1. McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9 Consolidation Ownership Issues

2. 9-2 Consolidation Ownership Issues Only simple ownership situations have been presented in the preceding chapters. In practice, however, relatively complex ownership structures are often found. For example, a subsidiary may have preferred stock outstanding in addition to its common stock, and in some cases a parent may acquire shares of both the common and the preferred stock of the subsidiary.

3. 9-3 Consolidation Ownership Issues Additionally, one or more subsidiaries may acquire stock of the parent or of other related companies. Further, the parent’s ownership claim on a subsidiary may change through its purchase or sale of subsidiary shares or through stock transactions of the subsidiary.

4. 9-4 Consolidation Ownership Issues The discussion in this chapter is intended to provide a basic understanding of some of the consolidation problems arising from complex ownership situations commonly encountered in practice. Specifically, the following topics are discussed: Subsidiary preferred stock outstanding. Change in the parent’s ownership interest in the subsidiary. Multiple ownership levels. Reciprocal or mutual ownership. Subsidiary stock dividends.

5. 9-5 Subsidiary Preferred Stock Outstanding Many companies have more than one type of stock outstanding. Each type of security typically serves a particular function, and each has a different set of rights and features. Because preferred shareholders of a subsidiary do have a claim on the net assets of the subsidiary, special attention must be given to that claim in the preparation of consolidated financial statements.

6. 9-6 Subsidiary Preferred Stock Outstanding Preferred stockholders normally have preference over common shareholders with respect to dividends and the distribution of assets in a liquidation. The right to vote usually is withheld from preferred shareholders, so that preferred stock ownership normally does not convey control, regardless of the number of shares owned.

7. 9-7 Subsidiary Preferred Stock Outstanding Many other features of preferred stocks are found in practice. For example, most preferred stocks are cumulative, a few are participating, and many are callable at some price other than par value.

8. 9-8 Subsidiary Preferred Stock Outstanding Occasionally a parent company will hold preferred stock of a subsidiary in addition to its investment in the subsidiary’s common stock. Because the preferred stock held by the parent is within the consolidated entity, it must be eliminated when consolidated financial statements are prepared.

9. 9-9 Subsidiary Preferred Stock Outstanding Likewise, any income from the preferred stock recorded by the parent also must be eliminated. Any portion of the subsidiary’s preferred stock interest not held by the parent is assigned to the noncontrolling interest.

10. 9-10 Subsidiary Preferred Stock Outstanding When a subsidiary with preferred stock outstanding is consolidated, the provisions of the preferred stock agreement must be examined to determine the portion of the subsidiary’s stockholders’ equity to be assigned to the preferred stock interest.

11. 9-11 Subsidiary Preferred Stock Outstanding A cumulative dividend provision provides some degree of protection for preferred shareholders by requiring the company to pay both current and omitted past preferred dividends before any dividend can be given to common shareholders. If a subsidiary has cumulative preferred stock outstanding, an amount of income equal to the current year’s preferred dividend is assigned to the preferred stock interest in consolidation whether of not the preferred dividend is declared.

12. 9-12 Subsidiary Preferred Stock Outstanding When there are dividends in arrears on a subsidiary’s cumulative preferred stock, recognition is given in consolidation to the claim of the preferred shareholders by assigning to the preferred stock interest an amount of subsidiary retained earnings equal to the passed dividends. No special consolidation procedures are needed with respect to undeclared dividends on noncumulative subsidiary preferred stock.

13. 9-13 Subsidiary Preferred Stock Outstanding Preferred stock participation features allow the preferred stockholders to receive a share of income distributions that exceed the preferred stock base dividend rate. Although few preferred stocks are participating, many different types of participation arrangements are possible. Once the degree of participation has been determined, the appropriate share of subsidiary income and net assets is assigned to the preferred stock interest in the consolidated financial statements.

14. 9-14 Subsidiary Preferred Stock Outstanding Many preferred stocks are callable, often at prices that exceed the par value. The amount to be paid to retire a subsidiary’s callable preferred stock under the preferred stock agreement is viewed as the preferred stockholders’ claim on the subsidiary’s assets, and that amount of subsidiary stockholders’ equity is assigned to the preferred stock interest in preparing the consolidated balance sheet.

15. 9-15 Changes in Parent Company Ownership Although preceding chapters have treated the parent company’s subsidiary ownership interest as remaining constant over time, in actuality ownership levels sometimes vary. Changes in ownership levels may result from actions of either the parent or the subsidiary.

16. 9-16 Changes in Parent Company Ownership The parent company can change ownership ratios by purchasing or selling shares of the subsidiary in transactions with unaffiliated companies. A subsidiary can change the ownership percentage of the parent by selling additional shared to or repurchasing shares from unaffiliated parties, or through stock transactions with the parent (if the subsidiary is less than wholly owned).

17. 9-17 Parent’s Purchase of Additional Shares from Nonaffiliate A parent company may purchase the common stock of a subsidiary at different points in time. When consolidated statements are prepared, the cost of each block of stock purchased is compared with the stock’s book value at the date of purchase and the difference is treated as part of the purchase differential to be assigned.

18. 9-18 Parent’s Purchase of Additional Shares from Nonaffiliate In the event a purchase of additional shares is make during the period, the eliminating entries will be altered so that consolidated net income will include only the earnings accruing to the parent company for the portion of period in which the additional shares are owned by the parent. Consolidation procedures for interim acquisitions are illustrated in Chapter 10.

19. 9-19 Parent’s Sale of Subsidiary Shares to Nonaffiliate A gain or loss normally occurs and is recorded on the books of the seller when a company disposes of all or part of an investment. APB 18 deals explicitly with sales of stock of an investee, requiring recognition of a gain or loss on the difference between selling price and the carrying amount of the stock.

20. 9-20 Parent’s Sale of Subsidiary Shares to Nonaffiliate A question arises, however, when the shares sold are those of a subsidiary and the subsidiary continues to qualify for consolidation. When a parent sells some of the shares of a subsidiary but continues to hold a controlling interest, the question is whether the gain or loss on the sale of shares should be carried to the consolidated income statement or eliminated in consolidation.

21. 9-21 Parent’s Sale of Subsidiary Shares to Nonaffiliate Recognizing a gain or loss in the consolidation income statement on a sale of subsidiary shares while continuing to consolidate the subsidiary seems inconsistent with the concept of a single economic entity. From a consolidated viewpoint, the subsidiary shares become part of the noncontrolling interest outstanding at the point they are sold to a nonaffiliate.

22. 9-22 Parent’s Sale of Subsidiary Shares to Nonaffiliate If recognition of the gain on the sale of the stock is considered appropriate in the consolidated income statement, no adjustment is needed in preparing consolidated statements, or in the periods that follow. On the other hand, excluding the gain from the consolidated income statement is more consistent with the view of a single economic entity. In that case, the gain is eliminated and additional paid-in capital is established.

23. 9-23 Subsidiary’s Sale of Additional Shares to Nonaffiliate Additional funds are generated for consolidated enterprise when a subsidiary sells new shares to parties outside the economic entity. A sale of additional shares to an unaffiliated party increases the total shares of the subsidiary outstanding and, consequently, reduces the percentage ownership held by the parent company.

24. 9-24 Subsidiary’s Sale of Additional Shares to Nonaffiliate At the same time, the dollar amount assigned to the noncontrolling interest in the consolidated financial statements increases. The resulting amounts of the controlling and noncontrolling interests are affected by two factors: The number of shares sold to nonaffiliates. The price at which the shares are sold to nonaffiliates.

25. 9-25 Subsidiary’s Sale of Additional Shares to Parent A sale of additional shares directly from a less than wholly owned subsidiary to its parent increases the parent’s ownership percentage. If the sale is at a price equal to the book value of the existing shares, the increase in the investment account of the parent equals the increase in the stockholders’ equity of the subsidiary. The net book value assigned to the noncontrolling interest remains unchanged.

26. 9-26 Subsidiary’s Sale of Additional Shares to Parent In preparing consolidated financial statements, the normal elimination entries are made based on the parent’s new ownership percentage.

27. 9-27 Subsidiary’s Sale of Additional Shares to Parent When the parent purchases shares directly from a subsidiary at an amount other than the book value of the subsidiary’s shares already outstanding, a differential is measured as the difference between the price paid and resulting increase in the total underlying book value of all shares owned by the parent. This increase in book value includes both the amount assigned to the new shares just acquired from the subsidiary and the increase or decrease in the book value of shares previously held by the parent.

28. 9-28 Subsidiary’s Sale of Additional Shares to Parent Once determined, the differential is treated in preparing consolidated financial statements in the same manner as a differential arising on a purchase from a nonaffiliate. However, because the parent may be able to influence the purchase price of the shares in this case, the amount of differential may or may not have an obvious connection to changes in the value of identifiable assets or liabilities and must be reviewed carefully in determining how it is to be assigned.

29. 9-29 Subsidiary’s Purchases of Shares from Nonaffiliate Treasury shares sometimes are purchased by a subsidiary from noncontrolling shareholders. Noncontrolling shareholders frequently find they have little opportunity for input into the activities and operations of the subsidiary and often are willing sellers. The parent company may prefer not to be concerned with outside shareholders and may direct the subsidiary to reacquire any of the noncontrolling shares that become available.

30. 9-30 Subsidiary’s Purchases of Shares from Nonaffiliate Although the parent is not a direct participant when a subsidiary purchases treasury stock from noncontrolling shareholders, the parent’s equity in the net assets of the subsidiary may change as a result of the transaction. When this occurs, the amount of the change must be recognized in preparing the consolidated statements.

31. 9-31 Subsidiary’s Purchases of Shares from Parent A subsidiary can reduce the number of shares it has outstanding through purchases from the parent as well as from noncontrolling shareholders. In practice, stock repurchases from the parent occur infrequently. That is, a parent reducing its ownership interest in a subsidiary usually does so by selling some of its holdings to nonaffiliates to generate additional funds.

32. 9-32 Subsidiary’s Purchases of Shares from Parent When a subsidiary reacquires some of its shares from its parent, the parent records a gain or loss on the difference between the selling price and the change in the carrying amount of its investment. There is some question as to whether a transaction of this type between a parent and its subsidiary can be regarded as arm’s-length, and consequently the reporting of the gain or loss in the parent’s income statement can be questioned.

33. 9-33 Subsidiary’s Purchases of Shares from Parent From a consolidated viewpoint, when a subsidiary requires its shares from the parent, the transaction represents an internal transfer and does not give rise to a gain or loss.

34. 9-34 Complex Ownership Structures Current reporting standards call for the preparation of consolidated financial statements whenever one company has direct or indirect control over another. The discussion to this point has focused on a simple, direct parent-subsidiary relationship. Many companies, however, have substantially more complex organizational schemes.

35. 9-35 Multilevel Ownership and Control In many cases, companies establish multiple corporate levels through which they carry out diversified operations. For example, a company may have a number of subsidiaries, one of which is a retailer. The retail subsidiary may in turn have a finance subsidiary, a real estate subsidiary, an insurance subsidiary, and perhaps other subsidiaries.

36. 9-36 Multilevel Ownership and Control This means that when consolidated statements are prepared, the statements will include companies in which the parent has only an indirect investment along with those in which direct ownership is held.

37. 9-37 Multilevel Ownership and Control The amount of income and net assets to be assigned to the controlling and noncontrolling shareholders, and the amount of unrealized profits and losses to be eliminated, must be determined at each level of ownership.

38. 9-38 Multilevel Ownership and Control Consolidation proceeds from the lowest level to the highest in these cases. In a relatively few cases, a subsidiary may own common shares of its parent. Usually those common shares are treated as treasury stock in consolidated financial statements.

39. 9-39 Subsidiary Stock Dividends Subsidiary dividends payable in shares of subsidiary’s common stock require slight changes in the elimination entries used in preparing consolidated financial statements. Because stock dividends are issued proportionally to all common stockholders, the relative interests of the controlling and noncontrolling stockholders do not change as a result of the stock dividend.

40. 9-40 Subsidiary Stock Dividends While the carrying amount of the investment on the books of the parent also is unaffected by a stock dividend, the stockholders’ equity accounts of the subsidiary do change, although total stockholders’ equity does not. The stock dividend represents a permanent capitalization of retained earnings, thus decreasing retained earnings and increasing capital stock and, perhaps, additional paid-in capital.

41. 9-41 Subsidiary Stock Dividends In the preparation of consolidated financial statements for the period in which a stock dividend is declared by the subsidiary, the stock dividend declaration must be eliminated along with the increased common stock and increased additional paid-in capital, if any. The stock dividend declared cannot appear in the consolidated retained earnings statement because only the parent’s dividends are viewed as dividends of the consolidated entity.

42. 9-42 You Will Survive This Chapter !!! Chapter 10 is the last chapter dealing specifically with consolidation topics.

43. McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9 End of Chapter