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The debate over consolidating statements.

With the FASB's recent publication of a discussion memorandum, on "Consolidation Policy and Procedures," many executives will be debating how to prepare consolidated financial statements over the next several years.

The DM is step one in the FASB's complete reconsideration of the existing standards for preparing the consolidated financial statements of two or more business corporations. (The Board, however, is not addressing the question of applying the principles of consolidation to joint ventures partnerships, and not-for-profit organizations; the FASB plans to examine those matters in separate future projects.)

Unquestionably, the main issue in this DM is when is consolidation appropriate. Does control alone justify consolidation, with ownership an indicator of control? Or are control and ownership two separate and necessary conditions? What constitutes control? Should an investee company be consolidated if its parent is clearly in control but owns less than a majority of its voting stock? And, if so, how far below majority should the consolidation line be drawn?


The control-versus-ownership question in the DM is not a new one. The accounting profession has debated it for nearly a century, since the advent of consolidated statements. In 1959, 5 1, "Consolidated Financial Statements," was issued as a solution and remains in force today.

Like other accounting pronouncements of its day, ARB 51 was written in terms of presumptions, suggestions, and descriptions of practice rather than in the more prescriptive language of today's standards. In some cases, ARB 51 expressly sanctions alternative practices; some important consolidation issues are omitted, and others are not addressed conclusively.

Read below for paragraphs 1 and 2 of ARB 51:

"1. The purpose of consolidated statements is to present, primarily for the benefit of the shareholders and creditors of the parent company, the results of operations and the financial position of a parent company and its subsidiaries essentially as if the group were a single company with one or more branches or divisions. There is a presumption that consolidated statements are more meaningful than separate statements and that they are usually necessary for a fair presentation when one of the companies in the group directly or indirectly has a controlling financial interest in the other companies."

"2. The usual condition for a controlling financial interest is ownership of a majority voting interest, and, therefore, as a general rule, ownership by one company, directly or indirectly, of over 50 percent of the outstanding voting shares of another company is a condition pointing toward consolidation

Although controlling financial interest is not defined, use of that phrase in paragraph 1 implies that the primary criterion for consolidation is control. Unfortunately, paragraph 2 muddies the waters by suggesting' that a controlling financial interest is usually conferred by owning a majority of voting stock without citing any other way that a controlling financial interest might be attained.

Consequently, under current accounting practice, an investee that is less than majority owned is seldom consolidated, even if there is no doubt about the investor's ability to control. The few exceptions tend to be foreign investees owned just a bit below the 50-percent level due to laws in the foreign country requiring majority local - in this case foreign-ownership, provided that the foreign owners are merely passive investors and not active in managing the foreign subsidiary.

Not only does control versus ownership as the basis for consolidation remain unsettled today, it looms as the single most significant issue in the FASB discussion memorandum.

That issue takes on even more prominence when you realize that, over the past five years, accounting standard-setting bodies in Australia, Canada, New Zealand, and the United Kingdom, the International Accounting Standards Committee, and the European Community ("Common Market") have all issued new accounting standards adopting control, in contrast to majority ownership, as the basis for consolidation.

Just as it took 30 years for the AICPA to issue the first standards for consolidated financial statements, 30 more years have passed with only one follow-up on the subject: an FASB amendment that replaced ARB 51's permitted exclusion of nonhomogeneous subsidiaries from consolidation with a requirement that all majority-owned subsidiaries be consolidated even if they are foreign or have dissimilar operations or a sizable minority interest. But it did not resolve the control-versus-ownership question or the myriad of other consolidation accounting practice problems that have been cited by the AICPA, the SEC, and others over the years.


The FASB's DM illustrates numerous consolidation measurement questions. Here are some examples:

* Identifiable assets - if a subsidiary is less than wholly owned, should 100 percent of the fair values of its identifiable net assets at the acquisition date be recognized in consolidation, or only the parent's proportionate share of fair values? * Goodwill - should the portion of the subsidiary's goodwill attributable to the noncontrolling, or minority, interest in the subsidiary be included in consolidation, or only the parent's share of goodwill? * Step acquisitions - if majority ownership of a subsidiary is acquired by purchasing small blocks of stock on different dates (a "step acquisition"), should fair values be attributed to the subsidiary's assets and liabilities in consolidation by recognizing separate layers of value as of the dates of the acquisition of each block of stock? Or should the subsidiary's assets and liabilities be measured in consolidation based solely on fair values on a single date, namely the date control is obtained? * Additional purchases and sales - if the parent buys or sells some shares in the subsidiary while maintaining control are those transactions considered acquisitions and dispositions of assets for purposes of consolidated statements (with gain or loss recognized), or are they treasury stock transactions with owners? * Intercompany transactions - Should 100 percent of any unrealized profit on transactions between a parent and its subsidiary be eliminated in consolidation or only the parent's percentage? Does it make a difference if the unrealized profit is on the parent's books or on the subsidiary's books?

Finally, the DM examines a series of accounting policy and financial statement display issues, including the following: * Balance sheet display - when preparing a consolidated balance sheet, is noncontrolling, or minority, interest a liability, part of stockholders' equity, or a separate classification between liabilities and stockholders' equity? * Income statement display - Does consolidated net income include both the parent's and the noncontrolling interest's share of earnings? Or should the noncontrolling interest's share be deducted before arriving at consolidated net income? * Conformity of accounting policies - If the subsidiary's separate accounting policies differ from those of its parent, should the subsidiary's reported figures be modified in consolidation? If so, how should the effect of the adjustment be allocated between the controlling and noncontrolling interests?

The DM examines these and other questions in the context of three basic concepts of consolidated financial statements.

The economic unit concept, referred to in accounting literature as the entity concept, regards control as the sole criterion for consolidation. It includes in consolidation 100 percent of the fair values of the subsidiary's identifiable net assets, even if owned less than 100 percent, and may or may not include in consolidation the noncontrolling interest's share of goodwill. Consolidated owners' equity includes the noncontrolling interest.

The parent company concept, sometimes called the proprietary concept, regards control and ownership as two separate and necessary criteria for consolidation. It includes in consolidation only the parent's share of the fair values of the subsidiary's net assets plus the noncontrolling interest's share at book values. It would never include in consolidation the noncontrolling interest's share of goodwill. Noncontrolling interest is not part of consolidated owners' equity.

And the proportionate consolidation concept, also known as pro rata consolidation, regards control and ownership as two separate and necessary criteria for consolidation. It includes in consolidated statements only the parent's share of a subsidiary's assets, liabilities, revenues, and expenses. It excludes the noncontrolling interest's share entirely, including its share of goodwill and ownership equity.

Each of these concepts implies answers to the control-versus-ownership questions as well as to many of the procedural questions for preparing consolidated financial statements. Consequently, the issue of control - when to consolidate what - is not independent of how to prepare the consolidated statements, using the measurements and presentation alternatives under the three concepts. While the DM allows for a comprehensive approach to resolving both categories of questions, it also leaves open the opportunity for a hybrid solution.


As the figure on page 24 shows, 43.1 percent, or 4,713, of the 10,931 companies with securities publicly traded in the U.S., as tracked in Dialog Information Service's Disclosure Database, are reported as having at least one subsidiary. (The data is collected from reports filed with the SEC.) Companies with larger sales volume tend to have more subsidiaries than those with smaller sales volumes. You can draw a similar conclusion when companies are compared by total assets. Also, fewer companies that report in a foreign currency tend to have subsidiaries than do companies that report in U.S. dollars.

Many of the procedural issues examined in the DM arise only if consolidated subsidiaries are less than wholly owned - that is, if they have a noncontrolling, or minority, ownership interest. To assess whether certain types of consolidated entities are more likely than others to include less-than-wholly-owned subsidiaries, we again looked at the data reported for the 10,931 companies in the Dialog database.

Of those companies, 1, 136, or 10.4 percent, either disclose noncontrolling interest on their balance sheets or show a deduction for earnings attributable to noncontrolling interest on their income statements. This number does not, however, include companies that disclose information about noncontrolling interest only in the notes to their financial statements rather than on the face of those statements.

The figure to the left provides a breakdown of the 1,136 companies by stock exchange or listing. While the percentage of New York and American Stock Exchange companies reporting noncontrolling interest on their balance sheets or income statements is considerably higher than the NASDAQ or other over-the-counter companies, a relatively large number of companies in the latter categories also report noncontrolling interest.

Also, evidence suggests that the incidence of noncontrolling interest is higher among heavy industry companies, such as mining, construction, manufacturing, transportation, and utilities, than it is in the retailing, wholesaling, and service sectors. Even so, a large number of companies in the lighter industries also report material noncontrolling interests in consolidated subsidiaries.


The issues in the FASB's consolidations DM are not new. Questions such as control versus ownership, economic unit versus parent company versus proportionate consolidation concepts, and procedures for measuring identifiable assets and liabilities and goodwill of consolidated subsidiaries have been percolating for about a century and, for the most part, have been addressed in the official accounting literature on an ad hoc basis, if at all.

The issues fall into two major groups:

* Whether to consolidate - control versus ownership as the basis for consolidation, how to define control, and what level of ownership.

* How to consolidate - measurement of the subsidiary's assets, liabilities, and goodwill; step acquisitions; increases or decreases in the parent's proportionate interest in a subsidiary; and elimination of intercompany transactions.

Most of the questions in the "how" group arise only if a subsidiary is less than wholly owned. As we mentioned earlier, over 43 percent of all public companies, and over 60 percent of those with sales in excess of $ 100 million, have at least one subsidiary. But only roughly one-fourth of those report a noncontrolling interest in their subsidiaries.

The "whether" issues - and most specifically the control-versus-ownership question - affect all companies with subsidiaries regardless of the percentage of ownership. Consequently, most companies are likely to regard control versus ownership as more important than the "how" issues as the FASB proceeds on this project, particularly in light of the international trend toward replacing majority ownership with control as the principal criterion for consolidation.

Nonetheless, the "how" issues can be enormously important to those companies whose subsidiaries are less than wholly owned, and the number of those companies will grow if the basis for consolidation does indeed move toward control rather than majority ownership.

The views expressed in this article are those of the authors, not necessarily those of the FASB. Official Positions of the FASB are determined only after extensive due process and deliberation.

The Road to the DM on Consolidated Financial Statements

Consolidated financial statements rose to prominence between 1900 and 1930 as a result of the growth in intercorporate investments and the reise of the holding company.

In 1890, the Sherman Antitrust Act prohibited pools, trusts, and other business combinations deemed in restraint of trade. In response, holding companies emerged (including Standard Oil, U.S. Steel, DuPont, and Kodak), often in the hope that conducting business through separate legal entities united by stock ownership rather than by merger would make it appear as if the activities were separate, thereby rendering the holding company immune from antitrust action. The courts soon quelled that hope by ordering the dissolution of holding companies that violated the Sherman Act. among them Standard Oil in 1911.

In 1914, the Clayton Act made it illegal for a corporation engaged in interstate commerce to acquire the stock of another company if the combination substantially lessened competition in the industry. The effect was to prohibit two competitors from combinining through intercorporate investment forming a monopoly was the intent. Interestingly, however, the Clayton Act did not prevent two competing companies from merging, since the merger was through acquisition of assets rather than stock.

Despite the restrictions imposed by the Sherman and Clayton Acts, both intercorporate investments and mergers continued as the two principal forms of business combination of the 20th century.

Though U.S. Steel was not the first company to publish consolidated financial statements, its decision to do so starting in 1902 led to their widespread use and public acceptance. Previously, U.S. Steel had issued parent company statements that included as income only the devidends received from subsidiary companies. Some say that by issuing consolidated statements aggregating the earnings of its constituent companies, U.S. Steel was trying to justify having acquired over 60 percent of Amercian steelmaking capacity in light of growing government antitrust activity - higher consolidated earnings and stronger financial position.

U.S. Steel's use of consolidated statements received the strong backing of their auditors, Prince Waterhouse & Co. Leading public accountants in the first quarter of the century, including Arthur Lowes Dickinson, Lawrence R. Dicksee, and Robert H. Montgomery, advocated their use on grounds that recognizing only dividends as income could present a misleading picture, particularly if the subsidiary was consistently incurring losses.

During the 1920s, other outside the accounting profession also urged the use of consolidated statements, including the Investment Bankers Association and the New York Stock Exchange, which began requiring listed companies to prepare either consolidated statements or parent company statements and separate statements for each material subsidiary. Consolidated statements also were required by tax legislation as early as 1917, though they were made optional by subsequent legislation. However, those early requirements did help to encourage the use of consolidated statements for financial reporting to keep financial and tax reporting consistent.

It was only after the use of consolidated financial statements became commonplace that theories were proposed to explain their purpose. Among the early debates was wether to limit consolidation to majority-owned subsidiaries or whether the consolidated statements should include all companies under common control regardless of ownership level. That issue is the single most significant issue in the FASB's new discussion memorandum.
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Title Annotation:Financial Accounting Standards Board's revised consolidation policy; includes related article
Author:Rosman, Andrew J.
Publication:Financial Executive
Date:Mar 1, 1992
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