McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 1
3-2

Consolidation: The Concept
 Parent creates or gains control of the subsidiary.
 The result: a single reporting entity.
P
S
3-3

Review
How do we report the results of subsidiaries?
Parent
Company
80% 51% 21%
Sub A Sub B Sub C
Consolidation
(plus the Equity Method)
Equity Method
3-4

Consolidated Financial Statements
Consolidated financial statements present the financial position and results of operations for:


 a parent (controlling entity) and one or more subsidiaries (controlled entities) as if the individual entities actually were a single company or entity.
3-5

Benefits of Consolidated Financial Statements
 Presented primarily for those parties having a long-run interest in the parent company:
 shareholders,
 long-term creditors, or
 other resource providers.
 Provide a means of obtaining a clear picture of the total resources of the combined entity that are under the parent's control.
3-6

Limitations of Consolidated Financial Statements
 Results of individual companies not disclosed (hides poor performance).
 Financial ratios are not necessarily representative of any single company in the consolidation.
 Similar accounts of different companies may not be entirely comparable.
 Information is lost any time data sets are aggregated.
3-7

Subsidiary Financial Statements
 Creditors, preferred stockholders, and noncontrolling common stockholders of subsidiaries are most interested in the separate financial statements of the subsidiaries in which they have an interest.
 Because subsidiaries are legally separate from their parents,
 the creditors and stockholders of a subsidiary generally have no claim on the parent, and
 the stockholders of the subsidiary do not share in the profits of the parent.
3-8

Practice Quiz Question #1
A primary benefit of consolidated financial statements is that they: a. provide information directly applicable to the needs of regulators.
b. obscure data of individual companies.
c. present data of two or more entities that clearly reports their individual performance.
d. give a picture of the use of resources under the parent’s control.
e. none of the above.
3-9

Learning Objective 2
3-10

Concepts and Standards
 Traditional view of control includes:


Direct control that occurs when one company owns a majority of another company’s common stock.
Indirect control or pyramiding that occurs when a company’s common stock is owned by one or more other companies that are all under common control.
3-11

Concepts and Standards
 Ability to Exercise Control

Sometimes, majority stockholders may not be able to exercise control even though they hold more than 50 percent of outstanding voting stock.

Subsidiary is in legal reorganization or bankruptcy

Foreign country restricts remittance of subsidiary profits to domestic parent company

The unconsolidated subsidiary is reported as an intercorporate investment.
3-12

Concepts and Standards
 Differences in Fiscal Periods

Difference in the fiscal periods of a parent and subsidiary should not preclude consolidation.

Often the fiscal period of the subsidiary is changed to coincide with that of the parent.

Another alternative is to adjust the financial statement data of the subsidiary each period to place the data on a basis consistent with the fiscal period of the parent.
3-13

Concepts and Standards
 Changing Concept of the Reporting Entity

FASB 94, requiring consolidation of all majorityowned subsidiaries, was issued to eliminate the inconsistencies found in practice until a more comprehensive standard could be issued.

Completion of the FASB’s consolidation project has been hampered by, among other things, issues related to:

Control

Reporting entity
3-14

Concepts and Standards
 The FASB has been attempting to move toward a consolidation requirement for entities under effective control.

Ability to direct the policies of another entity even though majority ownership is lacking.
 Even though FASB 141R indicates that control can be achieved without majority ownership, a comprehensive consolidation policy has yet to be achieved.
3-15

Concepts and Standards
 Defining the accounting entity would help resolve the issue of when to prepare consolidated financial statements and what entities should be included.
 FASB 160 deals only with selected issues related to consolidated financial statements, leaving a comprehensive consolidation policy until a later time.
3-16

Practice Quiz Question #2
P owns 60% of X and 75% of Y. If X and Y jointly own 100% of Z, under what circumstance would P not be deemed to control Z?
a. Z is a bank.
b. Z’s products are largely sold overseas.
c. Z is currently in Chapter 11 bankruptcy.
d. Z has a CEO known to have a bad temper and a serious gambling habit.
e. none of the above.
3-17

Learning Objective 3
3-18

The Rise and FALL of Enron
Press Release Tuesday, October 16, 2001
ENRON REPORTS NON-RECURRING CHARGES OF $1.01
BILLION AFTER-TAX.
3-19

Special Purpose Entities
 Corporations, trusts, or partnerships created for a single specified purpose.
 Usually have no substantive operations and are used only for financing purposes.
 Used for several decades for asset securitization, risk sharing, and taking advantage of tax statutes.
3-20

Variable Interest Entities
 A legal structure used for business purposes, usually a corporation, trust, or partnership, that either:
 does not have equity investors that have voting rights and share in all profits and losses of the entity.
 has equity investors that do not provide sufficient financial resources to support the entity’s activities.
3-21

Enron’s Accounting “Sleight of Hand”
Special Purpose Entities (SPEs)

What is normally the business purpose?

Bundle peripheral activities and have them done by an independent, but close, friend.

Examples:
 Acquire financing for a project
 Package receivables and sell them to third parties

What was Enron’s purpose?

Move liabilities off the balance sheet

Provide favorable terms for some transactions
3-22

“Raptors”
 Established by Enron CFO to provide a quick buyer for Enron assets.

Option 1: Find a bona fide third party.

Can’t find anyone?

Option 2: Establish a SPE to take the other side of the transaction.
 Where does the financing come from?


97% sponsoring institution
3% third party
3-23

Example: The Chewco Raptor
A diagram of the Chewco transaction is set forth below:
3-24

Raptor’s Impact on Earnings
Quarter Earnings Raptors
3Q 2000
4Q 2000
1Q 2001
2Q 2001
$364
286
536
530
$295
(176)
281
490
3Q 2001 (210) (461)
Total $1,506 $429
Raptor’s
Impact
$69
462
255
40
251
$1,077
3-25

Variable Interest Entities (VIEs)
 As a result of the Enron collapse and other notable scandals related to SPEs, the FASB issued Interpretation
No. 46 (FIN46) [the revised version is FIN46R].
 What is a VIE?

An entity that either

 does not have equity investors with voting rights and a percentage of profits and losses, OR
 has equity investors that do not provide sufficient financial resources to support the entity’s activities.
What is a variable interest?
 an interest that changes with changes in the VIE’s net assets.
3-26

Variable Interest Entities
 FIN 46 (an interpretation of ARB 51) uses the term variable interest entities to encompass SPEs and other entities falling within its conditions.

Does not apply to entities that are considered SPEs under FASB 140.
 FIN 46R defines a variable interest in a VIE as a contractual, ownership (with or without voting rights), or other money-related interest in an entity that changes with changes in the fair value of the entity’s net assets exclusive of variable interests.
3-27

Purpose of FIN46R
3-28

Example: Variable Interest Entities
Senior Debt
($85k)
Junior Debt
($12k)
ABC Corp.
Lease Pmts.
Use of Building
Leasing Corp.
Investor ($3k)
$100k
Building
Building Owner
 How would ABC Corp. typically determine whether to consolidate Leasing Corp.?
 A controlling financial interest through voting rights.
 What if ABC Corp. were a related party to Investor?
 What if ABC Corp. guaranteed the value of the building at the end of the lease?
 What if ABC Corp. received any residual value above $100k when building sold?
3-29

Variable Interest Entities (VIEs)
Variable Interest Relationships

Situations in which an entity receives benefits and/or is exposed to risks similar to those received from having a majority ownership interest.

Results from contractual arrangements.
3-30

VIEs: “Contractual Arrangements”
 Contractual Arrangement Types:

Options

Leases

Guarantees of asset recovery values

Guarantees of debt repayment
 Contractual arrangements may exist simultaneously with a less than majority ownership in a VIE.
3-31

VIEs: Most are “SPEs”
 Special Purpose Entities

Legally structured entities to serve a specific, predetermined, limited purpose.

May be a corporation, partnership, trust, or some other legal entity.

Creator is called the “sponsor.”

Usually thinly capitalized.

Most commonly used for securitizations (of receivables).
3-32

VIEs: Potential Variable Interests


Subordinated loans to a VIE.

Equity interests in a VIE (50% or less).

Guarantees to a VIE’s lenders or equity holders (that reduce the true risk of these parties).

Written put options on a VIE’s assets held by a VIE or its lenders or equity holders.

Forward contracts on purchases and sales.
3-33

VIEs: The Primary Beneficiary
 The primary beneficiary of a VIE must consolidate the VIE.
 The primary beneficiary is the entity that:

Will absorb a majority (more than 50%) of the VIE’s expected losses and/or

Will receive a majority (more than 50%) of the VIE’s expected residual returns.

Expected losses are given more weight than expected residual returns in certain situations.
 Only one primary beneficiary can exist for a VIE
(by definition).
3-34

Group Exercise 1: To Consolidate (or not)?
Parch Inc. and Rees Urch, Parch’s former head of R&D, formed
Sede Inc., which will perform research and development.
Sede issued 10,000 shares of common stock to Urch, who is now Sede’s president. Parch lent $800,000 to Sede for initial working capital in return for a note receivable that can be converted at will into 100,000 shares of Sede’s common stock.
Parch also granted Sede a line of credit of $1,000,000.
REQUIRED
1.
Is consolidation appropriate?
2.
What would Parch accomplish with this arrangement?
3.
If consolidation were not appropriate, what serious reporting issue exists regarding Parch’s separate financial statements?
3-35

Practice Quiz Question #3
On 1/1/X2, Pocahontas, Inc. invested $480,000 in
Smith (80% owned). For 20X2, Smith:
(1) earned $70,000,
(2) declared dividends of $60,000, and
(3) paid dividends of $50,000.
What amounts does Pocahontas report?
Cost
Investment income for 20X2
Investment in Smith at year-end
Retained earnings increase
Equity
3-36

Practice Quiz Question #4
On 1/1/X2, Pocahontas, Inc. invested $480,000 in
Smith (80% owned) and NCI shareholders invested
$120,000. For 20X2, Smith:
(1) earned $70,000,
(2) declared dividends of $60,000, and
(3) paid dividends of $50,000.
What amounts does Pocahontas report for the following items?
NCI in net income for 20X2
NCI in net assets at 12/31/X2
Parent’s retained earnings increase
3-37

Learning Objective 4
3-38

IFRS Differences Related to VIEs and SPEs
 U.S. GAAP and International Financial
Reporting Standards (IFRS) are rapidly converging.

The FASB and the IASB are working together to remove differences in existing standards.

They are also working jointly on all new standards so that agreed-upon standards can be adopted.
 Despite convergence efforts, there are still some differences related to VIEs and SPEs.
 See Fig. 3-1 on p. 117
3-39

Key Differences between U.S. GAAP and IFRS
Topic
Determination of Control
U.S. GAAP
 Normally, control is determined by majority ownership of voting shares.
 However, majority ownership may not indicate control of a VIE.
 Thus, VIE rules must be evaluated first in all situations.
 The primary beneficiary must consolidate a VIE.
 The majority shareholder consolidates most non-VIEs.
 Control is based on direct or indirect voting interests.
 An entity with less than 50 percent ownership may have “effective control” through other contractual arrangements.
IFRS
 Normally, control is determined by majority ownership of voting shares.
 In addition to voting shares, convertible instruments and other contractual rights that could affect control are considered.
 A parent with less than 50 percent of the voting shares could have control through contractual arrangements allowing control of votes of the board of directors.
 Control over SPEs is determined based on judgment and relevant facts.
 Substance over form considered in determining whether an SPE should be consolidated.
3-40

Key Differences between U.S. GAAP and IFRS
Topic
Related Parties
Definitions of
VIEs versus
SPEs
U.S. GAAP
 Interests held by related parties and “de facto” agents may be considered in determining control of a VIE.
 SPEs can be VIEs.
 Consolidation rules focus on whether an entity is a VIE
(regardless of whether or not it is an SPE).
 This guidance applies only to legal entities.
IFRS
 There is no specific provision for related parties or de facto agents.
 Considers specific indicators of whether an entity has control of an SPE: (1) whether the SPE conducts activities for the entity,
(2) whether the entity has decision-making power to obtain majority of benefits from the SPE,
(3) whether the entity has the right to majority of benefits from the SPE, and (4) whether the entity has majority of the SPE’s residual or risks.
 This guidance applies whether or not conducted by a legal entity.
3-41

Key Differences between U.S. GAAP and IFRS
Topic
Disclosure
Accounting for
Joint Ventures
U.S. GAAP
 Disclosures required for determining control of a VIE.
 Entities must disclose whether or not they are the primary beneficiary of related VIEs.
 Owners typically share control (often with 50-50 ownership).
 If the joint venture is a VIE, contracts must be considered to determine whether consolidation is required.
 If the joint venture is not a
VIE, venturers use the equity method.
 Proportional consolidation generally not permitted.
IFRS
 No SPE-specific disclosure requirements.
 There are specific disclosure requirements related to consolidation in general.
 Joint ventures can be accounted for using either proportionate consolidation or the equity method.
 Proportionate consolidation reports the venturer’s share of the assets, liabilities, income, and expenses on a line-by-line basis based on the venturer’s financial statement line items.
3-42

Practice Quiz Question #5
Which of the following differs between U.S. GAAP and IFRS in the determination of control?
a. In U.S. GAAP, control is solely based on ownership but IFRS considers other factors.
b. U.S. GAAP ignores direct stock ownership, while IFRS considers it.
c. In U.S. GAAP, rules related to VIEs must be followed, but IFRS has not specifically addressed VIEs (only SPEs).
e. The determination of control is identical under U.S. GAAP and IFRS..
3-43

Learning Objective 5
3-44

Noncontrolling Interest
 Only a controlling interest is needed for the parent to consolidate the subsidiary—not 100% interest.
 Shareholders of the subsidiary other than the parent are referred to as “noncontrolling” shareholders.
 Noncontrolling interest or refers to the claim of these shareholders on the income and net assets of the subsidiary.
NCI Parent
<50% >50%
Sub
3-45

Noncontrolling Interest (NCI)
 What is a noncontrolling interest (NCI)?


Voting shares not owned by the parent company
NCI was formerly called the “Minority Interest”
NCI
<50%
Parent
>50%
Sub
Two Issues:
(1)Should 100% of the financial statements be consolidated?
(2) Where to report
NCI in the financial statements?
3-46

Issue 1: Should 100% be Consolidated?
Proportional
Consolidation
Full
Consolidation
Percent
Consolidated?
Reports NCI
Amounts?
Complies with
US GAAP?
Relative
Complexity?
3-47

Issue 1: Should 100% be Consolidated?
 Full consolidation required by US GAAP
(100%)
 This means two special accounts appear in consolidated statements:


NCI in Net Income of Sub


Like an “expense” in the consolidated income statement
“Reported income that doesn’t belong to us.”
NCI in Net Assets of Sub


Equity of unrelated owners
“Net assets on our balance sheet not belonging to us.”
3-48

Issue 2: Where to report NCI in Net Assets?



FASB 160 makes clear that the noncontrolling interest’s claim on net assets is an element of equity, not a liability.
3-49

Noncontrolling Interest


In uncomplicated situations, it is a simple proportionate share of the subsidiary’s net income


FASB 160 requires that

 the term “consolidated net income” be applied to the income available to all stockholders, with the allocation of that income between the controlling and noncontrolling stockholders shown.
3-50

Practice Quiz Question #6
The noncontrolling interest in a corporation can best be describe as: a. a group of disinterested shareholders who rarely vote on company issues.
b. all employees below the manager level.
c. all shareholders other than the parent company.
d. a group of investors who plan to sell their stock within the next twelve months .
e. none of the above.
3-51

Learning Objective 6
3-52

Different Approaches to Consolidation
 Theories that might serve as a basis for preparing consolidated financial statements:

Proprietary theory

Parent company theory

Entity theory
 With the issuance of FASB 141R, the FASB’s approach to consolidation now focuses on the entity theory.
3-53

Proprietary Theory
 Views the firm as an extension of its owners.
 Assets and liabilities of the firm are considered to be those of the owners.
 Results in a pro rata consolidation where the parent consolidates only its proportionate share of a less-than-wholly owned subsidiary’s assets, liabilities, revenues and expenses.
3-54

Parent Company Theory
 Recognizes that though the parent does not have direct ownership or responsibility, it has the ability to exercise effective control over all of the subsidiary’s assets and liabilities, not simply a proportionate share.
 Separate recognition is given, in the consolidated financial statements, to the noncontrolling interest’s claim on the net assets and earnings of the subsidiary.
3-55

Entity Theory
 Focuses on the firm as a separate economic entity, rather than on the ownership rights of the shareholders.
 Emphasis is on the consolidated entity itself, with the controlling and noncontrolling shareholders viewed as two separate groups, each having an equity in the consolidated entity.
3-56

Recognition of Subsidiary Income
3-57

Entity Theory
 All of the assets, liabilities, revenues, and expenses of a less-than-wholly owned subsidiary are included in the consolidated financial statements, with no special treatment accorded either the controlling or noncontrolling interest.
3-58

Reporting Net Assets of the Subsidiary
3-59

Current Practice
 FASB 141R has significantly changed the preparation of consolidated financial statements subsequent to the acquisition of less-than-wholly owned subsidiaries.

Under FASB 141R, consolidation follows largely an entity-theory approach.

Accordingly, the full entity fair value increment and the full amount of goodwill are recognized.
3-60

Current Practice
 Current approach clearly follows the entity theory with minor modifications aimed at the practical reality that consolidated financial statements are used primarily by those having a long-run interest in the parent company.
3-61

Practice Quiz Question #7
Current consolidation practice in the
U.S. adopts the: a. Proprietary theory.
b. Parent company theory.
c. Equity theory.
d. Entity theory.
e. none of the above.
3-62

Learning Objective 7
3-63

Summary of differences in consolidation
Wholly Owned
Subsidiary
Partially Owned
Subsidiary
Investment =
Book Value
Chapter 2 Chapter 3
No
Differential
Investment >
Book Value
Chapter 4 Chapter 5 Differential
No NCI
Shareholders
NCI
Shareholders
3-64

Consolidation of Less-than-wholly-owned Subs
 The entity theory requires that the entity’s entire income and value be reported.



The subsidiary’s income is divided between the parent
(controlling interest) and the NCI shareholders.
The subsidiary’s net assets are divided between the parent (controlling interest) and the NCI shareholders.
Basic elimination entry is modified to split both:
Sub Equity Accounts
Income from Sub
NCI in Net Income of Sub
Dividends Declared by Sub
Investment in Sub
NCI in Net Assets of Sub
100%
XXX
XXX
100%
XXX
XXX
3-65

Practice Quiz Question #8
The primary difference in consolidating a less than wholly owned subsidiary relative to a wholly owned subsidiary is: a. Income and net assets of the subsidiary must be divided between the parent and the NCI shareholders.
b. The title of the worksheet must specify
“Less than wholly owned.” c. You only consolidate the parent’s % ownership.
d. There is no difference.
3-66

Group Exercise 2: Basic Elimination Entry
Given the following information:
1) Photo owns 70% of Snap
2) Snap’s net income for 20X4 is $160,000
3) Photo’s net income for 20X4 from its own separate operations is
$500,000.
4) Snap’s declares dividends of $12,000 during 20X4.
5) Snap has 10,000 shares of $4 par stock outstanding that were originally issued at $14 per share.
6) Snap’s beginning balance in Retained Earnings for 20X4 is $120,000.
Photo
70%
Snap
Book Value Calculations
Investment
Account
NCI (30%) (70%)
=
Additional
Common Paid-in
Stock Capital
Retained
Earnings
Beginning Balance
+ Net Income
 Dividends
Ending Balance
3-67

Group Exercise 2: Basic Elimination Entry
Book Value Calculations
Investment
Account
NCI (30%) (70%)
=
Additional
Common Paid-in
Stock Capital
Retained
Earnings
Beginning Balance
+ Net Income
Dividends
Ending Balance
Investment in Snap
Basic Elimination Entry
Common Stock
Add PIC – CS
Retained Earnings, BB
Income from Snap
NCI in Net Income
Dividends Declared
Investment in Snap
NCI in Net Assets
3-68

Learning Objective 8
3-69

Consolidation of < Wholly Owned Subs
 The worksheet is modified when the parent owns less than 100% of the subsidiary.

The total “Net Income” is divided between:

 the noncontrolling interest (NCI shareholders) and the controlling interest (the parent company)
Pinkett, Inc.
Smith, Inc.
Elimination Entries
DR CR Consolidated
Income Statement
Sales
Less: COGS
Less: Depreciation Expense
Less: Other Expenses
Income from Smith, Inc.
Net Income
NCI in Net Income
CI In Net Income
$ 840,000
(516,000)
(12,000)
(192,000)
32,400
$ 152,400
$ 152,400
$ 300,000
(156,000)
(10,000)
(98,000)
$ 36,000
$ 36,000
32,400
32,400
3,600
36,000
3-70

Practice Quiz Question #9
The primary difference in the worksheet when consolidating a less than wholly owned subsidiary is: a. only the parent’s % is consolidated.
b. extra columns are added to split the subsidiary into two or more pieces.
c. extra rows are added to divide the net income and net assets of the sub between the parent and NCI shareholders d. there is no difference.
3-71

Group Exercise 3: Consolidation < 100%
Income Statement
Sales
Less: COGS
Less: Depreciation expense
Less: Other Expenses
Income from Smith, Inc.
Net Income
NCI in Net Income
CI in Net Income
Statement of Retained Earnings
Balances, 1/1/X8
Add: Net Income
Less: Dividends
Balances, 12/31/X8
Balance Sheet
Cash
Accounts Receivable
Inventory
Investment in Sub
Property & Equipment
Accumulated Depreciation
Total Assets
Payables & Accruals
Long-term Debt
Common Stock
Retained Earnings
NCI in Net Assets
Total Liabilities & Equity
Pinkett, Inc.
$ 840,000
(516,000)
(12,000)
(192,000)
32,400
$ 152,400
$ 152,400
Smith, Inc.
$ 300,000
(156,000)
(10,000)
(98,000)
$ 36,000
$ 36,000
Elimination Entries
DR CR Consolidated
$ 124,800
152,400
(108,000)
$ 169,200
$ 72,000
36,000
(12,000)
$ 96,000
Assume Pinkett only purchases
90% of Smith.
REQUIRED
$ 58,800
114,000
204,000
140,400
336,000
(144,000)
$ 709,200
$ 168,000
360,000
12,000
169,200
$ 709,200
$ 48,000
66,000
90,000
210,000
(30,000)
$ 384,000
84,000
144,000
60,000
96,000
384,000
• Prepare an analysis of the investment for 20X8.
• Prepare all consolidation entries as of 12/31/X8.
• Prepare a consolidation worksheet at 12/31/X8.
3-72

Group Exercise 3: Solution
Book Value Calculations
NCI
Parent’s
(10%) Account (90%)
NCI (10%)
Investment
(90%)
Balances, 1/1/X8
+ Net Income
 Dividends
Balances, 12/31/X8
=
Subsidiary’s Equity Accounts
Common
Stock
Stock
Retained
Earnings
Earnings
Basic Elimination Entry
Common Stock
Retained Earnings, BB
Income from Smith
NCI in Net Income
Dividends Declared
Investment in Smith
NCI in Net Assets
3-73

Group Exercise 1: Solution
Don’t forget the accumulated depreciation elimination entry:
Accumulated Depreciation
Buildings and Equipment
20,000
20,000
Property, Plant & Equipment
210,000
Accumulated Depreciation
20,000
3-74

Group Exercise 3: Solution
Income Statement
Sales
Less: COGS
Less: Depreciation expense
Less: Other Expenses
Income from Smith, Inc.
Net Income
NCI in Net Income
CI in Net Income
Statement of Retained Earnings
Balances, 1/1/X8
Add: Net Income
Less: Dividends
Balances, 12/31/X8
Balance Sheet
Cash
Accounts Receivable
Inventory
Investment in Sub
Property & Equipment
Accumulated Depreciation
Total Assets
Payables & Accruals
Long-term Debt
Common Stock
Retained Earnings
NCI in Net Assets
Total Liabilities & Equity
Pinkett, Inc.
$ 840,000
(516,000)
(12,000)
(192,000)
32,400
$ 152,400
$ 152,400
Smith, Inc.
$ 300,000
(156,000)
(10,000)
(98,000)
$ 36,000
$ 36,000
Elimination Entries
DR CR
$ 124,800
152,400
(108,000)
$ 169,200
$ 72,000
36,000
(12,000)
$ 96,000
$ 58,800
114,000
204,000
140,400
336,000
(144,000)
$ 709,200
$ 168,000
360,000
12,000
169,200
$ 709,200
$ 48,000
66,000
90,000
210,000
(30,000)
$ 384,000
84,000
144,000
60,000
96,000
384,000
Consolidated
3-75

Conclusion
3-76