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 • Parent creates or gains control of the subsidiary. • The result: a single reporting entity. P S
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
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 • 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 • 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 • 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 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 Understand and explain how direct and indirect control influence the consolidation of a subsidiary.
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 X Does X control Z? Yes Does X control Y? Yes 51% 75% Y Z 20% 40% No K Does Z control K? Does Y control K? No Does X control K? Yes, indirectly through Y and Z! X must consolidate Y, Z, and K.
Concepts and Standards X • 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. 90% Y
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 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 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 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 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 Understand and explain differences in the consolidation process when the subsidiary is not wholly owned.
NCI <50% 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. Parent >50% Sub
NCI <50% 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? Parent >50% Sub
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? • 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 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 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 Make calculations and prepare basic elimination entries for the consolidation of a less-than-wholly-owned subsidiary.
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 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 • 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 Photo Investment Additional Account Common Paid-in Retained NCI (30%) (70%) Stock Capital Earnings 70% Snap = Beginning Balance + Net Income • Dividends Ending Balance
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 Dividends 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 Prepare a consolidation worksheet for a less-than-wholly-owned consolidation.
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 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% • Assume Pinkett only purchases 90% of Smith. • REQUIRED • 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 • 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: Solution Don’t forget the accumulated depreciation elimination entry: • Accumulated Depreciation • Buildings and Equipment Property, Plant & Equipment Accumulated Depreciation
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 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 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 #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 Understand and explain the rules related to the consolidation of variable interest entities.
The Rise and FALL of Enron Press Release Tuesday, October 16, 2001 ENRON REPORTS NON-RECURRING CHARGES OF $1.01 BILLION AFTER-TAX.
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 • 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” 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
“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
A diagram of the Chewco transaction is set forth below: Example: The Chewco Raptor