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Chapter 03 - The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential CHAPTER 3 THE REPORTING ENTITY AND CONSOLIDATION OF LESS-THAN-WHOLLY-OWNED SUBSIDIARIES WITH NO DIFFERENTIAL ANSWERS TO QUESTIONS Q3-1 The basic idea underlying the preparation of consolid...

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Chapter 03 - The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential

CHAPTER 3 THE REPORTING ENTITY AND CONSOLIDATION OF LESS-THAN-WHOLLY-OWNED SUBSIDIARIES WITH NO DIFFERENTIAL ANSWERS TO QUESTIONS Q3-1 The basic idea underlying the preparation of consolidated financial statements is the notion that the consolidated financial statements present the financial position and the results of operations of a parent and its subsidiaries as if the related companies actually were a single company. Q3-2 Without consolidated statements it is often very difficult for an investor to gain an understanding of the total resources controlled by a company. A consolidated balance sheet provides a much better picture of both the total assets under the control of the parent company and the financing used in providing those resources. Similarly, the consolidated income statement provides a better picture of the total revenue generated and the costs incurred in generating the revenue. Estimates of future profit potential and the ability to meet anticipated funds flows often can be more easily assessed by analyzing the consolidated statements. Q3-3 Parent company shareholders are likely to find consolidated statements more useful. Noncontrolling shareholders may gain some understanding of the basic strength of the overall economic entity by examining the consolidated statements; however, they have no control over the parent company or other subsidiaries and therefore must rely on the assets and earning power of the subsidiary in which they hold ownership. The separate statements of the subsidiary are more likely to provide useful information to the noncontrolling shareholders. Q3-4 A parent company has the ability to exercise control over one or more other entities. Under existing standards, a company is considered to be a parent company when it has direct or indirect control over a majority of the common stock of another company. The FASB has proposed adoption of a broader definition of control that would not be based exclusively on stock ownership. Q3-5 Creditors of the parent company have primary claim to the assets held directly by the parent. Short-term creditors of the parent are likely to look only at those assets. Because the parent has control of the subsidiaries, the assets held by the subsidiaries are potentially available to satisfy parent company debts. Long-term creditors of the parent generally must rely on the soundness and operating efficiency of the overall entity, which normally is best seen by examining the consolidated statements. On the other hand, creditors of a subsidiary typically have a priority claim to the assets of that subsidiary and generally cannot lay claim to the assets of the other companies. Consolidated statements therefore are not particularly useful to them. Q3-6 When one company holds a majority of the voting shares of another company, the investor should have the power to elect a majority of the board of directors of that company and control its actions. Unless the investor holds controlling interest, there is always a chance that another party may acquire a sufficient number of shares to gain control of the company, or that the other shareholders may join together to take control. Q3-7 The primary criterion for consolidation is the ability to directly or indirectly exercise control. Control normally has been based on ownership of a majority of the voting common stock of another company. The Financial Accounting Standards Board is currently working on a broader definition of control. At present, consolidation should occur whenever majority

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Chapter 03 - The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential

ownership is held unless other circumstances indicate that control is temporary or does not rest with the parent. Q3-8 Consolidation is not appropriate when control is temporary or when the parent cannot exercise control. For example, if the parent has agreed to sell a subsidiary or plans to reduce its ownership below 50 percent shortly after year-end, the subsidiary should not be consolidated. Control generally cannot be exercised when a subsidiary is under the control of the courts in bankruptcy or reorganization. While most foreign subsidiaries should be consolidated, subsidiaries in countries with unstable governments or those in which there are stringent barriers to funds transfers generally should not be consolidated. Q3-9 Strict adherence to consolidation standards based on majority ownership of voting common stock has made it possible for companies to use many different forms of control over other entities without being forced to include them in their consolidated financial statements. For example, contractual arrangements often have been used to provide control over variable interest entities even though another party may hold a majority (or all) of the equity ownership. Q3-10 Special-purpose entities generally have been created by companies to acquire certain types of financial assets from the companies and hold them to maturity. The special-purpose entity typically purchases the financial assets from the company with money received from issuing some form of collateralized obligation. If the company had borrowed the money directly, its debt ratio would be substantially increased. Q3-11 A variable interest entity normally is not involved in general business activity such as producing products and selling them to customers. They often are used to acquire financial assets from other companies or to borrow money and channel it other companies. A very large portion of the assets held by variable interest entities typically is financed by debt and a small portion financed by equity holders. Contractual agreements often give effective control of the activities of the special-purpose entity to someone other than the equity holders. Q3-12 FIN 46R provides a number of guidelines to be used in determining when a company is a primary beneficiary of a variable interest entity. Generally, the primary beneficiary will absorb a majority of the entity’s expected losses or receive a majority of the entity’s expected residual returns. Q3-13 Indirect control occurs when the parent controls one or more subsidiaries that, in turn, hold controlling interest in another company. Company A would indirectly control Company Z if Company A held 80 percent ownership of Company M and that company held 70 percent of the ownership of Company Z. Q3-14 It is possible for a company to exercise control over another company without holding a majority of the voting common stock. Contractual agreements, for example, may provide a company with complete control of both the operating and financing decisions of another company. In other cases, ownership of a substantial portion of a company's shares and a broad based ownership of the other shares may give effective control to a company even though it does not have majority ownership. There is no prohibition to consolidation with less than majority ownership; however, few companies have elected to consolidate with less than majority control. Q3-15 Unless intercompany receivables and payables are eliminated, there is an overstatement of the true balances. The result is a distortion of the current asset ratio and other ratios such as those that relate current assets to noncurrent assets or current liabilities to noncurrent liabilities or to stockholders' equity balances.

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Chapter 03 - The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential

Q3-16 The consolidated statements are prepared from the viewpoint of the parent company shareholders and only the amounts assignable to parent company shareholders are included in the consolidated stockholders' equity balances. Subsidiary shares held by the parent are not owned by an outside party and therefore cannot be reported as shares outstanding. Those held by the noncontrolling shareholders are included in the balance assigned to noncontrolling shareholders in the consolidated balance sheet rather than being shown as stock outstanding. Q3-17 While it is not considered appropriate to consolidate if the fiscal periods of the parent and subsidiary differ by more than 3 months, a difference in time periods cannot be used as a means of avoiding consolidation. The fiscal period of one of the companies must be adjusted to fall within an acceptable time period and consolidated statement prepared. Q3-18 The noncontrolling interest, or minority interest, represents the claim on the net assets of the subsidiary assigned to the shares not controlled by the parent company. Q3-19 The procedures used in preparing consolidated and combined financial statements may be virtually identical. In general, consolidated statements are prepared when a parent company either directly or indirectly controls one or more subsidiaries. Combined financial statements are prepared for a group of companies or business entities when there is no parent-subsidiary relationship. For example, an individual who controls several companies may gain a clearer picture of the financial position and operating results of the overall operations under his or her control by preparing combined financial statements. Q3-20 Under the proprietary theory the parent company includes only a proportionate share of the assets and liabilities and income statement items of a subsidiary in its financial statements. Thus, if a subsidiary is 60 percent owned, the parent will include only 60 percent of the cash and accounts receivable of the subsidiary in its consolidated balance sheet. Under current practice the full amount of the balance sheet and income statement items of the subsidiary are included in the consolidated statements. Q3-21 Under both current practice and the entity theory the consolidated statements are viewed as those of a single economic entity with a shareholder group that includes both controlling and noncontrolling shareholders, each with an equity interest in the consolidated entity. The assets and liabilities of the subsidiary are included in the consolidated statements at 100 percent of their fair value at the date of acquisition and consolidated net income includes the earnings to both controlling and noncontrolling shareholders. A major difference occurs in presenting retained earnings in the consolidated balance sheet. Only undistributed earnings related to the controlling interest are included in the retained earnings balance. Q3-22 The entity theory is closest to the newly adopted procedures used in current practice.

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Chapter 03 - The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential

SOLUTIONS TO CASES C3-1 Computation of Total Asset Values The relationship observed should always be true. Assets reported by the parent company include its investment in the net assets of the subsidiaries. These totals must be eliminated in the consolidation process to avoid double counting. There also may be intercompany receivables and payables between the companies that must be eliminated when consolidated statements are prepared. In addition, inventory or other assets reported by the individual companies may be overstated as a result of unrealized profits on intercorporate purchases and sales. The amounts of the assets must be adjusted and the unrealized profits eliminated in the consolidation process. In addition, subsidiary assets and liabilities at the time the subsidiaries were acquired by the parent may have had fair values different from their book values, and the amounts reported in the consolidated financial statements would be based on those fair values. C3-2 Accounting Entity [AICPA Adapted] a.

(1) The conventional or traditional approach has been used to define the accounting entity in terms of a specific firm, enterprise, or economic unit that is separate and apart from the owner or owners and from other enterprises. The accounting entity has not necessarily been defined in the same way as a legal entity. For example, partnerships and sole proprietorships are accounted for separately from the owners although such a distinction might not exist legally. Thus, it was recognized that the transactions of the enterprise should be accounted for and reported on separately from those of the owners. An extension of this approach is to define the accounting entity in terms of an economic unit that controls resources, makes and carries out commitments, and conducts economic activity. In the broadest sense an accounting entity could be established in any situation where there is an input-output relationship. Such an accounting entity may be an individual, a profit-seeking or not-for-profit enterprise, or a subdivision of a profit-seeking or not-forprofit enterprise for which a system of accounts is maintained. This approach is oriented toward providing information to the economic entity which it can use in evaluating its operating results and financial position. An alternative approach is to define the accounting entity in terms of an area of economic interest to a particular individual, group, or institution. The boundaries of such an economic entity would be identified by determining (a) the interested individual, group, or institution and (b) the nature of that individual's, group's, or institution's interest. In theory a number of separate legal entities or economic units could be included in a single accounting entity. Thus, this approach is oriented to the external users of financial reports. (2) The way in which an accounting entity is defined establishes the boundaries of the possible objects, attributes, or activities that will be included in the accounting records and reports. Knowledge as to the nature of the entity may aid in determining (1) what information to include in reports of the entity and (2) how to best present information about the entity so that relevant features are disclosed and irrelevant features do not cloud the presentation. The applicability of all other generally accepted concepts (or principles or postulates) of accounting (for example, continuity, money measurement, and time periods) depends on the established boundaries and nature of the accounting entity. The other accounting concepts lack significance without reference to an entity. The entity must be defined before

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Chapter 03 - The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential

the balance of the accounting model can be applied and the accounting can begin. Thus, the accounting entity concept is so fundamental that it pervades all accounting. b.

(1) Units created by or under law, such as corporations, partnerships, and, occasionally, sole proprietorships, probably are the most common types of accounting entities. (2) Product lines or other segments of an enterprise, such as a division, department, profit center, branch, or cost center, can be treated as accounting entities. For example, financial reporting by segment was supported by investors, the Securities and Exchange Commission, financial executives, and members of the accounting profession. (3) Most large corporations issue consolidated financial reports. These statements often include the financial statements of a number of separate legal entities that are considered to constitute a single economic entity for financial reporting purposes. (4) Although the accounting entity often is defined in terms of a business enterprise that is separate and distinct from other activities of the owner or owners, it also is possible for an accounting entity to embrace all the activities of an owner or a group of owners. Examples include financial statements for an individual (personal financial statements) and the financial report of a person's estate. (5) The entire economy of the United States also can be viewed as an accounting entity. Consistent with this view, national income accounts are compiled by the U. S. Department of Commerce and regularly reported.

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Chapter 03 - The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential

C3-3 Recognition of Fair Value and Goodwill MEMO TO: From: Re:

Mr. R. U. Cleer, Chief Financial Officer March Corporation , CPA Analysis of changes resulting from FASB 141R

March Corporation purchased 65 percent of the stock of Ember Corporation for $708,500 at a time when the book value of Ember’s net assets was $810,000 and March’s 65 percent share of that amount was $526,500. Management determined that the fair value of Ember’s assets was $960,000, and March’s 65 percent share of the difference between fair value and book value was $97,500. The remaining amount of the purchase price was allocated to goodwill, computed as follows: Purchase price Book value of 65 percent share of net assets Differential Fair value increment Goodwill

$708,500 (526,500) $182,000 (97,500) $ 84,500

The reporting standards in effect at January 2, 2008, required March to include in its consolidated balance sheet 100 percent of the book value of Ember’s net assets. The consolidated balance sheet also included the amount paid by March in excess of its share of book value, assigned to depreciable assets and goodwill. The noncontrolling interest was reported in the consolidated balance sheet at $283,500 ($810,000 x .35) and did not include any amounts related to the differential. Under FASB Statement No. 141R (ASC 805), the amounts included in the consolidated balance sheet are based on the $1,090,000 total fair value of Ember at the date of combination, as evidenced by the fair value of the consideration given in the exchange by March Corporation ($708,500) and the fair value of the noncontrolling interest ($381,500). The assets of Ember are valued at their $960,000 total fair value, resulting in a $150,000 increase over their book value. Goodwill is calculated as the difference between the $1,090,000 total fair value of Ember and the $960,000 fair value of its assets. The noncontrolling interest is valued initially at its fair value at the date of combination. The following comparison shows the amounts related to Ember that were reported in March’s consolidated balance sheet prepared immediately after the acquisition of Ember and the amounts that would have been reported had FASB Statement No. 141R (ASC 805) been in effect: Prior Standards $810,000 97,500 84,500 $992,000

Book value of Ember’s net assets Fair value increment Goodwill Total Noncontrolling interest

$283,500

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FASB 141R $ 810,000 150,000 130,000 $1,090,000 $381,500

Chapter 03 - The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential

Amortization of the fair value increment in March’s 2008 consolidated income statement was $9,750 ($97,500/10). Under FASB Statement No. 141R (ASC 850), the annual write-off would have been $15,000 ($150,000/10). Primary citations: FASB 141R (ASC 805) C3-4 Joint Venture Investment a. ARB No. 51 (ASC 810) and FASB Interpretation No. 46R (FIN 46R) (ASC 810) are the primary authoritative pronouncements dealing with the types of ownership issues arising in this situation. Under normal circumstances, the company holding majority ownership in another entity is expected to consolidate that entity in preparing its financial statements. Thus, unless other circumstances dictate, Dell should have planned to consolidate DFS as a result of its 70 percent equity ownership. While FIN 46R (ASC 810) is a highly complex document and greater detail of the ownership agreement may be needed to decide this matter, the interpretation appears to permit equity holders to avoid consolidating an entity if the equity holders (1) do not have the ability to make decisions about the entity’s activities, (2) are not obligated to absorb the expected losses of the entity if they occur, or (3) do not have the right to receive the expected residual returns of the entity if they occur [FIN 46...