3 The Reporting Entity and Consolidated Financial Statements

3 The Reporting Entity and Consolidated Financial Statements Mc. Graw-Hill/Irwin Copyright © 2009 The Mc. Graw-Hill Companies, Inc. All rights reserved.

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 -2

Consolidated Financial Statements • Consolidation is required when a corporation owns a majority of another corporation’s outstanding common stock and occasionally under other circumstances. • Two companies are considered to be related when one controls the other or both are under the common control of another entity. • The same accounting principles should be applied in preparing consolidated financial statements as in preparing separate-company financial statements. • More useful than the separate financial statements of the individual companies when the companies are related. 3 -3

Benefits of Consolidated Financial Statements • Presented primarily for those parties having a longrun interest in the parent company, including its management, shareholders, long-term creditors or other resource providers. • Often provide the only means of obtaining a clear picture of the total resources of the combined entity that are under the parent's control. 3 -4

Limitations of Consolidated Financial Statements • Results of individual companies included in the consolidation are not disclosed, thereby hiding poor performance. • Not all the consolidated retained earnings balance is necessarily available for dividends of the parent. • Financial ratios are not necessarily representative of any single company in the consolidation. 3 -5

Limitations of Consolidated Financial Statements • Similar accounts of different companies that are combined in the consolidation may not be entirely comparable. • Additional information about companies may be needed for a fair presentation, thus requiring voluminous footnotes. • Information is lost any time data sets are aggregated. 3 -6

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 -7

Concepts and Standards • Professional guidance is provided in ARB 51, FASB 94, and FASB 160. • Traditional view of control – ARB 51 indicates that consolidated financial statements normally are appropriate for a group of companies when one company “has a controlling financial interest in the other companies. ” – FASB 94 requires consolidation of all majority-owned subsidiaries unless the parent is unable to exercise control. 3 -8

Concepts and Standards • Less Than Majority Ownership – A company may be able to direct the operating and financing policies of another with less than majority ownership. – FASB 94 does not preclude consolidation with less than majority ownership, but such consolidations have seldom been found in practice. – FASB 141 R indicates that control can be obtained without majority ownership of a company’s common stock. 3 -9

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 -10

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 -11

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 -12

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 -13

Concepts and Standards • 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 141 R indicates that control can be achieved without majority ownership, a comprehensive consolidation policy has yet to be achieved. 3 -14

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 -15

Consolidation Process- Overview • Starting point: Separate financial statements of the companies involved. • Separate statements are added together, after some adjustments and eliminations, to generate consolidated statements. – Adjustments and eliminations relate to intercompany transactions and holdings. Parent Subsidiary Consolidated Entity 3 -16

Consolidation Process • Intercorporate Stockholdings – Common stock of the parent is held by those outside the consolidated entity and is viewed as the common stock of the entire entity. – Common stock of the subsidiary is held entirely within the consolidated entity and is not stock outstanding from a consolidated viewpoint. – Note: A company cannot report in its financial statements an investment in itself 3 -17

Consolidation Process • Intercorporate Stockholdings – Parent’s retained earnings (less the unrealized intercompany profit) remains as the only retained earnings figure in the consolidated balance sheet. Parent’s common stock Parent Subsidiary’s common stock Subsidiary Consolidated Entity 3 -18

Consolidation Process • Intercompany Receivables and Payables – A single company cannot owe itself money, that is, a company cannot report (in its financial statements) a receivable to itself and a payable to itself. – Therefore, an intercompany receivable/payable is eliminated Parent from both receivables and payables in preparing the consolidated balance sheet. Subsidiary Intercompany receivable/ payable Consolidated Entity 3 -19

Consolidation Process • Intercompany Sales – The sale should be removed from the combined revenues because it does not represent a sale to an external party. Cost of goods • Remaining inventory must be restated to its original cost to the consolidated entity (transferring affiliate). Parent Sales Subsidiary Consolidated Entity 3 -20

Consolidation Process • Difference between Fair Value and Book Value – Fair value of the consideration given usually reflects the fair value of the acquired company and differs from its book value. – An acquiree’s assets and liabilities must be valued based on their acquisition-date fair values, and any excess of the consideration given over the fair values of the net assets is considered goodwill. 3 -21

Consolidation Process • Single-Entity Viewpoint – To understand the adjustments needed, one should focus on: 1. identifying the treatment accorded a particular item by each of the separate companies and 2. identifying the amount that would appear in the financial statements with respect to that item if the consolidated entity were actually a single company. 3 -22

Mechanics of the Consolidation Process • A worksheet is used to facilitate the process of combining and adjusting the account balances involved in a consolidation. • While the parent company and the subsidiary each maintain their own books, there are no books for the consolidated entity. • The balances of the accounts are taken at the end of each period from the books of the parent and the subsidiary and entered in the consolidation workpaper. 3 -23

Mechanics of the Consolidation Process • Where the simple adding of the amounts from the two companies leads to a consolidated figure different from the amount that would appear if the two companies were actually one, the combined amount must be adjusted to the desired figure. • This is done through the preparation of eliminating entries. 3 -24

Noncontrolling Interest • For the parent to consolidate the subsidiary, only a controlling interest is needed—not 100% interest. • Those shareholders of the subsidiary other than the parent are referred to as “noncontrolling” or “minority” shareholders. • Noncontrolling interest or minority interest refers to the claim of these shareholders on the income and net assets of the subsidiary. 3 -25

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: 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 -26

Noncontrolling Interest • The noncontrolling interest’s claim on the net assets of the subsidiary was previously shown between liabilities and stockholders’ equity in the consolidated balance sheet. – Some firms reported minority interest as a liability, although it did not meet the definition of a liability. • FASB 160 makes clear that the noncontrolling interest’s claim on net assets is an element of equity, not a liability. 3 -27

Combined Financial Statements • Financial statements are also 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. • Combined financial statements are those that include a group of related companies without including the parent company or other owner. – Procedures are essentially the same as those used in preparing consolidated financial statements. 3 -28

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 -29

Special Purpose Entities • Qualifying SPEs – Types of SPEs widely used for servicing financial assets and meet very restrictive conditions established by FASB 140. – Conditions generally require that the SPE be “demonstrably distinct from the transferor, ” its activities be significantly limited, and it hold only certain types of financial assets. 3 -30

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 -31

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 46 R 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 -32

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 141 R, the FASB’s approach to consolidation has moved very much toward the entity theory. 3 -33

Recognition of Subsidiary Income 3 -34

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 -35

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 -36

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 -37

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 -38

Current Practice • FASB 141 R has significantly changed the preparation of consolidated financial statements subsequent to the acquisition of less-than-wholly owned subsidiaries. – Under FASB 141 R consolidation follows largely an entity-theory approach. – Accordingly, the full entity fair value increment and the full amount of goodwill are recognized. 3 -39

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 -40