Chapter 3

The Reporting Entity

and Consolidation of
Less-than-WhollyOwned Subsidiaries
with No Differential
McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 1

Understand and explain

the usefulness and
limitations of
consolidated
financial statements.

3-2

Consolidation: The Concept

Parent creates or gains control of the
subsidiary.
The result: a single reporting entity.

P
S
3-3

Review
How do we report the results of subsidiaries?
Parent
Company
80%

Sub A

51%

Sub B

21%

Sub C

Consolidation Equity Method

(plus the Equity Method)
3-4

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.

3-5

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.
3-6

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.
3-7

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.
3-8

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 parents
control.
3-9

Learning Objective 2

Understand and explain

how direct and indirect
control influence the
consolidation of a
subsidiary.

3-10

Concepts and Standards

Traditional view of control includes:

Direct control that occurs when one

company owns a majority of another
companys common stock.
Indirect control or pyramiding that
occurs when a companys common stock
is owned by one or more other companies
that are all under common control.

3-11

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
3-12

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.
3-13

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 FASBs consolidation

project has been hampered by, among other
things, issues related to:

Control

Reporting entity
3-14

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
3-15

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.
3-16

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. Zs 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.
3-17

Learning Objective 3

Understand and explain

the rules related to the
consolidation of variable
interest entities.

3-18

The Rise and FALL of Enron

Press Release Tuesday, October 16, 2001
ENRON REPORTS NON-RECURRING CHARGES
OF $1.01 BILLION AFTER-TAX.

3-19

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.

3-20

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 entitys activities.

3-21

Enrons 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 Enrons purpose?

Move liabilities off the balance sheet

3-22

Raptors
Established by Enron CFO to provide a
quick buyer for Enron assets.

Option 1: Find a bona fide third party.

Cant 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

3-23

Example: The Chewco Raptor

A diagram of the Chewco transaction is set
forth below:

3-24

Raptors Impact on Earnings

Quarte Earnin Raptor Raptors
r
gs
s
Impact
3Q
$364
$295
$69
2000
4Q
286
(176)
462
2000
1Q
536
281
255
2001
2Q
530
490
40
2001
3Q
(210)
(461)
251
2001
Total $1,506
$429
$1,0773-25

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
entitys activities.

What is a variable interest?

3-26

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 moneyrelated interest in an entity that changes
with changes in the fair value of the
entitys net assets exclusive of variable
interests.
3-27

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
3-28

Example: Variable Interest

Entities
Senior Debt
($85k)

Junior Debt
($12k)

Lease Pmts.

ABC Corp.

$100k

Leasing Corp.
Use of Building

Building Owner
Building

Investor ($3k)

How would ABC Corp. typically determine whether to consolidate

Leasing
Corp.?
A controlling
financial interest through

voting rights.

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?
3-29
What if ABC Corp. received any residual value above $100k
when

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.

3-30

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.

3-31

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).
3-32

VIEs: Potential Variable Interests

Potential Variable Interests

Subordinated loans to a VIE.

Equity interests in a VIE (50% or

less).

Guarantees to a VIEs lenders or

equity holders (that reduce the true
risk of these parties).

Written put options on a VIEs assets

held by a VIE or its lenders or equity
holders.
3-33

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

VIEs expected losses and/or

Will receive a majority (more than 50%) of the

VIEs 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).
3-34

Group Exercise 1: To Consolidate

(or not)?
Parch Inc. and Rees Urch, Parchs 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 Sedes
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
Sedes common stock. Parch also granted Sede a
REQUIRED
line
of credit of $1,000,000.
1. Is consolidation appropriate?
2. What would Parch accomplish with this
arrangement?
3. If consolidation were not appropriate, what
serious reporting issue exists regarding Parchs
3-35
separate financial statements?

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?
Cost
Equity
Investment income for 20X2
Investment in Smith at year-end
Retained earnings increase
3-36

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
Parents retained earnings increase
3-37

Learning Objective 4

Understand and explain

differences in
consolidation rules
under U.S. GAAP
and IFRS.

3-38

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
3-39

Key Differences between U.S.

GAAP and IFRS

Topic

U.S. GAAP

Determinati Normally, control is

on of
determined by majority
Control
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 nonVIEs.
Control is based on
direct or indirect voting
interests.
An entity with less than

IFRS

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
3-40 determining

Key Differences between U.S.

GAAP and IFRS
Topic

U.S. GAAP

IFRS

Interests held by related There is no specific

parties and de facto
provision for related parties
agents may be
or de facto agents.
considered in
determining control of a
VIE.
Definitions
SPEs can be VIEs.
Considers specific indicators
of VIEs
of whether an entity has
Consolidation rules
versus SPEs
focus on whether an
control of an SPE: (1)
entity is a VIE
whether the SPE conducts
(regardless of whether
activities for the entity, (2)
or not it is an SPE).
whether the entity has
decision-making power to
This guidance applies
only to legal entities.
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
3-41
the SPEs residual
or risks.
Related
Parties

Key Differences between U.S.

GAAP and IFRS
Topic
Disclosure

Accounting
for Joint
Ventures

U.S. GAAP

Disclosures required for

determining control of a
VIE.
Entities must disclose
whether or not they are
the primary beneficiary
of related VIEs.
Owners typically share
control (often with 5050 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

IFRS

No SPE-specific disclosure
requirements.
There are specific disclosure
requirements related to
consolidation in general.
Joint ventures can be
accounted for using either
proportionate consolidation
or the equity method.
Proportionate consolidation
reports the venturers share
of the assets, liabilities,
income, and expenses on a
line-by-line basis based on
the venturers financial
statement line items.
3-42

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 is3-43

Learning Objective 5

Understand and explain

differences in the
consolidation process
when the subsidiary is
not wholly owned.

3-44

Noncontrolling Interest
Only a controlling interest is needed for the
parent to consolidate the subsidiarynot
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
Parent
assets of the subsidiary.NCI
<50%

>50%

Sub
3-45

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:
Parent

NCI
<50%

>50%

Sub

(1)Should 100% of
the financial
statements be
consolidated?
(2) Where to
report NCI in
the financial
statements?
3-46

Issue 1: Should 100% be

Consolidated?
Proportional
Full
Consolidatio Consolidatio
n
n
Percent
Consolidated
?
Reports NCI
Amounts?
Complies
with
US GAAP?
Relative
Complexity?

3-47

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 doesnt belong to us.

NCI in Net Assets of Sub

Equity of unrelated owners
Net assets on our balance sheet not
belonging to us.

3-48

Issue 2: Where to report NCI in

Net Assets?

Old rules: Could report in in

equity, liabilities, or no mans
land between liabilities and
equity.
New rules: Must report in equity

FASB 160 makes clear that the

noncontrolling interests claim on net
assets is an element of equity, not a
liability.
3-49

Noncontrolling Interest

Computation of income to the

noncontrolling interest

In uncomplicated situations, it is a simple

proportionate share of the subsidiarys 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.

3-50

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 .
3-51
e. none of the above.

Learning Objective 6

Understand and explain

the differences in
theories of
consolidation.

3-52

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

FASBs approach to consolidation now
focuses on the entity theory.
3-53

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 lessthan-wholly owned subsidiarys
assets, liabilities, revenues and
expenses.
3-54

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 subsidiarys assets and liabilities,
not simply a proportionate share.
Separate recognition is given, in the
consolidated financial statements, to
the noncontrolling interests claim on
the net assets and earnings of the
subsidiary.
3-55

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.

3-56

Recognition of Subsidiary Income

3-57

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.

3-58

Reporting Net Assets of the

Subsidiary

3-59

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.
3-60

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 longrun interest in the parent company.

3-61

Practice Quiz Question #7

Current consolidation practice
in the U.S. adopts the:
a.
b.
c.
d.
e.

Proprietary theory.
Parent company theory.
Equity theory.
Entity theory.
none of the above.

3-62

Learning Objective 7

Make calculations and

prepare basic
elimination entries for
the consolidation
of a less-than-whollyowned subsidiary.
3-63

Summary of differences in
consolidation
Wholly
Owned
Subsidiary

Partially
Owned
Subsidiary

Investmen
t = Book
Value

Chapter
2

Chapter
3

No
Differentia
l

Investmen
t > Book
Value

Chapter
4

Chapter
5

Differentia
l

No NCI
NCI
Shareholders Shareholders
3-64

Consolidation of Less-than-whollyowned Subs

The entity theory requires that the
entitys entire income and value be
reported.
The subsidiarys income is divided between the
parent (controlling interest) and the NCI
shareholders.
The subsidiarys net assets are divided between
the parent (controlling interest) and the
NCI
Sub Equity Accounts
100%
shareholders.
Income from Sub
XXX
Basic elimination entry is modified to split both:
NCI in Net Income of Sub
XXX

Dividends Declared by Sub

100%
Investment in Sub
XXX
3-65

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 parents
% ownership.
3-66

Group Exercise 2: Basic

Elimination Entry

Given the following information:

Photo

1) Photo owns 70% of Snap

2) Snaps net income for 20X4 is $160,000
3) Photos net income for 20X4 from its own separate
operations is $500,000.
4) Snaps 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) Snaps beginning balance in Retained Earnings for 20X4
is $120,000.

Book Value
Calculations
Investment
Additional
Account CommonPaid-in
NCI (30%)
(70%) Stock
Beginning Balance
+ Net Income
Dividends

Retained
=
Capital Earnings

Ending Balance
3-67

70%

Snap

Group Exercise 2: Basic

Elimination Entry

Book Value Calculations

Investment
Additional
Account CommonPaid-in Retained =
NCI (30%)
(70%) Stock
Capital Earnings
Beginning Balance
+ Net Income
Dividends
Ending Balance

Investment in Snap

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
3-68

Learning Objective 8

Prepare a consolidation
worksheet for a lessthan-wholly-owned
consolidation.

3-69

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)

3-70

Practice Quiz Question #9

The primary difference in the
worksheet when consolidating
a less than wholly owned
subsidiary is:
a. only the parents % 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
3-71
d. there is no difference.

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.
3-72

Group Exercise 3: Solution

Book Value Calculations
Parents
Subsidiarys Equity Accounts
=
NCI Investment Common
Retained
(10%) Account (90%)
Stock
Earnings
NCI (10%)
Earnings
Balances,
1/1/X8 (90%) Stock
+ 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
3-73

Group Exercise 1: Solution

Dont forget the accumulated depreciation elimination
entry:
Accumulated Depreciation
20,000
Buildings and Equipment
20,000
Property, Plant &
Equipment

Accumulated
Depreciation

210,000

3-74

20,000

Group Exercise 3: Solution

3-75

Conclusion

The End

3-76