Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 03 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential

3-2 Learning Objective 1 Understand and explain the usefulness and limitations of consolidated financial statements. Understand and explain the usefulness and limitations of consolidated financial statements.

3-3 Consolidation: The Concept  Parent creates or gains control of the subsidiary.  The result: a single legal entity. P S

3-4 Parent Company Sub CSub BSub A 80%51%21% Review How do we report the results of subsidiaries? Consolidation (plus the Equity Method) Equity Method

3-5 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.

3-6 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.

3-7 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.

3-8 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.

3-9 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. 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.

3-10 Learning Objective 2 Understand and explain how direct and indirect control influence the consolidation of a subsidiary. Understand and explain how direct and indirect control influence the consolidation of a subsidiary.

3-11 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.

3-12 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.

3-13 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.

3-14 Concepts and Standards  Changing Concept of the Reporting Entity FASB 94, 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

3-15 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 FASB 141R indicates that control can be achieved without majority ownership, a comprehensive consolidation policy has yet to be achieved.

3-16 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.

3-17 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. 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.

3-18 Learning Objective 3 Understand and explain the rules related to the consolidation of variable interest entities.

3-19 The Rise and FALL of Enron Press Release Tuesday, October 16, 2001 ENRON REPORTS NON-RECURRING CHARGES OF $1.01 BILLION AFTER-TAX.

3-20 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.

3-21 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.

3-22 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

3-23 “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

3-24 Example: The Chewco Raptor A diagram of the Chewco transaction is set forth below:

3-25 Raptor’s Impact on Earnings

3-26 Variable Interest Entities (VIEs)  As a result of the Enron collapse and other notable scandals related to SPEs, the FASB issued Interpretation No. 46 (FIN46) [the revised version is FIN46R].  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.

3-27 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 46R 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.

3-28 Purpose of FIN46R The main effect of Fin46R 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.

3-29 Example: Variable Interest Entities  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. ABC Corp. Leasing Corp. Senior Debt ($85k) Junior Debt ($12k) Investor ($3k) Building Owner $100k Building Lease Pmts. Use of Building

3-30 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.

3-31 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.

3-32 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).

3-33 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.

3-34 VIEs: The Primary Beneficiary  The primary beneficiary of a VIE must consolidate the VIE.  The primary beneficiary is the entity that: Will absorb a majority (more than 50%) of the VIE’s expected losses and/or Will receive a majority (more than 50%) of the VIE’s expected residual returns. Expected losses are given more weight than expected residual returns in certain situations.  Only one primary beneficiary can exist for a VIE (by definition).

3-35 Group Exercise 1: To Consolidate (or not)? REQUIRED 1.Is consolidation appropriate? 2.What would Parch accomplish with this arrangement? 3.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.

3-36 Group Exercise 1: To Consolidate (or not)? 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. ParchSede $800,000 loan Option 100,000 shares $1,000,000 Line of credit Former Head of Research Rees Urch 10,000 shares

3-37 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? CostEquity Investment income for 20X2 Investment in Smith at year-end Retained earnings increase 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? CostEquity Investment income for 20X2 Investment in Smith at year-end Retained earnings increase

3-38 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 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

3-39 Learning Objective 4 Understand and explain differences in consolidation rules under U.S. GAAP and IFRS. Understand and explain differences in consolidation rules under U.S. GAAP and IFRS.

3-40 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 Fig. 3-1 on p. 117

3-41 Key Differences between U.S. GAAP and IFRS TopicU.S. GAAPIFRS Determination of Control  Normally, control is determined by majority ownership of voting shares.  However, majority ownership may not indicate control of a VIE.  Thus, VIE rules must be evaluated first in all situations.  The primary beneficiary must consolidate a VIE.  The majority shareholder consolidates most non-VIEs.  Control is based on direct or indirect voting interests.  An entity with less than 50 percent ownership may have “effective control” through other contractual arrangements.  Normally, control is determined by majority ownership of voting shares.  In addition to voting shares, convertible instruments and other contractual rights that could affect control are considered.  A parent with less than 50 percent of the voting shares could have control through contractual arrangements allowing control of votes of the board of directors.  Control over SPEs is determined based on judgment and relevant facts.  Substance over form considered in determining whether an SPE should be consolidated.

3-42 Key Differences between U.S. GAAP and IFRS TopicU.S. GAAPIFRS Related Parties  Interests held by related parties and “de facto” agents may be considered in determining control of a VIE.  There is no specific provision for related parties or de facto agents. Definitions of VIEs versus SPEs  SPEs can be VIEs.  Consolidation rules focus on whether an entity is a VIE (regardless of whether or not it is an SPE).  This guidance applies only to legal entities.  Considers specific indicators of whether an entity has control of an SPE: (1) whether the SPE conducts activities for the entity, (2) whether the entity has decision-making power to obtain majority of benefits from the SPE, (3) whether the entity has the right to majority of benefits from the SPE, and (4) whether the entity has majority of the SPE’s residual or risks.  This guidance applies whether or not conducted by a legal entity.

3-43 Key Differences between U.S. GAAP and IFRS TopicU.S. GAAPIFRS Disclosure  Disclosures required for determining control of a VIE.  Entities must disclose whether or not they are the primary beneficiary of related VIEs.  No SPE-specific disclosure requirements.  There are specific disclosure requirements related to consolidation in general. Accounting for Joint Ventures  Owners typically share control (often with ownership).  If the joint venture is a VIE, contracts must be considered to determine whether consolidation is required.  If the joint venture is not a VIE, venturers use the equity method.  Proportional consolidation generally not permitted.  Joint ventures can be accounted for using either proportionate consolidation or the equity method.  Proportionate consolidation reports the venturer’s share of the assets, liabilities, income, and expenses on a line-by-line basis based on the venturer’s financial statement line items.

3-44 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.. 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..

3-45 Learning Objective 5 Understand and explain differences in the consolidation process when the subsidiary is not wholly owned.

3-46 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 or refers to the claim of these shareholders on the income and net assets of the subsidiary. Parent Sub >50% <50% NCI

3-47 Noncontrolling Interest (NCI)  What is a noncontrolling interest (NCI)? Voting shares not owned by the parent company NCI was formerly called the “Minority Interest” Parent Sub >50% <50% NCI Two Issues: (1)Should 100% of the financial statements be consolidated? (2) Where to report NCI in the financial statements?

3-48 Issue 1: Should 100% be Consolidated? Proportional Consolidation Full Consolidation Percent Consolidated? Reports NCI Amounts? Complies with US GAAP? Relative Complexity? < 100%100% NoYes NoYes EasyHard

3-49 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.”

3-50 Issue 2: Where to report NCI in Net Assets?  Old rules: Could report in in equity, liabilities, or “no man’s land” between liabilities and equity.  New rules: Must report in equity FASB 160 makes clear that the noncontrolling interest’s claim on net assets is an element of equity, not a liability.

3-51 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.

3-52 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. 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.

3-53 Learning Objective 6 Understand and explain the differences in theories of consolidation.

3-54 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 141R, the FASB’s approach to consolidation now focuses on the entity theory.

3-55 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.

3-56 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.

3-57 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.

3-58 Recognition of Subsidiary Income

3-59 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.

3-60 Reporting Net Assets of the Subsidiary

3-61 Current Practice  FASB 141R has significantly changed the preparation of consolidated financial statements subsequent to the acquisition of less-than-wholly owned subsidiaries. Under FASB 141R, consolidation follows largely an entity-theory approach. Accordingly, the full entity fair value increment and the full amount of goodwill are recognized.

3-62 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.

3-63 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. 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.

3-64 Learning Objective 7 Make calculations and prepare basic elimination entries for the consolidation of a less-than-wholly-owned subsidiary. Make calculations and prepare basic elimination entries for the consolidation of a less-than-wholly-owned subsidiary.

3-65 Summary of differences in consolidation Wholly Owned Subsidiary Partially Owned Subsidiary Investment = Book Value Chapter 2Chapter 3 No Differential Investment > Book Value Chapter 4Chapter 5 Differential No NCI Shareholders NCI Shareholders

3-66 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 Accounts100% Income from SubXXX NCI in Net Income of SubXXX Dividends Declared by Sub100% Investment in SubXXX NCI in Net Assets of SubXXX

3-67 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. 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.

3-68 Group Exercise 2: Basic Elimination Entry InvestmentAdditional AccountCommonPaid-inRetained NCI (30%)(70%)StockCapitalEarnings Beginning Balance + Net Income  Dividends Ending Balance = Given the following information: 1)Photo owns 70% of Snap 2)Snap’s net income for 20X4 is $160,000 3)Photo’s net income for 20X4 from its own separate operations is $500,000. 4)Snap’s declares dividends of $12,000 during 20X4. 5)Snap has 10,000 shares of $4 par stock outstanding that were originally issued at $14 per share. 6)Snap’s beginning balance in Retained Earnings for 20X4 is $120,000. Book Value Calculations Photo Snap 70%

3-69 Learning Objective 8 Prepare a consolidation worksheet for a less-than- wholly-owned consolidation. Prepare a consolidation worksheet for a less-than- wholly-owned consolidation.

3-70 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)

3-71 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. 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.

3-72 Group Exercise 3: 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.

3-73 Group Exercise 3: Solution Parent’s Subsidiary’s Equity Accounts NCIInvestmentCommonRetained (10%)Account (90%)StockEarnings NCI (10%)(90%)StockEarnings Balances, 1/1/X8 + Net Income  Dividends Balances, 12/31/X8 = Book Value Calculations

3-74 Group Exercise 1: Solution Don’t forget the accumulated depreciation elimination entry: Accumulated Depreciation20,000 Buildings and Equipment20, ,000 20,000 Property, Plant & EquipmentAccumulated Depreciation

3-75 Group Exercise 3: Solution

Conclusion The End