Consolidations: an overview of the FASB DM.
Procedures for preparing consolidated financial statements evolved quietly over 50 years ago and have not changed much since. The prevailing authorities guidance, Accounting Research Bulletin no. 41, Consolidated Financial Statements, issued more than 30 years ago, described accepted practice at the time and expressed some preferences but set few hard and fast rules. Since then, considerable merger and acquisition activity has taken place. And, except for a 1987 amendment to ARB no. 51 by the Financial Accounting Standards Board, no U.S. standard-setting body has completed a conceptual consideration of consolidations.
In recent years, numerous consolidation policy and procedure questions have been brought to the FASB's attention by the American Institute of CPAs, the Securities and Exchange Commission and others. In an effort to address those questions, the FASB recently published a discussion memorandum, Consolidation Policy and Procedures. The DM is part of a multi-phased FASB project on accounting for affiliations between entities.
FUNDAMENTAL ISSUES IN THE DM
The fundamental issues in the DM are whether and how separate financial statements of tow or more affiliated entities should be combined into a single set of consolidated statements.
"Whether" focuses on the importance of control and ownership as conditions for consolidation and on defining control.
"How" considers procedural matters such as the following:
* Measuring a subsidiary's identifiable assets and liabilities at acquisition date.
* Measuring a subsidiary's goodwill at the acquisition date.
* Treating an investee that becomes a subsidiary through a series of purchases of small blocks of stock.
* Handling subsequent increases and decreases in a parent's proportionate interest in a subsidiary.
* Eliminating intercompany transactions.
* Structuring the information for the most meaningful financial statement display.
* Conforming parent and subsidiary accounting practices and fiscal periods.
CONTROL VS. OWNERSHIP
Historically, consolidation in the United States has almost always been limited to the financial statements of an investor and the investees in which it owns more than a 50% voting interest. In the past few years, Canada, Australia, New Zealand, the United Kingdom, Germany, France, Japan, the European Community and the International Accounting Standards Committee have adopted control as the principal consolidation criterion - broadening the reporting entity to include all controlled affiliates, even if they are less-than-majority owned.
Control versus ownership is probably the most important issue in the DM. Does one entity's ability to control another's operating and financing policies justify consolidation (with ownership of a substantial voting interest serving as an indicator of control)? Or are control and level of ownership two district conditions that must be separately tested and met?
Varying viewpoints have led to three concepts of consolidated financial statements - the economic unit concept, the parent company concept and the proportionate consolidation concept. Exhibit 1, at right, describes them. The examples exhibits 2 and 3, pages 59 and 60, and the more extensive examples in the DM itself, show the three concepts can result in significantly different accounting measurements.
Three concepts of consolidated
Economic unit concept
* Consolidated financial statements are intended to provide information about a group of legal entities, a parent and its subsidiaries, operating as a single unit. All of their assets and not just the parent's portion, belong to the consolidated entity. * Unless the subsidiary is wholly owned, the consolidated entity;s proprietary interest is divided into a controlling interest (the parent;s stockholders) and one or more noncontrolling interests in subsidiaries. * Control is the basis for consolidation, with ownership an indicator of, but not a separate criterion from, control.
Parent company concept
* Consolidated financial statements are intended to provide information about the beneficial interest of the parent's stockholders in the various assets and liabilities controlled by the parent, including their undivided interest in the net assets of the parent's subsidiaries. * The noncontrolling (minority) stockholders;s equity in the subsidiaries' net assets is considered outside the proprietary interest in the consolidated entity. * Ownership is a criterion separate from control. Without ownership, the parent's stockholders do not have a beneficial interest in the investee's net assets. Beneficial interest means the right to share in profits, receive dividends and recover one's investment through stock resale or asset liquidation. Views differ about the level of beneficial interest below which consolidation is not meaningful.
Proportionate consolidation concept
* Only the parent's share of a subsidiary's assets, liabilities, revenues and expenses is included in consolidated financial statements. The noncontrolling interest's share is excluded. * To proponents of this concept, perhaps even more than to parent company advocates, ownership is an essential and distinct condition for consolidation, because it is ownership of a subsidiary, not just control, that gives the parent;s stockholders a beneficial interest in the subsidiary's net assets. * An advantage often cited for proportionate consolidation is its extensibility beyond parent-subsidiary relationships to jointly controlled investees, such as joint ventures, and to investees now accounted for by the equity method. * Some people view proportionate consolidation as a variant of the parent company concept.
Views differ on the appropriate ownership level for consolidation, whether as a separate condition or as a control indicator. For some, the minimum is ownership of a majority of voting stock. Others support consolidation if a parent is able to exercise a majority of voting rights through a legal device such as a pyramid (a sequential tier of corporations whereby each corporation is controlled through majority stock ownership by corporations at higher levels); use of multiple classes of voting stock with disproportionate voting rights; or through a voting trust.
Still others make the consolidation cutoff at ownership levels below a majority. For example, the owner of a large minority interest could have effective control, depending on the dispersion, disorganization or apathy of other owners.
The DM defines control as "the power of one entity to direct or cause the direction of the management and operating and financing policies of another entity." In addition to examining control through majority or large minority ownership, the DM discusses other circumstances that may indicate current control, including the power to obtain a majority voting interest in another entity (by unilateral action or by occurrence of a specified event) and the power to control by contract or lease. Also considered is whether a subsidiary should be included in consolidated statements if its parent's control is temporary.
ACQUISITION OF A SUBSIDIARY
IN A SINGE TRANSACTION
Under the parent company concept, if a subsidiary is acquired in a single transaction, its identifiable assets and liabilities are included in consolidation at the parent's proportionate share of their fair values at the acquisition date plus the subsidiary's book value for the noncontrolling interest's proportionate share. Goodwill is the difference between the parent's investment cost and its proportionate interest in the net fair values of the subsidiary's identifiable assets and liabilities. Under proportionate consolidation, the only difference is the book values of assets and liabilities representing the noncontrolling interest's proportionate share are omitted from the consolidated balance sheet, as it the noncontrolling interest.
Under the economic unit concept, if controlling interest in a subsidiary is acquired in a single transaction, 100% of identifiable assets and liabilities - both the parent's and the noncontrolling interest's shares - are included in consolidation at their fair values at the acquisition date. Goodwill is recognized under either a full or purchased goodwill interpretation.
Full goodwill interpretation. All the subsidiary's goodwill (not just the parent's purchased share) is recognized at the time control is attained. Ideally, an appraisal should serve as the basis for estimating the entire subsidiary's fair value, though the value of the subsidiary as a whole often is inferred from the per-share price the parent paid to obtain control. The full goodwill interpretation generally is considered the purest form of the economic unit concept.
Purchased goodwill interpretation. Only goodwill the parent purchases on the acquisition date - the difference between the price paid to obtain the controlling interest and the related share of the fair values of the subsidiary's identifiable net assets - is recognized. Goodwill for the noncontrolling (minority) interest is omitted. Proponents believe the fair value of all an entity's goodwill cannot be reliably appraised or inferred from the purchase price of a controlling interest because the amount may include a control premium. Exhibit 2 illustrates the alternatives.
Sixty percent interest in subsidiary acquired
in a single transaction
Fair market value Book value of subsidiary's of subsidiary's Stock Amount identifiable identifiable purchased paid net assets net assets 60% $900 $1,200 $800
Parent company concept
The subsidiary's identifiable net assets are included in consolidation at $1,040 [(60% x $1,200) + (40% x $800)]. Another way to look at the $1,040 is it represents the book value of the subsidiary's identifiable net assets plus the parent's share of the excess of the fair values over the book value of those assets [(100% x $800) + (60% x [$1,200 - $800])]. Goodwill recognized is $180 [$900 - (60% x $1,200)]. Noncontrolling interest is $320 (40% x $800).
Proportionate consolidation concept
The subsidiary's identifiable net assets are included at $720 (60% x $1,200), goodwill is $180 and noncontrolling interest is zero.
Economic unit concept
The subsidiary's identifiable net asset are included at $1,200. * Full goodwill interpretation. The subsidiary's full value must be determined either by appraisal or by extrapolation from the $900 said to acquire 60%. If fair value of the subsidiary is #1,500 ($900 /.6), identifiable assets and liabilities are recognized in consolidation at $1,200 fair value, and $300 of goodwill is recognized ($1,500 - $1,200). The $300 includes a $180 parent's 60% share plus a $120 noncontrolling interest's 40% share. Noncontrolling interest is reported at $600 (40% x $1,500) in the balance sheet. * Purchased goodwill interpretation. Goodwill is $180 [$900 - (60% x $1,200)]. Noncontrolling interest is $480 (40% x $1,200).
If the controlling interest is obtained by purchasing two or more blocks of the subsidiary's stock on different dates (a step acquisition), under the economic unit concept all the subsidiary's identifiable tangible and intangible assets and liabilities are included in the consilidated statements at their fair values at the date control is attained. On that date the fair value of the subsidiary's goodwill is measured by appraisal or is inferred from the price the parent paid in the control transaction. The economic unit is considered to have acquired all the subsidiary's assets and liabilities at the time it gains control. Before that, it was just an investor in stock.
On the date control is attained in a step acquisition, a holding gain or loss must be recognized on any previously purchased shares, under the economic unit concept, if the shares' current fair value differs from that carried on the parent's books. Why? Because the economic unit concept accounts for all a subsidiary's stock owned by its parent as alike. Shares purchased earlier are accounted for as having the same carrying amount (fair value at the date control is attained) as those purchased later, requiring the parent's investment account to be increased or decreased to reflect fair value at the control date.
Once control is attained, the parent's additional subsidiary stock purchases are accounted for under the economic unit concept as distributions to owners - like treasury stock acquisitions in the sense outstanding shares in the economic entity are reduced through asset transfers to owners. Share sales by the parent maintaining a controlling interest are accounted for as investments by owners - gain, as treasury stock - with no gain or loss recognized. Newly issued subsidiary shares are accounted for similarly.
Under the parent company concept, each parent purchase of an investee's stock is accounted for separately. Separate acquisitions are aggregated after control is attained to determine the amounts of acquired assets and assumed liabilities included in the consolidated statements. Thus, a parent's investment account contains a series of layers, one for each stock purchase, and corresponding layers are found in consolidated statements for each of the subsidiary's assets and liabilities, including goodwill, at the parent's stock purchase dates. Under the parent company concept, a fraction of the then-current fair values of the assets acquired and liabilities assumed and another slice of goodwill are recorded for each acquisition. The noncontrolling interest is accounted for at its share of the subsidiary's book value, unaffected by the fair values of either identifiable net assets or goodwill on the acquisition dates. The same measurements are made under proportionate consolidation, except the noncontrolling interest's share is excluded.
After control is attained, additional purchases of the subsidiary's stock result in additional layers of identifiable net assets and goodwill. If the parent sells some of the subsidiary's stock while maintaining a controlling interest, gain or loss in recognized under the parent company concept; transactions with noncontrolling interests are regarded as transactions with outsiders. Proponents believe recognizing gain or loss is necessary to enable the parent company's shareholders to assess performance and cash flows. To measure gain or loss on sale, layers acquired earlier must be peeled away using a method such as first-in first-out, last-in first-out, or average cost. Exhibit 3 illustrates the alternatives.
Sixty percent interest in subsidiary
acquired in a step acquisition - two blocks
of stock purchased one year apart
Fair market value Book value of subsidiary's of subsidiary's Stock Amount identifiable identifiable purchased paid net assets net assets 30% $350 $1,000 $700 30% 450 1,200 800 Increase $100
The $100 increase in the book value of the subsidiary's net assets is entirely due to undistributed net income for the year between the two purchase dates. The investor uses the equity method to recognize its $30 share of earnings (30% x $100) and amortizes the implicit $50 of goodwill [$350 - (30 x $1,000)] over 40 years, or $1.25 per year. As a result, income recognized is $28.75. The carrying amount of the investment is $378.75 ($350 + $30 - $1.25).
Parent company concept
The subsidiary's identifiable net assets are measured in consolidation at $1,010, consisting of a $300 fair value layer from the initial 30% purchase (30% x $1,000), the parent's $30 share of the investee's preconsolidation net income (30% x $100), another 30% fair value layer (30% x $1,200), plus noncontrolling interest at book value (40% x $800). Consolidated goodwill is $138.75 ($50 + $90 - $1.25 amortization under the equity method), and noncontrolling interest is $320 (40% x $800).
Proportionate consolidation concept
This is identical to the parent company concept except for omitting the $320 of net assets attributable to the noncontrolling interest and the corresponding noncontrolling interest itself.
Economic unit concept
The subsidiary's identifiable net assets are included at $1,200. * Full goodwill interpretation, Consolidated goodwill is $300, which is the excess of $1,500 total value of the subsidiary (based on an appraisal or inferred at $450 / .30) over the $1,200 fair value of its identifiable net assets. Noncontrolling interest is $600 (40% x $1,500), and a holding gain of $71.25 is recognized on the 30% of the stock purchased earlier and held while its price increased ($450 - $378.75 carrying amount). * "Purchased goodwill" interpretation. Only the portion of the subsidiary's goodwill purchased by the parent on the date it obtains control is recognized. No goodwill is recognized from the earlier stock purchase, nor any related to the noncontrolling interest. Accordingly, consolidated goodwill is $90 [$450 - (30% x $1,200)]. Noncontrolling interest is $480 (40% x $1,200). And a holding loss of $18.75 is recognized on the original 30% interest. That interest was purchased for $350, and while 30% of the identifiable net assets are not worth $360 (30% x $1,200), the $10 gain is more than offset by the $28.75 previously recognized by the investor under the equity method. Hence the $18.75 loss.
DISPOSITION OF A SUBSIDIARY
Disposition of a subsidiary occurs if a parent-subsidiary relationship is terminated, even if a noncontrolling interest is retained. Under both the economic unit and parent company concepts, the parent's gain or loss on disposition is recognized in the consolidated statements. Under the economic unit concept, the gain or loss results from the economic unit's disposal of individual assets and liabilities; under the parent company concept, the gain or loss results from the parent's selling the subsidiary's stock. The amount of gain or loss may differ because of different investment carrying amounts on the parent's books. The DM provides illustrations.
An intercompany transaction is on between a parent and its subsidiary or between two subsidiaries of the same parent. Under the economic unit concept, such a transaction is considered an internal transfer, and profit or loss is not realized pending resale to an outside entity. Under the parent company concept, the transaction is partly an internal transfer to be eliminated in consolidation and partly an exchange between the parent and an outside party (the subsidiary's noncontrolling stockholders).
If a 75%-owned subsidiary sells inventory to its parent, under the economic unit concept 100% of the unrealized intercompany profit is eliminated from the parent's inventory and from the subsidiary's income and retained earnings. The elimination is divided between controlling and noncontrolling interests. Under the parent company concept, the transaction is 75% internal transfer and 25% exchange between the parent and the subsidiary's noncontrolling stockholders. The parent's 75% share of unrealized intercompany profit is eliminated against its income and retained earnings; the rest is recognized as realized profit to the noncontrolling interest.
If the sale is from the parent to the subsidiary, the transaction and all unrealized intercompany profit is eliminated under the economic unit concept. Since the profit is entirely on the parent's books, the controlling interest absorbs 100% of the elimination. Most parent company advocates also eliminate the entire transaction and all unrealized intercompany profit; some recognize 25% of the profit as having been realized in a sale by the parent to the noncontrolling interest.
In addition to intercompany inventory sales, the DM also examines intercompany
* Receivables and payables.
* Sales of plant assets or intangible assets, including adjustment of gain or loss and depreciation.
* Investments in bonds.
BALANCE SHEET AND INCOME
Three choices for displaying noncontrolling interest in the consolidated balance sheet are as a liability, a separate item between liabilities and stockholders' equity and a component of stockholders' equity. The first two options are consistent with the parent company concept; the last, with the economic unit concept. Display of noncontrolling interest is not an issue under proportionate consolidation.
The choices for displaying noncontrolling interest in the consolidated income statement are to deduct income attributable to the noncontrolling interest in computing net income (parent company concept) or to deduct it from net income to compute net income attributable to the controlling interest (economic unit concept).
Preparing consolidated financial statements is a pervasive and long-standing accounting practice. If the United States decides to replace majority ownership with control as the principal consolidation criterion - as Canada, Australia, the United Kingdom, the EC and the IASC have done - that practice would be extended to many more intercorporate affiliations. Moreover, some of the alternatives discussed in the DM would dramatically change current practices for measuring a subsidiary's assets and liabilities. CPA practitioners should take notice: The DM has awakened a sleeping dog.
Single copies of the DM are available without charge by writing the FASB at 401 Merritt 7, P.O. Box 5116, Norwalk, Connecticut 06856 or by calling (203) 847-0700, ext. 555. Because of the subject's importance and complexity, the board established a July 15, 1992, comment due date.
* REACTING TO A NEED for up-to-date guidance on consolidated financial statements, the FASB has issued a discussion memorandum, Consolidation Policy and Procedures. * THE FUNDAMENTAL ISSUES in the DM are whether and how separate financial statements of two or more affiliated entities should be combined into a single set of consolidated statements. * IN RECENT YEARS other countries, including the European Community and the International Accounting Standards Committee, have replaced majority ownership with control as the principal consolidation criterion, broadening the reporting entity. * THREE CONCEPTS of consolidated financial statements exist: the economic unit concept, the parent company concept and the proportionate consolidation concept. Each can result in significantly different accounting measurements. * THE FASB INVITES responses on the DM from practitioners by the July 15, 1992, deadline.
PAUL PACTER, CPA, PhD, is professor of accounting at the University of Connecticut Stamford MBA program. As a consultant to the Financial Accounting Standards Board he wrote the DM on consolidations. He is a member of the American Institute of CPAs, the New York State Society of CPAs and the American Accounting Association.
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||includes related articles; Financial Accounting Standards Board, discussion memorandum: Consolidation Policy and Procedures|
|Publication:||Journal of Accountancy|
|Date:||Apr 1, 1992|
|Previous Article:||What's new in computers.|
|Next Article:||The FDIC Improvement Act: a precedent for expanded CPA reporting?|