they meet the needs of interested parties.
The objectives are mainly twos
(1) to present and
weigh basic concepts Tinderlying consolidated statements, and
(2) to reach some reasonable conclusions as to the value of
consolidated statements to selected segments of the business
world,
Scope of the Study
Specifically, two broad areas will be covered: (1)
the theory of preparation of consolidated statements, including (a) the circumstances of preparation and (b) the standards
and principles underlying their preparation; (2) the purposes
served or utility, to the accountant, management, investors,
and creditors.
The work deals with the subject of consolidated statements in the following manner:
The institutional background
of consolidated statements is traced in Chapter II; the circumstances of preparation are presented in Chapter III; the
standards and principles underlying their preparation are
15
described in Chapters IV through VI; the value and utility
from various selected viewpoints are covered in Chapter VII;
a summary and conclusions are drawn in Chapter VIII,
Limitations
Because of the vastness of the subject, no consideration will be given to five areas and problems: no emphasis
is placed on the mechanical phases of consolidated statements;
the precise technical form (as opposed to content) that the
statements should take is excluded; the problem of the extent
to which reports submitted to regulatory and other agencies
should agree with the published consolidated statements is
avoided; generally, the practical applications of the theoretical concepts are excluded; and situations involving indirect and reciprocal share ownership relations are excluded.
Basic Premises and Assumptions
It is necessary that the foundation of assumptions be
laid, and these premises will serve to underlie all the subsequent discussion and conclusions.
15
the essential economic lanity
The first two premises,
of the holding company group,
and the auxiliary nattxre of consolidated statements, will be
derived from a discussion on their relation to consolidated
Hereafter referred to as a "business entity" since
"economic unity" has many conflicting connotations.
16
statements,
TUne last three, the primacy of proper asset
valuation, adherence to the concept of a going concern, and
the desirability of consistency, are derived from concepts
16
common to the body of general accounting doctrine.
Essential Business Entity of the Holding Company Group
Consolidated statements are predicated on the assumption that the entire group of companies, legal entities in
17
themselves, form one business and accounting entity.
Ihis view is based upon the historical development of the
holding company-subsidiary relationship and upon the functions performed and powers conferred (^.£., common control)
-j o
by consolidation through share ownership.
It seems that accountants move more quickly to recognize changes in traditional concepts and modes of behavior
than do the courts or legislatures.
But there is a lag
between the changes themselves and their expression in cases
and statutory law.
For example, accountants for years have
treated a partnership as an entity distinct from treatment
of the partners as individuals. However, only recently has
the entity concept been recognized and expressed in the
16
•^ Moonitz, E n t i t y Theory, p . 1 2 .
17
John A. Carson, "Accounting for Mergers and Consolidations," The Canadian Chartered Accountant, LXXIV
(April, 1959), p. 327.
16
Moonitz, E n t i t y Theory, p . 1 2 .
17
Uniform Partnership Act,
The commercial world has similarly treated the single
proprietorship as distinct from its owner, but this concept
has not as yet been given legal effect,
Consistent with this
attitude of a distinct entity are the income tax regulations
in that they treat an individual's business revenues and expenses differently fro™ his personal receipts and outlays.^^
Specifically with reference to corporate combinations
through stock ownership, the law has been hesitant and confusing; as a consequence, a well-settled, consistent body of
legal rules and doctrines is not available to resolve the
accounting problems in the same field.
The authorities are not completely in accord as
to when several corporations will be considered as
a single entity. . . . The rule followed in many
cases is that the legal fiction of distinct corporate existence may be disregarded when a corporation
is so organized and controlled, and its affairs are
so conducted, as to make it merely an instrumentality
or adjunct of another corporation.^*^
19
Moonitz, E n t i t y Theory, p . 3 .
20
Moonitz, E n t i t y Theory, p . [|..
18
There have been a few cases
21
adjudicated in which
were expressed opinions which are more consonant with the
assumptions that are made by accountants in preparing consolidated statements.
The most notable of these opinions, in that
it expresses a virtually complete break with the concept of
the separateness of each corporate entity, was the Judg3ment
in the case that had involved the rights of creditors of a
subsidiary in the assets of the parent. Consolidated Rock
Products Co, V du Bois /5l2 U.S, 510, 61 S,Ct. 675 (19l4.1i7.
There has been a unified operation of those several
properties by Consolidated pursuant to the operating
agreement. That operation not only resulted in extensive commingling of assets. All management functions of the several companies were assumed by Consolidated. The subsidiaries abdicated. Consolidated
operated them as mere departments of its own business.
Not even the formalities of separate corporate organizations were observed, except in minor particulars
such as the maintenance of certain separate accounts.
In view of these facts. Consolidated is in no position to claim that the assets are insulated from
such claims of creditors of the subsidiaries. . . .
A holding company which assumes to treat the properties of its subsidiaries as its own cannot take the
benefits of direct management without the burdens.^^
21
Among the more notable are those cited by Moonitz
(Entity Theory): Robothman v. Prudential Insurance Company,
^k *l.»).Eq. 6V5, 53 Alt. 614.2 (1903); U.S. v. Reading Company,
253 U.S. 26, l|.0 S.Ct. 1^.25 (1920); Hart Steel Company v.
Railroad Supply Company, 2kk U.S. 291+, 37 S.Ct. 506 (1917)}
Chicago, Milwaukee and St. Paul Railway Company v. Ninneapolis Civic and Commerce Association, 21^7 U.S. i;90, 38 S.Ct.
553 (1918); Industrial Research Corporation v. General Motors
Corporation, 29 F.2d 623, D.C. Ohio (1928).
22
Moonitz, E n t i t y Theory, p p . 5 - 6 .
19
Therefore, there has been limited legal recognition of
the essential business entity regarding combinations affiliated
by stock ownership rather than by merger.
The tendency is for
recognition only in special situations and under certain circumstances, and is not a rule or doctrine applicable to the
23
ordinary transactions of a going concern.
Consequently,
the preparation of consolidated statements is predicated upon
the assumption that the consolidation is an entity in itself,
ISiis entity, however, is almost wholly, though not entirely,
outside the scope of complete legal recognition.
Therefore,
consolidated statements need special Justification, a condition not required of the statements of a single corporation.
The Auxiliary Nature of Consolidated Statements
Because of the limited status, in the eyes of the law,
of the entities to which they refer, consolidated statements
must be regarded as auxiliary.
•:vi;
t-'
They are special-purpose re-
ports; they are not primary, all-purpose exhibits supplanting
23
For example, in Cintas v. American Car and Foundry
Company /12>1 N.J.Eq. 4l9, 2S A.2d i|.l8 {l^k^Y/, the court held
that prior cases dealt with special points and are therefore
not binding in a dispute concerning the status of intercompany
dividends declared and paid in the ordinary course of business.
(See Moonitz, Entity Theory, p, 6.) For analysis of the consolidation accounting implications of this case, see George
0, May, "The American Car and Foundry Decision," The Journal
of Acco\mtancy, LXXIV (December, 191+2), pp. 517-522, and also
the following editorial: "Consolidated and Separate Statements," The Journal of Accountancy, LXXIV (October, 19^2),
P. 293.
20
o\
or displaying the statements of legally recognized entities.
•Rie leading principle of the technique of preparing a
consolidated statement, viz, the elimination of all evidences
of intercompany relationship, requires a shift in viewpoint
from a legal concept—that of a business corporation—to an
accounting concept--that of the business entity.
25
This
method of financial reporting was appropriately described by
M, B, Daniels:
A consolidated statement is a synthetic statement
or accounting device, and a legal fiction. It is the
statement of no single corporation but an amalgamated
statement giving accounting data of two or more separate corporations. Indeed, the final Justification
of the device must rest on the reality of the group
as a single economic and administrative enterprise
despite the existence of the separate legal entities
involved.
Therefore, because of the general lack of recognition
and inadequate comprehension of the essential business entity
of a combination through stock ownership, the courts have not
generally accepted consolidated statements as replacements of
the separate legal-entity reports.
Their status remains that
of a supplement to, but not a substitute for, the statements
2k
Moonitz, E n t i t y Theory, p . 6,
25
Gertrude Mulcahy, " C o n s o l i d a t e d S t a t e m e n t s - - P r i n c i p l e s and P r o c e d u r e s , " The Canadian C h a r t e r e d Accountant.
LXIX (August, 1 9 5 6 ) , p , 152,
——
of.
Mortimer B. D a n i e l s , F i n a n c i a l S t a t e m e n t s , American
Accounting A s s o c i a t i o n ( C h i c a g o , 1 9 3 9 ) , p . ^^»
21
of the individual corporate units.
Consolidated statements
should not be presented in isolation from the individual
27
reports of a parent company and its major subsidiaries.
•Riis view is in harmony with the statement by Eric L. Kohleri
Combined financial statements portray the Joint
position or operating results of two or more business
or other units as though but one existed. They are
secondary rather than primary in character, and, as
enlargements of the financial statements of a common
controlling interest, they assist in explaining the 28
relationships of that interest to the outside world.
Should the principal legal unit become the combination
as a whole, this premise would be revised; at that time consolidated statements will become primary in character, and the
statements of constituent units will be relegated to the status
29
analagous to departmental operating statements.
Until this
legal transition takes place, the position of the consolidated
statement should remain secondary.
At the present, the use of the consolidated statement
has progressed so rapidly that many regard the statement as
the prime medium of financial reporting by holding companies;
an increasing number of companies include only these statements
27
Moonitz, E n t i t y Theory, p . 10.
E r i c L. Kohler, "Some Tentative P r o p o s i t i o n s Underl y i n g Corporate R e p o r t s , " The Ac covin t i n g Review, XIII (March,
1938, p . 6 3 . H e r e a f t e r c i t e d as Kohler7 "Tentative Propositions."
29
Moonitz, E n t i t y Theory, p . 10.
22
in their published annual reports,
Childs supports this
development:
The majority of published statements of companies
listed on the New York Stock Exchange are consolidated statements. They have come to be looked upon
by stockholders and bondholders of a parent company
as substitutes for the legal entity statements of
that company and are usuall^Qthe only accounts provided in its annual report,-'
In further evidence that the concept of a business entity is
gaining in popularity, the state of California by statute has
placed the consolidated balance sheet on a plane of full
31
equality with the balance sheet of the parent company.
It must be emphasized, however, that this statute adheres to
the concept of a supplement, rather than that of a substitute.
In addition to the example of California, formal legal status
has been achieved in Canada by the Companies Act of 1931!-,
which sanctions the publishing of consolidated stat*3ments
without the statements of the constituent companies accora32
panying them.
Nevertheless, until the consolidated statements are
generally legally recognized as substitutes for the separate
30
Childs, Consolidated Statements, pp, 2-3•
31
Rufus Wixon, editor, "Consolidated Statements,"
Accountant's Handbook, The Ronald Press Company (New York,
1956), l4.th ed., chap. 23, p. 5.
Gertrude Mulcahy, "Consolidated Statements--Principles and Procedures," p. 152,
23
legal-entity reports, they should not be used as such, but
rather should be utilized as secondary to the separate parent
and subsidiary statements.
In the light of this basic premise, that of the consolidated statement's auxiliary status, the question arises:
to what groups or interests will consolidated statements prove
most useful?
This question is the subject matter of Chapter
VII,
The Primacy of Proper Asset Valuation
Hie premise of proper asset valuation primacy is derived from the basic attributes of the fundamental accounting
process.
The value of the proprietary equity is equal to the
difference between the values that are assigned to assets and
the values that are assigned to liabilities.
The principal
variable in this case is the value of the total assets.
"This
underlying conception of the whole process of rational bookkeeping is merely a formal reflection of the fact that an
enterprise derives value for its owners through actual and
prospective favorable changes in assets under its control,"
33
The principal problem then is one of the determination
of appropriate values for assets.
Once these values are de-
termined, the size of owner equity is determined by deducting
the amount of creditor clains.
/ further problem is that
•33
Moonitz, E n t i t y Theory, p , 17.
21+
of assigning the charges to the proper accounting period and
to the several ownership interests.
The application of this premise to specific consolidation problems is taken up in a later discussion of controlling and minority interests—as equals in status.
It may be
pointed out here that the assets must not be used as balancing figures to affect values which already have been assigned
to equities.
Adherence to the Concept of a Going Concern
The going concern concept does not require extended
comment since it is an integral part of accotanting and is
generally understood.
The situations in the discussion of
consolidation involve those companies which are not in the
process of dissolution or liquidation.
A combination is pre-
sumed to continue into the indefinite future as a functioning
entity.
Therefore, the special problems which surround liqui-
dation or reorganization of a combination are excluded.
35
The Desirability of Consistency
Consistency of treatment from period to period is
desirable as a means of obtaining statistical c^riparability.
In this regard, reliance is placed on certain objective rules
^
Moonitz, Entity Theory, pp. 17-16.
35
Moonitz, E n t i t y Theory, pp. 18-19.
25
and standards which will serve to mai:e accounting proced\ires
coherent over the periods.
But this reliance must not become
so rigid as to oppose any necessary alterations.
Alterations
must be made if conditions appear to have changed, and more
proper accounting may be obtained under the alteration.
The
argijment may be advanced that this alteration, of itself, does
not violate the premise of consistency, for the conditions
upon which the prior treatment were based have changed, and
consistency in relation to the previous treatment ends with
the change; a new treatment will now be consistently followed
36
over the periods under the changed conditions.
Terminology and Concepts
At the outset of a discussion of this kind, it is
necessary to define the terms which will be used.
Also it is
necessary, in this case, to distinguish between differing concepts of the same subject.
A basic goal in defining many of the following terms is
to attach specific meanings to words often used interchangeably.
For example, because it has many other connotations, "consolidation" is a poor word to describe the process of preparing
consolidated statements. Many similar problems, which will be
clarified in the present section, exist.
36
Moonitz, E n t i t y Theory, p . 19.
26
Consolidation
A consolidation takes place when the properties and
debts of two or more corporations are taken over by a new
corporation that is organized for the purpose of acquisition,
and the selling corporations thereafter cease to exist.
The process of preparing consoiiaated statements is
also often referred to as "consolidation."
For lack of a
more accurate term, "consolidation" will be used in this work
according to this latter definition; namely, the preparation
of consolidated financial statements from the individual
financial statements of the affiliated companies.
Merger
By a merger is meant the transfer of the assets of one
or more corporations to another corporation, whereby the
latter corporation, a single legal entity containing within
itself the corporate life of all its constituents, remains as
.,
38
the single and sole owner of the combined assets.
A merger
differs from a consolidation (in the first sense, as stated
above) in that in a merger no new concern is created, whereas
in a consolidation a new entity acquires the net assets of
37
Homer V. Cherrington, Business Organization and
Finance, The Ronald Press Company (New York7 19.'i-b), p. ' ^ 0 .
38
James C. Bonbright, and Gardiner C. Means, Holding
Companies; its Public Significance and its Regulation,
McGraw-Hill Book Company, Inc. (New York, 1933), p. 27.
27
the combining units.
Amalgamation
An amalgamation is a combination under a single head
of all or a portion of the assets and liabilities of two or
^ .
39
more business iinits by merger or consolidation.
The word
"amalgamation" is preferred by some as a synonym for consolldation and not for merger.
Combination
The terra "combination" as used in this work will
designate a method of external expansion of business by which
conjoined corporations retain their positions as sepsu^ate
legal entities.
Parent, Subsidiary, and Control
A "parent" is a corporation which is in a position,
however attained, to direct or cause the direction of the
corporate affairs and operations, or only the operations, of
another corporation,
A "holding company" is commonly termed
a "parent" and the two terms are considered to be synonymous.
39
Eric L, Kohler, A Dictionary for Accountants,
Prentice-Hall, Inc, (Englewood Cliffs, New Jersey, 195o),
2nd e d . , p . 3 0 .
ijo
,
C h e r r i n g t o n , B u s i n e s s O r g a n i z a t i o n and F i n a n c e , p . J!20.
Childs, Consolidated Statements, footnote no. 1, p . 3 .
28
A "subsidiary* is a corporation whose corporate affairs
and operations m a y be directed, or whose operations may be
k2
directed only, by another corporation,
"Control" (including the terms "controlling" and
"controlled b y " ) as used herein, means the possession,
directly or indirectly, of the power to direct or cause the
direction of the management and policies of a corporation,
however it is attained.
In some cases there may exist a
Joint control by two or more entities of a corporation; this
Joint control is termed a "community of interest," and is not
a parent-subsidiary relationship since no one company is in
the dominating position.
Affiliated Company
An affiliate or affiliated company is a corporation or
other organization related to another by owning or being owned,
i|5
by common management, or any other control device.
Or,
parent and subsidiaries, or subsidiary companies, taken together, are termed "affiliates"; that i s , any separate entity
ii6
of the group is an "affiliate."
^
Childs, Consolidated Statements, p. i|.
k-3
Edward A. Kracke, "Consolidated Financial Statements,"
The Journal of Accountancy, LXVI (December, 1 9 3 8 ) , p. 376.
^^ Childs, Consolidated Statements, p. 5.
k5
Kohler, A Dictionary for Accountants, p. 26.
I4.6
Childs, Consolidated Statements, p. k>
29
Various Affiliating Devices.
The usual method of
forming and maintaining a parent-subsidiary relationship is
the acquisition and retention by one company of a controlling
interest in the voting stock of another; that is, a control
device commonly used is intercorporate stock ownership. From
a practical point of view, such action may be equivalent to
a merger or consolidation since properties are now under
unified management and control; legally, however, a separate-
^ ^
k7
ness of identities remain
regardless of the corporate con-
trol that may be exercised.
Ordinarily the state laws do not forbid this type of
affiliation; they may specifically permit the organization of
companies for the sole purpose of acquiring and holding the
k9
stock of other corporations.
The distinction Is sometimes
made between a "pure" and the "operating holding company."
The sole business of the former is the ownership of controlling interests for the purpose of control (as opposed to
investment only) of stocks of other companies.
The latter
'^ Howard S. Noble, Wilbert E. Karrenbrock, and Harry
Simons, Advanced Accounting, South-We stern Publishing Company,
Inc. (Cincinnati, 191]-1), p. 562.
li.8
See the case of Majestic Co. v. Orpheum Circuit,
Inc. (21 F.2d 720) for the legal conception of the separateness of the corporation and its stockholders and those circmistances that may call for a denial of such separateness.
k9
Wilbert E. Karrenbrock and Harry Simons, Advanced
Accounting--Comprehensive Volume, South-Western Publishing
uompany. Inc. (Cincinnati, 1955), 2nd ed., p. 319.
30
usually manages subsidiaries as adjuncts to its own business,
Since intercorporate stock ownership is the usual
affiliating device, a parent is usually a holding company.
Purtheinnore, it is generally assumed that a holding company
is in a position to iirect both the corporate pblicies and
the operations of a subsidiary.
The control is usually in50
direct through parent-appointed directors and officers.
^ ® co3:'P0i*ate lease is another method of establishing
a parent-subsidiary relationship.
This method of obtaining
control, however, relates to the use of the physical proper-
51
ties rather than to the management of corporate policies;
that is, the transfer of property under lease presumes no
necessary intervention by the lessee parent in the corporate
policies of the lessor subsidiary.
Therefore, under this
method, one corporation may lease for a period of years
(999 years not being uncommon) the entire property of one or
more other corporations.
Thus, while the parent manages its subsidiary's properties (i.e., directs the operations), a function which the
subsidiary would do in the absence of a lease, the corporate
organization of the subsidiary remains untouched by outside
interference.
This arrangement is contrasted to holdinT
50
Childs, Consolidated Statements, p. o.
51
William T, Stmley and William J, Carter, Corporation Accoimting, The Ronald Pr^ss Company (New York, l^il"),
revised ed,, pT 288,
31
company control, in which the parent dominates both the
operations and the policies of the subsidiary.^^
Still another way of effecting a parent-subsidiary
relationship is by means of the management contract.
Such
a contract usually provides that a "service corporation"
(the parent) undertake the management of an operating company (the subsidiary).
The service corporation may furnish
engineering, financing, accounting, and general supervisory
services.
Through this device, the scope of the combination may
be expanded with little or no additional investment of
capital.
"Here, again, when the contract is the sole con-
Joining factor, the parent has the right to direct the operations only; the subsidiary retains its independence in the
^ 53
conduct of its corporate affairs 22'£*' policie^7"
The three most important affiliating devices have
been briefly described above.
The principal point of differ-
ence between them is in the respective rights of the parent
to dominate the strictly corporate policies or affairs of
the subsidiary.
Concerning the direction of operations,
however, much the same result is had under the three methods.
Outside control is present under each case.
Since the acquisition and retention of a oontrollin:;
52
Childs, Consolidated Statements, p. 9.
53
Childs, Consolidated Statements, p. 9.
32
interest in the stock of one corporation by another is the
usual affiliating device, that type is the most important
one for the purpose of this study.
The consolidated state-
ment has as its purpose the showing of the financial position
and operating results of two or more affiliated enterprises
as they would appear if they were one organization.
There-
fore, the control over operations or corporate policies of a
subsidiary may have an important bearing upon the decision
to include or exclude it from the group presented in the con-
?k
solidated statement.
Such situations will be discussed in
Chapter III,
Relationship Concepts of Affiliation.
An Accountant
usually holds one of two basic attitudes toward the affiliate
relationship.
Whichever concept is held will affect the
parent company's accounting procedures and the consolidated
statement.
Inasmuch as the consolidated statements will be
affected by the method employed, a brief discussion of the
two concepts follows:
5S
As discussed above,
the courts are slow and reluctant
to recognize the concept of a group entity, or business entity,
upon which accountants have frequently based the consolidated
9x
Cf. the discussion of leased and contracted subsidiaries as ^ i n g "uncontrolled" in Kohler, "Tentative Propositions," p. 6Ij..
So
See the section "Auxiliary Nature of Consolidated
Statements," page 19,
33
report.
The courts appear to believe that great harm would
be done if the corporate entity were to be treated with
flexibility in consolidation.
Thus, consistent with the
legal-entity concept at law is the "cost method" of valuing
the investment account on the parent's books, and this is
unadjusted unless, for conservatism, it appears that a perma-
. ^
56
nent decline in value has taken place.
Likewise, an affil-
iate may realize an immediate profit on a transaction with
another affiliate or in an affiliate's securities.
And the
earnings of a subsidiary do not accrue to a parent \mtil
57
dividends from those earnings have been declared.
These
topics will receive more extended attention in later chapters
According to the legal-entity concept, the consolidated statements should show the combined accounts of a
"central-financial interest."
This interest is composed of
the stockholders of a holdin^r company who, through c iTnership
of the parent company, may be said to constructively own the
subsidiaries also.
According to this view, the consolidated
statement is regarded as an expanded parent compmy report
and as a substitute for the parent's statement.
For the
56
H. A. Finney and Herbert E. Miller, Principles of
Ac counting;--Advanced, Prentice-Hall, Inc. (New York, 1952),
i|.th ed., p, 3k-3t and H. A. Finney, Principles of AccountingAdvanced, Prentice-Hall, Inc. (New Yorl:, 191i6j, 3rd ed., p.
^99. THe former will be hereafter oited as '^inney ind Miller
Advanced Accovmting, 14-th ed., and the latter as Finney,
ACvaneed Accounting, 3rd ed.
"^7
" Childs, Consolidated Statements, pp. [L7-1'.8.
i
3k
purpose of minimum ambiguity in terms, the concept which
stresses ownership as the area of the entity, the legal entity
concept or "control financial interest," will be renamed the
58
"financial-'unit" point of view.
A proponent of the second concept (that of a "business
entity") holds that the peculiar relationship existing among
affiliates gives rise to the necessity for special handling
of intercompany transactions on the books of both com-panies
involved.
This view is accompanied by the suspicion that
intercompany transactions are not likely to be at arra's
length.
This concept of the business entity, like the finan-
cial-unit concept, takes the position that, theoretically,
the consolidated statements should reflect the effects of
all the affiliate's transactions as though they were in fact
those of one company.
According to the second concept, the purpose of consolidated statements is to present the assets, equities, and
earnings of the business entity.
That is, the statements
display the combined financial and operating data of all the
affiliates which cooperatively produces goods or services.
This philosophy is not concerned with whether or not the consolidated proprietorship presents the stockholders' equities
of one or several interests; rather, it is concerned with the
presentation of relationships which have no legal status, and
58
Childs, Consolidated Statements, pp,
kl'SO,
35
is likely to be misleading if it shows signs of adhering
closely to the pattern of accounts of a particular legal
entity (the parent company).
59
Therefore, consistent with
this concept is the "equity" or "book value" method of
valuing the investment account on the parent's books; the
investment is recorded at acquisition at cost, but is adJusted for earnings and dividends and losses of the subsid60
iary as those events occur.
According to the business entity concept, the consolidated statement is regarded as secondary and axixiliary to
the affiliated companies' reports.
Again, for the purpose
of minimum ambiguity in terms, the concept which stresses
operations as the area of the entity, the "business entity,"
61
will be renamed the "operational-unit" point of view.
As was noted before, whichever concept is followed
will affect the consolidated statements of the business
entity.
Specifically, the effect will be upon the treatment
of minority interests and upon the inclusion and exclusion
of affiliates in consolidation.
Ihe concepts in relation to
these two topics will be discussed in later chapters.
The foregoing discussion was predicated on the
59
Childs, Consolidated Statements, p. [|-7.
60
Finney, Advanced Accounting, 3rd ed., pp. 297-299,
and Finney and Miller, Advanced Accounting, [|.th ed., p. 3I4.3.
61
Childs, Consolidated Statements, p. 50.
36
assumption that the consolidated statement is a report that
combines the position and activities of two or more corporations which are affiliated but are of themselves separate
entities.
That is, the statement is prepared as if it rep-
resented the position and activities of a single business
entity.
That the group of companies constitute a single
business entity, however, is not the only theory that has
been advanced.
For example, the fund theory is applied to
consolidated reports in the following statement:
The fund theory viewpoint is something of an extension of entity theory, to embrace a less personalis tic set of ideas, and to emphasize even more
the "statistical" viewpoint in dealing with accounting problems, XJnier fund theory, the basis of accounting is neither a proprietor nor a corporation.
The area of interest covered by a set of acco\mts
is independent of legal patterns of organization.
The accounting-unit-area is defined in terms of a
group of assets and a set of activities or functions for which these assets are employed. Such
a group of assets is called a f\ind.
A partial use of this conception obviously underlies accounting for a sinking fund in ordinary financial reporting. The fund concept is less obvious, but
nonetheless relevant to the notions that lie behind
the preparation of consolidated financial reports.
Strict /legal/ entity theory is too closely related
to the legal""concept of a corporation to fit an organization comprising a number of corporate units.
The notion of a fund which encompasses all of the
assets and activities of a group of corporations
is, however, a perfectly reasonable approach to
consolidated statements.°2
62
William J. Vatter, "Corporate Stock Equities, in
Handbook of Modem Accounting Theory, Morton Backer, ed.,
Prentice-Hall, Inc. (New York, 1955), p. 367. Hereafter
cited as Vatter, Modem Accounting Theory.
37
Similarly, Moonitz points out the possibility of applying
the partnership theory:
The partnership concept may possibly be invoked
as a basis on which to construct consolidated statements. This alternative may assume two forms: first,
the statements are based upon a presumed partnership
of corporations, or second, they reflect a presumed
partnership of controlling and outside interests.
The first fonn assumes that the constituent companies
are on a plane of rough equality, an assumption not
consistent with the actual functioning of a holding
company group. Fundamentally the same objection may
be made to the second form. No partnership in any
but the most strained sense exists between controlling and outside interests. True, a minority interest in a subsidiary has rights which must be
respected but this consideration acts merely as
a limit to the freedom of action of the controlling group. Ihe minority may not act Independently
or exercise veto power over business policy determined
by a controlling interest,^3
These alternative concepts will not be analyzed; an
extensive analysis would be possible, and probably enlightening, but limitations of time and space necessarily narrow
the discussion to the scope already mentioned.
63
Moonitz, S n t i t y Theory, pp. 16-17.
CHAPTER II
INSTITUTIONAL BACKGROUND OF
CONSOLIDATED STATEMENTS
Consolidated statements do not exist in a social
or economic vacuum, Ttiey were developed to fulfill
a real need arising out of specific historical conditions; they are reflections on the accotinting level
of the distinctive pattern assumed in this coiintry
by the combination movement. When those historical
conditions alter sufficiently, consolidated statements will be supplanted by forms more congenial
to the changed circumstances.-^
Historical Background of the Holding Company
in the United States
The trend towards combining business undertakings
spread from England to the United States, and increased
rapidly the number and size of industrial combinations from
the late l880's to the depression of 1903. However, the
form was somewhat different from the pattern of consolidation set in Britain.
For the most part, these combinations
were in the trust form of organization in which a board of
trustees assumed ownership of the corporate shares of numerous
2
small competing firms.
"The holding company is an American invention--a
1
Moonitz, Entity Theory, p. 1.
p
Certrude Mulcahy, "History of Holding Companies and
Consolidated Financial Statements." The Canadian Chartered
Accountant, LXIX (July, 1956), PP. 59-^0. Hereafter cited
as wuicany, "History of Holding Companies."
38
39
product of the nineteenth century,"
Prior to 1893, however,
the holding company was practically imknown in American financial history.
For many years state legislatxires exclusively
reserved the prerogative of deciding in individual cases
whether corporations should be authorized to buy at will the
stock of other organizations.
And these authorizations were
k
granted only by specific acts to a certain company.
The federal government's national economic policy
followed the theory of laissez-faire, and, therefore, the
giant trusts and monopolies developed without legal restrictions or control,
^ i s development stifled competition and
limited business opportiinities; as a result, the federal
government was forced to intervene and to regulate certain
business practices.
This regulation was accomplished in
1890 by the Sherman Ant1-Trust Act which, in effect, outlawed the use of the trustee method of control.
Stimulus to the control of several corporations by
means of stock ownership was given by the Sherman Act.
The
legal means of evading the Sherman Act were provided in 1893
by New Jersey, when it amplified by amendment its corporation
law that was originally adopted in I888 to permit one
3
Cherrington, Business Organization and Finance,
p, 1+01,
Cherrington, Business Organization and Finance,
p, 1^01.
Mulcahy, "History of Holding Companies," p. 60.
i^o
corporation to hold shares in other corporations.
6
Other states followed New Jersey in enacting legislation to permit the holding company form of combination; however, the motive of monopolistic control was not changed.
The form merely changed while the substance behind the form
remained vindisturbed.
This shift from business-trust ani
voting-trust types of combination to the holding-company form
7
did, however, stimulate the growth of the holding company.
In practice, the holding company device proved defective as a means of circumventing the Sherman Act, A 1901;
Supreme Court decision (Northern Securities, 193 U,S, 197)
finally established that, without any doubt, the holding
companies were subject to the anti-monopoly legislations.
Further emphasizing the point, a decision (221 U,S. 1) in
1911 dismembered by court decree the Standard Oil Company,
a holding company.
In 191ij-, the Clayton Act was passed,
amending the Sherman Act to increase its effectiveness.
The
Clayton Act made illegal the acquisition by one organization
of stock in another company engaged in interstate commerce
where the result might be a substantial lessening of compe-
8
tition between the two companies.
"Since the passing of
6
Arthur Stone Dewing, Financial Policy of Corporations,
The Ronald Press Company (New York, 1953), vol. Z, ed. 5, p. 572.
7
Mulcahy, "History of Holding Companies," p. iM.
8
Moonitz, E n t i t y Theory, p . 2 , and Mulcahy,
of Holding Companies, " p . ^^0.
"History
kl
the Clayton Act, the holding company has been used primarily
as a method of combining business enterprises which are
9
largely non-competing:"that is, by the creation of circular
or of vertical combinations.
Except during the depression years of the 1930's, the
period since 191I4. has been characterized by a growth, in the
majority of industries, of the holding company which was
based upon the principles of efficiency of operations rather
than upon the suppression of competition.
Most of the large industrial corporations today are
operating holding companies, thus, the company can operate
its own enterprise and, at the same time, can manage by
corporate ownership of controlling shares, the affiliates
corporation through a board of directors of its own choosing.
History of the Consolidated Statement
The history of the consolidated statement may be
traced through the published reports of corporations, the
literature of acco\inting, and the questions and problems on
CPA examinations.
As might be expected, the consolidated
Mulca;hy, "History of Holding Companies," p. 61.
Moonitz, Entity Theory, p. 2.
Mulcahy, "History of Holding Companies," p. 61.
12
Mulcahy, "History of Holding Companies," p. 61.
k2
statement was used in practice before the philosophy and
procedures of consolidation were discussed in the literature
13
and examinations treating the subject.
Consolidated statements emerged as an accoiinting byproduct of the development and growth of the combination
movement in the United States and were adopted later in
other parts of the world.
Therefore, the history of the
development of their use in published reports has been
largely the history of the development of the holding company.
There is available some evidence which indicates the
earlier presentation of statments In combined or consolidated
form, but widespread use did not appear until the first decade of the present century.
Ik
Sir Arthur Lowes Dickinson, a senior partner of Price
Waterhouse & Company, was perhaps the most instrumental among
accountants in initiating the movement which led to the general use of consolidated statements by holding company groups
in the United States.
In 1902, Dickinson developed for US
Steel the first consolidated balance sheet that was published
and circulated in the United States.
A precedent being set,
this publication was influential and was followed by many
13
Childs, Consolidated Statements, p . ^ 3 .
^ Moonitz, E n t i t y Theory, pp. 6-7.
k3
15
others.
The consistent use of consolidated statements by
US Steel provided a great stimulus to the initial stages of
16
recognition of the value and general use of the statements.
Bie first extended discussion of the consolidated
statement in American business publications was an article
by Dickinson in the first volume ^19067 of The Journal of
17
Accountancy,
in which he took the position that a consolidated statement is necessary for the proper presentation of
the accounts of a holding company.
In the July, 1925 issue of The Journal of Accountancy,
an editorial provided an interesting observation on the early
recognition of the value and use of consolidated statements.
Some years ago It was frequently necessary for
accountants to impress upon clients the value of
a consolidation in financial statements in giving
shareholders in holding companies a general view
of the effective financial condition of the enterprises in which they were investors. The reform
did not meet with immediate acceptance and in
many cases it was a matter of some difficulty to
carry conviction to the minds of clients. Later,
however, such bodies as the New York stock exchange,
the federal reserve board, and the ways and means
15
-^ Percival P, Br\indage, "Consolidated Statements,"
Contemporary Accounting, American Institute of Accountants
(new lork, 19i|.5), chap7 5, p. 1. Hereafter cited as
Brundage, Contemporary Accounting,
Mulcahy, "History of Holding Companies," pp. 61-62.
17
Arthus Lowes Dickinson, "Some Problems Relating to
the Accounts of Holding Companies," The Journal of Accountancy, I (April, 1906), pp. I|.87-l|91.
hk
committee of the house of representatives became
appreciative of the value of consolidated accounts
and of the meagreness of the light afforded in
many cases by purely holding company accounts, and
the practice of consolidation extended rapidly so
that to-day the standing of consolldatedQaccounts
in American finance is beyond question,^"
An early textbook. Consolidated Statements for Holding Company and Subsidiaries, by H, A, Finney, was published
19
in 1921^,
This was a work of notable importance and was
followed by G, H, Newlove's Consolidated Balance Sheets
/I9267
and was followed by his Consolidated Statements
^ o^ 21
Including Mergers and Consolidations /19l|.£/.
Now, almost
all accounting textbooks which treat the more advanced subjects have a section dealing with the preparation of consolidated statements.
"Aside from the holding company itself, probably the
most influential factor in shaping the uneven development of
the popularity, the form, and the content of consolidated
18
"Development of Consolidated Statements," The
Journal of Accountancy, XL (July, 1925), p. 39.
19
H, A. Finney, Consolidated Statements for Holding
Companies and Subsidiaries, Prentice-PIall, Inc. (New York,
1924). Hereafter cited as Finney, Consolidated Statements.
20
George Hillis Newlove, Consolidated Balance Sheets,
The Ronald Press Company (New York,192D).
21
George Hillis Newlove, Consolidated Statements
Including Mergers and Consolidations, D. C. Heath and
uompany fNew York, 1914-^), Hereafter cited as Newlove,
Consolidated Statements.
statements has been the various Federal revenue acts."
22
There has been a continuous, but varying, interest in the
technical development of the statement, the interest varying
directly with the extent to which consolidated returns are
23
acceptable for income-tax purposes.
In addition to the Bureau of Internal Revenue, other
public and quasi-public agencies have given partial or complete recognition to consolidated statements. The California
2ll
Corporation Law has already been cited;
the Securities and
Exchange Commission has discretionary power to require consolidated statements ^^ecurities Exchange Act of 19314-, Sec.
13(bJ[7 and prescribes directions in Regulation S-X, Article
kf
for the "consolidated and combined statements" for those
25
electing to use them;
the Stock List Department of the New
York Stock Exchange also provided to the holding companies
the option of publishing separate statements for the parent
and each subsidiary or consolidated statements for the group,
26
with specific requirements laid down for the latter choice.
Regarding the topic of consolidated statements included
22
Moonitz, E n t i t y Theory, p . 7 . See a l s o Kracke,
" C o n s o l i d a t e d F i n a n c i a l S t a t e m e n t s , " p p . 373-375•
23
Moonitz, E n t i t y Theory, p . 7 . See a l s o Brundage,
Contemporary A c c o u n t i n g , c h a p . 5 , PP. 2-3*
2h
^ See page 2 2 ,
25
K r a c k e , " C o n s o l i d a t e d F i n a n c i a l S t a t e - i e n t s , " P , 375.
26
Moonitz, E n t i t y Theory, p p . b - 9 .
1+6
in early C,P,A, examinations, Childs states:
The first C P . A , examination found, , ,which
included a problem on the accounts of a holding
company was the June, 1901^., "Practical Accounting"
examination set b y the State of New York. A similar
problem w a s assigned on the Illinois "Practical
Accounting" examination of M a y , 1905, and on the
Pennsylvania "Theory of A c c o u n t s " examination on
the same date. There were also similar problems
in the New York "Auditing" examination of October,
1 9 0 7 , and in the Illinois "Practical Accounting"
examination of 1 9 0 7 ,
A problem on the Illinois "Practical Accounting"
examination of M a y , 1 9 1 2 , was the first found in
w h i c h a consolidated balance sheet was required.
This w a s a very simple o n e , calling for the combination of the accounts of parent and subsidiaries
at date of acquisition. No adjustments and only
two eliminations were required, A more difficult
problem was set on the Illinois "Practical Accounting" examination of M a y , 191ij-, '
Since that time, questions and problems on consolidation procedures and theory have occurred with relative
frequency.
In the light of the brief historical survey presented
above, it appears that the device of consolidated
statements
for presenting group accoimts of affiliated companies has
been used by accountants for almost sixty years.
About
fifty years ago the philosophy and procedures were first
discussed in the literature of accounting; about that time,
also, questions and problems on consolidation were first
27
Childs, Consolidated Statements, p. 1^6.
k7
included in CPA examinations.
28
Quantitative Importance of the Holding Company
in the United States
The parent-subsidiary organization has a very important place in the American economy,
A study was made in 19i;0
by the Work Projects Administration under the sponsorship of
the Securities and Exchange Commission and showed that 1,114-7
of the 1,961 (58^) registrants studied (out of 2,14.85 with
securities listed on the national securities exchanges on
29
June 30, 1938) had one or more subsidiaries apiece.
Of the above 1,114.7 holding companies, the following
distribution was given:
90 registrants reported no active subsidiaries
675 registrants reported 1 to 5 active subsidiaries
177 registrants reported 6 to 10 active subsidiaries
85 registrants reported 11 to 20 active subsidiaries
l4i4- registrants reported 21 to 30 active subsidiaries
38 registrants reported 3I to 50 active subsidiaries
25 registrants reported 51 to 100 active subsidiaries
13 registrants reported 101 and over active
28
Childs, Consolidated Statements, p. I4.6.
29
Childs, Consolidated Statements, p. 11. The study
was made by the Work Projects Administration of the Securities and Exchange Commission, entitled Statistics of Ancrican Listed Corporations, Part 1 (December, 19U-0).
^8
30
subsidiaries.
The 1,114.7 reported the control of 13,233 subsidiaries in the
31
year 1937, or an average of 11,5 pe3? company
or an average
32
of 10,1 active subsidiaries per registrant.
Except for
the electric light and power industry, the active domestic
subsidiaries were classified as to the number of steps they
were removed from their parent companies, as follows:
70 per cent were one step removed from their parents
23 per cent were two steps removed from their parents
5 per cent were three steps removed from their parents
2 per cent were four or more steps removed from the
33
parent company.
More than four-fifths of the subsidiaries were controlled by
their immediate parents through ownership of at least 95 per
cent of their voting power. More than 20 per cent of all
subsidiaries were incorporated abroad.
3k
From the study, Moonitz concludes that:
30
^,
Newlove, Consolidated Statements, p. 26.
31
Childs, Consolidated Statements, p. 11.
32
Moonitz, E n t i t y Theory, p . 1 1 .
33
Newlove, Consolidated Statements, p. 26.
3k
Moonitz, E n t i t y Theory, p . 1 1 .
k9
• , ,for the important segment of American business
represented by the Securities and Exchange Commission's summary, (1) the type of intercorporate relationship giving rise to the use of consolidated
statements is prevalent in all sectors of the economy, (2) foreign subsidiaries play a significant
part in the American corporate structure, (3) subholding companies are employed extensively enough
to warrant some attention, and (k) the problem of
outside or minority interest is of strategic importance in about one-fifth of the cases,35
A similar though less exhaustive study was made by
the American Institute of Certified Public Accountants, and
published in Accounting Trends and Techniques,
The 1955
edition shows that in 195^, 8l,i|. per cent of the 600 companies included in their annual survey had subsidiaries.
•^6
In the 1957 edition, of the 600 companies surveyed, 510, or
37
85 per cent had subsidiaries.
It is not to be denied that, over the years, the
holding company form of combination has been established as
an integral part of American industrial activities.
35-^ Moonitz, Entity Theory, p. 11.
•^6
Mulcahy, "History of Holding Companies," p. 61.
37
American Institute of Certified Public Accountants,
Accounting Trends and Techniques in Corporate Annual Reports-televenth Fdition, American Institute of Certified Public
Accomitants (New York, 1957), p. 126.
.liuU
CHAPTER III
CONDITIONS UNDERLYING CONSOLIDATION
There has been extended discussion among accountants
about the conditions which should be present to Justify the
1
preparation of consolidated statements.
At the outset of
a discussion of this topic, it may be well to state a general
rule:
", , .when power to control is present, that principle
of inclusion or exclusion should be followed which will most
clearly exhibit the f,inancial condition and results of opera2
tion of the parent company and its subsidiaries."
Generally, the presentation of consolidated statements
is in order when there exists a business entity composed of
3
two or more legally separate units.
And conversely, since
consolidated statements are designed to reflect the position
and operations of a group of closely related business units,
they should not be prepared unless the assumption of a business entity can be Justified.
The general principle is
clear; and, in the majority of cases, its application is
easy.
However, in other situations the principle is far
•^ William A. Paton and Robert L. Dixon, Essentials
of Accounting, The Macmillan Company (New York, 195^5), p. 726.
Carman G. Blough, ed., "Criteria Involved in the
Preparation of Consolidated Statements," The Journal oi
Accountancy, LXXXVIII (November, 19i+9), p. 14-37.
3 Moonitz, Entity Theory, p. 20.
^ Carson, "Accounting for Mergers and Consolidations,"
p, 32Q.
50
51
from easy to apply.
Thus, to make it objective and definite,
the principle must be recast into concrete form,
"The need for explicitly stated objective standards
arises from the wide circulation accorded published consolldated statements,"
When the statements are given general
circulation, their specific frame of reference must either
be known to potential users or clearly expressed in the
statements themselves, otherwise, there is room for misimder6
standing of the data as presented,
7
As was noted above,
the financial-Tmit or operational-
unit concept that is followed will affect the consolidated
statements of the business entity; under consideration here
is the effect upon the inclusion or exclusion of the affiliates in consolidation.
The basic areas of conflict are the
percentage of ownership and the control exercised.
Common
criteria exist, however, among both concepts, and these
criteria include the agreements that only economically related companies be included, and that subsidiaries which
were not to be held for any length of time be excluded, to
name only two.
The presence of the common criteria concern-
ing inclusion or exclusion of a subsidiary appears to indicate
that the two points of view are different only in degree.
-^ Moonitz, Entity Theory, p, 20,
Moonitz, Entity Theory, p. 20.
7
See page 32,
52
and not different in kind; both are trying to show as much
of the data of business entity as their basic philosophies
8
will allow.
Regardless of the choice of concept, niamerous criteria
have been employed for the determination of the area of consolidation.
Attention will be directed to the major criteria,
Percentage of Stock Ownership and Control as Standards
It is obvious that consolidation through stock ownership cannot exist without the concentration of the subsidiary's shares in the hand of the dominant parent company.
As a consequence, a percentage of stock ownership is fre9
quently cited as an appropriate standard to use.
Further-
more, it is generally accepted that the actual circumstances
rather than hard and fast rules concerning the percentage of
stock ownership should be permitted to settle the matter of
inclusion or exclusion of subsidiaries from consolidation.
That is to say, percentage of share ownership is not the
10
only criteria;
control is equally, if not more important.
8
-. ^x
Childs, Consolidated Statements, pp. 53-5^^; Jennie
M. Palen, Report "Writing for Accountants, Prentice-Hall, Inc.
(Englewood Cliffs, New Jersey, 1955), PP. 260-261.
9
Moonitz, Entity Theory, p. 21.
Mulcahy, "Consolidated Statements--Principles and
Procedures," pp, 152-153; Walter A, Staub, "Some Difficulties
Arising in Consolidated Financial Statements," The Journal of
Accountancy, LIII (January, 1932), p. 12.
53
The inclusion and exclusion of subsidiaries in consolidation depend upon the accepted concept.
Adherents to
the financial-unit concept say that a subsidiary in which
the parent holds at least a majority of the voting stock will
be included.
In theory, this premise would mean that considera-
tion is proper at any level above 50 per cent ownership; but,
in practice, consolidation policy generally followed by
corporations set self-imposed ownership requirement standards which are far higher than a simple majority of voting
shares.
The following reasons seem to support a requirement
to consolidate only the 100 per cent-owned subsidiaries:
(l) such a standard of consolidation may be said to more exactly manifest the characteristics of the individual statement of the parent company and to be an acceptable substitute
for it; (2) such a high degree of ownership minimizes the
possibility of distortion when the several financial positions and results are combined; (3) a statement for a closelyheld group may be deemed better to exhibit the position of a
central financial Interest, a single body of stockholders.
Generally, "the adherents of the financial-unit concept appear to believe it necessary for a parent to be pre„12
pared for any eventuality in its exercise of control.
On the other hand, if managerial, rather than financial.
^^ Childs, Consolidated Statements, pp. 68-69.
^2 Childs, Consolidated Statements., p. 69.
5^
control is the basic criterion for inclusion, the consolidated statement will follow the adherents of the operationalunit concept.
That is, the statement will show the combined
position and results of operations of a group of companies
unified by common management rather than by common ownership.
Therefore, "the statement may include those affiliates whose
stocks are wholly-owned, and those controlled by minority
ownership, lease, management contract, or in some other way. "-^3
As the discussion indicates, an irreconcilable
difference in philosophy exists between the two
concepts of the purpose of consolidated statements.
But, since most parent companies hold at least
maJority--often 100 per cent--interests in the
stocks of all subsidiaries, the difference may be
of little practical Importance, Howev r, because
subsidiaries are usually held by ties of majority
' ownership, the fact that a consolidated statement
is designed to reflect one or the other concept
should not be obscured. The difference is actually
in the point of view, not in the devices by which
subsidiaries are affiliated. Thus, a consolidated
statement for an operational unit may be constructed
when the subsidiaries are majority-owned or whollyowned if all—and only--economically related companies under common operation are included.-'-MThus, accounting authorities generally agree that
consolidated statements are to be used only when the holding
company owns a controlling interest in the affiliated corpo-I r'
ration; -^ the dispute is within the interpretation of
TT
Childs, Consolidated Statements, p. 70.
Childs, Consolidated Statements, p. 71.
^ Sidney I. Simon, "Consolidated Statements and the Law,"
The Accounting Review, XXVIII (October, 1953), PP. 509-510.
55
control—should the consolidation be based on managerial or
financial control?
scope of this work.
A resolving of this issue is beyond the
It may be said, however, that, consistent
with the assumption that consolidated statements are to be
regarded as auxiliary and supplementary statements, are to
be designed primarily for a particular ownership and management interest, and are not to be permitted to be used as
substitutes for the legal-entity reports, it is entirely
proper to adopt a broad view with respect to the tests to be
16
applied in determining whether or not to consolidate.
However, the exact percentage of stock ownership which
should be obtained before the statements of the controlled
company are to be included in consolidation cannot be stated.
The only points on which there seems to be practical agreement are: (1) all wholly-owned subsidiaries (assuming similar
and/or complementary operations) should be included; (2) all
companies in which ownership is below 50 per cent would,
ordinarily, be excluded. 17 In the interest of conservatism
and since operating control in the last analysis depends
upon voting control, the principle might be adopted that
16
Paton and Paton, Corporation Accounts, p. 577.
See also the discussion of "control" in Kohler, "Tentative
Propositions," p. 614..
17
Wixon, Accountant's Handbook, chap. 23, p. 3;
"Percentage of Ownership Required for Consolidation,"
The Journal of Accoimtancy, LXXI (June, 19l|.l), pp. 553-53i4-.
56
those subsidiaries that are less than 50 per cent owned
would be consolidated only if some good purpose can be served
1 ft
by the consolidated statement.
In that way the policy
would be directed toward the general objective of producing
the most informative and useful statements for the purpose
19
for w h i c h they are designed.
As a practical matter, the operational-unit
"principle
of consolidation" has not been widely adopted for two reasons:
(1) the conviction of the majority of accountants that consolidated statements properly are designed to exhibit the
equities of a central financial interest, and (2) the rules
of governmental agencies irtiich contemplates that flnancial20
unit statements are to be constructed.
The Securities and Exchange Commission, in Regulation
21
S-X;
has adopted the rule that "the registrant shall not
consolidate any subsidiary which is not a majority-owned
subsidiary."
And a "majority-owned subsidiary" is defined
1 ft
Paton and Paton, Corporation Accounts, p. 577;
Staub, "Some Difficulties Arising in Consolidated Financial
Statements," p . 1 7 .
19
American Institute of Accountants--Research Department, "Some Problems Regarding Consolidated and Parent Company Statements," The Journal of Accountancy, XCVI (November,
1953), p. 571.
20
Childs, Consolidated Statements, pp. 70,7l4--76,7B-80.
21
Securities and Exchange Commission, "Consolidated
Statements of the Registrant and its Subsidiaries," Regulation S-X, Rule 4-02 (I95I4-), p . 9.
57
as a company in which securities "representing in the aggregate more than 50 per cent of the voting power owned directly
by its parent and/or one or more of the parent's major!ty..22
owned subsidiaries."
Although the commission implements
the financial-unit concept, it recognizes that consolidated
statements may conceal deficiencies when the statements are
used as a substitute for those of the parent and therefore
the commission requires that the parent's individual statement also be given.
The Treasury Department adheres more to the financialunit concept than does the commission.
According to the 195^4-
Intemal Revenue Code, a group of affiliated corporations may
file consolidated tax returns.
An affiliated group is de-
fined as a group that
is formed when (1) at least 80^ of all classes of
voting power stock and at least 80^ of each class
of nonvoting stock of each includible corporation
(except the common parent corporation) is owned
directly by one or more cf the other includible
corporations, and (2) the comrion parent corporation owns directly 80^ of all classes of the voting
stock and at least 80^ of each class of nonvoting
stock of at least one of the other includible corporations. The terra "stock" does not include nonvoting stock which is limited and preferred as to
dividends /§ec, 1501; 1.1501-1, 1.1502-27.
Election to file a consolidated return is binding for subsequent years unless: (1) The affiliated
22
Securities and Exchange Commission, Regulation
S-X, Rule 1-02, p. 1, as stated in Childs, Consolidated
Statements, p, 75.
58
group adds a new member which was not organized
directly or Indirectly by any other member of the
group,
(2) An amendment of the tax laws or regulations
makes consolidated returns less advantageous to
affiliated groups as a class.
23
(3) The commissioner consents /See. 1.1502-117.
Two features of the above definition are that it contemplates
indirect control of affiliates, and that the ownership of nonvoting as well as voting stock is required,
"The high ownership requirement in the /Code/ was
probably made to forestall any question as to the unity of
2k
the group of included affiliates."
There must be maintained, however, a distinction between broad i*ules designed to cover virtually all possible
cases of a parent-subsidiary relationship, and a standard of
accovmting procedure.
The broad rules aid in defining the
boundaries within which the business entity sought may reasonably be expected to be fo\md.
A standard of accounting
is an injunction to proceed beyond a mere survey or examination of the field to the preparation and presentation of a
relatively precise description, in accounting terms, of the
well-defined entities discovered.
25
3 William F, Connelly and Robert B. Mitchell, Prentice
Hall 1958 Federal Tax Course, Prentice-Hall, Inc. (Englewood
Cliffs, New Jersey, 1957), paragraph 3105, P. 3107.
^ Childs, Consolidated Statements, p. 79.
^^ Moonitz, Entity Theory, p. 27.
59
For example, consider the following definition by
Bonbright and Means:
•^^^^•^^^^^ company may then be defined in terms of
its distinguishing characteristic as any company with
share capital which is in a position to control or
materially influence the management of one or more
companies by virtue, in part at least, of its ownership of securities of the latter.^^
As a general guide to parent-subsidiary relationship, the
definition is useful.
However, as a standard of accounting,
the definition is not adequate; for, unless the parent exercises that influence sanctioned by majority stock ownership, no parent-subsidiary relationship exists.
That is to
say, the influence must be actual, not merely potential; on
this basis, "controlling influence," of itself, cannot be
accepted as a guide to inclusion or exclusion of subsidiaries
in consolidation. '
Also, in brief, percentage of stock ownership is not
in itself satisfactory as a standard indicating the precise
extent of the area of consolidation.
Except for somewhat
arbitrary boundaries (useful in taxation and regulation),
there may not be devised a general quantitative formulation
26
Moonitz, Entity Theory, pp. 28-29; Bonbright and
Means, Holding Companies--its Public Significance and its
Regulation, p7 10.
^^ Moonitz, Entity Theory, pp. 28-29; John Peoples,
"Preparation of Consolidated Statements: When Subsidiaries
Should be Included and How They Should be Treated," The
Journal of Accountancy, CIV (August, 1957), p. 33•
60
which will equate the essential factor, control, with the
amount of a parent's stock interest in its subsidiaries.
Several classes of stock may have actual or potential voting
ri^ts; or conversion rights may hinder adequate control by
the parent--elther of these (and other situations) may exist;
and each case must be decided upon its own merits.
Included
in the statement should be the criteria upon which was based
28
the decision of the existence of centralized control.
Similarity of Operations as a Standard
Assuming that a satisfactory criterion of control is
available, there is the additional problem of deciding on
the inclusion or exclusion of those subsidiaries which are
not homogeneous with the parent company or with other com29
panles•
Since the purpose of consolidated statements is to
present a over-all picture of the financial position and of
the results of operations of a group of companies as If^ they
30
were one company,
and, since the objective of preparation
should be to make a financial presentation which is most
28
Moonitz, Entity Theory, p, 27,
Wixon, Accountant's Handbook, chap. 23, pp. 3-i4-.
3^ Ralph Dale Kennedy and Stewart Yarwood McMullen,
Financial Statements—^o™9 Analysis, and Interpretation,
Richard D. Irwin, Inc, Uomewood, Illinois, iv5Y), jra revised
ed., p. lj.10.
61
meaaJUagful under the circiimstances, it follows that the
character of the business has an important bearing on whether
a subsidiary should be included or excluded from the consolidation.
There may be present within the affiliation not only
a similarity of general objectives, but also a dissimilarity
of the means employed to those ends.
Regardless of the opera-
tions conducted within the combination, the objective is the
strengthening of the financial position and earning power of
the group in power.
However, the constituent units may be
32
engaged in activities of such diverse nature
that a single
combined presentation of financial data would be unrealistic
33
and of doubtful, if not without, value.
31
Brundage, Contemporary Accounting, chap, 5, p. k»
32
Moonitz, E n t i t y Theory, p . 2 9 .
33
Karrenbrock and S.imons, Advanced Accounting—Comprehensive Volume, p, 325. Cf. the contrary view expressed
by H, W, Bordner in "Consoli"3ated Reports," The Accounting
Review, XIII (March, 1938), p. 291: ", . .there is some
credit apparently given to the position that subsidiaries not
homogeneous with the controlling company should not be Included
in consolidated statements. This point has been over-emphasized. The homogeneity of activities of a single corporation
does not cause accountants to exclude the assets, liabilities
and operations of such activities from the corporate statements. Net income is net income, regardless of the nature of
the activity producing it. It is thought that in such cases
confusion in the financial statements can be avoided by showing the net income of nonhomogeneous activities as a special
item or items under the heading of other income in the consolidated profit-and-loss statement, and perhaps by showing
Investments in plant and equipment of such activities as
separate items in the balance sheet,"
62
A composite picture of the affairs of a group of companies
which are closely integrated or allied in their activities
obviously has more significance than a Joint report for a
heterogeneous collection of enterprises.3-!- Moreover, the
strongest case for consolidated statements is the situation
where a parent company and its wholly-owned subsidiaries
together constitute an integrated line of endeavor under a
common management,35
The Committee on Accounting Concepts and Standards of
the American Accounting Association state the following concerning similarity of operations.
An affiliate, to be included in consolidation,
must ordinarily manufacture a product or perform
a function or render a service which contributes
directly to the activities in which the over-all
enterprise is primarily engaged. Consolidated
statements are useful representations when integration of the productive and distributive processes is accomplished through the interrelated
activities of the parent company and its subsidiaries. In some instances, the activities of an
enterprise may be so extensively integrated that
a subsidiary is performing a function, such as
a finance or insurance function, which extends
beyond the ordinary productive and distributive
processes. A subsidiary of this type may be excluded from consolidation in order to avoid the
commingling of dissimilar assets and sources of
income. In view, however, of the marked trend
toward diversification of activities on the part
3k
Paton and Paton, Corporation Accounts, p. 579;
William A. Paton, Advanced Accounting, The I'acmillan Company
(New York, I9I4.I), p. 752.
35
Kohler, "Tentative Propositions," p. 6iL.
63
of American businesses, care should be exercised
in the use of the "primary activity" of the enterprise as a criterion of inclusion or exclusion.3^
Consistent with this line of thought concerning diversification is the statement by Finney and Miller:
However, a lack of homogeneity in the assets and
operations of a parent and a subsidiary is not a
reason, without exception, for the exclusion of the
accounts of the subsidiary; consolidated statements
of a heterogeneous group may be as meaningful as
those of a single company engaged in a variety of
oy
activities. Each case must be decided individually.
Thus, as a practical consideration, the presence of
an economic relationship between parent and subsidiary and/or
between subsidiaries is fundamental to any consolidation.
To
be included, a subsidiary must, ordinarily, contribute
directly to the productive, distributive, or service activities in which the business entity is primarily engaged.
Its
function may be either similar or auxiliary to those of the
other affiliates.
In any case, there must be some integrat38
ing factor among the consolidated subsidiaries.
National Concentration as a Standard
The fundamental criteria governing the propriety of
36
„
American Accoiinting Association, "Consolidated
Financial Statements," p. 14.3.
37
Finney and Miller, Advanced Accounting, Li-th ed., p. 522.
Childs, Consolidated Statements, p. 71.
61;
including the accounts of legally separate entities in consolidated statements has been examined, and it is appropriate
now to examine the special circumstances relating to the investment in a foreign corporation, insofar as these circumstances may affect the application of these criteria.
Immediately after the termination of World War II and
for several years thereafter, no problem of consolidating
foreign accounts existed for the majority of US corporations
owning investments abroad.
Foreign trade was largely doiroiant
and was secondary to the demands from the domestic economy.
Moreover, the exchange rate situation made intelligent estl39
mates of realization on investments extremely difficult;
the rates were uncertain and often unstable, and restrictions
between the United States and the rest of the world were enforced.
Today, however, the situation faced by these corporations and their accountants is quite different.
Foreign sub-
sidiaries and branches of US companies are increasingly
i4.0
active.
The question of inclusion or exclusion has become
more pertinent.
Moreover, the answer is difficult because
standard translation and consolidation procedures that are
39
William D. Cranstoun, "Consolidation of Foreign
Subsidiaries," The Journal of Accountancy, LXX (September,
1914-0), p. 272.
James A, Kelley, "Should a Corporation Consolidate
its Foreign and Domestic Accounts?" New York Certified Public
Accountant, XXVI (October, 1956), p. 5^5.
65
followed consistently may yield differing results for separate foreign locations because of varying conditions.
It is within the area of the existence of effective
control that arise the bulk of the problems which are created
by investanent in a foreign subsidiary.
For example, owner-
ship of all or of a substantial portion of the foreign affiliate's voting shares does not represent an adequate indication of the existence of effective control.
There may exist
at least three types of restrictions which are imposed by a
foreign government and which operate to limit the degree of
control, conveyed by dominant stock ownership, over corporate
resources and operations.I4-I
As the first restriction, it is not -uncommon for
foreign governments to impose legal regulations requiring
nationals to own a certain per cent of the voting stock of
every subsidiary incorporated in that country.
Obviously,
this restriction inmiediately bars complete ownership of the
voting shares; in some cases, the requirement may be substantial, if not prohibitive.
The effect of this restriction
would be a direct result of the identity of the foreign holders
of the voting shares, and of their attitude toward cooperation
with the American corporate stockholder in matters of policy
and operations of the foreign subsidiary.
Consequently, no
^ Samuel R. Hepworth, Reporting Foreign Operations,
volume XIII of Michigan Business Studies, Bureau of Business
Research, School of Business Administration, University of
Michigan (Ann Arbor, Michigan, September, 1956), No. ", p. 162.
66
general conclusion may be drawn about the results of this
restriction upon the existence of effective control.
Another
similar regulatory measure may involve the requirement that
a specified number of the members of the board of directors
of the foreign corporation be nationals of the country of
incorporation, regardless of the ownership of the voting
shares.
The result of this sort of requirement on the effec-
tiveness of parent company control must also be determined
in view of the specific circumstances and in consideration
of the attitude of the foreign representatives on the board.
If regulations of the type mentioned above become so restrictive that they actually impair the effectiveness of the control which may be exercised by the American parent corporation over the activities of the foreign affiliate, it is
necessary to exclude the foreign affiliate from the consollI4.2
dated statement,
Moonitz effectively summarizes the possibilities in this area:
It is hardly likely that a corporation would acquire or establish a foreign subsidiary in the face
of local prohibitions effectively preventing control,
but the restrictions might very well be enacted subsequently. As a result a continuing examination of
foreign business regulations is essential in order
to determine whether or not a constituent xmit has
been converted into a mere foreign investment. As
soon as the obstructions become onerous enough to
^ Hepworth, Reporting Foreign Operations, pp. 16:>163.
See Kelley, "Should Corporation Consolidate its Foreign and
Domestic Accounts?" for some pertinent positive and negative
arguments in connection with this problem.
67
render integrated operations impossible the subsidiary should be dropped from consolidation and the
investment therein classified as non-operating.^3
The second type of restriction which must be considered
in reaching a decision concerning the existence of effective
control over a foreign subsidiary at a particular time, and
hence, concerning the propriety of including the accounts of
the foreign subsidiary in consolidation, relates to restrictions on the convertibility of the foreign currency for the
purpose of obtaining dollars to remit to the American parent
company.
In general, restrictions on convertibility in connection with the withdrawal of capital should have no effect on
the recognition by the parent company of undistributed subsidiary earnings.
Further, restrictions on the withdrawal of
funds representing current earnings should have no necessary
influence on the propriety of recognition of undistributed
earnings of the foreign subsidiary by the American parent.
With regard to the impact of convertibility restrictions on
the concept of effective control in connection with the inclusion of foreign subsidiaries in consolidated statements,
a similar conclusion must emerge.
Restrictions on interna-
tional capital movements should not be considered as impairing the control exercisable by the parent corporation over
^-^ Moonitz, Entity Theory, pp. 32-33.
•WIW^XPTIW
68
subsidiary operations to a degree sufficient to necessitate
exclusion of the subsidiary's accounts from consolidation.
Limitations on the ability of any corporation to make to
stockholders distributions which represent a return of invested capital are a traditional part of the legal framework
governing the relations between a corporation and its stockholders.
Restrictions of this type are not considered to
impair the effectiveness of intercorporate lines of control
in a strictly domestic situation to a degree which renders
the preparation of consolidated statements inadvisable; and
there would seem to be no reason to interpret differently
restrictions on capital withdrawals in a situation involving
kk
a foreign subsidiary.
When we turn to the examination of the effect of restrictions on the remittance of current earnings of a foreign
subsidiary to its parent corporation upon the concept of control, the situation becomes less clear-cut than was the case
of restricted capital movements.
Restrictions on the remit-
tance of foreign earnings to an American parent vary in
severity, serving to make difficult the formulation of any
generally applicable conclusion.
Restrictions may include
limitations on the amount of current earnings which may be
^ Hepworth, Reporting Foreign Operations, pp. I63-I6I4.;
Percival F, Brundage, ^'Some Shortcomings in Consolidated
Statements." The Journal of Accountancy, L (October, 1930),
p, 289,
^'W
69
withdrawn; discrimination between countries to which earnings
may be paid; approval or disapproval of each application for
exchange for this purpose based on the merits of each particular case; the making of special arrangements with particular American corporations; or outright prohibition on the
withdrawal of earnings under the circumstances.
This extreme
degree of variability makes essential the emphasis of the
necessity of considering the specific circumstances of each
parent-subsidiary relationship in reaching a decision about
the impact of convertibility restrictions on the existence
of effective intercorporate control and the resulting appro-
k5
priateness of consolidation.
The following statement serves
to summarize the conclusions in this area, and to indicate
some of the pertinent considerations which may soften the
effect of currency restrictions on intercorporate control.
In addition to specific restraints on control of
local companies, a foreign country may place general
obstacles in the way of the free transfer of funds,
culminating in some instances in outright prohibition of the export of foreign exchange. So long as
the restrictions remain on the financial level merely
to force transfer through officially designated channels or to implement some phase of monetary policy,
essential unity of operations is not destroyed. The
hazards of foreign operations are probably thereby
increased but their nature is not materially changed.
In a sense restrictions of this type are a commonplace everywhere, except that usually they are imposed by contract, not by governmental decree.
k5
Hepworth, Reporting Foreign Operations, p. lt«!j.;
Stempf, "Consolidated Financial Statements," pp. 367-36o.
70
For example, a domestic subsidiary may be restrained
by a bond indenture from paying dividends or lending
money until provision is made for creditors. A curtailment of this kind in domestic affairs is usually
not considered severe enough to warrant excluding
the subsidiary from consolidation, and complications
in foreign affairs may be dealt with in a similar
manner.
When foreign exchange exports are prohibited entirely the traditional basis of international business operations is shorn away. In most instances
the basis of continued unified operations is likewise
seriously impaired. Assuming no commodity exportimport prohibitions other than customary tariff
barriers, however, a foreign subsidiary engaged in
an extractive industry, processing basic raw materials, or manufacturing may easily continue to operate as an integral part of a far-flung international
holding company empire. In such a case the American
parent would finance foreign operations and be reimbursed by bringing out of the foreign country the
ores, metals, or manufactured products to be used or
sold elsewhere.
In a similar manner revenues from foreign sales
could be recovered by purchasing raw or finished
materials abroad and using them in other phases of
a combination's operations. The impact of restrictions on funds transfers must therefore be determined in the light of operations actually carried
K^
on and the adjustments available to meet restraints.
The preceding statement by Moonitz emphasizes that the
existence of currency restrictions at a particular time does
not in itself necessarily impair the effectiveness of the
control which an American parent corporation may exercise
over a foreign subsidiary.
Rather, it is necessary to con-
sider the impact of such restrictions in each case in view
of the effect on normal relationships between the parent and
Moonitz, Entity Theory, pp. 33-31^.
71
the foreign subsidiary and in recognition of the possible
abrogation of some of the usual rights which accompany majority stock ownership—specifically, the power to freely control the administration of corporate funds.
The existence of
restrictions which limit or abolish the right of a parent
company to initiate the declaration and payment of dividends
is not adequate evidence to Justify the conclusion that the
control is impaired to a degree that exclusion from the consolidated statements be imperative.
That is, the existence
of restrictions is not of itself enough evidence to Justify
the conclusion that control is impaired sufficiently to make
consolidation inappropriate.
The third type of restriction may be imposed by a
foreign government with the resulting effect on the freedom
of control which the parent corporation might otherwise exercise.
This type of control restricts international trans-
actions at the real rather than the financial level, ±»±»,
on the transfer of commodities by such regulations as import
or export quotas or prohibitions.
Where restrictions of this
type exist--particularly where they accompany currency restrictions--the effect upon the continued existence of effective control by the American parent is likely to be nuch more
Hepworth, Reporting Foreign Operations, pp. 165-166;
B. Bernard Greidinger, Preparation and Certification of Financial Statements, The Ronald Press Company (New York, 1950),
t>. 3%.
72
severe than it would be in the case of currency restrictions
alone.
The parent in this situation could no longer resort
to commodity exchanges in lieu of the payment of cash dividends.
Although it is again essential to evaluate the cir-
cumstances in a particular case, the resulting conclusion
may be that control is actually impaired, with the result
that the criteria appropriately applied to the problem of
14.8
consolidation are no longer adequately fulfilled.
The first criterion of effective control and the related consideration of consistency of treatment are summed
up in a statement by Palen:
Ordinarily it is well to exclude from consolidation any foreign subsidiaries whose operations are
materially affected by foreign exchange restrictions
or whose operations and assets are Jeopardized by
economic or political considerations abroad. If
it is considered advisable to include them in spite
of these conditions their inclusion must not prevent
a clear and fair presentation of the consolidated
financial position and operating results and disclosure should be made, so far as can reasonably be
ascertained, of the effect of the exchange restrictions and political or economic developments on the
consolidated position and results.^*^
The second fundamental criterion, that of inclusion
within an integrated business unit, is applied to the reaching of a decision concerning the appropriateness of
Moonitz, Entity Theory, p. 3kl
Foreign Operations, pp. 166-167.
Hepworth, Reporting
1x9
^
Palen, Report Writing for Accountants, p . 2 6 l .
73
consolidating the accounts of a legally separate corporation
and will not create any special problem in the case of an investment in a foreign subsidiary.
Usually the operations of
the foreign subsidiary are closely related to the principal
activities of the parent and domestic subsidiaries; nevertheless, the criterion is the same:
any subsidiary which is
outside the area of consolidation—whose operations are not
an integrated unit in the operations of the business entity-will ordinarily be excluded from the consolidation.
Regarding the determination of the appropriateness of
including the accounts of the foreign subsidiary in the consolidated statements, the following statements set forth the
position of the Committee on Accounting Procedure of the
American Institute of Certified Public Acco\mtants:
In view of the uncertain values and availability
of the assets and net income of foreign subsidiaries
subject to controls and exchange restrictions and
the consequent unrealistic statements of income that
may result from the translation of many foreign currencies into dollars, careful consideration should
be ,given to the fundamental question of whether it
is proper to consolidate the statements of foreign
subsidiaries with the statements of United States
companies. Whether consolidation of foreign subsidiaries is decided upon or not, adequate disclosure of foreign operations should be made.50
50
American Institute of Accountants--Committee on
Accounting Procedure, Restatement and Revision of Accounting;
Research Bulletins--Accounting Research Bulletin No. k3,
American Institute of Accountants (New York, 1953), p. 112.
Hereafter cited as AICPA, Bulletin No. ,'J3.
7k
Essentially, the preceding statement reduces itself
to a wamtiig regarding the inclusion, in consolidated statements, of the accounts of foreign subsidiaries, without providing any objective criteria which can be brought to bear
on the problem of "whether it is proper to consolidate the
statements of foreign subsidiaries with the statements of
United States companies,"
Much the same situation is encountered in viewing the
Securities and Exchange Commission's pronouncement regarding
consolidation of foreign subsidiaries:
Due consideration shall be given to the propriety
of consolidating with domestic corporations foreign
subsidiaries whose operations are effected in terms
of restricted foreign currencies. If consolidated,
disclosure should be made as to the effect, insofar
as upon the consolidated financial position and
operating results of the registrant and its subsidiaries. 5^Here, again the emphasis is upon adequate disclosure,
rather than upon the development of any suggested criteria
which may be employed in evaluating the effect of exchange
and related controls on the desirability of consolidating
foreign subsidiaries.
Along the same lines, the Committee
on Concepts and Standards of the American Accounting Association stated:
51
Securities and Exchange Commission, Regulation
S-X, p. 10.
75
With disturbed conditions in foreign countries,
which may take the form of exchange restrictions
or unstable political or economic conditions, it
may be desirable to omit some or all foreign subsidiaries from consolidation. In any case, appropriate disclosure of the results of foreign operations and of their status ^ the consolidated
statements should be made,^
Thus far, the discussion has been preoccupied with the
problem of the existence of the consolidated group.
Granting
the existence of the group as a business entity, there arises
the related problem of the procedure to be followed in the
light of present unstable exchange rates.
It is logical
that in consolidation involving foreign affiliates, the results must be expressed in the terms of a common denominator,
presumably the local currency in which the accounts of the
parent are kept.
So long as exchange rates fluctuate within
narrow and well-defined limits, the task of translating a
foreign currency into local terms is purely mechanical and
presents no serious theoretical problem.
The gains or losses
resulting from slight fluctuations in rates may then be easily
absorbed as inevitable accompaniments of a business conducted
in this manner.
Violently fluctuating rates over short periods
of time, however, result in discrepancies which represent
53 See AICPA, Bulletin No. 14.3, VP* 113-116, for the
various exchange rates to be used
in the translation of the
—artH
various items appearing in the balance sheet and income statement. See also M. B. Daniels, "Financial Statements," in
Selected Readings in Accounting and Auditing, Mary E. Murphy,
ed,, pp, If9-lti0, for a discussion of exchanr;e rates.
76
speculative gains or losses, and, as such, distinction should
at least be made between those gains or losses which are already realized and those which resulted from the accidental
effect of the rate of exchange prevailing on the balance51i
sheet data, ^
The inability to reconcile the conflicting demands In
translation of two currencies that are subject to erratic and
uncorrelated fluctuations may necessitate the abandoning of
the consolidation of accounts.
This step should be taken
only as a last resort, however, and only after all possibilities of reconciliation through explanatory notes and other
devices have been exhausted.
Where reconciliation is decided
to be impractical, a group statement of the excluded subsidiaries may be feasible and may represent the best available
substitute for complete consolidation,
A group statement is
a combined statement from which the controlling interest is
absent; therefore, it merely purports to exhibit a segment
of the combined operations, and, as a consequence, its formal requirements of preparation are less than are those of a
consolidated statement.
In the face of irreconciliable ex-
change fluctuations, no serious objections may be made to the
practice of presenting the group statement in terms of the
foreign currency, with a brief resume of pertinent exchange
fluctuations.
Similarly, the group statement device may be
A Moonitz, Entity Theory, p. 3k-
77
employed to support the investment account for controlled
companies which are excluded from consolidation for reasons
other than foreign exchange instability.
However, the device
should be introduced only when inclusion of controlled sub-
55
sldiarles is clearly unsatisfactory or impossible.
Consistency of Treatment as a Standard
Consistency in consolidation is much to be desired so
the maxiravim value may be obtained from comparisons of state56
ments of successive years.
Moreover, in describing the
proper area over which consolidation may occur, procedures
must be developed and adopted which will result in comparability from period to period.
Changes must be reflected in
the going concern, but the distinction must be maintained
between alterations that result from business activities and
those that are imposed in response to a new conception of the
problem at hand—consistency is violated in the latter instance and not in the foi*mer.
57
Subsidiaries over which control has been recently acquired must be included in consolidation, and no inconsistency
exists by having more constituent units during this period
than last.
The entity has expanded, and the expansion nust
55
^-^ Moonitz, E n t i t y Theory, pp. 35-36.
56
Kohler, "Tentative Propositions," p. 65.
57
Moonitz, E n t i t y Theory, p . 36.
78
be reported in the consolidated statement.
An inconsistency
does exist, however, if temporarily controlled companies were
included during the last period, but excluded from the present
consolidation.
Unless former procedures are wholly indefen-
sible (and in that case abandonment is proper), a redefining
of the area of consolidation is to be avoided in the interest
of comparability.
If it does become necessary to change the
basis of consolidation, specific attention should be called
to the change, and an estimate should be made of the effect
of the change upon important statement categories.
Through
such procedure, deliberate or unintentional misstatement of
58
a company's progress will be avoided.
Since inclusion and subsequent exclusion would adversely affect the comparability of succeeding statements, a
subsidiary which is likely to lose that status through sale
or dissolution should ordinarily be excluded.
Similarly,
adherence to the going concern concept requires that subsidiaries which are controlled incidently or temporarily be excluded from consolidation since they are not an integral part
of the concern's operations.
The investments in such subsid-
iaries will, however, be included along with other similar
holdings in nonaffiliated companies.
For the same reasons,
companies in the process of promotion, liquidation, or reorganization should be excluded, except where reorganization
58
Moonitz, E n t i t y Theory, pp. 36-37.
79
is purely formal and does not interfere with the normal ac-
59
tivities of the business.
The treatment accorded companies
whose status has changed, therefore, must necessarily be determined by the nature of the altered circumstances.
Again, to be included in consolidation, a subsidiary's
balance sheet must be as of approximately the same date as
that of the parent and its profit and loss statement must
60
cover approximately the same period as that of the parent.
The rules of the Securities and Exchange Commission require
that the statements of a consolidated subsidiary shall not
be as of a date differing nor a period ending more than 93
days from the dates of the corresponding statements of the
, 61
registrant (parent).
Regarding differing closing dates,
Moonitz states:
Clearly a company may not be excluded from consolidation merely because its accounting period
tei»minates on a date different from the closing
59
Childs, Consolidated Statements, p. 73; Moonitz,
Entity Theory, p. TT'
An
American Accounting Association, "Consolidated
Financial Statements," p. k3; E. I. FJeld and Lawrence W.
Sherritt, Advanced Accoimting, The Ronald Press Company
(New York, 19i4-6), p. li|.5, and Carman G. Blough, ed., "Consolidation of Balance Sheets of Domestic Corporations with
those of Foreign Subsidiary," The Journal of Accountancy,
LXIII (April, 1937), p. 298.
6l
Securities and Exchange Commission, Regulation S-X,
Rule 14.-02, p. 9; Carman G. Blough, ed., "Treatment of Subsidiaries in Consolidated Statements," The Journal of Accountancy, LXXIII (April I9I4.2), pp. 383-3tii|..
80
date of one or more affiliates. To permit exclusion
on this basis would make the area of consolidation a
function of an essentially arbitrary and perhaps
shifting determination of the boundaries of the business year. By a mere reshuffling of closing dates,
in other words, an individual or group in control
could artifioally alter the accounting projection
of a concern's activities—an obviously undesirable
situation.
Inclusion of companies with dissimilar fiscal
years must be handled carefully and provision made
for eliminating or at least reducing the effect of
the overlapping of dates. The effect of transactions occurring between the close of a subsidiary's
fiscal period and the date of a consolidated statement should be indicated, and handled on a consistent basis from year to year.
Regardless of its other claims to inclusion, a subsidiary may be excluded if its assets or revenues are immaterial in amoTint.
This relaxing of rules must not be used to
produce distorted results.
A number of subsidiaries, each
in itself of immaterial importance, together would represent
a large part of consolidated activity, and all, therefore,
must be Included.
63
The existence of a foreign investment raises an interesting problem:
the observation of the principle of con-
sistency when consolidating the accounts of a foreign subsidiary.
In general, while consistency of accoimting and
62
Moonitz, E n t i t y Theory, p . 3 8 .
•^ C h i l d s , C o n s o l i d a t e d S t a t e m e n t s , p . 7 3 ; T. B. Hobson,
" C o n s o l i d a t e d and Other Group Accounts: P r i n c i p l e s and Proc e d u r e , " i n S e l e c t e d Readings i n Accoimting and A u d i t i n g ,
Mary E. Murphy, e d . , p p . 159-190.
~
81
reporting procedures is desirable. It is not satisfactory to
insist upon the use of techniques which will lead to a permanent application regardless of economic and political changes.
In the light that there will always exist the possibility of
rapid and/or material alteration in the intematinnal financial and internal political position of any coxmtry, and adherence to a criterion which demands the strictest consistency of treatment is untenable.
Necessity for Disclosure of Basis of Inclusion or Exclusion
In view of the range given to individual Judgment and
choice, financial statements should make clear the principles
used in determining which majority-owned subsidiaries are
included in consolidation and which are excluded, as well as
show the result of any change from the consolidation princi-
65
pie followed in the preceding year.
Along similar lines,
the American Accoimting Association states:
Published statements should disclose the principles of consolidation actually followed. Such
disclosure Is particularly important at the present
time because of the diversity of rules and standards
6ii
^ Hepworth, Reporting Foreign Operations» p. 167.
Palen, Report Writing for Accountants, p. 271; see
also Greidinger, Preparation and Certification""of Financial
Statements, p, 30b, for the S,E,C, Accounting Series Release
IJo, 32, slating the requirements of disclosure of the consolidating principle and material of excluded subsidiaries.
82
in current use.66
If a majority-owned affiliate is omitted from consolidation, reasons for the exclusion should be given.
The ex-
planation would refer, for example, to administrative control which was incomplete because of some specifically stated
reason of law, custom, or economic condition which dictated
that the operations of the excluded imit must be carried
on by a separate company and cannot be integrated with those
of its affiliates.
Where the excluded company is of signifi-
cant size, appropriate disclosure should be made by footnote
or by separate schedule of the parent's share of (1) the
subsidiary's profits and losses for the current accounting
period, (2) the dividends declared by the subsidiary during
such period, and (3) the subsidiary's undistributed earnings
from date of acquisition.
Under these conditions it would
be most likely that the separate statements of the excluded
subsidiary company would accompany the consolidated statements.
Whether or not consolidation of foreign subsidiaries
is decided upon, adequate disclosure of foreign operations
66
American Accounting Association, "Consolidated
Financial Statements," p. kk*
' Carson, "Accounting for Mergers and Consolidations,"
p. 331; Peoples, "Preparation of Consolidated Statements:
When Subsidiaries Should be Included and How they Should be
Treated," p. 314.,
83
and conditions should be made,
A useful guide for consoli-
dation policy and for disclosure that is required with respect to foreign assets and operations is stated in Bulletin
No, 14.3 of the American Institute of Certified Public Account-
68
anzbs.
Concerning disclosure of nonconsolidated subsidiaries,
Finney and Miller state:
If the accounts of any subsidiary or subsidiaries
are omitted from the consolidated statements, information should be given. In footnotes or otherwise,
about such matters as the policy followed in determining which of the subsidiaries should be consolidated, the reasons for the exclusion of nonconsolidated subsidiaries, their financial condition and
operating results, the relation of their profits or
losses during the period to their dividend payments,
and the difference between the carrying value of the
parent's investments and the underlying book values
of the investments as shown by the subsidiaries' accounts. If a subsidiary not consolidated is of material size, or if its profits or losses during the
period or since acquisition are significant, the consolidated statements should be supplemented by statements of the subsidiary,^°
A conclusion that one must necessarily reach when observing the standards employed to define the area of consoli'
dation is that individual Judgment is inescapable.
The
Judgment to be made, however, concerns one main inquiry:
68
AICPA, Bulletin No. 14-3, PP 112-113; American Institute of Accountants, "Some ^Problems Regarding Consolidated and Parent Company Statements," pp. 572-575.
69 Finney and Miller, Advanced Accounting, i|th ed.,
522.
81+
does an area of integrated operations exist, and, if so,
where may a definite boundary be drawn so that all constituent units are included and those not a part of the enterprise excluded?
As a result of focusing attention on this
leading query, the Judgment is removed from the realm of
pure opinion to that of a verifiable process of examination
and assessment of a limited variety of pertinent data.
The
criteria discussed above are continual reminders of the series
of conditions necessary for integrated operations, and emphasize the presence of a set of circijmstances which sustain
70
a Judgment that consolidation is in order.
70
Moonitz, E n t i t y Theory, p . 39
CHAPTER IV
STANDARDS UNDERLYING INTERCOMPANY
OPERATING TRANSACTIONS
A Characteristic Feature of Consolidation—Eliminations
It is only after the area of consolidation has been
definitely defined that the actual consolidation of accounts
may properly proceed.
It must be borne in mind that the con-
solidated statements are not those of any one of the constituents, but are reports which show the position and the operating results of a number of closely affiliated companies as
if they were a single business entity.
When the group of
companies is thus dealt with as a single entity, any intercompany relations become virtually interdepartmental and have
no place in the statement which is intended to show merely
2
the relations of the business entity to outsiders.
Therefore, the key technical feature of the process of consolidation is the elimination or cancellation of overlapping ele3
ments, thus avoiding double coimting.
In the preparation
of a consolidated statement, then, the accounts of parent
and subsidiaries should be viewed as those of the head
•'- Finney, Consolidated Statements, p. II4..
2
H. A. Pinney, Principles of Accounting--Advanced,
II, Prentice-Hall, Inc. (New York, 1932), revised ed., chap.
14-8, p . 5 .
^ Paton and Dixon, Essentials of Accounting, p. 725.
o5
86
offices and branches or the departments of a single company,
whereby, in the process of consolidation, all reciprocal accounts between the "departments" are eliminated, and all
similar nonreclprocal accoionts are combined,
A nonreciprocal
element is an amoimt which is represented in the net assets
of only one of the affiliates; a reciprocal element is an
amount which is reflected in the net assets of both affili-
k
ates.
On the subject of intercompany accounts, Moonitz and
Staehling said that what should"^ . . . .
be kept in mind continuously is the fact that elimination in consolidation of these pairs of accounts
in no wise constitutes, in and of itself, a correction or revision of the accoxmts of the individual
companies involved. They are eliminated only in the
consolidated work papers, never from the accounts of
the constituent companies, jHieir continued presence
in the underlying accounts is necessary in order to
reflect properly the intercorporate debt or investment situation. They are eliminated in consolidation solely because we have shifted our point of
view--a shift from the view that each corporation
is a separate entity to a view that each corporation
is but a cell in a larger business unit. Prom this
latter point of view only does the pair of accounts
lose its significance as a measure of assets or of
liabilities of the group as a whole.
This postulate of elimination of duplication is
universally acknowledged, and underlies all the
detailed procedures found in the preparation of
^ Childs, Consolidated Statements, pp.
8IL-67.
Maurice Moonitz and Charles C. Staehling, Accounting—An Analysis of its Problems, II, Foundation Press, Inc
(Brooklyn, 1952), p. 671.
87
combined statements, whether the combination is
among (a) departmental financial statements in a
single company, (b) branch and home office accoimts
of the same legal unit, or (c) the financial statements of two or more separate corporations unified
under a parent company exercising centralized control. This postulate of elimination is almost self
evident; its application to concrete instances may,
however, prove difficult to a greater or lesser
degree.
As is implied, the general principle of consolidated
statements "1« simplicity itself, but its application gives
rise to many difficult problems,"
The preparation of the
eliminating entries and the disposition of differences between accounts shown on parent and subsidiary books involve
many difficult questions of accounting principle.
Transactions Involving the Debtor-Creditor
Relationship
An advance from one affiliated company to another
affiliated company, whether on open account or evidenced by
a written instrument such as a note and if properly made and
authorized, rauaks legally in the same manner as if the companies were not related and is fully as valid and enforceable
as a claim held by an outside creditor,
A relatively large
liability from one affiliated company to another carries with
it the same power to the creditor as it would were such a
6
Mulcahy, "Consolidated Statements--Principles and
Procedures," p, 153.
88
creditor an outside interest.
Financing affiliated corpora-
tions by making loans or advances rather than by making ownership investments has the advantage of placing more power in
the hands of the loaning organization if circumstances arise
7
which would cause financial support to be withdrawn.
Intercompany Receivables and Payables
Since consolidated statements are prepared primarily
to present the financial condition and the operating results
8
of the entire consolidated group as a single business entity,
the Indebtedness of one corporation to another in the same
group—in their individual statements a payable to the one
and receivable to the other—will offset each other.
In
consolidation, these reciprocal items will be eliminated Just
9
as if they were interdepartmental items.
This elimination
is necessary because such reciprocal balances simply
CFII
for
the transfer of cash from one company to another; and, viewed
as a single unit in relation to the outside world, such inter10
company balances lose their significance.
The net am.ount
7
' Homer St, Clair Pace and Edward J, Koestler, Corporation Accounting, Pace and Pace (New York, 195^), P. 222.
Q
Greidinger, Preparation and Certification of Financial Statements, p. 312.
~~"~
" Noble, Karrenbrock, and Simons, Advanced Accounting,
pp. 586-587.
Karrenbrock and Sirions, Advanced Accounting--Comprehensive Volume, p. 367.
89
carried to the consolidated balance sheet would be, therefore, only those receivables and payables which represent
dealings between the business entity and the outside world."^"^
This practice of eliminating intercompany receivables and
payables is wholly consistent with the basic premise of the
existence of the consolidated group as a business entity.
In the ideal situation, intercompany receivables and
payables are in agreement and offset each other exactly in
the consolidation.
However, where intercompany transactions
are numerous, there will often be differences, mainly because
of in-transit items. Major differences should be investigated
and adjusted on the books, to bring them up to date, but small
differences may cause more disturbance than their effect upon
the statement warrants.
In such cases, the smaller of the
two balances should be eliminated, leaving the remainder in
12
either accounts payable or receivable.
Long-Term Loans Among Affiliates
Long-term loans between affiliates are eliminated in
consolidation for the same reasons as stated above for intercompany receivables and payables.
Borrowings against notes
by one constituent unit from a related company transfers cash.
Finney, Principles of Accounting—Advanced, II,
rev. ed., chap. 51, P» 1«
Palen, Report Writing for Accountants, p. 27 -.
90
but does not move it outside the area of unified operations.
An inflation of the totals assigned to assets and debts is
avoided by removing from each the amount of purely intercompany conveyances, and carrying to the consolidated balance
sheet only those loans secured with those interests outside
the business entity.
Long-term Bonds Among Affiliates
The acquisition by one company of bonds of an affiliated unit gives rise to an intercompany debtor-creditor relationship similar to those described above. However, certain special features require further consideration.13 The
problems arise mainly from the fact that the individual constituent company's statements must correctly state any premium or discount applicable to its bonds payable and must
correctly amortize the item; also, the purchasing affiliate
may have bought the bonds in the market after the date of
original issue and at a price which is not likely to correspond precisely with the amount of liability shown on the records of the issuing company.
Too, there is the problem of
consolidated statement treatment of the intercompany bonds.
The effect of intercompany bondholdings, from the
•^ Karrenbrock and Simons, Advanced Accoimting--Comprehensive Volume, p. k3k*
^ Paton, Advanced Accounting, p. 772.
Ik
91
viewpoint of the entire consolidated group, is a reduction
of the original debt owed to outsiders.
Consequently, inter-
company bondholdings are closely analagous to treasury bonds
15
and are usually treated as such.
Three recommended techniques for handling in the consolidated statement the par value of intercompany bonds in16
elude the following:
(1) Failure to eliminate, but usually the supplying in
the body the extent of the investment in intercompany bonds
(at par) to show that they are treasury bonds. /In preparing the formal consolidated balance sheet, the treasury bonds
are deducted at par from the bonds Issued to show the bonds
17
outstanding—held by outsider_s7«
(2) Elimination of the par value of the intercompany
bonds purchased against the par value of the bonds issued
15
Wixon, Accountant's Handbook, chap. 23, pp, 32-33.
16
Newlove, Consolidated Statements, pp. I;0-l4.1.
17
For those commenting upon or recommending this
treatment, see: Finney, Principles of Accounting--Advanced,
II, rev. ed,, chap, 51, p, 3; Finney and Miller, Advanced
Accounting, ij-th ed,, p, 353; Noble Karrenbrock and Simons,
Advanced Accoimting, pp, 590-592; Pace and Koestler, Corporation Accounting, pp, k3k-k3Q> Moonitz and Staehling,
Accounting--An Analysis of its Problems, pp, 719-7^1; VMxon,
Accountant's Handbook, chap. 23, p. 32; Childs, Consolidated
Statements, p. 125.
92
without re-establishing them as treasury bonds,
(3) Elimination of the par value of the intercompany
bonds purchased against the par value of the bonds issued,
but allowance of their optional re-establishment as treasury
19
bonds.
Commenting upon these three methods, Newlove states:
While the failure of the second method to reestablish the intercompany bonds as treasury bonds
is not vitally important, the conventional consolidated balance sheet does show the intercompany bonds
as treasury bonds. The first method is more memory
aiding than the third method, so it should be used
provided that the investment in intercompany bonds
is marked /^Treasury Bondsjy ^^ ^^^ consolidated
balance sheet column.
Encountered is a difficulty in which bonds are issued
at a price other than par value and are acquired, either at
the date of Issue or at a later date, by an affiliate at a
price other than the book value of the bonds on the books
18
For those commenting upon or recomraending this
treatment, see: James 0. McKlnsey and Howard S. Noble, Accounting Principles, South Western Publishing Co. (Cincinnati,
IVJJV), 3rd ed., p. 671; Moonitz, Entity Theory, pp. 61^-65;
Sunley and Carter, Corporation Accounting, p. 375; Paton,
Advanced Accounting, p. 772.
19
For those commenting upon or recommending this
treatment, see: William A. Paton, ed.. Accountant's Handbook, The Ronald Press Co. (New York, 1914-7), 3rd ed.,
i), 1095-1097; George H, Newlove, Aubrey Smith, and John Arch
White, Intermediate Accounting, D, C, Heath & Co, (Boston,
1939), P- 567,
20
Newlove, Consolidated Statements, p. ;il.
93
_
21
of the issuer.
Such conditions serve to complicate matters.
When the investing affiliate carries the intercompany
bonds at the same book value per bond as the issuing affiliate (as may well be the purchase by an affiliate at the date
'of issue), any bond premium should be eliminated against bond
premium, and any bond discoimt should be eliminated against
22
bond discount.
This elimination, of course, assumes that
the same write-off method is used by both affiliates, result^ing in exact reciprocals.
If bonds were held by an affiliate as an investment
prior to or on the date of stock control, and if that acquisition was at costs differing from the book value of the liability on the books of the issuer at the date stock control
was secured, an adjustment In consolidated goodwill or consolidated surplus is needed because the cost of the equity
23
is affected by that difference.
In the situation where an issue is sold in the open
market at one price and later acquired in the open market at
a different price, complexities arise. How shall the difference between prices of issuance and acquisition be treated
21
Wixon, A c c o u n t s m t ' s Handbook, chap. 2 3 , p . 3 3 .
22
Newlove, Consolidated Statements, p. I4.I.
23
Newlove, Consolidated Statements, p. kl; George J.
Nowak, "Preparation of Consolidated Statements," Standard
Handbook for Accountants, J. K. Lasser, ed., McGraw-Hill
aook Company, Inc. (New York, 1956), chap, 5, p. I67. The
latter is hereafter cited as Nowak, Standard Handbook,
91^
in the l i g h t of the concept of the business elrtlty--the parent and subsidiary as one unit?
As a single business entityi,
such bondholdings lose their significance; the amount paid
for bonds reacquired is viewed as the cost of bond retirement, and the difference between investment cost and the
carrying value of the obligation represents a current gain
or loss to the enterprise.
The difference would be closed
to consolidated earned surplus.
Also, there have been pro-
posals that would treat the difference as a deferred item.
Of the two treatments, Newlove states that it is , , , .
more conservative to set up a deferred credit than
to increase the Consolidated Earned Surplus account,
but the reverse is true as to establishing a deferred
charge in lieu of debiting Consolidated Earned Surplus, The author agrees with Professor Paton when
he wrote /In the Accountant's Handbook, Ronald Press
^o», 193^/2
'From the standpoint of the combination
of internests, such a premium or discount is not a
true investment premium or discount, but has its
analogy in the premium or discount of a company's
retirement of its own securities at a price above
or below the par of the contract of i s s u e . ' ^
Assuming a gain on the reacquisition, there arises
the question concerning the assignment of the gain to a particular affiliate and, depending upon the assignment, the
distribution to minority interests.
The nature of the gain is usually quite unclear:
for
example, if the bonds when issued were sold at a premium and
2I4.
Newlove, Consolidated Statements, p. 9 0 .
95
if the rate of amortization was too slow on the original issue, the gain is in reality a correction of past understatements of the issuer's net income.
Alternatively, a decline
in bond prices may have enabled the purchaser to realize the
gain.
On the other hand, if it can be assumed in the con-
solidated group that the purchaser acts as agent for the
issuer, the gain is always assignable to the issuer.
In
this latter case, the gain represents the discounted amount
of an increase in interest rates.
If the assignment of the gain or loss is to the parent, the entire amount would be applied to consolidated surplus.
Conversely, if the gain or loss were assignable to
the subsidiary, the percentage of the parent's ownership in
that subsidiary would govern the amount to be applied to
25
consolidated surplus and to minority interests.
However,
it must be remembered that the gain or loss is recognized
only as of the date of the bond acquisition.
The subsequent
history of the bonds should not be permitted to affect consolidated capital as long as the bonds are held within the
affiliation.
As a consequence, no further consolidated gains
or losses may result from the bonds as long as they are
^ Some would treat the whole gain or loss as an item
of consolidated earned surplus (see Wixon, Accountant's Handbook, chap. 23, p, 33), while others would recognize only the
controlling interest's share of these items (see Finney and
Miller, Advanced Accounting, [{.th ed., pp. 505~5ll).
96
held intercompany,
Kohler pertly sums up the current treatment of intercompany bondholdings in the following statement:
7. Elimination in consolidation of intercompany
investments in obligations against the accumulated
obligations shown by the books of the issuing company gives rise to the adjustment of the consolidation excess or surplus or of current loss and gain
as the circumstances may require.
(a) Intercompany obligations should form no part of
consolidated outstanding obligations.
(b) Any premium or discount at the date of acquisition, arising from the difference between the investment cost and the accumulated obligation on the
books of the issuer (i.e,, face amount less any unamortized discount, plus any accrued premium to be
paid on retirement) should be combined with the consolidation excess or surplus arising from ^ e subsidiary affected; any differences from acquisitions
thereafter should be regarded as current gains or
losses,27
When an affiliate's bonds are acquired at a cost that
is less than that at which they are carried on the books of
26
For comments and discussions of this point, see
George J. Nowak, "What to Eliminate in the Preparation of
Consolidated Balance Sheets," The Journal of Accountancy,
LXXXIV (July, I9I4-7), pp. 38-39; Carman G. Blough, ed.,
"Premium on Bonds of Subsidiary," The Journal of Accountancy,
LXXXII (September, 1914^6), p. 259; Wixon, Accountant's Handbook, chap, 23, p. 33; Childs, Consolidated Statements, pp.
'ra5::621; William H. Bell, Accountant's Reports, The Ronald
Press Company (New York, 19I|-9), i4-th ed., pp. 188-I89;
Karrenbrock and Simons, Advanced Accounting--Comprehensive
Volume, pp. i4.3l4.-i4.38; Newlove, Consolidated Statements, pp.
i4-i-90; Finney and Miller, Advanced Accounting, l|th ed.,
pp. 505-511.
27
Kohler, "Tentative Propositions," p. 67.
97
the debtor, there is an alternative and presumably more conservative treatment.
Rather than treating the credit that
emerges from the elimination of reciprocal items as a gain
and as an increase in the parent and minority equities, thei»e
might be the recognition of such an excess as a deferred income balance under a heading such as "Unrealized Gain on Intercompany Bondholdings."
If the affiliate holding the bonds
were to sell at cost these bonds to the issuing company, a
gain would emerge on the books of the Issuing company; however, if the sale at cost were to be made to outsiders, the
gain would not be recognized.
Treatment of a credit excess
as unrealized income recognizes the latter situation to be a
28
possibility.
Holdings of Preferred Stocks by Affiliates
Although intercompany holdings of subsidiary preferred
stock is not strictly of a debtor-creditor relationship, its
nature is analogous to intercompany bondholdings.
As with the price of bonds, the acquisition price of
the stock may not correspond to the amount appearing in the
issuing company's accounts; therefore, a "plug" is required
to balance the consolidated data when the related accounts
are eliminated (to the extent of the intercompany holdin,'?;).
This completely feasible idea was set out in
Karrenbrock and Simons, Advanced Accounting--Comprehensive
Volume, p. 14.83.
98
Again, like that found in bonds, such a difference is hard
to interpret.
From the affiliation standpoint, there is the
possibility of viewing the difference as a plus or minus adjustment of the consolidated common stock equity resulting
from the retirement (in effect) of the senior securities.
Should the preferred shares held intercompany have a vote,
the holding of those shares represents a part of the overall control position of the parent company.
Preferred stock of the parent may be held by one or
more subsidiaries.
If the holdings were acquired at the
date of issue, this condition indicates that subsidiary resources have been utilized to finance parent company activities; where the securities were purchased at a later date
from outside holders, the transaction may be viewed as a
"retirement" of parent senior securities through the use of
subsidiary fimds.
The consolidated statement problems here
are similar to those which were discussed above and which
involved intercompany bonds.
In this case, however, any
difference between the amount invested and the book value of
those securities relates to the parent company accounts
29
rather than the subsidiary's accoimts.
Paton and Paton, Corporation Accounts, pp. 620-621;
Staub, "Some Difficulties Arising in Consolidated Financial
Statements," pp. 2lj.-25.
99
Transactions Involving Intercompany Merchandising
Or Accommodating Activities
Affiliates are often closely related from the operating standpoint.
As a consequence, all or a major part of
the output by one affiliate may be acquired by another affiliate. Moreover, a particular company may acquire all or most
of the equipment used from an affiliate; transfers of land,
buildings, and other property is not unheard of.
Transactions between affiliates should be made on a
sound basis—at fair market value, if possible.
It is essen-
tial that fair treatment be afforded to the interested partiescreditors and minority stockholders.
Each of the contracting
corporations is a legal entity in its own right, and equity
between the contracting parties can be preserved only if the
transaction is established on a sound commercial basis—arm'slength transactions.
Intercompany Sales and Purchases of Goods
In adherence to the proposition that the consolidated
statements show the financial position and operating results
of a group of affiliates as if they were one, it follows that
sales and purchases effected between the affiliates should be
eliminated as an internal transaction from the total amount
of sales and purchases, resulting in the display of only the
purchases and sales effected with the outside world.
If such
-'.• fsm-
100
an elimination were not made, the sales to outsiders would
duplicate the amount of the sale from the viewpoint of the
V. .
30
business entity.
The elimination with regard to intercompany sales and
intercompany cost of sales (exclusive of the adjustment of
the latter for unrealized profit in inventories) usually
follows one of two procedures.
In the first procedure, sales
are eliminated, and, in equivalent amounts, the corresponding
intercompany purchases are removed from cost of sales, without any differential resulting.
In the second procedure,
intercompany sales are similarly eliminated from the aggregate sales, but rather than a like amount from purchases,
there is eliminated from the aggregate cost of sales the
amount computed by the selling company as its cost of sales,
resulting in a differential which represents the operating
results (profit or loss) of the selling unit in connection
with those intercompany transactions.
It is then necessary
to make a separate consolidating adjustment in the consolidated results for this differential which relates to the entire amount of such intercompany transactions during the
period, inclusive of the profit or loss realized on the product finally Included in consolidated sales to outsiders as
•^^ William B, Castenholz, Auditing Procedure, La Salle
Extension University (Chicago, 1929), p. 2'44; Mortliier B.
Daniels, Corporation Financial Statements, VI, Michin:an Business Studies, University of Michigan, School of Business Research (Ann Arbor, Michigan, 1931^), No. 1, p. 115.
101
well as that imreallzed on the products still on hand in the
inventories of the buying affiliate.
The latter profit item,
together with the effect of the related adjustment attaching
to the opening inventories, will require in each procedure a
supplementary adjustment which affects final surplus.
This
second method is used where it is desired, for informative
purposes, to have the consolidated income statement make
specific disclosure of the profit and loss attributable to
31
certain activities of the business.
Therefore, when goods are acquired from a related company and the same goods are resold to outsiders, the aggregate profit made by both companies is totally realized.
Thus, other than the full elimination of the reciprocal sales
and purchases accounts, no further consideration needs to be
given in preparing the consolidated statements to the intercompany profits made on those intercompany transactions because the business entity has sold an item to an outsider at
32
a profit or loss which is fully realized.
However, when a sale of merchandise is effected between affiliates and a part or all of that merchandise remains unsold and in the inventory of the purchasing affiliate
on the date of consolidation, it is necessary to reduce the
31
Kracke, "Consolidated Financial S t a t e m e n t s , " p . 386
32
McKlnsey and Noble, Ac count ing Principle s, p. 671;
Karrenbrock and Simons, Advanced Accounting--Comprehensive
Volume, p. 14-20.
102
inventory to cost by canceling any profit that has emerged
on the transfer.
The reason for this reduction is that an
entity cannot make a profit on sales to itself; in effect,
only a transfer of Inventories has taken place and the uninflated inventory value must also be transferred.
The
amount at which the consolidated inventories will appear in
the consolidated statements should represent the actual cost
(or other measurement basis) Just as if the entire process
were carried on by a single entity.
The corresponding off-
set to this reduction in inventory is to the dollar amoimt
33
of the consolidated earned surplus.
The ideal is clear; unfortunately, there is no imianimity about the means of approaching the ideal.
For in-
stance, major differences concerning the basis of computation
of the profit in inventory exist.
Also, if a minority inter-
est exists in the selling affiliate, how much of the profit
is to be eliminated?
And, how should Intercompany profits
in inventories held at date of acquisition be treated?
Basis for Intercompany Profit Computation
Regarding the computation of intercompany profit, the
question is:
should the ainount of the deduction for inter-
company profit be based on the gross or the net profit of
33
Roy B. K e s t e r , Advanced Accounting, The Ronald
Press Company (New York, 19^4-6), Ltth e d . , p. 608.
103
the selling company?
Often merchandise acquires costs of
fabrication and handling as it passes through the various
constituent companies, and these costs must be added to the
initial cost to determine a full cost basis from which the
profit of the business entity can be correctly computed.
From the group standpoint, it does not matter where the profit lies, for the over-all amount becomes the important factor.
It seems that the fundamental problem is in the diffi-
culty of identification of the goods in the inventory and
persists all the way back through the manufacturing costs of
the companies to the costs of the company which originally
purchased the raw materials.
Assuming such identifications
are possible, an elaborate cost system and sales record would
be needed to detei*mine the profit margins (whether gross or
net) on different products at different times.^^
Concerning the basis upon which the profit should be
computed, Finney and Miller state r35
^-^
The gross profit is the generally accepted basis.
It has been suggested by some accountants that the
amount of the deduction should be determined by using
the affiliate's ratio of net income to sales rather
than its rate of gross profit. This procedure would,
of course, result in a smaller deduction. The use
-^^ Kester, Advanced Accounting, p. 609; E. J. Erp,
"Preparing Consolidated Statements for Management, The Controller, XXI (August, 1953), p. 363.
•^•^ Finney and Miller, Advanced Accoimting, l4-th ed.,
p. 391; see also Childs, Consolidated Statements, p. ll-'^.
1014.
of the ratio of net income to sales might be Justified if all expenses varied in exact proportion to
the sales; this, however, is not the normal condition. Many expenses are fixed; others vary, but not
in direct proportion to the sales; and it is therefore incorrect to assume that the elimination of the
intercompany sales would result in a corresponding
reduction in the expenses. Neither is it practicable
to undertake to allocate expenses between intercompany
and outside sales. Under the circumstances, therefore,
the expedient and conservative procedure is to compute
the deduction for intercompany profit on the basis of
the rate of gross profit.
A contrary, though equally feasible, argument for the
net income ratio is advanced by Paton:
Selling costs are not likely to be quantitatively
significant in connection with intercompany transactions. There will be, however, packing and shipping
costs involved, if nothing else, and such costs should
be included in consolidated inventories as legitimate
additions to cost. Under an ideal treatment, in fact,
all charges actually incurred from the standpoint of
the consolidated entity, and reasonably applicable to
goods on hand in the group as opposed to goods sold
to the outside, should be deferred. In other words,
the amount to be eliminated as unrealized is the element of net income, not gross markup over assigned
production cost.
It seems that both arguments have merit, but the final
decision to use either the rate of gross profit or the rate
of net profit would depend upon the practical circumstances;
although the view expressed by Paton seems more theoretically
correct, the practical considerations mentioned by Finney and
Miller would most surely carry weight depending upon the
^^ Paton, Accountant's Handbook, pp. 1092-1093; Paton,
Advanced Accounting, p. 796*
105
circumstances Involved.
Intercompany Profits and Minority Interests.
There
also seems to be no unanimous agreement about the treatment
of intercompany profit in relation to minority interests regarding sales within the affiliation.
^ e problem deals with intercompany profit in the
following cases, in which a minority interest is assumed:
106
Treatment of Inventories in Intercompany Accounts^*^
(A)
Inventory in the hands of the subsidiary sold by the
parent company.
Proposed Treatments:
(1) Elimination of all the profits against
the parent company's surplus.
(2) Elimination of a percentage of profit
against the parent company's surplus
based on the percentage of subsidiary
stock in the parent company's possession.
(B)
Inventory in the hands of the parent company sold
by the subsidiary.
Proposed Treatments:
(1) Elimination of all the profit and application of the reduction against the
parent company's surplus and the
minority interest in amounts proportioned to their respective interests
in the subsidiary's surplus.
(2) Elimination of all the profit against the
parent company's surplus.
(3) Elimination of a percentage of profit
against the parent company's surplus
based on the percentage of subsidiary
stock in the parent's possession.
For the precise wording of the proposed treatments,
see the original article by Carrn.an 0. Blough, "Treatment ot^
Inventories in Intercompany Accounts," The Journal of Accountancy, LV (March, 1933), P» ^33»
107
In situations involving sales by the parent to a
wholly or partially-owned affiliate,^
there is general agree-
ment among accountants that the inventory deduction should
be for the full amount of the profit applicable thereto.^^
The entire amount of the intercompany profit is yet unrealized, and, even though a minority interest may exist in the
subsidiary's equity, the existence of this interest cannot
be used to Justify the recognition of profit on a transaction
which, from the parent's viewpoint, is no more than an intercompany transfer of goods.
Profit to both the parent and the
minority interest will emerge only upon the resale of the
goods to outsiders.
A second possibility emerges from sales by the parent
to the subsidiary:
the elimination of a percentage of prof-
it from the parent's surplus based on the percentage of
ownership in the subsidiary.
Not unlike the position in the
preceding paragraph, this second possibility does not affect
minority interests.
Its main contention is two-fold:
of
the sales to the subsidiary, a part of those sales were in
a sense sold to the minority interest; and the profit that
Assuming there is no ownership of parent company
shares by its affiliates.
^^ Finney and Miller, Advanced Accoimting, i^th ed.,
p. 393.
^^ Karrenbrock and Simons, Advanced Ac count in,.---Comprehensive Volume, p. 14-22.
108
was included in the sale which was applicable to the minority
interest is actually realized.
This argument seems untenable
since the parent's earned surplus was increased by the entire
profit from consolidated earned surplus, it will be in a position to inflate that account by forcing the subsidiary to
purchase merchandise at the profit which the parent company
may dictate,^-''
The presence of a minority interest in the selling
company, however, gives rise to a conflict of treatment.
The basic difference is in the acceptance of the financlallinit concept or the operational-unit (the business entity)
concept of consolidated statements.
Those who adhere to the
operational-unit concept would eliminate the entire intercompany profit and charge the retained earnings applicable
to the minority interest and controlling interest with their
proportional shares.
The followers of the financial-unit
concept are not uniform in their treatment.
Some would elim-
inate only the share of the controlling interest, while other
exponents of the financial-unit concept would deduct the total of the intercompany profits from the consolidated earned
k2.
surplus.
eration.
These differences warrant more detailed consid-
^"^ Finney and Miller, Advanced Accoimting, i^th ed.,
p. 393.
Palen, Report Writing for Accountants, p. 279.
109
Consistent with the assumption that the constituent
companies comprise a business entity in itself is the operational-unit concept, which would eliminate the total intercompany profit in the proportionate majority and minority
ownership interests (in the selling company).
Full compli-
ance with this assumption will restore the interests, insofar as the intercompany profit is concerned, to their relative position before the transaction occurred.
This result
appears proper since the nature of the sale is but an interdepartmental transfer.
On this point, Kohler states:
Eliminations in consolidated statements of intercompany gains and losses should be complete, notwithstanding the presence of outside stockholders of
subsidiaries. If, for example, there is a 60^ control over a subsidiary, not 60% of any intercompany
profits in inventories should be cast out but 100^.
Without this procedure, confusion of "costs" remains
which does not reflect the unitary position of the
combined enterprises.
A full elimination of intercompany profits and
losses necessitates an adjustment of the equities
of the outside stockholders of the subsidiary that
has taken the profit or loss. This is Justifiable
because the purpose of the consolidated balance
sheet is to display both assets and equities in the
amount at which they would be stated if the several
legal entities composing the consolidated group were
reduced to one. Outside stockholders are entitled
to know what portion of their book equities is represented by a "controlled" profit: that is a profit that has not yet been realized through a sale
to the public.
k3 Kohler, "Tentative Propositions," pp. 66, 67-66.
110
But Moonitz^ disagrees with Kohler:
Full compliance with the principle of intercompany
eliminations requires the cancellation of all intercompany markups and markdowns (in the sense of net
profit), regardless of the relative sizes of the
controlling and outside interests. Once the existence of an integrated area has been established,
the proportionate equities held by controlling and
outside interests are of importance in allocating
consolidated capital and consolidated net income,
but not in determining their amounts. The number
of shares held by outsiders is ignored until the
accounting for consolidated assets, debts, capital,
and profits has been completed; then, and only then,
do the relative interests attain significance.
Both Moonitz and Kohler subscribe to the business entity theory; both agree that the elimination of intercompany
profits will ultimately result in the reduction of majority
and minority interests in the ratio of ownership in the selling subsidiary.
However, a close reading will glean the
underlying difference between the two statements:
the deduction.
time of
Kohler would have the elimination made as an
adjustment in the consolidated working papers before computing consolidated net income, whereas Moonitz would apply the
minority interest percentage to the consolidated retained
earnings with the results being the same as that derived by
Kohler (other things being equal).
The latter procedure
seems preferable.
Similarly, the Committee on Accounting Concepts and
kk Moonitz, E n t i t y Theory, p . 70; see also Moonitz
and Staehling, Accoun
unting--An Analysis of i t s Problens, pp.
736-7I4-3.
Ill
Standards of the American Accounting Association stated their
position in 195k about the basis of computation and the percentage of intercompany profits remaining in inventory to be
eliminated!
The elimination of intercompany markups in assets
should be complete, irrespective of the presence or
absence of an outside (minority) interest. This
procedure is necessary to insure a cost basis which,
properly, should not be affected by the pattern of
share ownership.
The amount of intercompany markup to be eliminated
is the intercompany gross margin, reduced by any inventoriable costs incurred in the movement of the
goods from one affiliate to another.
The intercompany gain to be eliminated from assets
logically is applied in consolidation as a reduction
of the income or retained earnings of the affiliates
that have recorded the gain. If any such affiliate
is a subsidiary with a minority interest, the per
share equity of that interest is thus reduced, in
the consolidated statements, in the same manner and
in the same proportionate amount as the controlling
interest. The practice of reflecting a minority
interest's share of unrealized intercompany profit
as if realized, while widely accepted, conflicts
with the underlying purpose of consolidated statements as herein contemplated, namely, to reflect
the activities of a group of companies as though
they constituted a single unit.^-^
This statement is consistent with the views expressed
by Kohler and Moonitz, and with the assumption of the consolidated unit as a single business entity underlying this
k-5 American Accounting Association "Consolidated
Financial Statements," p. [{.5.
112
paper .^
The second method of treating intercompany profits
eliminates all the intercompany profit against thf parent's
surplus and follows the financial-unit concept of consolidated statements.
This procedure would eliminate from the
controlling interest in earnings the entire intercompany
marlcup In inventory, even though the sale was made by the
subsidiary to the parent.
The basis of this method is the
contention that the controlling interest should stand the
entire write-down because, as far as the minority stockholders are concerned, sales to an affiliate are indistinguishable from sales to persons outside the consolidation.
This method is not consistent with the underlying assumption
of this work because the method attempts to make consolidated
statements primarily a reflection of the minority interest
and not of the business entity.
Specifically, the inven-
tories are shown without any element of intercompany profit.
1±6
For additional pro and con arguments, see: Finney
and Miller, Advanced Accounting, ij-th ed., pp. 393-3914-;
Herbert E. Miller, ed., CP.A. Review Manual, Prentice-Hall,
Inc. (New York, 1956), 2nd ed., p. 3i{-7; W. T. Sunley,
"Minority Interests in Intercompany Profits," The Journal of
Accountancy, XXXVI (May, 1923; pp. 350-355; Ceorge H. Webster,
"Consolidated Accounts," The Journal of Accountancy, XXVIII
(October, 1919), p. 265; Peoples, "Preparation of Consolidated Statements," p. 3I4.; Carson, "Accounting for Mergers
and Consolidations," pp. 329-330; American Institute of
Accountants, "Some Problems Regarding Consolidated and Parent
Company Statements," The Journal of Accountancy, VIC (November,
1953), pp. 57k-575} Simon, "Consolidated Statements and the
Law," pp. 512-513; PJeld and Sherritt, Advanced Accounting,
p. 206; Stempf, "Consolidated Financial Statements, p. 3^9.
113
The omission is a desirable result, but the equities of both
minority and controlling interests are distorted.
The
following statement by Kester shows that his bases for the
choice of this method were the considerations of consistency
and the separate legal entity status of the individual companies:
A more logical and consistent policy writes down
the whole inventory to an integrated measurement
basis, charging the entire amount written off against
the majority interest earned surplus and so does not
affect the earned surplus of the minority interest.
This will result in a consistent measurement of all
inventories for the consolidated statements and is
probably the best method of handling the matter; the
legal rights and obligations of the stockholders—
both minority and majority groups—of each affiliate
are governed by the status of that affiliate as a
legal corporate entity and not by its status as a
part of on economic entity.H-8
The third method, fractional elimination, treats with
intercompany profits on unsold goods which are in the hands
of the parent and which were acquired from the partiallyowned subsidiary and eliminates a percentage (based on the
nijmber of subsidiary shares in the parent's possession) of
profit against the parent's surplus.
This method is also
clearly at variance with the business-entity concept of
^ Wixon, Accountant's Handbook, chap. 23, p. 27;
Pace and Koestler, Corporation Accounting, p. 2I4.5; Charles H.
Porter and Wyman P. Fiske, Accoimting, Ifenry Holt and Company
(New York, 1935), p. 300.
^
Kester, Advanced Accounting;, p. 6IO.
1114.
consolidated statements.
The reasoning behind the recommendation of fractional
elimination is that intercompany profit is realized from the
point of view of the minority; all sales made by the company
to an affiliate are final transactions, and any income earned
on such transactions is effectively realized as far as they
k9
are concerned.^
Since this realization is the contention,
it follows that that portion of the profit accruing to the
minority interest should be retained in the consolidated
balance sheet.
This
position assumes that the consolidated
statement should reflect the minority interest at its value
on the books of the subsidiary.
Such a presentation cannot
be denied to be desirable, if it can be done without violating the primary objective of consolidated statements--to
present the group as a business entity.
In support of this approach is the view stated by
50
Daniels:
k9
^ Paton and P a t o n , C o r p o r a t i o n Accoimts, p . 668;
Nowak, "What t o E l i m i n a t e i n the P r e p a r a t i o n of Consolidated
Balance S h e e t s , " p . 3 7 ; S t a u b , "Some D i f f i c u l t i e s a r i s i n g i n
C o n s o l i d a t e d F i n a n c i a l S t a t e m e n t s , " p . 28; Carson, "Accounting
f o r Mergers and C o n s o l i d a t i o n s , " p . 329; Sunley, ^'Minority
I n t e r e s t s i n Intercompany P r o f i t s , " p p . 350-3551 Nowak,
S t a n d a r d Hsindboo]^, c h a p . 5 , PP. 160, 166; Brundage, Contemp o r a r y A c c o u n t i n g , c h a p . 5$ p p . 5 - 6 ; Karrenbrock and S i r e n s ,
Advanced Ac counting--Comprehensive Volume, p p . I4.2I1.-I4.25;
C h a r l e s B. Couchman, Balance S h e e t : I t s " P r e p a r a t i o n , Content,
and I n t e r p r e t a t i o n , The J o u r n a l of Accountancy, I n c . (New
York, I92I4.), p . 233; Sunley and C a r t e r , Corporation Accounti n g , p p . 383-38i|.
50
Daniels, Financial Statenents, p. 96.
115
^7 pT^otlts made by one corporation in dealing with
another member of a consolidated group represent
realized income of that particular company. As far
as the consolidation is concerned, however, intercompany profits are income of the majority interest
only as realized in reference to the outside world.
z£ *^® laajority interest is construed as part of
the outside world"--a reasonable construction as
far as the stockholders of the parent company are
concerned--intercompany profits must be eliminated
from the majority interest only. Intercompany profits are automatically cancelled in the preparation
of the consolidated Income statement to the extent
that the profits of the selling company become the
expenses of the purchasing company. It is only that
portion of the intercompany profits which has been
capitalized, that is which is comprised in assets of
the combined group, that must become the object of
adjustment to eliminate intercompany profits. . . .
To obtain the proper amount to be eliminated from
assets and from consolidated surplus, it is necessary to apply against the total Intercompany profit
involved the percentage representing the holding
company's equity in the selling company's income
and surplus. The resulting figure will be deducted
from inventories on the consolidated balance sheet.
Reflecting the business entity point of view, Moonitz
answered Daniels:51
The alternative procedure of limiting the elimination to the controlling interest's share of intercompany markups and markdowns is clearly at variance with
the conception of consolidated statements as accounting projections of a business entity composed of numerous legal units. Concretely, the objectionable nature
of partial elimination is strikingly illustrated by
its effect on consolidated assets. Inventories, for
example, will be shown as the sum of two types of noncomparable amounts, namely, cost to the whole entity
for the portion from which intercompany adjustments
have been eliminated and cost to a specific legal
unit for the part retaining markups and markdowns.
^1
^ Moonitz, E n t i t y Theory, pp. 70-71.
116
The result is an inventory figure defying interpretation: it is not at cost to the consolidation, nor
at cost to the affiliated units, nor at market or any
^rtt^ coj^ventional basis to either. It is a number
without significance to anyone interested in the consolidated group or in any specified member of the
group. It is, in the most invidious connotation of
the phrase, a "mere bookkeeping entry."
The plea is made that this. . .procedure is valid
because from the point of view of the minority interest profit on intercompany sales is definitely established. This is undoubtedly correct, but of what
importance is the contention in consolidation? Consolidated statements are not prepared because of the
presence of minority interests but in spite of their
existence. Of course the minority is entitled to
regard profits on intercompany sales as definitely
established and admissible as a basis for dividends;
the statements of the legal unit in which they hold
shares will reflect those sales and the resultant
profits. lh.e statements of these individual units
are the sources of information on these points. But
consolidated statements are not prepared for the use
of a minority interest and consequently the argument
may not be considered as pertinent to the problem.
In conclusion, it may be said that there exists two
main objections to the financial-unit proposal mentioned
above.
First, the removal of only a portion of an intercom-
pany profit leaves the Inventory stated at an amount made up
of actual costs plus various pieces of profit.
Secondly,
the methods indicate that the minority is regarded as an outside interest, whereas the business entity concept views both
majority and minority interests as elements of the entity
proprietorship.
52
Co
"^ Childs, Consolidated Statements, p. 116.
117
I n t e r c o m p a n y Prof U s
sition.
in Inventories' atrDate'"of A c q u i -
W h e n companies which are already doing b u s i n e s s
w i t h e a c h o t h e r become m e m b e r s of an affiliated group, the
I
I
p r o b l e m arises of the treatment of intercompany profits
w i t h i n the transactions w h i c h are consummated before affili a t i o n takes p l a c e .
This situation will be a problem only
in p r e p a r i n g the consolidated balance sheet at the date of
a c q u i s i t i o n or at the end of the first accounting period
immediately following, since after that time the intercomI
i
pany p u r c h a s e s will ordinarily have b e e n disposed of to out53
siders.
"The status accorded intercompany m a r k u p s in inventories held at date of acquisition is not unifoiro.
One group
supports the r e t e n t i o n in consolidation of these initial profit a m o u n t s ; another group contends that these markups shoulc^
be eliminated in exactly the same m a n n e r as markups at subsequent d a t e s . "
The contention of the first group is that no intercompany transaction can occur prior to affiliation and that,
as a c o n s e q u e n c e , no intercompany profit on intercompany
transfers exist at the time of acquisition.
55
This view
W i x o n , Accoimtant's Handbook, chap. 23, p . 3 0 .
514' M o o n i t z , Entity Theory, p . 7 2 .
Finney, Consolidated Statements, pp. 1 0 5 - 1 0 6 ;
F i n n e y , P r i n c i p l e s of Accounting--Advan'ce'd, II, rev. ed.,
_ Lchap, 52, p. lo.
~
116
reflects the financial-imit concept of consolidated statements inasmuch as, at the time of control or acquisition, the
dollar amounts of all assets, including inventories, are
viewed as correct from the standpoint of each company as an
4 ^
56
independent operating unit.
In this connection, it is
argued that the price paid for the stock of the subsidiary
is based upon the market value of the assets, including inventories, and not upon costs; therefore, all elements of
profit already accrued are reflected in the investment
account.
57
According to the opposing view, that of the business
entity, the merchandise has merely been shifted from one
unit to another.
The cost (assuming that this is the basis
employed) should mean the cost for the whole group; it should
not mean cost to the group for part of the Inventory and cost
58
to one unit within it for the remainder.
Consequently, any
intercompany markups should be eliminated in the same manner
See Kester, Advanced Accounting, p. 613; Robert H.
Montgomery, Auditing, Theory and Practice," The Ronald Press
Company (New York, l9i|0}, 6th ed., p. 373; Karrenbrock and
Simons, Advanced Accounting--Comprehensive Volume, p. li-3i: .
57
Finney and Miller, Advanced Accounting, I|.th ed.,
pp. 395-396.
58
Paton, Accountant's Handbook, p. 1095.
119
as they are for transactions ocouring after acquisition,^^
Kester commented upon this problem:
From the standpoint of the /Eusiness/ entity, however, such a practice /of non-elimination/ places the
results of the first period's operation "at a disadvantage when compared with those of subsequent periods,
in that the first period will have a relatively higher
cost of goods sold because of the higher price level
of the initial inventory. It is often deemed best,
therefore, to eliminate these unrealized profits as
well as such profits from subsequent inventories."^
Another related argument against non-elimination Is
that such a procedure results in inconsistency and impairs
the comparability.
The consolidated net profit of the
second and subsequent years after acquisition of control is
computed on a basis that is different from that employed for
the computation of consolidated net income in the first year
after acquisition--at acquisition, beginning inventory includes
intercompany profit, ending inventory excludes intercompany
61
profit by being stated at cost.
Therefore, all intercompany profits in inventories
of the parent at acquisition should be eliminated in full.
Co
See Childs, Consolidated Statements, pp. 122-123;
Stempf, "Consolidated Financial Statements," pp. 369-370;
Staub, "Some Difficulties Arising in Consolidated Financial
Statements," pp. 28-29; Finney and Miller, Advanced Accounting, l4.th ed., p. 713.
Kester, Advanced Accounting, p. 613.
61
Moonitz and Staehling, Accounting--An Analysis of
its Problems, p. 713.
120
this elimination being consistent with the business-entity
assumption.
And it follows that the elimination should be
against the majority and minority interests in the same ratio
of those interests in the vendor subsidiary company; and, if
the subsidiary held the inventories sold by the parent, the
total profit would be eliminated against the majority interest.
Fixed Assets Bought and Sold Among Affiliates
An intercompany sale of a fixed asset is parallel with
62
that of merchandise.
If one of the companies had purchased
property from an affiliate at a price greater than the amount
at which it was carried by the selling company, the intercompany profit must be eliminated to reduce the value of the
property to its original cost to the seller.
However, the
same divergence of opinion concerning the treatment of a
minority interest's share of the profits is present. Consistent with the business-entity viewpoint, the same conclusions
which are reached in the discussion of intercompany profits
in merchandise must be derived here; hence, the foregoing
62
Paton, Accountant's Handbook, p. 109i|.
6"^
Palen, Report Writing for Accountants, pp. 279-280.
121
arguments will not be presented againi^
A difference in the adjustments required for the two
cases exists, however, because fixed assets remain with the
vendee for a number of accounting periods, whereas merchandise usually leaves the affiliated group in fairly short
order.
This difference is the depreciation on the fixed
asset.
A further problem will exist since, in all probabil-
ity, the depreciation will be taken by the holder of that
asset on the basis of its cost to the holder, not on cost to
the affiliated unit,
^ e result is a characteristic over-
statement, from the consolidated point of view, of both depreciation and book value of the fixed asset.
Solving this
problem, and pointing out a related difficulty, Moonitz
stated:
The remedy in principle is clear: book value should
be adjusted to cost to the affiliation less depreciation on the cost, and depreciation corrected to reflect amortization of cost to the group. In the
case of a group of trading companies, given the
6Ji
See page 105; Carman G. Blough, ed., "Sale of Fixed
Assets by Parent to Subsidiary; Question and Answer," The
Journal of Accountancy, LXXXIV (July, 1914-7), p. 66; Erp,
"Preparing Consolidated Statements for Management," p. 380;
FJeld and Sherritt, Advanced Accounting, pp. 213-220; Bell,
Accountant's Reports, pp. 159-190; Finney and Miller, Advanced
Accounting, l\.th e6,,
pp. 397-i4-02; Kester, Advanced Accoimting,
pp. 615-515; Karrenbrock and Simons, Advanced Accounting-Comprehensive Volume, pp. Ii29-11.314-; Nowak, "What to Eliminate
in the Preparation of Consolidated Balance Sheets," p. 3^.
65
Wixon, Accountant's Handbook, chap. 23, P. 3 1 .
122
exlste"hce of records" adequate to permit the computation of intercompany markups, the required adjustments are not difficult. In those cases, depreciation appears as an expense; once adjusted it is
disposed of finally and completely. If an asset is
used in manufacturing operations, however, the problem may become most difficult. Not only is depreciation then capitalized in work in process or finished goods but may also be embodied in transfers of
finished goods to affiliates. To trace through these
ramifications completely may defy the skill and ingenuity of the best-qualified staff. Under these
circumstances, beyond the first transfer of the cost
of the fixed asset, the use of estimates to remove
intercompany markups is probably all that may reasonably be expected.86
The net result of the adjustments is to reflect the
asset at cost to the affiliation from outsiders and the current depreciation expense and total valuation account for
depreciation (if used) as based on that cost.
Also, as a
result, none of the intercompany profit will be shown as
67
realized until the asset is ultimately retired.
Other Intercompany Transactions and Considerations
In the present chapter we have been concerned with
transactions, between affiliates, that have be n of an operating nature, and that involve both the debtor-creditor relationship, and merchandising or accommodating activities.
The remaining part of the chapter will treat, first, of the
revenue and expense reciprocals relating to operating
66
Moonitz, E n t i t y Theory, p . 7K*
67
Childs, Consolidated S t a t e i i e n t s , p. l-i-
123
transactions other than sales and pixrchases, and secondly,
of considerations pertinent to the operations of the units
as a group.
Reciprocal Revenue and Expense Accounts
As in the case of the biilance sheet items, intercompany items of profit and loss are eliminated in full so that
duplication In the consolidated statement can be avoided.
Typically, these items take the form of re venue-expense
pairs—a revenue item in the accounts of one company which
is matched by an expense item in the accounts of an affiliate.
Such pairs of accounts may arise from intercompany
financing, involving the borrowing and lending of money.
From a combined point of view, the transaction causes no
effect on assets, debts, or net worth, but involves merely
a shift of resources between the affiliates.
As a result,
in consolidation the payable and receivable (if they remain)
and the interest income and interest expense arising out of
68
the financing operations are eliminated.
In similar fashion, any revenue or expense reciprocals
resulting from intercompany services—management fees, royalties revenue, rental payments, commissions, and so on--would
68
Moonitz and Staehling, Accounting--An Analysis of
its Problems, p. 725; Childs, Consolidated Statements, pp.
r50-151.
1214-
69
be eliminated in full.
Reflecting the relative simplicity
of the principle, Moonitz and Staehling claimed:
No special complications impede the elimination
of a true re venue-expense pair. The elimination is
gQ-^^^y for the purpose of avoiding inflated totals
intEe consolidated financial statements: the fact
of elimination asserts nothing with respect to the
wisdom or desirability of the transactions on which
the accounts are based; the fact of elimination does
not effect in the slightest the amoimt of net profit
of any constituent unit, of the consolidation as a
whole, or its allocation among the stockholders. If
for some reason one of these eliminations has been
overlooked, consolidated revenues and consolidated
expenses will both be overstated by precisely the
same amount; consolidated net profit, however, will
still be correct.70
An intercompany dividend paid or payable in assets is
properly recorded as income to the payee affiliate in the
period declared.
However, the consolidated income is not
affected since the transfer of resources remained within the
affiliation.
Therefore, intercompany dividends should be
eliminated to the full extent of the intercompany dividends,
and the consolidated statements will show only the results
of distributions to stockholders outside the affiliation.
° In their Corporation Accounting, Pace and Koestler
state: "In the preparation of a consolidated profit and loss
statement when a minority interest exists in one or more of
the subsidiaries, the entire amount of each intercompany income and expense is eliminated--not Just a proportionate
amount." For the opposite attitude, see Nowak, Standard
Handbook, chap. 5, PP* 167-165.
Moonitz and Staehlin::, Ac counting---An Analysis of
its Problems, p. 726.
125
Even the portion of an intercompany dividend attributable to a minority interest in a recipient affiliate should
be eliminated—that is, returned to consolidated surplus—inasmuch as the assets have not left the group and minority is
viewed here as an "inside" interest.
The majority and minor-
ity equities in the consolidated surplus may have changed,
however; and this change must be taken into consideration.
As a result of a dividend to the minority stockholders by the
subsidiary company, or a dividend by the parent to its stockholders, there will be a reduction of consolidated surplus
and consolidated assets.
Only these dividends can be viewed,
from the business entity standpoint, as distributions of
71
consolidated surplus.
Contingent Liabilities for Debts of Affiliates
"The manner in which a contingent liability originated
will determine its disposition in a consolidated balance
72
sheet."
If the contingent liability arose out of a transaction between an affiliate and an outsider, _i.e^., on a
guarantee of performance, it will be handled exactly as in
73
an Individual balance sheet, by a footnote reference.
^^ Childs, Consolidated Statements, pp. Il4.8-U'.9;
Moonitz and Staehling, Accounting--An Analysis of its Problems, pp. 725-726.
Paton, Accountant's Handbook, p. 1097.
Palen, Report Writing for Accountants, p. 276.
126
However, where an affiliate has accepted a note from a related company and has discounted it outside the affiliation,
the liability is no longer an intercompany concern, but is a
debt owed to outsiders, and therefore must be shown as a direct liability on the consolidated balance sheet."^^
A third
possibility with regard to contingencies is that situation in
which an affiliate has guaraxiteed the debt of another affiliate to an outside interest.
Then, the contingent liability
of the guarantor is entirely eliminated in the consolidated
balance sheet, since the liability will have to be paid only
once.
That is, the group as a whole will have to pay the
obligation one time, and if a company other than the one
originally obligated to pay must liquidate the debt, it is
of no consequence to the business entity.
Therefore, only
the liability shown on the books of the one company will be
carried into the consolidated balance sheet. 75
Regarding the second situation above--that of an affiliate discounting another affiliate's note--accoimtants differ
'^ Nowak, Standard Handbook, chap. 5, P. 161|.; Palen,
Report Writing for Accountants, p. 276; Moonitz and Staehling,
Accounting--An Analysis of its Problems, pp. 721-722; Kester,
Advanced Accounting, p. 617; Walter M. LeClear, "Consolidated
Balance Sheets and Contingent Liabilities," The Journal of
Accountancy, XXXXII (July, 1926), pp. 12-16; Moonitz, Entity
Theory, p* k3; Kracke, "Consolidated Financial Statements,"
p. 3tio.
Wixon, Accoimtant's Handbook, chap. 23, pp. 33-^'i;
Moonitz, Entity'g^eory, pp. Lj.2-'|3; Montgomery, Audit inn;.
Theory and Practice, p. I4.OI.
127
about whether the consolidated balance sheet should show the
liability as a Note Receivable Discounted, or as a Note Payable,
The contention of those who favor the first title is
that the note is a direct liability of one and a secondary
liability of the other, and that showing the liability as a
note payable would not make this distinction.
Those favor-
ing the title of Notes Payable contend that the liability is
as much that of one company as it is that of the affiliate,
and in fact, carmot be differentiated from a combined viewpoint.
Also, the title Discounted suggests only a contin76
gent liability, and may therefore be misleading.
This
latter view is consistent with the operational-unit concept
of consolidated statements and the business entity assumption
of affiliation.
In a similar fashion, other contingency conditions
must be examined to determine if the principle of intercompany elimination applies, and if necessary disposal must be
made accordingly.
Intercompany Bad Debts
The payment of purely intercompany debts merely shifts
cash from one constituent unit to another with no direct
effect on the total cash resources of the affiliated group.
76
Finney and Miller, Advanced Accounting, i4.th ed.,
pp. 35k''355l Newlove, Consolidated Statements, pp. 3^-kO.
126
And by the same token nonpayment has no effect on the total
cash of the group; as a result, no significance may be
attached in the consolidated statements to any entries or
accounts reflecting actual or estimated intercompany bad
debts.'^^
'^^ Moonitz, Entity Theory, p. I4-I; Wixon, Accountant's
Handbook, chap. 23, p. ko; Paton and Paton, Corporation
Accounts, p* 623.
CHAPTER. V. „
STANDARDS UNDERLYINa INTERCOMPANY
FINANCIAL TRANSACTIONS
There exist among accountants controversies which
concern proper consolidation procedure and the underlying
theory thereof.
The differences center around a few rather
characteristic and well-defined situations:
(1) the proper i
area of consolidation, (2) the reconciliation of identical
items appearing on two sets of books at different values,
(3) the effect of the presence of minority interests, (I4.)
the treatment of investments in affiliated companies, and
(5) the nature of consolidated surplus.*^ The first situation
has been dealt with in Chapter III; numbers two and three
have been partially treated upon in their connection with
intercompany operating transactions in Chapter IV; the present chapter deals with situations numbers two and three in
their connection with intercompany financial transactions,
and with the treatment of investments in affiliated coFipanies.
A discussion of situations numbers three and five will be
contained in Chapter VI.
Investments in Affiliates on Owner's Books
As noted above, a special problem in the affiliate
relationship is concerned with the method to be employed in
Moonitz, Entity Theory, p. :'i.5
129
130
recording the investment in the subsidiary on the parent's
books.
The variety of methods available and the unstandard-
ized titles by which they are designated in no way diminish
the problem; quite the contrary, the problem is intensified.
The following section will consider the more predominant of the methods employed in accounting for the parent's
investment in the subsidiary.
It must be said, however, that
satisfactory consolidated statements may be prepared regard2
less of the parent's method of recording its investments."
This fact is true because underlying the preparation of consolidated statements is the assumption that the group is a
single business entity; and the statements which emerge will
reflect this assumption.
The method of carrying the invest-
ment merely determines the nature of the elimination to be
made in the working papers, with the same result under all
3
methods.
Methods of Carrying the Investment;
Arguments of Each
According to the "Equity Method."
When the equity
method is employed, the parent accounts for its investment
in the subsidiary in a fashion parallel to the method used
in accounting for an investment in a branch.
It is thereby
2
Moonitz, Entity Theory, p. i4.7.
- Karrenbrock and Simons, Advanced Accounting--Comprehensive Volume, p. 357.
131
maintained that the parent and controlled subsidiaries are
parts of an integrated whole Just as are home office and
branch units; profits and the over-all subsidiary success,
therefore, need to be shown on the parent's books if these
books are to reflect the status and progress of the parent
company.
Losses would also be recognized.
Despite the di-;
vision of the companies as legal entities in themselves, the
accounting for the subsidiary investment is based on the
economic and practical Implications of the relationship.^
It is for this reason that this method is sometimes called
the economic-basis method.
5
If the parent company adopts the equity method, the
investment account will initially show the cost of the subsidiary shares, and that account will be periodically adJusted with the parent's share of any increases or
Karrenbrock and Simons, Advanced Accounting--Comprehensive Volume, pp. 357, 358; W. E. Dickerson and J. Weldon Jones, "Observations on 'the Equity Method' and Intercompany Relationships," The Accounting Review, VIII (September, 1933), pp. 200-206; Carman G. Blough, Practical Applications of Accounting Standards, American Institute of
Certified Public Accountants (New York, 1957), pp. ^19-14-21;
Jerome R. Hellerstein, "Consolidated Equity Invested Capital,"
The Journal of Accountancy, LXXX (December, 1914-5), PP. ^-5''lj,6i4.; Stempf, "Consolidated Financial Statements," p. 372.
5
Finney and M i l l e r , Advanced Accounting, i|th e d . , p.
314-3.
132
decreases in the subsidiary's net assets,
or for changes in
net equity.
The equity procedure is defended primarily on two related grounds.
In the first place, it is urged that the
value of the investment changes as the subsidiary earns income or suffers losses, and, therefore, a realistic handling
of the investment account requires recognition of the parent's
portion of such changes.
Secondly, it is contended that the
declaration and payment of subsidiary dividends are merely
nominal transfers from one company to another, since (in view
of the relationship between the parent and the subsidiary)
the policies regarding retention and distribution of subsidiary earnings are completely imder the control of the parent.
The objection to the first contention is that the cost
of the investment (at acquisition, market value) is not likely
to coincide with the amount on the subsidiary's books (except where the investment is made at date of issue), and the
increase or decrease in subsidiary book value through retained
income or losses cannot be expected to match the changes in
6
Sunley and Carter, Corporation Accoimting, p. 291;
Finney and Miller, Advanced Accounting, [j.th ed., p. 3I4.3;
FJeld and Sherritt, Advanced Accounting, pp. 152-15^1-; Mauri ce
M. Lindsay, Holding Companies and Consolidation Statements,
The Bently School of Accounting and Finance (Boston, 1939),
pp. 28-30; Pace and Koestler, Corporation Accoimting, pp.
208-209.
7
Paton and Paton, Corporation Accounts, p. 582;
Moonitz, E n t i t y Theory, p . l t ^ t
133
market value.
Therefore^ the "actual value" of the invest-
ment will not ordinarily be shown in an account which shows
cost modified by after-acquisition changes in subsidiary book
value,
The objection to the second point is answered in part
by the preceding answer to the first point.
In addition,
there are grounds for challenging the idea that declaration
and payment of subsidiary dividends are nominal transactions.
The dividend policy of a corporation should always be based
on careful consideration of the corporation's financial circumstances, including cash position and alternative cash
uses.
This consideration is necessary for a company with a
dominant stockholder as well as for other companies. The
deoision, therefore, is a determination based on Judgment,
rather than a mere clerical routine. Moreover, the distribution of dividends is not an automatic operation, and therefore, the parent company, being the dominant stockholder,
does not realize income on its investment until dividend ac9
tion is taken by the subsidiary.
An additional objection to the equity method is that
the main purpose of consolidated statements is to show the
financial position and the operations of a related group of
' Paton and Paton, Corporation Accounts, pp. 5S2,'^63;
William A. Paton and William A. Paton, Jr., Asset Accounting, The Macmillan Company (New York, 1952), p. 13^.
9
Paton and Paton, Corporation Accounts, pp. 582,5^3.
13l|
legally separate companies as if they were a single business
entity.
From the viewpoint of the separate constituent com-
pany, to record the investment at a value different than cost
and likewise not to maintain that value (except for realized
losses) would be adverse to accoimting valuation principles.
As a consolidated statement is a facilitating device to effect an overall picture, to introduce the function of the
statement into the accounts of the parent company is in effect replacing the consolidated statement; and there is
little point, therefore, in proceeding with the process of
10
consolidation.
A practical disadvantage is that an income statement
of the parent using the equity method may be grossly misleading about the amoimt of dividends which the parent company is able to pay.
Earnings of the subsidiaries may be in
the form of plant additions or other assets, or may be needed
for such acquisitions.
In fact, the needs may be of such
volume that payment of dividends to the parent would be impossible, and it is obvious that the parent could not distribute such earnings to its own stockholders. Moreover,
the inclusion of subsidiaries' earnings in income statements
of both parent and subsidiaries is likely to confuse the
10
Moonitz, Entity Theory, p. [4.6 (editor's note to
orporation ACC
chap.
V);
Paton
and
Paton,
Corporation
Accounts, p. 563;
Paton and Paton, Asset Accounting
nting, p. 13^:^.
135
readers,
Pinney and Miller effectively summarize the related
advantages and disadvantages of the equity method in the
following statement:
Advantages:
becausei
The method reflects economic realities
The carrying value of the investment is increased
or decreased by the parent's equity in the increase or decrease in the net assets of the
subsidiary, which underlie the investment.
The parent's earned surplus reflects the parent's
share of the results of the subsidiary operations (conducted for its benefit) as well as
the results of its own operations.
The parent's income statement shows its economic
income from the subsidiary, instead of an
arbitrary amount received as dividends during
that period*
Disadvantages: The method ignores the legal realities
of separate corporate entities because the parent's
income and earned surplus are affected by subsidiary profits and losses, although legally they are
affected by subsidiary dividends rather than by
subsidiary profits and losses.-'-^
It must be said, therefore, that the equity method of
recording the subsidiary investment is inconsistent with the
assumption that the consolidated statements show the related
companies £S i^ they were a unified and single business entity;
the method is also inconsistent with the assumption that
363.
11 Palen, Report Writing for Accountants, p. 95.
12
Finney and M i l l e r , Advanced Accounting, i+th e d . , p,
136
consolidated statements are auxiliary in nature and are secondary to the individual constituent company's statements
which should themselves be based on proper asset valuation.
According to the "Cost Method,"
When the parent com-
pany employs cost method to account for its investment in the
subsidiary, the procedure would be the same as it would be
for any other long-term investment in securities.
Only the
original cost would be recorded in the investment account.
Here, cost refers to cash or to the equivalent assets expended for the subsidiary's stock. However, among adherents
to the cost method there is not unanimous opinion concerning
whether a strict cost basis should be adhered to after the
Initial entry at acquisition.
The majority of the proponents
hold that a subsidiary's dividend which was charged to the
surplus that was accumulated prior to the date of acquisition should be treated as a reduction of the cost of the investment.
On the other hand, the minority would make no
adjustment of cost except to reflect a permanent decline in
value.
The latter would thus carry, with no compromise and
like any other investment, an investment in a subsidiary.
The latter treatment seems to be in keeping with the arm's13
Karrenbrock and Simons, Advanced Accounting--Comrehensive Volume, p. 386; Moonitz and Staehling, Account"^
n5—An Analy3ls""of its Problems, pp. 698-702; Noble, Karrenbrock, and Simons, Advanced Accounting, p. 582; Newlove, Consolidated Statements, pp. 3i4.-35, for a discussion and conparison of the cost and equity methods, and for the argunents
favoring each.
f
137
length concept of the affiliate relationship."^^
The cost basis has also been called the legal-basis
method, 5 because the investment account is recorded at cost
and dividends do not adjust that investment account but are,
rather, recorded as income to the parent.
That is, from the
legal standpoint, a parent and its subsidiaries are separate
corporate entities, and the profits and losses are of the
subsidiary and are not of the parent.
Until the subsidiary
acts (such as through a dividend declaration), any available
evidence of changes in the status of one company's investment in another must be Ignored completely.
Specifically,
the emphasis is placed on conventional accoimting treatment
for the parent company, without regard for its position as
"kingpin" of the consoli(5ated structure ."^"^
The cost basis, however, is not without opposition.
Moonitz points out that the cost basis "is in large part a
reaction to a world of uncertainty, and in that regard is
Ik
Childs, Consolidated Statements, pp. 60, 61;
Kohler, "Tentative Propositions," pp. 6t3-69; Bordner, "Consolidated Reports," pp. 290-291, for a rebuttal to Eohler's
arguments; Lindsay, Holding Companies and Consolidation
Statements, p. l8; Karrenbrock and Simons, Advanced Accounting— Cofnprehens 1 ve Volume, p. 386; Dickinson, Selected Readings in Accounting and Auditing, pp. 173-1714-.
15
Finney and M i l l e r , Advanced Accoimting, i4.th e d . ,
p. 3k3.
16 „,
Finney and Miller, Advanced Accoimting, I|.th ed., p
17
Moonitz, E n t i t y Theory, p , 14.8.
138
inapplicable to relationships between a parent and a controlled
1o
affiliate,"
His explanation of this doubt is that the cost
basis should not be used to create an appearance of uncertainty where none exists, for adequate knowledge of subsidiary
affairs is usually had by the parent company. Moonitz continues:
Moreover, it may be noted that the cost mile has
never been consistently applied to purely financial
relationships, as evidenced by the treatment in
general accounting of interest, discount, and premium on bonds and notes, of receivables and payables,
and of cash. Its proper sphere is with respect to
the nonfinancial items, inventories and fixed operating assets in particular, yhere the "pool of costs"
concept is most appropriate,-"-'
The advantages and disadvantages of the cost basis as
stated by Finney and Miller effectively summarize the theme
of opposition by Moonitz and the arguments advanced by the
adherents to the equity basis:
Advantages: The method conforms to the legal realities of the separate corporate entities, because
subsidiary dividends are taken into the parent's
income and earned surplus.
Disadvantages: The method doss not conform to the
economic realities because:
The investment is carried at cost, regardless of
the changes in the underlying net assets.
The parent's income and earned surplus include
Moonitz, Entity Theory, p. 14.0.
19
l i o o n i t z . E n t i t y Theory, p . I4.6.
139
arbitrary amounts of dividends instead of the
amounts of economic benefits derived or losses
suffered from the subsidiary's operations.20
In view of the basic premise that consolidated statements are supplementary and auxiliary to the individual constituent's reports, and of the assumption that the purpose of
the consolidated statement is to show the financial position
and operations of the related companies _as IJP they were one,
the consistent method of recording the subsidiary investment
would be according to the cost basis, with adjustments therefrom only if subsidiary dividends are a distribution of surplus accumulated prior to acquisition of control by the
parent.
Other Methods Proposed.
A variety of methods have
been proposed to carry the investment in subsidiary account;
but for the most part, these proposals have been merely modifications of the cost and equity methods stated above.
To point out the difference and deviations from the basic
cost and equity methods, a brief discussion of these proposals will follow.
As proposed by some, the modified cost basis would
record at cost or the equivalent the initial acquisition of
the investment in subsidiary stock, but there would be a
periodical entry recording the change in the underlying book
20
Finney and M i l l e r , Advanced Accounting, [{.th e d . ,
p . 36I4-.
114-0
value of its investment.
The book value of the parent's in-
vestment is altered to the same extent as is the change in the
subsidiary's earned surplus account.
The adjustment, however,
would be to a special account (such as Increase of Equity in
Subsidiary Since Acquisition) instead of earned surplus, with
the offsetting debit or credit to the investment account.
The thought behind the adoption of this method would be to
obtain the advantages while avoiding the disadvantages of
21
both the cost and equity methods.
Another alternative is to make the initial entry at
acquisition.
Initially, the book entry is made at the sub-
sidiary book value and is subsequently adjusted for the
appropriate fraction of changes in the equities behind the
investment.
This procedure might be termed (quite arbitrar-
ily) the modified-equity method, which has the advantage of
placing the investment account on the same basis with the
subsidiary's records, thus emphasizing in the most direct
accounting manner possible for what the investment stands.
And, although difficulties (to be discussed in detail in a
later section) would arise in reconciling the parent's investment account with the subsidiary equity which it represents, these problems would be minimized by the modified-
21
Finney and Miller, Advanced Accounting, Ij-th ed.,
p. 3614.; Paton and Paton, Corporation Accounts, po. '^:3-5Bl4.
114.1
22
equity method.
Regarding a choice among the various methods available, it seems that the one chosen should be that method
which is most closely in accord with the nature of the accounts that are involved.
In the absence of a satisfactory
explanation of the discrepancy between cost and book value,
the initial entry at cost seems appropriate because it results in a showing of a new application of resources but
still leaves unaffected the parent's total assets, debt, and
capital.
In any case, the method should not, it seems, be
merely utilized because it facilitates the mechanics of con23
solidation.
Treatment of Changes in Equity due to Subsidiary's Actions
Although the parent company may have bought a stated
percentage of the stock of a subsidiary at a price which
represented a definite book value at the time of acquisition,
that book value is constantly changing and is being influenced by actions of the subsidiary.
It is the purpose of
the present section to study the effect upon the investment
in subsidiary by those subsidiary actions, specifically, subsidiary dividends, operations, and stock transactions.
^ Moonitz, Entity Theory, pp. 50-51; Paton and Paton,
Corporation Accounts, p. 5^3; Sunley and Carter, Corporation
Accounting, pp. 303-307*
23
Moonitz, E n t i t y Theory, p . 5 l .
Ik2
according to the cost and equity methods.
Subsidiary Cash Dividends,
No special problem arises
from recording under the cost method subsidiary cash dividends that are a distribution of accumulated earnings after
acquisition.
In this case the parent's investment account
continues to show the cost figure at acquisition.
The parent
records the dividend as income with no adjustment of the investment account.
However, as noted above, there is no unan-
imous opinion regarding the treatment when the dividend is
a distribution of prior-acquisition accumulations of surplus.
This distribution is usually held to be a return of capital
to the parent, and the dividend is an adjustment of the investment account.
2k
Commenting upon this situation, Kohler
writes:
If paid from surplus earned prior to the date of
acquisition, dividends of subsidiaries should be
treated as liquidation dividends and credited to a
valuation account applicable to the investment;
should such dividends exceed the investment cost,
the excess should be credited to an "acquired surplus" account in order to distinguish it from other
sources of earned surplus.^5
It may be well to note again that, in the consolidation process, the dividends account of the subsidiary is
^
Paton and Dixon, Essentials of Accounting, p. 732;
Childs, Consolidated Statements, p. 110; Paton, Accountant's
Handbook",' pp. 1071-1072; fjelci and Sherritt, Advanced Accounting, p. 169; Moonitz, Entity Theory, pp. 51-5^^
"
^5 Kohler, "Tentative Propositions," p. 69.
114-3
offset by the parent's dividends income account; the net effect is a movement of cash from one affiliate to another,
with no increase in the total of consolidated assets.
Regarding a cash dividend under the equity method,
the amount of the dividend will be shown to be a reduction
26
of the investment account.
The idea behind this procedure
is that the dividends actually do result in a decrease of
subsidiary net assets and that this decrease in the parent's
equity therein should be reflected.^*^
A dividend is thus
recognized by the parent as a recovery or realization of a
portion of the parent's investment in the subsidiary.
tJnder this view, there is no pre-or post-acquisition distinc29
tion in the surplus account.
Subsidiary Stock Dividends.
When a subsidiary declares
a stock dividend to be payable in the same class of stock as
that held by the parent, no change takes place in the latter's
equity either at the time of the declaration or when the stock
P6
/
FJeld and Sherritt, Advanced Accounting, p. 169;
Moonitz, Entity Theory, chap. V, for strong arguments for
this point, a rebuttal to the same by Max Zimering, "Entity
Theory of Consolidated Statements," The Accounting Review,
XXI (January, 1911-6), pp. 9i4.-95, and a re Joiner to this by
Moonitz, "Entity Theory of Consolidated Statements--ReJoiner,"
The Accounting Review, XXI (January, I9I4-6), pp. 96-96.
' Finney and Miller, Advanced Accounting, 14.th ed.,
p. 3kk'
Karrenbrock and Simons, Advanced Accounting--Comprehensive Volume, p. 35^*
2^ Moonitz, Entity Theory, p. 52.
Ikk
is issued.
Therefore, under either the cost or equity method,
the investment is not affected; and, upon receipt of such a
30
dividend, the stockholder parent may recognize no income.
This treatment Is consistent with the nature of this type of
stock dividend because no change in the underlying equity of
the same class of stock results from the transactions, and
therefore no alternation occurs In the status of the stock31
holders,
it is well that a memorandum entry be made, however, to indicate that the number of shares has been increased
32
and that the cost assigned to each share has been reduced.
A slightly different situation is presented by a stpck
dividend which is payable in a different class of stock from
that held by the parent company.33
Wixon supports this fact
and comments that ", , .the most defensible treatment, under
the cost method of handling the Investment account, is that
30
This is in accord with the view of the AICPA, Bulletin No. ij-j^ pp. i}.9-5lj viz., that such a dividend does not
constitute income to the parent. See also Newlove, Consolidated Balance Sheets, p. h5»
-'^ Moonitz, Entity Theory, p. 53', for a discussion of
the subject of income recognition. Carman G. Blough, ed.,
"Should Stock Dividends From Subsidiary be Recoi^nized on Parent's Books?" The Journal of Accountancy, LXXXXII (October,
1951), vv- k^7'^^K^^*
^ Karrenbrock and Simons, Advanced Accounting—Ccnprehensive Volume, p. i4.l8.
33
For an extended d i s c u s s i o n on t h i s m a t t e r , see
Moonitz, E n t i t y Theory, pp. 53-55> and the r e b u t t a l to
Moonitz's arguments by Zimering, " E n t i t y Theory of Consolidated S t a t e m e n t s , " p . 95.
ik5
which spreads the total cost equitably over the two classes
of stock held."^^
And Childs added that:
According to the present /!.£., 19^9/ income-tax
3?ule, a stock dividend constifu'ies income if it "gives
the shareholder an interest different from that which
his former stockholdings represented."36 Therefore,
it should probably be so recorded on the parent's
books. If the investment account is carried /under
the equity metho^, the entry will be a charge to
a new investment account for the dividend stock and
a credit to the old investment; if at cost, the credit
will be to income.
It would seem that the recommendation of the American
Institute of CP.A.s would apply equally well in the case
of a stock dividend of unlike kind; the dividend still does
not constitute income to the recipient, but rather it initiates
a revaluation of the cost between the old and new shares held
by the parent.
Subsidiary's Profits or Losses from Operations.
As
previously indicated under the cost method, an Investment in
subsidiary is kept at the price that is paid (or equivalent)
by the parent, and like any other investment, is unadjusted
except for permanent declines in value.
Increases (profits)
and decreases (losses) in subsidiary capital are disregarded.
^
Wixon, Accountant's Handbook, chap. 23, p. 12.
35
Childs, Consolidated Statements, p. 111.
"^6
Under the 1958 Revenue Code, stock dividends are
nontaxable, with two unapplicable exceptions; see Connelly
and Mitchell, Prentice-Hall 1958 Federal Tax Course, paragraph 1703, pp. 17014.-1703.
114.6
Earnings are taken up as income by the parent only at the
time when and to the extent that they are declared as cash
dividends by the subsidiary, and have no effect on the carrying value of the investment.
When the dividends are declared
they are recorded as income, regardless of when they were
earned by the subsidiary.
Therefore, even though changes
occur in the book value of the subsidiary shares that are
held by the parent, under the cost method the investment
account is maintained exclusive of these equity changes.
37
Under the equity method, however, profits are said
to accrue to and losses to be attributable to the parent in
the period earned or sustained by the subsidiary.
Thus, on
its books, the. parent company recognizes the increase or decrease of its equity in the subsidiary's net assets, and
adjusts its investment-in-subsidiary account and an income
account.
Since such income is unrealized to the parent, a
preferable treatment would be a transfer of that Income account to a special surplus account which remains unavailable
for distribution by the parent.
Also, since the parent's
ownership supposedly reflects its entire equity, a dividend
declaration by the subsidiary will mean that the parent
merely substitutes, in the amount of the dividend, another
asset (cash or receivable) for the investment-in-subsidiary
^' Karrenbrock and Simons, Advanced Accounting--Comprehenslve Volume, p. 386; Childs, Consolidated StatementsT
pp. 108, 10^.
11^7
accountt
Also, a corresponding amount of the special sur-
plus should be transferred to earned surplus.^^
Subsidiary's Stock Transactions with Outsiders. As
a result of the issuance of additional stock or of the retirement of its stock outstanding by the subsidiary company
at more or less than book value, the parent's interest in a
subsidiary is changed.
When the equity method is employed, it is necessary
to determine the alteration that occurs in the parent company's equity and that results from the change in its ownership interest in the subsidiary.
The increase or the de-
crease in the parent's equity is taken up in the investment
account in the same manner as regular profits or losses that
affect the investment.
But when the cost method is used, eliminations are
made in the usual manner and on the basis of the original
equity acquired, and minority interest is computed in terms
of the current minority percentage.
The subsidiary surplus
Childs, Consolidated Statements, p. 109; Karrenbrock and Simons, Advanced Accounting--Comprehensive Volume,
p. 358; Finney and Miller, Advanced Accounting, Ij.th ed., pp.
3i4-3-3l44; "Classification of Loss by Subsidiary," The Journal
of Accountancy, LXII (September, 1936), pp. 226-227; "Profits
and Losses of Subsidiaries," The Journal of Accountancy, LXXI
(May, 1914-1) > PP- lj-62-14.614.; William W. Wemtz, "Some Problems
as to Parent Companies," The Journal of Accountancy, LXVII
(June, 1939), pp. 339-3i4-0; Carman G. Blough, "Adjustment of
Investment in Subsidiary," The Journal of Accountancy, XC
(September, 19:'0), pp. 265-^571
114-8
after deductions for eliminations are made and the minority
interest after it is determined represents the increase or
decrease that is identified with the parent's present investment,
Regarding the subsidiary's stock transactions with
o u t s i d e r s , Childs w r i t e s : ^ ^
W h e n a subsidiary acquires treasury stock in the
open m a r k e t , i.e., from the minority interest, the
majority's percentage of equity will be increased.
And a dilution of or accretion to the majority and
surviving minority i n t e r e s t s — d e p e n d i n g on the price
p a i d — m a y occur. Any, such accretion will n o t accrue
to one interest because of the other's dilution, however. Each interest will share in proportion to its
equity. A surplus reserve may be established, in
consolidation, to cover the portion of the cost of
the treasury stock charged to capital stock. If
this is done, the amount set up will be divided
proportionately as deductions from the allocations
of consolidated surplus to the majority and minority
interests. If the treasury stock is retired, the
n e w majority-minority ratio may be deemed permanent;
if it is resold to outsiders, the interests are restored to their original relationship.
When treasury stock is acquired by a subsidiary
from a parent at cost to the parent, an excess of
cost over equity applicable to those shares will be
obscured in consolidation. Since this acquisition
is an intercompany transaction, the write-down of
excess may be restored to assets and to surplus in
consolidation.
^^ Karrenbrock and Simons, Advanced Ac count in r:--Cor-prehensive Volume, p p . l 6 l , I63-I6I1.; Pinney and Miller,
Advanced Accounting, Ij-th ed., pp. k30'\\3h,
14-36-^38.
•
Childs, Consolidated Statements, pp. 212-213.
114-9
Treatment of Change in Equity due to Parent's Actions
After the parent has, through majority share ownership, gained initial control over the subsidiary it may increase or decrease its equity in the subsidiary by successive
transactions either in the open market or with the subsidiary.
A brief discussion of the considerations involved under the
cost and equity methods follows.
Parent's Stock Transactions in the Open Market, At
W
— i . i « ^ w » ^ i • 111 Ml
•••••••
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,mm»m
. • • • • n — 1 1 iwi i • I H M I I
i IM •
W>M—MII.K
IIWIIIIBII >IMII
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mm
different t,imes and at different prices parent may make
several purchases of subsidiary stock in the open market.
When the equity method is used to carry the investment in
subsidiary, the profits and losses are recognized to the extent of the percentage of the stock that is owned.
If the
stock holdings are increased, the percentage of profit or
loss to be recognized is increased on the date of the additional purchase; therefore, the total profit (or loss) for
the year would be divided according to the interest therein—
the previous percentage as a basis for the time before, and
the succeeding percentage as a basis for the time after the
additional purchase.
Under the cost method, the investment account would
be increased by the cost of the additional acquisition, but
no adjustment is made in the investment account for the increased equity in profits or losses between the additional
acquisition and consolidaticn.
Under these circumstances.
150
the elimination attributable to the parent in consolidation
would be the sum of two computations:
first, the ownership
interest preceding the additional stock purchase is applied
to the net increase in the subsidiary earned surplus since
acquisition to the additional purchase; second, the ownership interest succeeding the additional stock purchase is
applied to the net increase in the subsidiary earned surplus
since acquisition to consolidation.
Under the cost method,
the computation is likely to become more complicated because
a number of acquisitions may be effected over a number of
periods.
In any event, the principle is the same: elimina-
tion should be based on actual percentage of share ownership.^
Likewise, a parent may sell In the open market subsidiary shares which were previously acquired.
And to prop-
erly record a sale of stock, it is necessary to designate
. 14-2 ^
the block of stock from which the sale was made.^
The
carrying value of the stock sold, is computed as a fraction
or percentage of the carrying value of the block from which
Karrenbrock and Simons, Advanced Accounting--Com:prehensive Volume, pp, l|.50-l4-51|-; Childs, Consolidated Statements, pp. 179, l8l; Wixon, Accountant's Handbook, chap. 23,
p, 23; Moonitz and Staehling. Accounting--An Analysis cf its
Problems, pp. 751-753; Finney and Miller, Advanced Accounting, 14-th ed,, pp. i4.2O-l4.22; FJeld and Sherritt, Advanced Accounting, p. 187.
^
A "FIFO" or other basis may be assumed.
-'Wfe'ifai*
151
the sale is made, and will be credited to the investment In
subsidiary account.
If the investment has been adjusted
periodically to reflect the changes in equity since acquisition (as under the equity method), the difference between
the carrying value of the stock sold and the selling price
will constitute a profit or loss on the sale of investments,
The change in the subsidiary's interest that is allocable
to the stock will have already been reflected in the parent's
surplus.
But if the investment had been carried according
to the cost method, the difference may represent in part a
change in equity since acquisition and in part a profit or
loss on the sale of investments.
Parent's Stock Transactions with the Subsidiary,
No unusual problems are encountered when successive purchases
of a subsidiary's stock are made in the open market.
This
is because the book value per share Is the same directly
following an acquisition as it was directly preceding an acquisition.
The purchase of a subsidiary's previously unissued
stock, however, is another matter.kk
In the latter case.
^^ Childs, Consolidated Statements, p. 179; FJeld
and Sherritt, Advanced Accoimting, pp. 153-187; Kohler,
"Tentative Propositions," p. 69; Blough, Practical Applications of Accoimting Standards, pp. I1-O0-I4.IO; Moonitz and
Staehling, Accounting--An Analysis of its Problems, pp.
7I4.6-75I; Noble, Karrenbrock, and Simons, Advanced Accounting,
pp, 636-639; Karrenbrock and Simons, Advanced Accounting-Comprehensive Volume, pp. I4.57-14-61.
^
Childs, Consolidated Statements, p. 191.
152
new capital is invested in the company, and, as a consequence,
the relative interests of parent and outsiders in the subsidiary may shift.^^ If the amount that Is invested is exactly
proportional to the existing interests, the book value of
the shares after the sale will rem.aln the same after as they
were before the transaction.
But, if the new issue price is
more or less than the book value of the old shares, the difference is evidence of a recognition of an upward or downward revaluation of the subsidiary's assets. An adjusting
entry may be made for that difference on the books of the
subsidiary, or on the working papers in the consolidation,
thereby increasing the book value per share of all shares
to that of the new issue,^
Usually, however, no such action is taken.
The price
paid above or below the book value will then be assumed to
be distributed over all outstanding shares, new and old
alike.
The result will be an Increase or decrease in the
book value per share of the old investment with a corresponding decrease or increase in book value per share to the new
investment.
The concern, therefore, is of a possible dilu-
tion or accretion to the majority or minority interest as a
whole.
If the acquisition is proportional to former holdings.
kb<
Moonitz and Staehling, Ac count inf^--An Analysis o^
its Problems, p, 7^3.
^ Childs, Consolidated Statments, p. 192.
153
there will occur no dilution or accretion, regardless of the
price paid for the new stock.
On the other hand, if the ac-
quisition is unproportional, some dilution of one and accretion to the other interest will take place,^'
Where unproportional acquisition is the case, the
analysis presented in the preceding discussion of purchase
of shares from outside interests is directly applicable to
the purchase insofar as the allocation of the subsidiary's
profits and surplus is concerned.
In other words, the prob-
lem of allocating a subsidiary's net worth and changes therein is not influenced by the manner in which the relative
holdings of the controlling and outside interests were altered.^
If a parent company makes a donation of subsidiary
stock to the subsidiary for resale either immediately or at
a later date, there is a dilution of the parent's interest
either immediately or both immediately and at the date of
the resale (the total of which is the same), and the investment and earned surplus accounts must be adjusted according-
1L7
Childs, Consolidated Statements, pp. 192-193.
^ Moonitz and Staehling, Accounting--An Analysis cf
its Problems, p. 753.
, , ^7 ^Finney and Miller, Advanced Accoimting, 'th ed.,
pp. I4.3VI4.35.
1514-
Intercompany Shareholdings—Eliminations
In preparing consolidated statements, the view should
prevail that the accoimts of the parent and subsidiaries are
those of a single company.
With the erasure of corporate
lines of legal separation, certain duplications become evident.
Thus, the actual net assets of a subsidiary at the
date of acquisition are duplicated, wholly or partly, in the
parent's investment account.
Obviously, the presentation of
both assets and both equities on a consolidated balance sheet
would mean an Improper inflation of consolidated assets and
equities.
Therefore, the parent's portion of the subsidiary's
proprietorship is set off against the investment in subsidiary account on the parent's books; and nonreciprocals arising
50
from the elimination will then be combined.
When the parent company has itself organized the subsidiaries, and the cost of its investment is the exact amount
that is shown by the subsidiaries' capital stock accoimts,
elimination of the investment account in consolidation is a
51
simple process.
When the parent has acquired the subsidiary's shares in the open market, however, the exact elimination of the investment and subsidiary proprietorship is a
50
Childs, Consolidated Statements, pp. 105-106.
^ Palen, Report Writing for Accountants, p. 28l;
Perry Mason, Fundamentals of Accounting, The I^oundation
Press Company (Chicago, 191+2), p. 367.
155
52
condition not often met.
Healizlng the complexities in-
herent in the latter condition. Bell comments:
The most troublesome feature in the preparation of
consolidated balance sheets is the adjustment of the
difference between the value at which the stocks of
subsidiary companies are carried on the books of the
parent company and^^their book value at the date of
acquisition. . . ,53
Therefore, if the cost of the investment is greater than the
equity of the parent at date of acquisition, the elimination
of investment and equity will result in the emergence of an
excess of cost over equity.
But if the equity is greater
than the cost, an excess of equity over cost will appear in
5k
consolidation.
In the former situation there emerges "posi-
tive goodwill"; in the latter, "negative goodwill."
Before the difference /representing positive or
negative goodwill/ ^^^y properly be disposed of /In
con sol Ida tion/the reasons for its existence musx be
determined, and the treatment followed should be in
harmony with the conditions. Under no circumstances
is it satisfactory to adopt a technical solution
framed solely for the purpose of keeping the
-^ Kester, Advanced Accounting, p. 573.
•^^ Bell, Accountant's Reports, p. 190.
5^ These items are known by a variety of titles—cost
over equity: "consolidated goodwill," "premium on subsidiary stock," "positive goodwill," "consolidation excess,"
and various other descriptive titles; equity over cost;
"negative goodwill," "consolidation surplus," "discoimt on
subsidiary stock," and various others.
156
statements^"^In T^alance.
n55
The nature of the residual debit or credit balance
after elimination of acquisition book value is, therefore, a
matter sufficient to deserve analysis. On the surface, these
balances are simply a difference between the acquisition price
j(whether "market" or "bargained") and the acquisition book
56
value.
It is not always clear that a debit or credit excess
(positive or negative goodwill) Is attributable to or represents specific items or circumstances; the excess may represent a number of different things.
The difference may be a
result of several causes, including (a) a gain or loss on the
purchase, (b) errors in the accounting for specific assets
or liabilities of the subsidiary, (c) changes In values of
specific assets which have not been recorded, and/or (d) an
unassignable difference between book value and market value
of the subsidiary as a going concern.
An excess of book value over cash (or equivalent) cost
may indicate a gain to the parent; conversely, acquisition
at more than book value may Indicate a loss sustained. However, in order to verify the gain or loss on the purchase,
the accounts would have to reflect proper values; and the
fact would have been established that the price agreed upon
S5 Moonitz, Entity Theory, pp. 55-56.
56
_ Vatter, Modern Accounting Theory, p. 1|13
157
was in reality not in accord with such value.
This situa-""
tion is, therefore, virtually impossible to verify, and such
an explanation would thus carry little weight.
''
An interpretation that the excess is due to errors in
I accounting seems more tenable, since it is very seldom possible to maintain absolute accuracy in all the accounting
^records with regard to classification and matching operations.
Moreover, recorded costs do not purport to reflect fair market value or exchange values.
Consequently, seldomly would
an interest in a company be acquired at a price which was
fair and equal to the book value.
If the excess was established to be attributable to,
for example, an over- or undervaluation of specific assets, a
revaluation on the subsidiary's books may be in order. However, as was noted above, this procedure is not usually followed, although in some cases it may be desirable and wholly
Justifiable.
A case for revision may be based on the inclu-
sion of the subsidiary in the area of integrated operations,
and adjustinent of its accoimts to agree with the cost basis
at acquisition would serve the useful purpose of welding it
more firmly to its affiliates.
The final interpretation of the debit or credit excess is that it may, in fact, be specifically unassignable.
In the case of excess of cost over book value, the difference
may arise because the subsidiary possesses unrecorded goodwill, or the business entity'will acquire it as a result of
158
the affiliation.
Similarly, the excess of book value over
cost indicates an overvaluation of the assets of the business,
or "negative goodwill,"
In the absence of evidence establish-
ing an acquisition gain or loss, the conclusion must be that
the interest that was acquired was worth the purchase price.
Any excess of cost above book value after adjustment (in consolidation) for assignable factors must, therefore, be the
result of imrecorded goodwill.
As a practical matter, con-
ventional procedure attributes a value to positive or negative goodwill which is equal to the difference between the
price paid and the book value of the portion of the acquired
equity.
The practice of absorbing the negative goodwill in
consolidation surplus is occasionally encountered.
Such
action in effect recognizes a profit on the acquisition,
and thereby denies the usual position that, when cost exceeds
book value, the acquired Interest is worth what the parent
paid for it.
A consistent and logical technique for dispos-
ing of the difference may be developed by assuming that
either the price paid by the parent or the book value cf the
subsidiary is the proper measure of the interest acquired.
57
^' Moonitz, Entity Theory, pp. 56, 57, 59, 60, 61-61L;
Carman CJ. Blough, ed., ^'Excess of Investment Cost over Related Subsidiary Book Value: Question and Answers," The
Journal of Accountancy, LXXXV (June. I9I4-8), pp. I4.86-L1.TT9T
American Institute of Accountants, "Some Problems Regarding
Consolidated and Parent Company Statements," p. 570; Nowa:,
"What to Eliminate in the Preparation of Consolidated Balance
159
In their Supplementary Statement No. 7, the Committee
on Accounting Concepts and Standards of the American AccountIng Association set forth the important considerations involved in the elimination of intercompany shares:^^
In the elimination of shares of stock held intercompany, the following points are of special importance:
The difference between the price paid and the underlying book value of the interest acquired should be
disposed of according to the reasons for its existence.
For example, if specific assets of a subsidiary are
undervalued or overvalued, they should, in consolidation, be restated to conform to the level employed in
arriving at the price for the shares; if the shares
were acquired by an exchange of securities, the possible existence of premium or discoimt on the securities issued for the shares should be investigated;
if the acquiring company has paid for the shares
partly on the basis of a previously unrecorded intangible, an appropriate asset, properly described,
should be introduced into the consolidated financial
statements.
The preceding discussion is largely applicable to the
determination of the nature and existence of goodwill at the
Sheets," pp. 36-37; Ainerican Accoimting Association, "Consolidated Financial Statements--Supplementary Statement No. 7,"
The Accounting Review, XXX (April, 1955), p. 196; Paton,
Accountant's Handbook, pp. 1077-1083; Nowak, Standard Handbook, chap. 5, pp. 129-130; Paton, Essentials of Accounting,
pp. 728-729; Castenholz, Auditing Procedure, pp. 2k0'2h,2\
Paton and Paton, Corporation Accounts, pp. 589-603; Lindsay,
Holding Companies and Consolidation Statements, pp. 13-II4-;
Moonitz and Staehling, Accounting--An Analysis of its Problems, pp. 672-695; Palen, Report Writing for Accountants,
pp. 281-287.
58
American Accounting Association, "Consolidated
Financial Statements," p. kk*
Compare that view with that
of the AICPA, Bulletin No. 1^3, p. 1^0.
160
date of acquisition.
If the proportionate ownership in the
subsidiary increases or decreases, the corresponding goodwill figure will not be adjusted.
However, under the con-
ventional procedure of restricting goodwill to the proportion "purchased" by the parent, a new amoimt must be computed
each time a change in proportionate interest occurs.
It is
hardly necessary to say that the consolidated goodwill may,
after numerous purchases and sales of a subsidiary's shares,
become nothing more than a "plug"--an amount which cannot be
readily interpreted--to balance the elimination.
Another problem which arises is the question of propriety in indefinitely carrying consolidated goodwill, or
whether it should be only a temporary part of the total assets.
If the goodwill is viewed as a terminable intangible,
it should be amortized against revenue over its anticipated
life.
But if the benefits are expected to be indefinite, it
59
Moonitz, Entity Theory, p, 63; Paton and Paton,
Corporation Accounts, pp. 607-609; Karrenbrock and Simons,
Advanced Accounting--Comprehensive Volume, pp. 329-314-3;
darman G. Blough, ed., "Some Quesrions Which Arise in the
Preparation of Consolidated Statements," The Journal of
Accountancy, LXXXXIII (June, 1952), pp. 712-713; Kracke,
"Consolidated Financial Statem.ents," pp. 382-383; Zimerinfr,
"Entity Theory of Consolidated Statements," pp. 95-96; Moonitz,
"Entity Theory of Consolidated Statements—Re Joiner," p. 98;
Erp, "Preparing Consolidated Statements for Management," pp.
363-361L; Carson, "Accounting for Mergers and Consolidations,"
pp. 318-320; Miller, C.P.A, Review Manual, pp. 319-322;
Blough. Practical Applications of Accounting Standards, pp.
Ii0l|-[j.08; Thomas H. Sanders, Henry ft. Hatfield, and Underbill
Moore, Statement of Accounting Principles, American Institute
of Accountants (New York, 1930), pp. 103-105.
161
should be carrle~d~unimpaired in all subsequent statements,^°
Recognizing the possibility of a fixed life for consolidated
goodwill, the American Institute of Certified Public Accountants claims that:
• . .the excess of a parent company's investment in
the stock of a subsidiary over its equity in the net
assets of the subsidiary as shown by the letter's
books at the date of acquisition, in so far as that
excess would be treated as an intangible in consolidated financial statements of the parent and the subsidiary, may represent intangibles of either type (a)
/Fixed life/ or type (b) /Indefinite life"/ or a com"Bination o? both,^^Regardless of whether the investment in subsidiary
accoimt was carried on the parent's books according to the
equity or cost method, the amount of goodwill--positive or
negatlve--will be the same; at acquisition both record initial cost based upon the same amoimt of net assets on the
books.
Because the original difference between cost and
equity Is encountered at each consolidation, the goodwill
will remain the same under either method only if the propor62
tionate ownership interests do not change.
Therefore, a nonreciprocal--positive or negative good,
will—usually emerges in the elimination of the reciprocal
60
Moonitz, Entity Theory, pp. 63-61;; and Robert B.
Dale-Harris, "Accounting for aoodwill," The Canadian Chartered Accountant, LXXIV (April, 1959), p. 319.
^^ AICPA, Bulletin No. I4.3, p. 38.
62
Karrenbrock and Simons, Advanced Accoimtinr:--Comprehensive Volume, pp. 376, 398.
162
investment in subsidiary and of the equity of the parent in
the net assets of the subsidiary.
If the investment cost is
greater than is the book equity, the nonreciprocal is reflected in the net assets of the parent and not in those of
the subsidiary; conversely, if the cost of the subsidiary's
stock is less than the parent's book equity, the nonreciprocal element is reflected in the net assets of the subsidiary
63
and not in those of the parent.
^^ Childs, Consolidated Statements, p. 87.
CHAPTER VI
MINORITY" INTERESTS AND CONSOLIDATED SURPLUS
Minority Interests
Among accountants there is again a difference in
points of view toward the relationship existing in consolidation between the majority and minority interests in affiliates.
As noted before, these are the majority interest
(financial-unit) and combined (operational-unit) points of
view.
To those who adhere to the financial-unit concept, the
minority interest is an outside interest, since the consolidated statement is an instrument for presenting the equity
or earnings constructively allocable to a single proprietary
interest, the majority stockholder.
!Iherefore, the "consoli-
dated" capital stock is the parent's stock; the "consolidated"
surplus is the parent's surplus adjusted for increases or
decreases in equity in subsidiaries after acquisition; and
the "consolidated" profit or loss is the parent company's
profit or loss which is adjusted by its share of the undistributed profits or the losses of subsidiaries.
Thus the
minority interest's equity in the subsidiary is looked upon
as a sort of quasi-liabillty and is excluded from the stockholders' equity section of the consolidated balance sheet.
Childs, Consolidated Statements, pp. 51|-^^; Mulcahy,
"Consolidated Statements--Princlples and Procedur^is," p. 15I4.;
163
161|.
To those who accept the combined or operational-unit
point of view, the minority interest is a- propriatortary
element of the subsidiary equal in stature to the majority
interest; in this concept the consolidated statement shows
the total assets and earnings of a business enterprise, with
2
less emphasis on ownership.
Therefore, the minority share-
holders are stockholders in one unit of a consolidated group;
their rights and obligations are the same as are those of
any other shareholders in the same subsidiary holding the
same class of stock.
Finney, Consolidated Statements, p, 20; Montgomery, Auditing,
Theory and Practice, pp, 393-396; Nowak, "What to Eliminate
In the Preparation of Consolidated Balance Sheets," p. 38;
FJeld and Sherritt, Advanced Accoimting, p. 114-3; Charles L,
Prather, Financing Business Firms, Richard D. Irwin, Inc.
(Homewood, Illinois, 1955)$ P. 108| Kohler, A Dictionary for
Accountants, p. 312; Taxation and Financial Relations Commltte"e of the Institute of Chartered Accoimtants in England
and Wales, "Group Accounts in the Form of Consolidated Accounts," Selected Readings in Accounting and Auditing, Mary
E, Murphy, ed,, p, 196,
2
C^il<^s, Consolidated Statements, pp. 5k-55*
^ Moonitz and Staehling, Accounting--An Analysis of
its Problems, p. 697* Kohler, A Dictionary for Accountants,
p, 312; Bell, Accountant's Reports, p. 193; Harry G. Guthmann,
Analysis of Financial Statements, Prentice-Hall, Inc. (New
York, 1953), 14-th ed., p. 55^1 Ralph D. Kennedy and Steward Y.
Mcmullen, Financial Statements--Form, Analysis, and Intertat ion , R1 chard D. Irwin, Inc. (Homewo'od, Illinois, 195"/)»
jjrd reV. ed., p. 1|20; Perry Mason and Sidney Davidson,
Fundamentals of Accounting, The Foundation Press, Inc. (Brooklyn, 195'J)", PP. I|58-l4.59; Mulcahy, "Consolidated Statements-Principles and Procedures," p. l51i; Robert R:. Milroy and
Geoffery L. Carmichael, Introduction to Accounting, Houp-hton
Mifflin Company (New York, 19I|-9 > p. bll; Lindsay, Holding
Companies and Consolidation Statements, p. 17; Mason,Funaamentals/ of Accounting, pp. 369-370
165
The presence of a minority interest in consolidation
is a continual reminder that the consolidated net worth that
is owned by the majority interest does not constitute the
total net worth; there are others who have interests which
must be recognized and reported.
And, if this co-ordinate
interest were not disclosed, an overstatement of the size of
the majority interest in the net worth would be reported on
the consolidated balance-sheet.
Moreover, the size of the
minority interest is dependent upon the valuations assigned
to assets and debts, and not vice versa.
Therefore, if the
subsidiary's net worth is increased or decreased in the consolidation process, the reported value of the minority interest must show a proportionate increase or decrease as
compared with the amount which is reflected in the subsidI4.
iary's unadjusted records.
Consistent with the assumption that the area of integrated operations is a single business entity and in adherence to the operational-unit concept of the purpose of
consolidated statements, minority interests should not affect the determination of the size of consolidated assets,
debts, or total capital.
This position is reflected in the
preferable handling of positive and negative goodwill and of
intercompany profits in assets.
The values assigned should
^ Moonitz and Staehling, Accounting—An Analysis of
its Problems, p. 697.
166
be determined without consideration of the size of minority
interest in the subsidiary.
Such treatment results in con-
solidated statements which reflect the position of the single
business entity, and not only the position of the majority
5
interest.
Allocation of Consolidated Profit or Loss
According to the concept adhered to, there are two
definitions of "consolidated profit or loss?" (1) the individual profit or loss of the parent company adjusted by
the majority's portions of the undistributed profits or of
the losses of the subsidiaries; (2) the difference between
the total income and expenses of the group of affiliates as
a unit regardless of the presence or absence of minority interests.
The first definition, consistent with the financial-
unit concept, attributes consolidated profit or loss only to
the stockholders of the parent; the second, consistent with
the operational-unit concept, distributes the consolidated
profit or loss between the majority and minority interests.
Consistent with the combined or operational-unit concept that is supported here, consolidated profit or loss is
conceived to be the difference between the total income and
expense of the multicorporate enterprise, with that
^ Moonitz, Entity Theory, p. 76; Newlove, Consolidated
ints, pp. 5k-55, 49-51, for a "table of disputed points,"
Stateme]
including minority interest treatment.
167
difference properly distributed between majority and minority
o
equities.
Reflecting the operational-unit concept, Moonitz
writes that the necessary adjustments should be made to the
constituent company's profit or loss before allocation.
Where, however, an outside interest exists in one
or more subsidiaries, care must be taken to assign
to the outside interest its appropriate share of
the net profit of the subsidiary after adjustment or
correction for profit or loss not realized from a
combined point of view /as on inventories sold at
a profit to an affiliate/, or for gains or losses
recognized In consolidation but not reflected this
period in the records of the subsidiary.'
But sometimes it may be impossible to attribute intercompany gain or loss to a specific company.
In this case a
direct assignment to consolidated surplus seems to be the
most reasonable, thereby leaving minority interest unaffected.
In essence, this treatment assigns the whole gain or loss to
the dominant company in its capacity as representative of the
whole integrated group.
This disposal should, however, be
the exception and not the rule, for consolidated surplus
should not be used as a catch-all for items which are clearly
applicable to specific companies.
An example of such a pro-
cedure which commonly occurs is found in the charging of the
intercompany profits on inventories to the consolidated
Childs, Consolidated Statements, pp. I[i0-ll|.l.
"^ Moonitz and Staehling, Accounting--An Analysis of
its Problems, p. 736.
168
surplus because the minority has realized a profit and the
majority interest should assume the entire deduction.^
Therefore, the most direct method of assiwiing a proper
apportionment of net income is to make as many consolidated
adjustments as possible against the accounts of the individual companies involved, and not against the categories employed in the consolidated statements.^
Allocation of Consolidated Capital
The minority interest is usually exhibited as the sum
of the nominal value of the shares held by outsiders plus an
interest in surplus.
Therefore, the amount of consolidated
capital assigned to the minority interest is computed as the
sum of the interest at the beginning of the period, plus its
share of net income of the subsidiary for the period, less
dividends, and plus or minus any unconsolidated adjustments
made directly to the capital accounts of the subsidiary.
A primary function of allocating consolidated capital
to minority is to prevent an overstatement of the size of
the majority interest; only secondarily does it furnish information of the minority interest.
The consolidated assets,
debts, and net income shown are those of the whole group,
^ Moonitz, Entity Theory, p. 77.
^ Moonitz, Entity Theory, p. 77.
•^^ Moonitz, Entity Theory, p. 78.
169
and consolidated capital is that of the entire affiliation.
If a minority interest exists, the entire consolidated capital may not be assigned to the majority interest—to do so
would be an overstatement of the interest.
From this point
of view, the practice of showing minority interest as a
liability is quite objectionable. Moreover, no particular
significance can be attached to the ratio of minority to
majority equity, but only to the absolute amounts involved.
Such is the case because the minority interest in consolidated capital will vary with the subsidiary's profitable
operations concluded with outsiders, and will not be a function of the progress of the whole group.
Consolidated Surplus
Reflecting the importance of the consolidated surplus
account, Wixon writes that the "link between a consolidated
balance sheet and a consolidated income statement is provided
,,12
by a consolidated 'surplus' statement."
Consolidated capital is defined as the excess of consolidated assets over consolidated debts.
These three items,
as ordinarily used, refer to the whole integrated area.
Con-
solidated surplus, a part of consolidated capital, on the
other hand, usually refers exclusively to the interest of
Moonitz, Entity Theory, pp. 78-79.
12
Wixon, Accountant's Handbook, chap. 23, p. "^0.
170
the parent corporation.
Thus, consolidated surplus should
reflect additions, deductions, and appropriations as though
the individual constituent affiliates did not exist.
Con-
solidated surplus, at any time, consists of the surplus of
the parent company (exclusive of any adjustments for investments in subsidiaries), plus the parent company's equity in
the subsidiaries' gains or losses that were sustained since
date of acquisition, less dividends, plus or minus consolidated adjustments which are not directly applicable to constituent companies. '^
15
In his Dictionary for Accountants,
Kohler writes a
similar definition for consolidated surplus:
Consolidated Surplus: Ihe combined surplus accounts
of all companies whose accounts are consolidated, after
deducting minority stockholders' interest therein, the
interest acquired by the parent company in the subsidiary companies' surpluses existing at the date of their
acquisition, and intercompany eliminations.
Kohler's definition suggests that a number of component
parts may make up consolidated surplus.
composed of three items;
Basically, it is
(1) earned surplus of the parent
(unadjusted for changes in the book value of the subsidiary),
(2) the parent's equity in subsidiaries' gains or losses
Childs, Consolidated Statements, p. 15I4-.
•^^ Moonitz, Entity Theory, p. 80.
15
Kohler, A Dictionary for Accountants, p. 112.
171
since the date of acquisition, and (3) capital surplus items
arising from transactions not ordinarily considered as establishing realized gains or losses.
That the foregoing items
(1) and (2) constitute consolidated earned surplus is seen
in the following statement by the Committee on Accounting
Concepts and Standards:
Consolidated retained earnings consist of the retained earnings of the parent, or controlling interest, plus the portion, or portions, of subsidiary-company earnings accumulated subsequent to
the date or successive dates of acquisition, and
attributable to_the shares making up the controlling interest.-'-'
The consolidated earned surplus will equal the parent
company's earned surplus provided the equity method has been
used in accounting for the investment in all the affiliated
companies.
But if the cost method is used, consolidated
earned surplus equals the parent company's earned surplus
minus or plus its share of the undistributed earnings or
losses realized by the affiliated companies since the date
of affiliation, if the proportional ownership interest there18
in has not changed.
-1 z:
Moonitz, Entity Theory, pp. 81-82.
•^' American Accounting Association, "Consolidated
Financial Statements," p. k^i.; see also the definitions set in
Finney and Miller, Advanced Accounting, k^h ed., p. 3h-7;
Kester, Advanced Accounting, p. 5^ii; Koonitz, Entity Theory,
p. 81. An Interesting discussion on this topic is to be
found in Vatter, Modern Accounting Theory, pp. 1|11-U13.
•^^ Miller, C.P.A. Review Manual, p. 358.
CHAPTER VII
CONSOLIDATED STATEMENTS' UTILITY* FROM
VARIED VIEWPOINTS
Thus far the presentation has been concerned with consolidated statements and the theory of their preparation, including the circi3mstances of preparation, and the standards
and principles underlying their preparation.
then arise:
The questions
of what value are the consolidated statements;
do they accomplish the purpose for which they are intended?
Ihe present chapter will attempt to answer these questions
from the viewpoint of varied interested parties with the emphasis upon the inherent limitations of consolidated statements.
From the Viewpoint of the Accountant
"It must be emphasized that a consolidated statement
. . .has practical meaning and value only as showing the
position of the group as a whole, . . .*
This statement
in effect summarizes the position of the accoimtant preparing the consolidated statements.
He is preparing statements
of a single business entity, as it were, that is in reality
composed of separate companies which are legal entities in
1
Taxation and Financial Relations Conmiittee of the
Institute of Chartered Accountants in England and Wal^s,
"Group Accounts in the Form of Consolidated Accounts,"
Selected Readings in Accounting and Auditing, I Iary E. Murphy,
ed., p. 193.
172
173
themselves but which are stripped of this separateness for
the purpose of combining their accounts to stress financial
and managerial unity.^
In spite of the consolidated state-
ments' usefulness for presenting a composite picture of the
affiliates, they cannot be regarded as properly taking the
place of the statements of the individual companies.
Along
these lines, Paton writes:
The objective of consolidated statement is to provide the management and stockholders of the dominant
corporation with a picture of over-all position and
activity. Accordingly, in preparing such statements,
the accoimtant is viewing the affairs of the two or
more companies involved from the standpoint of-through the eyes ojf--the executives and owners of
the parent entity.^
In preparing the consolidated statements, the accountant has a duty to point out any dangerous situations that
5
may be obscured in consolidation; however, it nust be concluded that consolidated statements are not of themselves
panaceas for reporting--they have their inadequacies and
limitations.
The preparation of the consolidated reports
should be with full knowledge of these shortcomings, and an
effort should be made either to restrict circulation where
Stempf, "Consolidated Financial Statements," p.
375; Paton, Advanced Accounting, p. 751.
Finney, Advanced Accounting, 3rd ed., pp. 389-390.
^ Paton and Dixon, Essentials of Accoimting, p. 725.
Paton, Advanced Accoimting, p. 753.
"'m
I7I4-
misleading inferences may be drawn, or to bring out the inadequacies in the report in some wa^.
A previously noted limitation of consolidated statements is the lack of disclosure of the conditions of any
distinct legal'^entity.
Rather the statements report the
comb.ined position of an artificial entity.
It is for this
reason that consolidated statements are auxiliary to the
affiliate's statements.
Indeed, "the individual statements
are essential in order to obtain a fuller and more adequate
composite picture of the holding company economic unit. The
distortion of pertinent facts and the concealment of individual company differences may be discovered through the scrutiny of the legal statements."
An insolvent subsidiary,
for example may be hidden in the statements.
Also, the var-
iations in the net Working capital position, in the longterm debt, and in the over-all financial condition of the
different subsidiaries are not revealed.
Moreover, the con-
solidated balance sheet may give the impression to the average reader that all the assets which are shown are available
to meet creditor and equity claims, when most probably this
fact may not be precise in specific instances.
7
A second Imitation is the Incomparability of the
Kennedy and McMullen, Financial Statements--i''cnn,
Analysis, and Interpretation, p. k25.
7
Nfwlove, Consolidated Statements, p. 27.
175
accounts which underlie the consolidated statements.
A lack
of comparability would result if major classifications are
not the same, if a diversity of basis for valuing assets exists, or if dissimilar statement dates and periods occur.
Material inconsistencies between the companies' books of accounts should be either adjusted or disclosed.^
A third and the most significant limitation is the
use of financial ratios which are drawn from the consolidated
statements.
"Financial ratios designed to throw light on
earning power, immediate and ultimate solvency, operating
efficiency, etc. are necessarily weighted averages which may
be in no way typical of the consolidated companies."
For
example, the combination of data of a company having a very
strong current ratio position with one having a very weak
current ratio may result in an average which is not typical
of either company and which is likely, therefore, to be mls10
leading.
Thus, it must be concluded that general ratios
should be computed in terras of the reports of only specific
companies.
If it becomes necessary to apply this method of
interpretation to the data in consolidated statements, the
n
Kennedy and McMullen, Financial Staternents--Form,
Analysis, and Interpretation, pp. k25, i;26, 1;29; Mulcahy,
"Consolidated Statements—Principles and Procedures," p. 156.
Mulcahy, "Jonsolidated Statements--PrinciplGS and
Procedures," p. 156.
Paton and Paton, Corporation Accounts, p. 575.
176
limited significance of the resulting ratios should be made
clear to avoid misleading inferences therefrom."''^
A general conclusion may be drawn with regard to the
accountant's viewpoint of the consolidated statement's utility.
It can be said that the consolidated statements have a
legitimate function to perform in certain circumstances, but
they should hot replace the constituent companies' reports
as the primary reports; furthermore, the consolidated statements should be presented with a full recognition of the inherent limitations.
From the Viewpoint of Management
Consolidated statements are designed primarily to aid
management and investors; the statements represent a special
phase of the reporting to top management of the dominant com12
pany.
Herein is where their chief utility lies.
The es-
sential feature in a combination through share ownership is
central direction and control.
Reports and statements re-
lating to the field of direct control logically go along
with this feature.
This relation between control and reports
is expressed in the following statement:
The interests of the management and the usefulness
of consolidated statements to it vary with the degree
Paton, Advanced Accounting^, p. 7^3.
12
Paton and Paton, Corporation Accounts, p. 57]-.
177
of centralization of authority. If managerial authority is highly centralized in the parent company officials, consolidated statements are essential in measuring the over-all performance and effectiveness of
the executives. If centralization of authority is
not great, the consolidated statements are useful in
connection with the broader aspects of the economic
unit ."**-^
Management is an agent of the owners, and is in direct control of the affairs of the combination.
It must have data
regarding the consolidation's functioning; the major source
is the financial data expressed in the consolidated statements of the group as a whole. ^
It must use this consoli-
dated data in evaluating the effects of its larger policies
upon the combination.
15 In this light, the consolidate J
statements tend to become primary in character, with the constituent companies' statements fulfilling the function of
schedules supporting the principal generalized presentation.
16
Consolidated statements prepar d for publication are
usually of little value to management for the purpose of
evaluating the effects of its broad policies on the whole
group.
Obviously, this slight value is the result of the
13
Kennedy and McMullen, Financial Statements--Form,
Analysis, and Interpretation, p. ^LIO.
Moonitz, Entity Theory, p. IL^; Edison E. Easton
and Bryon L. Newton, Accoimtin?; and the Analysis of ^inancial Data, Mcaraw-Hlll Book Company (New York, 195<^), p. 2^7;
Kester. Advanced Accounting, p. 651.
'^^ Childs, Consolidated Statements, p. 35.
•^^ Moonitz, Entity Theory, pp. Ia-15.
178
condensation of the group financial data.
Therefore, special
"internal" consolidated reports are generally desirable for
the use of management.
Such reports would present the com-
bined position and operations of all companies under common
operating control, regardless of the ownership or other ex17
isting relationships among them.
Generally, infoi^ation concerning the entire affiliated group, as expressed in financial terms in the consolidated statements, is of prime importance to the management
of the dominant company.
There is one notable limitation
to this general statement, however.
The consolidated statements do not reveal to management (1) the amount of surplus that is available for dividends to the parent company's stockholders, (2) the amoimt
of earnings that are available to the holding company, and
(3) the amount of cash that is available for dividends to
the parent company.
Assuming decentralized management exists, the management of the subsidiary is primarily concerned with the
activities of the corporation under its direction, rather
19
than the activities of the affiliation as a whole.
17
Childs, Consolidated Statements, p. 3518
Kennedy and McMullen, F i n a n c i a l S t a t e m e n t s - - y o m .
A n a l y s i s , and I n t e r p r e t a t i o n , p . •i26.
' Paton and P a t o n , C o r p o r a t i o n Accounts, p . 3 7 3 .
179
Therefore, the individual corporation's statements are primary for its purposes, with the consoiiaated statements being merely an informative supplementary schedule.
The lat-
ter 's importance would vary naturally with the degree of
operating integration between the parent company and its
affiliates.
From the Viewpoint of Investors
As stated above, consolidated statements are designed
primarily to aid management and investors.
If the statements
are to be an aid to investors, it is important that the reports be prepared from the investors' point of view.
But
since an affiliation is composed of two or more members,
there will be a divergence of shareholder-owners.
They are,
as a minimum, shareholders of the parent company and shareholders of the subsidiary, composed of the parent company
and minority shareholders.
Consolidated statements are the best medium yet devised for presenting a "bird's-eye" view of a group of individual corporations that are operated as a single enterprise.^
To the stockholders of the parent company, this
point is important.
As oimers of the dominant unit of the
group, they may be said to constructively own their company's
M. B. Daniels, "Financial Statements," Selected
Readings in Accounting and Auditing, Mary E. >iurphy, e c ,'
p. 176:
180
subsidiaries.
Moreover, the value of their investment in
the parent company may depend in a large measure on the overall financial position and the operating results.
For this
reason, a parent's stockholders tend to view the consolidated
statements as the primary statements of that company.
The
shareholders, being the owners, are entitled to a full report on their investment:
the question is, are consolidated
statements alone adequate for a full report?
From a long-range point of view, the consolidated
statements are undoubtedly superior to the statements of the
parent company alone.
Over a period of years the dividend
policy of the parent company and the value of the stock
would, in all probability, correlate closely with the pro22
gross of the entire group.
Regarding the immediate future, however, the investors
in the parent company are concerned with the statements of
their company as a separate and distinct corporation, and
are only secondarily interested in the Joint picture of the
23
affiliated enterprises.
Prom this point of view, the practice of issuing to stockholders no statements other thsn the
consolidated statements of the parent and consolidated
Childs, Consolidated Statements, p. 33.
^^ Moonitz, Entity Theory, p. l5.
23
Paton and Paton, Corporation Accounts, p. ^^7^.
181
subsidiaries is most unfortunate.^
The most important single feature in gauging the immediate prospects of the business appears to be the likelihood of early dividends; the parent's dividend policy must,
however, be guided by legal considerations.
The dividend
policy of the parent company will depend upon the composition
of its own surplus and of its assets, the state laws, and
its future financial needs and prospects.
The earnings of
the subsidiary are not actual earnings to the parent, and
form no part of the income of the parent unless they are declared and transferred in the form of dividends. Moreover,
the assets of the subsidiary are not available to meet the
claims of the parent's creditors in the usual going-concern
situation.
In view of the inadequacy of consolidated statements
in reporting to the single interest of parent company stockholders in the short run, the minimum requirement should be
the presentation of the separate statements of the parent
and major subsidiaries, supplemented by the consolidated reports, if such supplement is warranted in view of the nature
of the subsidiaries and their relation to the parent
Paton and Paton, Corporation Accoimts, p. 57k'
25
Kennedy and McMullen, Financial Statements--Form
Analysis^ and I n t e r p r e t a t i o n , ppTl4^"rar?77nFaFon7~l£co^iJ
a n t ' s Handbook, p . iu6u.
182
26
concern.
The foregoing discussion has been concerned with a
parent's present stockholders,
A similar analysis may be
made of the value of consolidated statements to potential or
prospective stockholders in the parent company, for their
attitudes and interests are similar to the present investors.
27
Because the consolidated statements do not reflect
the financial condition of each individual subsidiary, the
position of minority stockholders in the subsidiary cannot
28
be determined from them.
Minority shareholders are concerned with the financial reports of only the particular
29
company to which their rights attach,
and must look to
them for information about the earnings and assets representing
26
Paton and Paton, Corporation Accoimts, pp. 57k-575l
see also Controllership Foundation, Inc~., Wha"F"People Want to
Know About Your Company, Controllership Foundation, Inc.
(New York, 191|.b), for an enlightening discussion and report
on what stockholders learn from, and the value placed on,
corporate annual reports.
27
Childs, Consolidated Statements, p. 33; see also
John C. Clendenin, Introduction to Investments, McCrrawHill Book Company, Inc. (New York, 1955}» 2nd"'ed., pp. 332'33k»
for a discussion of the problems of consolidated stateiTi?nts
analysis from the investor's viewpoint.
Kennedy and McMullen, Financial Statements--F^or'i,
Analysis, and Interpretation, pp. I|.25-i4.26.
29
Paton and Dixon, Essentials of Accounting;, p. 725;
Thomas M. Hill and Myron J. Cordon, Accoimting: "A^Manairement Approach, Richard D, Irwin, Inc. (Homewood, Illinois,
X959), vev^ "id., p. 230; T. B. Robson, "Consolidated and
other Grroup Accoimts: Principles and Procedures," ^el^t^d
Readiness in Accounting and Auditing, Ilary E. Murphy, • .,
pp. lb?-18b.
183
their interests.
(This statement may be qualified somewhat
if there is a guarantee by the parent company of the minority
shareholders equities.)
Reflecting the auxiliary nature of
consolidated statements from the viewpoint of minority stockholders, Paton writes:
In general the minority stockholders (if any) of
a subsidiary company are concerned only with the affairs of such company; their interests are not directly affected—or should not be affected—by developments with respect to the earning power or financial
standing of other subsidiaries or by the changing
fortunes of the corporate stockholder exercising
control. The welfare of the subsidiary. Indeed, is
no more dependent on the condition of a dominant
corporate stockholder than is the welfare of any
company dependent upon the physical or financial
status of a dominant individual stockholder. (In
some situations, it must be admitted, the subsidiary does not stand on its own feet. . ." . )^
Therefore, since they must accept the decisions of
the controlling group, the minority interests are in no position to direct the ordinary course of business events which
may affect the stability of their investments.
For infor-
mation concerning their investments, they must look to the
statements of the legal entity whose stocks they own, and
not exclusively to the consolidated statements.
From the Viewpoint of Creditors
The long-term creditors of the parent company are in
Paton and Paton, Corporation Accounts, p. ^73.
18J^
much the sam.e position regarding the utility of the consolidated statements as are the parent company stockholders.
This position is so because the statements reflect the aggregate resources behind their investments and the consolidated
earnings to which they may look (in the long-rim) for their
income.
There may be discerned from the consolidated state-
ments probable future trends in the over-all stability and
earning power of the affiliation, and the nature and value
of the parent's assets which underlie their claims,-^
The short-term creditors of the parent company, on
the other hand, are in the same position with respect to the
utility of consolidated statements as are the minority shareholders of the subsidiaries.
They are immediately concerned
with the statements of their company as an independent organization, and only secondarily with the combined picture
32
of the affiliation.
They must look for payment only out
of the liquid assets of the parent company.
Through control
of the subsidiaries' managements, the parent company may
possess the power to appropriate the current assets of the
subsidiaries through borrowings and dividends, but the shortterra creditors have no legal right to insist that this appropriation be made exclusively for their benefit.
The claims
Stempf, "Consolidated Financial Statenents," p.
359* Kennedy and McMullen, Financial Statements--H^onn,
Analysis, andlnterpre tation, p. LJIO; Moonitz, Entity Theory,
pp. l5-li;'ToFter and Fiske, Accounting, p. 317.
•^^ Paton, Advanced Accounting, p. 752.
185
are against a single legal entity, the parent, and only its
statements will provide information of that company's current assets that may be available to liquidate their claims.
33
Regarding the utility of the information in consolidated statements, the creditors--long or short term--of a
subsidiary company are in the same relative position as are
minority shareholders in the subsidiary or short-term creditors of the parent.
In the absence of intercompany guarantees
of debt payment, subsidiary creditors must look to the earning power and assets of the debtor corporation, and not to
its stockholders, for the protection and satisfaction of
their claims. ^
A specific example of the Inadequacy of
consolidated statements to portray the position of subsidiary creditors is given in the following statement.
The subsidiary bondholders. . .are interested in
knowing the number of times that the bond interest
. , .have been earned. Information to compute such
ratios is not generally supplied by the consolidated
statements.35
Consolidated statements, therefore, are primarily of
33
Moonitz, Entity Theory, p. 13; Mulcahy, "Consolidated Statements--Prlnciples and Procedures," p. 155.
Paton and Paton, Corporation Accounts, p. 573;
Moonitz, Entity Theory, pp. 12-13; Childs, Consolidated
Statements, pp. 33-3k] Kennedy and McMullen, Financial
St'atemenIi--Form, Analysis, and Interpretation, pp. ulO-Ml.
Kennedy and McMullen, Financial Statements--Forn,
Analysis, and Interpretation, p. i|.29.
186
interest to the management and stockholders of the parent
company; and, in their role of presenting an over-all picture
of the affiliation, the statements tend to overshadow the
constituent companies' reports in importance.
Occasionally,
other groups such as creditors and minority stockholders may
find special use for them, but not as essential primary reports.
It is for this reason that consolidated statements
must be prepared and presented in a manner which will be
36
useful to the parent's management and stockholders.
^^ Moonitz, Entity Theory, p. 17.
pej
CHAPTER VIII
SUMMARY AND CONCLUSIONS
Summary
The movement in business toward affiliation through
share ownership has made necessary the invention of an adequate reporting technique to match these business forms.
Conflicting requirements of the law, conflicting prevailing
corporate practices and procedures, and other influencing
pressures combined to form a confusing array of rules for the
preparation and presentation of consolidated statements.
Although consolidated statements have been used for
almost sixty years, there still exists divergencies in the
viewpoints among accountants regarding the principles which
underlie their preparation, divergencies regarding the conditions which should be met before consolidation is proper,
and divergencies about the purpose for which they are prepared.
The professional accounting organizations have under-
taken to narrow the gap.
Consolidation is a complex subject, and principles
to be followed in preparing consolidated statements are formulated only with great difficulty.
Underlying the difference
of views are the different concepts of consolidated statements--whether (according to the legal-entity concept) th^y
are merely expansions of the parent company data, or whether
(according to the business-entity concept) they are reports
187
188
which state the position and results of operations of a
group of related companies as if they were a single business
entity.
The latter concept was assumed to be the more valid
of the two, and there has been derived from this assumption
a consistent theory to guide the preparation of the consolidated statements.
Wherever a difference of opinion existed,
that fact was brought out, and, in the interest of a valid
comparison and consistent deduction, the varying opinions
were presented.
Whenever an area of integrated operations exists
among affiliates, there arises a question about the desirability of preparing consolidated statements.
Proposed have
been criteria by which a decision may be reached regarding
the inclusion or exclusion of specific subsidiaries.
The
determination of the exact boundary of the consolidation in
any set example may be difficult, but is rarely Impossible
since the determination is not always based on wholly objective criteria.
Affiliation of separate legal entities
is usually accomplished through share ownership, and a basic
criterion of consolidation is met when there is sufficient
share ownership present to constitute effective and positive
centralized control over the subsidiary.
Where this control
is coupled with closely integrated operations among the affiliates, there exists the basic conditions which are essential
to consolidation.
Other related criteria that are frequently
proposed deal with foreign-based subsidiaries and consistency
189
of treatment.
But, regardless of the criteria employed, the
reader of the consolidated statements has a right to know
the basis upon which the statements were prepared.
A foot-
note should give the basis of preparation.
The pr.imary principle of preparing consolidated statements is the elimination of all evidences of intercompany
relationships.
The objective to be attained by elimination
is to rid the single business entity of all amounts and accounts which reflect transactions among the separate affiliates, and to retain only the nonreciprocal elements, the
combination of which will show to the outside world the
affiliation as a single business entity.
The major controversies among accountants arise in
the application of the principle of elimination and can be
conveniently divided into the following categories:
(1)
elimination of transactions involving (a) the debtor-creditor relationship; (b) intercompany merchandising or accommodating activities; (c) other intercompany transactions and
considerations; and (2) the elimination of intercompany
shareholdings.
Representative of the reciprocals to be eliminated
is that of intercompany receivables and payables.
Payment
and receipt of the debt is but a transfer of cash between
the affiliates, and the business entity as a whole is not
affected.
Long-term loans have a similar result; without
elimination, an inflation of the totals of assets and debts.
190
from the group viewpoint, is inevitable.
The holding of
long-term bonds among affiliates poses a problem which arises
mainly because the individual constituent company's statements must correctly state any premium or discount applicable
to its bonds payable, and correctly amortize the item.
The
purchasing affiliate may have bought the bonds in the open
market at a price not corresponding with the reciprocal liability.
Moreover, there is dissension over the treatment on
the consolidated statements of the intercompany bonds since
from the group viewpoint they have the status, in effect, of
treasury bonds.
Since from the operations viewpoint affiliates are
ordinarily closely related, there is very likely to be movement of goods and fixed assets among affiliates.
These move-
ments are transactions within the business entity, and all
traces of the reciprocals must be eliminated.
If the goods
that were acquired from an affiliate have been sold to outsiders at the consolidation date, the profits made by both
affiliates is fully realized.
Any profits, however, on goods
remaining in the inventory of the buying affiliate is unrealized to the combination as a whole, and must be elbiinated.
The principle behind this elimination is that an entity cannot make a profit on a sale to itself; without the elinination an inflated inventory accoimt wculd result.
The ideal, as Just stated, is clear, but major differences exist in several cases.
What should be the basis
191
of computation of the profit in inventory?
If a minority
interest exists in the selling affiliate, how much of the
profit is to be eliminated?
How should intercompany profits
in inventories held at the date of acquisition be treated?
At the root of these difficulties, for the most part,
is the adherence to either the financ ial-unit or the operational-unit point of view.
The dissension carries over to
the matter of purchase and sale of fixed assets between
affiliates, and the arguments about profits on inventories
advanced by both sides apply equally well to profits on
fixed assets that were purchased from an affiliate and yet
unretired.
In the latter case one additional problem arises:
the fixed asset remains with the buyer for a number of accounting periods, and the depreciation thereon will more than
likely be based upon the cost to the buyer, resulting in the
depreciation of the profit amount as well as the original
cost (to the seller).
From the consolidated viewpoint, there
is an overstatement of both depreciation
the fixed asset.
SLQG
book value of
An adjustment, therefore, must be made to
reflect the asset at cost to the affiliation from outsiders
and to reflect depreciation expense and allowance on the
original cost basis.
Miscellaneous intercompany transactions involve revenue and expense reciprocals which relate to oper?-tin^ transactions other than sales and purchases, and other considerations which are pertinent to the operations of the consolidated
192
units, such as contingent liabilities and intercompany bad
debts.
In reciprocals of revenue and expense and from a combined point of view, the transaction causes no change in
assets, debts, or net worth, but involves merely a shift of
resources between the affiliates; all such amounts will be
eliminated in full.
Contingent liabilities for debts of affiliates will
be disposed of in the same manner in which they originated.
If no outside interest is involved, the situation is of no
consequence; if the contingent liability is to an outsider,
that must be shown as either a footnote or a liability, depending upon the circurastances.
The situation of intercompany bad debts is much like
that of other reciprocals: nonpayment of its debts to an
affiliate does not affect the total cash resources of the
consolidated group, and as a result no significance may be
attached to this item in preparing consolidated statements.
The elimination of intercompany shareholdings is dependent upon the method of carrying the investment in subsidiary on the parent's books; regardless of th-^ method employed, the result will be the same since the consolidated
statements will reflect the assumption of a single business
entity.
The equity method Initi^Jly records the acquisition
at cost, but adjusts that investncnt account periodi-^lly
with the parent's share of any increases or decreases in the
193
subsidiary's net equity.
The cost method initially records
the investment at cost, and there is no adjustment of that
amount except to reflect a permanent decline in value.
Intercompany shareholding elimination may be affected
by changes in equity interest of the parent in the subsidiary
because of actions of either the parent or the subsidiary.
If the stock transactions of either the parent or subsidiary,
between themselves or with outsiders, change the equity ratios
of the controlling and minority interest, that change must
be computed and the new ownership ratio must be applied in
preparing the consolidated statement.
In eliminating the investment account on the parent's
books against the parent's percentage of the subsidiary
equity section, a difference is likely to arise because the
net worth of the subsidiary was not the same as was the purchase price at acquisition.
If the cost is greater than is
the equity purchased, "positive goodwill" results; if the
equity purchased is greater than is the purchase price "negative goodwill" results.
The reason for this difference
should be determined, if possible, and appropriate adjustments should be made in the consolidation process.
Profession of the financial-unit concept or the operational-unit concept will determine the treatment of minority
interests in the consolidated statement.
To the forner, the
minority interest is an outside interest; to the latter, the
minority interest is an element of proprietorship equal In
1914stature to the majority interest.
Thus, it follows that, to
the former, minority interest is a quasi-liability, appearing
in the consolidated statement either in the liability section
or between the liability and equity sections with a special
heading; to the latter, the minority interest is an integral
part of the equity section.
Allocating consolidated profit or loss likewise is
based upon the concept adhered to.
The financial-unit con-
cept attributes consolidated profit or loss to the parent
only; the operational-unit concept attributes it to both
majority and minority interests.
In the allocation of con-
solidated capital to minority interests, the amount is computed as the sum of the interest at the beginning of the
period, plus its share of subsidiary net income for the
period, less dividends, plus or minus any unconsolidated
adjustments made directly to the capital accounts of the
subsidiary.
A primary function of allocation to minority
interest is to prevent an overstatement of the size of the
majority interest.
Consolidated surplus is composed of the parent's
earned surplus (unadjusted for subsidiary book value changes),
the parent's equity in subsidiaries' gains or losses since
the date of acquisition, and capital surplus iteris arising
from transactions not ordinarily considered as establishing
realized gains or losses.
Of the three component parts
mentioned, the first two constitute consolidated earned
195
surplus.
These items of consolidated earned surplus and
consolidated surplus usually refer to the exclusive interest
of the parent company.
Concerning the value of the consolidated statements
in accomplishing the purposes for which they are intended,
it may be said that from the accountant's viewpoint they are
an excellent means of portraying the operations and financial
position of the affiliation as a whole, though the limitations must be recognized.
The information contained in the
consolidated statements is almost exclusively significant
to the management and investors of the parent company, and
even here there is a possibility of inaccurate and misleading conclusions being drawn from the consolidated reports.
The minority stockholders, creditors of subsidiary corporation, and short-term creditors of the parent company are
concerned with the financial data of the specific corporate
entity in which they have an equity and to those interests
consolidated statements are of little consequence.
The long-
term creditors of the parent may gain through the consolidated statements some insight, but only of an extremely general nature, into future trends relating to the financial
status of their debtor.
Conclusions
Involved in this study was research which has provided the writer with considerable insight into the theories
196
underlying consolidated statements, and with the opportunity
to observe and weigh the conflicting points of view, as well
as observe and weigh the statements' shortcomings.
The con-
clusions that were formulated about the major debated topics
in consolidation are summarized in the following paragraphs.
The consolidated statement should be looked upon as
auxiliary to the individual companies' reports, and not used
as a substitute for the reports.
The consolidated statements
are a natural exhibit of a business entity that is divested
of separating legal boundaries; thus, the statements are
clearly superior to the parent's reports for presenting the
enterprise's resources on which the equity of the stockholders in part depends and the results of operations from
which their earnings in part derive.
In this light, the
minimum to be included In the stockholder's report would be
the parent's reports and the consolidated reports.
The consolidated statement should be viewed as the
result of the combination of accounts of the whole enterprise-- the operational-unit.
That unit may be composed of
the parent company and its majority-held subsidiaries and
also, where Justifiable, those over vjhich the ri'::;ht tc control exists (and this right is exercised) by virtue of Minority stock ownership, lease, or management contract, or in
some other way.
The basic criteria for inclusion in consoli-
dation are that the included affiliates be under un:f'ed
and common management, and that they contribute to the
197
productive activities in which the business entity is primarily engaged.
Needless to say, a consistent consolidation
policy should be followed and set out in the consolidated
statement.
In view of the legal attitude that a corporation is
a separate and distinct entity, the arm's length, operational-unit concept of the relationship existing between
affiliates appears to be the most realistic position when
dealing with intercompany transactions and accounts on the
constituent company's books.
Therefore, the subsidiary in-
vestment should be carried, according to the cost method,
like any other investment; the profit or loss of the parent
company is properly computed on an "unconsolidated" basis,
and assets that were obtained from affiliates must be shown
at cost (or other conventional basis) to the affiliation
that is viewed as an entity of itself, regardless of the
size of the minority interest.
Obtaining assets from affil-
iates calls for the Inclusion of inventories and fixed assets
at amounts that are free from all traces of interco?'-pany
profits; depreciation should likewise be included on a fully
consolidated basis, and not be influenced by minority interest
size.
Thus, the accounts of each affiliate should be kept
independent of all other affiliates; but, conversely, when
consolidation is undertaken, the legal entity should be disregarded, as far as possible.
Th'' difference between the consolidatec essets and
/
198
the consolidated liabilities is the proprietorship of the
business entity; likewise, the difference between the total
income and total expense of the constituent companies is the
consolidated profit or loss.
The consolidated proprietor-
ship is likely to have majority and min6rlty elements, and,
if such is the case, the consolidated profit or loss will be
distributed to both majority and minority interests after
consolidated adjustments are made.
These interests are
viewed in the operational-unit concept as co-ordinate elements in the total proprietorship.
Thus, minority inter st
should not he presented as a liability or quasi-liability,
but as a part of the equity section.
A final conclusion, in view of the diversity cf
opinion which exists in many areas of consolidation, is
that the theory, purposes, and procedures underlying the
preparation of consolidated statements are still in a state
of evolution, and further study and objective discussion
on this vast subject is essential.
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