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Chapter 3. The Reporting Entity and the Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential. Learning Objective 3-1. Understand and explain the usefulness and limitations of consolidated financial statements. Consolidation: The Concept.

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chapter 3
Chapter 3

The Reporting Entity and the Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential

learning objective 3 1
Learning Objective 3-1

Understand and explain the usefulness and limitations of consolidated

financial statements.

consolidation the concept
Consolidation: The Concept
  • Parent creates or gains control of the subsidiary.
    • The result: a single reporting entity.




How do we report the results of subsidiaries?






Sub A

Sub B

Sub C


(plus the Equity Method)

Equity Method

consolidated financial statements
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.
benefits of consolidated financial statements
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.
limitations of consolidated financial statements
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.
subsidiary financial statements
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.
practice quiz question 1
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.

learning objective 3 2
Learning Objective 3-2

Understand and explain how direct and indirect control influence the

consolidation of a subsidiary.

concepts and standards
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.
indirect control example
Indirect Control Example


Does X control Z?


Does X control Y?










Does Z control K?

Does Y control K?


Does X control K?

Yes, indirectly through Y and Z!

X must consolidate Y, Z, and K.

concepts and standards1
Concepts and Standards


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



concepts and standards2
Concepts and Standards
  • Differences in Fiscal Periods
    • Difference in the fiscal periods of a parent and subsidiary should not preclude consolidation.
    • Often the fiscal period of the subsidiary is changed to coincide with that of the parent.
    • Another alternative is to adjust the financial statement data of the subsidiary each period to place the data on a basis consistent with the fiscal period of the parent.
concepts and standards3
Concepts and Standards
  • Changing Concept of the Reporting Entity
    • Guidance in ASC 810-10-55, requiring consolidation of all majority-owned subsidiaries, was issued to eliminate the inconsistencies found in practice until a more comprehensive standard could be issued.
    • Completion of the FASB’s consolidation project has been hampered by, among other things, issues related to
      • control
      • reporting entity
concepts and standards4
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 ASC 805-10-55 indicates that control can be achieved without majority ownership, a comprehensive consolidation policy has yet to be achieved.
concepts and standards5
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.
  • ASC 810 deals only with selected issues related to consolidated financial statements, leaving a comprehensive consolidation policy until a later time.
practice quiz question 2
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.

learning objective 3 3
Learning Objective 3-3

Understand and explain differences in the consolidation process when the subsidiary is not wholly owned.

noncontrolling interest



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




noncontrolling interest nci



Noncontrolling Interest (NCI)
  • What is a noncontrolling interest (NCI)?
    • Voting shares not owned by the parent company
    • NCI was formerly called the “Minority Interest”
  • Two Issues:
  • Should 100% of the financial statements be consolidated?
  • (2) Where to report NCI in the financial statements?




issue 1 should 100 be consolidated1
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.”
issue 2 where to report nci in net assets
Issue 2: Where to report NCI in Net Assets?
  • Old rules: Could report it in equity, liabilities, or “no man’s land” between liabilities and equity.
  • New rules: Must report in equity
    • ASC 810-10-55 makes clear that the noncontrolling interest’s claim on net assets is an element of equity, not a liability.
noncontrolling interest1
Noncontrolling Interest
  • Computation of income to the noncontrolling interest
    • In uncomplicated situations, it is a simple proportionate share of the subsidiary’s net income.
  • Presentation
    • ASC 810-10-50 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.
practice quiz question 6
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.

learning objective 3 4
Learning Objective 3-4

Make calculations and prepare basic elimination entries for the consolidation

of a less-than-wholly-owned subsidiary.

consolidation of less than wholly owned subs
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 100%
  • Income from Sub XXX
  • NCI in Net Income of Sub XXX
    • Dividends Declared by Sub 100%
    • Investment in Sub XXX
    • NCI in Net Assets of Sub XXX
practice quiz question 8
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.

group exercise 1 basic elimination entry
Group Exercise 1: Basic Elimination Entry
  • The following information is given:
  • Photo owns 70% of Snap
  • Snap’s net income for 20X4 is $160,000
  • Photo’s net income for 20X4 from its own separate operations is $500,000.
  • Snap’s declares dividends of $12,000 during 20X4.
  • Snap has 10,000 shares of $4 par stock outstanding that were originally issued at $14 per share.
  • Snap’s beginning balance in Retained Earnings for 20X4 is $120,000.
    • Book Value Calculations


Investment Additional

Account Common Paid-in Retained

NCI (30%) (70%) Stock Capital Earnings




Beginning Balance

+ Net Income

  • Dividends

Ending Balance

group exercise 1 basic elimination entry1
Group Exercise 1: Basic Elimination Entry
  • Book Value Calculations

Investment Additional

Account Common Paid-in Retained

NCI (30%) (70%) Stock Capital Earnings


Beginning Balance

+ Net Income


Ending Balance

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

Investment in Snap

learning objective 3 5
Learning Objective 3-5

Prepare a consolidation worksheet for a less-than-wholly-owned


consolidation of wholly owned subs
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)
practice quiz question 9
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.

group exercise 2 consolidation 100
Group Exercise 2: Consolidation < 100%
  • Assume Pinkett only purchases 90% of Smith.
  • 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.
group exercise 2 solution
Group Exercise 2: Solution
  • Book Value Calculations

Parent’s Subsidiary’s Equity Accounts

NCI Investment Common Retained

(10%) Account (90%) Stock Earnings

NCI (10%) (90%) Stock Earnings


Balances, 1/1/X8

+ Net Income

 Dividends

Balances, 12/31/X8

Basic Elimination Entry

  • Common Stock
  • Retained Earnings, BB
  • Income from Smith
  • NCI in Net Income
    • Dividends Declared
    • Investment in Smith
    • NCI in Net Assets
group exercise 2 solution1
Group Exercise 2: Solution

Don’t forget the accumulated depreciation elimination entry:

  • Accumulated Depreciation
      • Buildings and Equipment

Property, Plant & Equipment

Accumulated Depreciation

learning objective 3 6
Learning Objective 3-6

Understand and explain the purpose of combined financial statements and how they differ from consolidated financial statements.

combined financial statements
Combined Financial Statements
  • Combined financial statements are sometimes prepared for a group of companies when no one company in the group owns a majority of the common stock of any other company in the group, such as when
    • an individual, not a corporation, owns or controls multiple companies.
    • a parent company prepares financial statement that only include its subsidiaries, and not itself.
    • a parent company prepares financial statements for its subsidiaries by operating group.
combined financial statements1
Combined Financial Statements
  • The procedures used to prepare combined financial statements are essentially the same as those used in preparing consolidated financial statements:
    • Eliminate all intercompany receivables, payables, transactions, unrealized profits and losses, ownership, and the associated portion of stockholders’ equity.
    • The remaining stockholders’ equity is divided into the portions accruing to the controlling and non-controlling interests.
practice quiz question 61
Practice Quiz Question #6

Which of the following statements is true regarding combined financial statements:

a. The parent company is always included in combined financial statements.

b. Companies included in combined financial statements simultaneously own a majority of each others stock.

c. Combined financial statements combine the financial statements of a group of companies that have the same owner.

d. All intercompany transactions remain in the accounts of combined financial statements.

learning objective 3 7
Learning Objective 3-7

Understand and explain the rules related to the consolidation of variable interest entities.

the rise and fall of enron
The Rise and FALL of Enron

Press Release Tuesday, October 16, 2001


special purpose entities
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.
variable interest entities
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, or
    • has equity investors that do not provide sufficient financial resources to support the entity’s activities.
enron s accounting sleight of hand
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
  • 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
variable interest entities vies
Variable Interest Entities (VIEs)
  • As a result of the Enron collapse and other notable scandals related to SPEs, the FASB issued guidance on VIEs in 2003 (ASC 810-10-25) and updated this guidance later the same year (ASC 810-10-38C).
  • 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.
variable interest entities1
Variable Interest Entities
  • ASC 810-10-25 uses the term “variable interest entities” to encompass SPEs and other entities falling within its conditions.
  • ASC 810-10-38C 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.
purpose of asc 810
Purpose of ASC 810

The main effect of ASC 810-10-38C is to capture those investment relationships in which a controlling financial interest is not indicated by voting rights, but is indicated by residual interests in risks and benefits, which is the conceptual definition of ownership in CON6.

example variable interest entities
Example: Variable Interest Entities

Senior Debt ($85k)

Junior Debt ($12k)

Lease Pmts.


ABC Corp.

Leasing Corp.

Building Owner

Use of Building


Investor ($3k)

  • How would ABC Corp. typically determine whether to consolidate Leasing Corp.?
  • 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?

 A controlling financial interest through voting rights.

variable interest entities vies1
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.
vies contractual arrangements
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.
vies potential variable interests
VIEs: Potential Variable Interests
  • 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.
vies most are spes
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).
vies the primary beneficiary
VIEs: The Primary Beneficiary
  • The primary beneficiary of a VIE must consolidate the VIE.
  • The primary beneficiary is the entity that
    • has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance.
    • will absorb losses of the VIE that could potentially be significant to the VIE or will receive the benefits from the VIE that could potentially be significant to the VIE.
  • Only one primary beneficiary can exist for a VIE (by definition).
group exercise 3 to consolidate or not
Group Exercise 3: To Consolidate (or not)?


  • Is consolidation appropriate?
  • What would Parch accomplish with this arrangement?
  • If consolidation were not appropriate, what serious reporting issue exists regarding Parch’s separate financial statements?

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.

practice quiz question 3
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?


Investment income for 20X2

Investment in Smith at year-end

Retained earnings increase

practice quiz question 4
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

learning objective 3 8
Learning Objective 3-8

Understand and explain differences in consolidation rules under U.S. GAAP

and IFRS.

ifrs differences related to vies and spes
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 Figure 3-1 on p. 124 of the text.
practice quiz question 5
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.

appendix 3b
Appendix 3B

Understand and explain the differences in theories of consolidation.

different approaches to consolidation
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 ASC 805, the FASB’s approach to consolidation now focuses on the entity theory.
proprietary theory
Proprietary Theory
  • Views the firm as an extension of its owners.
  • Assets and liabilities of the firm are considered to be those of the owners.
  • Results in a pro rata consolidation where the parent consolidates only its proportionate share of a less-than-wholly owned subsidiary’s assets, liabilities, revenues, and expenses.
parent company theory
Parent Company Theory
  • Recognizes that although 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.
entity theory
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.
entity theory1
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.
current practice
Current Practice
  • ASC 805-50-30 has significantly changed the preparation of consolidated financial statements subsequent to the acquisition of less-than-wholly owned subsidiaries.
    • Under ASC 805-50-30, consolidation follows largely an entity-theory approach.
    • Accordingly, the full entity fair value increment and the full amount of goodwill are recognized.
current practice1
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.
practice quiz question 7
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.


The End