Consolidation of Financial statements

1. INTRODUCTION

In business, consolidation or amalgamation is the merger and acquisition of many

smaller companies into much larger ones. In the context of financial accounting,

consolidation refers to the aggregation of financial statements of a group company

as consolidated financial statements. The taxation term of consolidation refers to the

treatment of a group of companies and other entities as one entity for tax purposes.

Under the Halsbury's Laws of England, 'amalgamation' is defined as "a blending

together of two or more undertakings into one undertaking, the shareholders of each

blending company, becoming, substantially, the shareholders of the blended

undertakings. There may be amalgamations, either by transfer of two or more

undertakings to a new company, or to the transfer of one or more companies to an

existing company".

.

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2. MEANING

Consolidated financial statements are the "Financial statements of a group in which

the assets, liabilities, equity, income, expenses and cash flows of the parent

(company) and its subsidiaries are presented as those of a single economic entity",

according to  International Accounting Standard 27 "Consolidated and

separate financial statements", and International Financial Reporting Standard 10

"Consolidated financial statements".

3. SIGNIFICANCE OF CONSOLIDATION OF FINANCIAL STATEMENTS

Sticking to the standalone figures to judge a company, therefore, may prove rather

disastrous sometimes. Given that a company may have subsidiaries aplenty, whether

or not in the same line of business, where these are profitable, they add to

shareholder's wealth. But poor performance of a subsidiary will affect the earnings of

the parent. Companies can even suffer a loss on a consolidated basis while making

profits independently and vice versa. Take the case of Shoppers' Stop. Its nascent

business of opening hypermarkets is yet to break even. A Rs. 12-crore standalone

profit for the June '11 quarter slipped into losses of Rs. 1.5 crore on a consolidated

level after incorporating the hypermarket subsidiary. Therefore, where a company

declares consolidated figures, especially on a quarterly basis, comb through it.

Compare consolidated numbers to the standalone figures to judge whether the

company has benefited from the subsidiary activities, which subsidiary adds to or

detracts from the company. It may just sway your investment decision.

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4. COMPANIES ACT 2013 PROVISION RELATED TO CONSOLIDATION

The 2013 Act now mandates consolidation of financial statements for any company

having a subsidiary, associate or a joint venture [section 129(3)]. The manner of

consolidation is required to be in line with the requirements of AS 21 as per the draft

rules. Further, the 2013 Act requires adoption and audit of consolidation of financial

statements in the same manner as standalone financial statements of the holding company

[section 129(4)]. Apart from consolidation of financial statements, the 2013 Act also

requires a separate statement, containing the salient features of financial statements of its

subsidiary (ies) in a form as prescribed in the draft rules* [First proviso to section 129

(3)]. Further, section 137(1), also requires an entity to file accounts of subsidiaries outside

of India, along with the financial statements (including consolidation of financial

statements).

While section 129 of the 2013 Act, requires all companies to file a statement containing

salient features of the subsidiaries financial

Statements, in addition to the consolidation of financial statements, section 137 of the

2013 Act further requires entities with foreign subsidiaries to submit individual

Financial statements of such foreign subsidiaries along with its own standalone and

consolidated financial statements. There seems to

Be significant amount of overlap and additional burden on companies with respect to

these compliances.

To illustrate this point, in order to comply with these requirements, a company which has

a global presence, with subsidiaries both

Within as well as outside India will need to comply to the following:

Prepare its standalone financial statements [section 129(1) of the 2013 Act]

Prepare a consolidation of financial statements, including all subsidiaries, associates

and joint ventures (whether in India or outside) [section 129(3) of the 2013 Act]

Prepare a summary statement for all its subsidiaries, associates and joint ventures of

the salient features of their respective Financial statements [Proviso to section 129(3)

of the 2013 Act]

Submit the standalone financial statements of subsidiary(ies) outside India to the

Registrar of Companies (roc) [section 137(1) of The 2013 Act].

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This situation clearly indicates the extent of duplication and additional costs which will

be incurred by entities in order to provide the Same information in multiple forms or

formats.

Differing compliance requirements imposed by multiple regulators will lead to hardship as well increased cost of compliance for companies.

Also, the requirement for unlisted entities to prepare a CFS, would substantially increase the cost of compliance. Further, it does not serve a similar purpose as in the case of a listed entity.

Since there is already a requirement to attach a statement containing salient features of the financial statements of the subsidiary, associate and joint venture, preparation of a CFS will would lead to duplication of preparing and presenting the same information in different forms.

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5. APPLICABILITY

Applicability of Consolidated Financial Statement (CFS):

Private Limited Company

Public Unlisted Company and

Listed Company

Companies Act 2013 (‘the Act’), in terms of Section 129(3), establishes the requirement

for consolidated financial statements for Indian companies and provides that where a

company has one or more subsidiaries, it shall prepare a consolidated financial statements

of the parent company and its subsidiaries, joint ventures and associates.

6. NON APPLICABILITY

 The Ministry of Corporate Affairs (‘MCA’) had also issued a couple of amendments

Companies (Accounts) Rules, 2014 to provide that preparation of consolidated financial

statement shall not be required by;

an intermediate wholly-owned subsidiary, other than a wholly-owned subsidiary

whose immediate parent is a company incorporated outside India

a company which does not have a subsidiary or subsidiaries but has one or more

associate companies or joint ventures or both for the financial year 2014-15

More recently, on 16 January 2015, the MCA issued another amendment that provides

that the requirements in respect of consolidation of financial statements shall not

apply to a company having subsidiary or subsidiaries incorporated outside India only

for the financial year commencing on or after 1 April 2014.

Apparently it seems that all unlisted companies with a foreign subsidiary are exempt

from preparing consolidated financial statements for the financial year 2014-15.

However, on a plain reading, it is not completely clear whether the exemption is

available if a company has at least one foreign subsidiary along with Indian

subsidiaries, or will be available if a company has only foreign subsidiaries but no

Indian subsidiaries.

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7. LIMITATIONS OF CONSOLIDATED FINANCIAL

STATEMENTS

While consolidated financial statements are useful, their limitations also must be kept

in mind.

Some information is lost any time data sets are aggregated; this is particularly

true when the information involves an aggregation across companies that have

substantially different operating characteristics.

Results of individual companies included in the consolidation are not

disclosed, thereby hiding poor performance.

Not all the consolidated retained earnings balance is necessarily available for

dividends of the parent

Financial ratios are not necessarily representative of any single company in the

consolidation

Similar accounts of different companies that are combined in the consolidation

may not be entirely comparable.

Additional information about companies may be needed for a fair

presentation, thus requiring voluminous footnotes

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8. CONCEPTS RELATING TO CFS

8.1 HOLDING COMPANY

A holding company is a company that owns other companies' outstanding stock.

The term usually refers to a company that does not produce goods or services

itself; rather, its purpose is to own shares of other companies to form a corporate

group. Holding companies allow the reduction of risk for the owners and can

allow the ownership and control of a number of different companies

DEFINITION OF 'HOLDING COMPANY:

A parent corporation, limited liability company or limited partnership that owns

enough voting stock in another company to control its policies and management.

A holding company exists for the sole purpose of controlling another company,

which might also be a corporation, limited partnership or limited liability

company, rather than for the purpose of producing its own goods or services.

Holding companies also exist for the purpose of owning property such as real

estate, patents, trademarks, stocks and other assets. If a business is 100% owned

by a holding company, it is called a wholly owned subsidiary.

Utilities:The Public Utility Holding Company Act of 1935 caused many energy companies to

divest their subsidiary businesses. Between 1938 and 1958 the number of holding

companies declined from 216 to 18. An energy law passed in 2005 removed the 1935

requirements, and has led to mergers and holding company formation among power

marketing and power brokering companies.

Personal holding company:In the United States, a personal holding company is defined in section 542 of

the Internal Revenue Code. A corporation is a personal holding company if both of

the following requirements are met

Gross income test: At least 60% of the corporation's adjusted ordinary gross

income is from dividends, interest, rent, and royalties.

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Stock ownership test: More than 50% in value of the corporation's outstanding

stock is owned by five or fewer individuals.

Parent company:

A parent company is a company that owns enough voting stock in another firm

(subsidiary) to control management and operations by influencing or electing

its board of directors. A parent company could simply be a company that wholly

owns another company. This would be known as a "wholly owned subsidiary".

When an existing company establishes a new company and keeps majority shares

with itself, and invites other companies to buy minority shares, it is called a parent

company.

8.2 SUBSIDIARY COMPANY

DEFINITION of 'Subsidiary'A company whose voting stock is more than 50% controlled by another company,

usually referred to as the parent company or holding company. A subsidiary is a

company that is partly or completely owned by another company that holds

a controlling interest in the subsidiary company. If a parent company owns a foreign

subsidiary, the company under which the subsidiary is incorporated must follow the

laws of the country where the subsidiary operates, and the parent company still carries

the foreign subsidiary's financials on its books (consolidated financial statements). For

the purposes of liability, taxation and regulation, subsidiaries are distinct legal

entities.

Meaning:

A subsidiary, subsidiary company or daughter company is a company that is

owned or controlled by another company, which is called the parent company, parent,

or holding company. The subsidiary can be a company, corporation, or limited

liability company. In some cases it is a government or state-owned enterprise.

Subsidiaries are a common feature of business life, and all multinational

corporations organize their operations in this way. Examples include holding

companies such as Berkshire Hathaway, Time Warner, or Citigroup; as well as more

focused companies such as IBM or Xerox. These, and others, organize their

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businesses into national and functional subsidiaries, often with multiple levels of

subsidiaries.

8.3 MINORITY INTEREST

DEFINITION of 'Minority Interest'

1. A significant but non-controlling ownership of less than 50% of a company's voting

shares by either an investor or another company.

2. A non-current liability that can be found on a parent company's balance sheet that

represents the proportion of its subsidiaries owned by minority shareholders.

In accounting, minority interest (or non-controlling interest) is the portion of a

subsidiary corporation's stock that is not owned by the parent corporation. The

magnitude of the minority interest in the subsidiary company is generally less than

50% of outstanding shares, otherwise the corporation would generally cease to be a

subsidiary of the parent. It is, however, possible (e.g. through special voting rights)

that a controlling interest requiring consolidation be achieved without exceeding 50%

ownership depending on the accounting standards being employed. Minority interest

belongs to other investors and is reported on the consolidated balance sheet of the

owning company to reflect the claim on assets belonging to other, non-controlling

shareholders. Also, minority interest is reported on the consolidated income

statement as a share of profit belonging to minority shareholders.

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8.4 CAPITAL PROFIT/ GAIN DEFINITION

1. An increase in the value of a capital asset (investment or real estate) that gives it a

higher worth than the purchase price. The gain is not realized until the asset is sold. A

capital gain may be short term (one year or less) or long term (more than one year)

and must be claimed on income taxes. A capital loss is incurred when there is a

decrease in the capital asset value compared to an asset's purchase price.

2. Profit that results when the price of a security held by a mutual fund rises above

its purchase price and the security is sold (realized gain). If the security continues to

be held, the gain is unrealized. A capital loss would occur when the opposite takes

place.

Concept and Meaning Of Capital Profits

The amount of profit earned by the business from the sale of its assets, shares, and

debentures is capital profit. If assets are sold at a price more than their book

values then the excess of book value is capital profit. Similarly, if the shares and

debentures are issued at a price more than their face value, then the excess of face

value or premium is capital profit. Such profit is not earned in the ordinary course of

the business. It is not available for the distribution to shareholders as dividend. Such

profits are transferred to capital reserve. It is used for meeting capital losses. It is

shown on the liabilities side of balance sheet.

Items relating to capital profits

Profit on sale of fixed assets

* Premium on issue of share

* Premium on issue of debenture

* Share forfeited amount

* Profit on sale of investment

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8.5 Revenue profits

Concept and Meaning of Revenue Profits

Revenue profit is the difference between revenue incomes and revenue expenses. It

is earned in the ordinary course of the business. It results from the sale of goods and

services at a price more than their cost price. Revenue profit is he outcome of regular

transactions of the business. It is shown as gross profit and net profit in trading

and profit and loss accounts. It is available for the distribution to shareholders as

dividend or for creating reserve and fund for various purposes. It shows the efficiency

of the business. In fact, earning revenue profit is the main objective of every business.

In the income statement, there are four levels of profit or profit margins - gross profit, operating profit, pre-tax profit and net profit. The term "margin" can apply to the absolute number for a given profit level and/or the number as a percentage of net sales/revenues. Profit margin analysis uses the percentage calculation to provide a comprehensive measure of a company's profitability on a historical basis (3-5 years) and in comparison to peer companies and industry benchmarks.

Revenue profits comprises of;

Gross profit

Operating profit

Pre-tax profit

Net profit

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8.6 DIFFERENCE BETWEEN CAPITAL PROFITS

AND REVENUE PROFITS

Following are the main differences between capital profit and revenue profit.

Mode of Earning

Capital profit is earned by selling assets, shares and debentures at a price more than

their book value and face value. Revenue profit is earned in the ordinary course of the

business.

Distribution

Capital profit is not available for the distribution to shareholders as dividend. Revenue profit

is available for the distribution to shareholders as dividend.

Use

Capital profit is transferred to capital reserve and used for meeting capital losses. Revenue

profit is used to distribute dividend and create reserve and fund for various purposes.

Treatment

Capital profit is shown on the liabilities side of the balance sheet as capital reserve. Revenue

profit is shown as debit balance on the debit side of the trading and profit and loss

accounts and on asset side of the balance sheet as accumulated loss.

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9 ACCOUNTING STANDARD 21- BASIC PRINCIPLES

OF CONSOLIDATION

Comparative international standards and highlights

Key objective: To provide for preparation and presentation of consolidated financial

statements in the books of a holding company

Related accounting standards

• Investments in associates

• Investments in Joint ventures

• Comparison between IAS and AS

Scope

• Two types of accounts of holding companies

– Group financial statements Group financial statements

Consolidating financial statements of subsidiaries

– Separate financial statements

Key definitions

Subsidiaries and parents

o Subsidiary is one which is “controlled” by a parent

o Need not be a company

o Subsidiary can be any type of organization

Control

– Ownership, directly or indirectly through one or more subsidiaries, of more than

half of voting power of an enterprise more than half of voting power of an enterprise

– Controlling composition of board of directors in case of a company or governing

council so as to obtain economic benefits from the enterprise.

Analysis of definition of control Analysis of definition of control

– Deliberately set so as to avoid conflict with Companies Act definition

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Subsidiaries under Companies Act

– Are these examples of subsidiaries?

• A controls B

• A controls B, B controls C

• A controls B and C. B and C together control D

Exceptions to consolidation

There are two exceptions:

- Where control is temporary

- Subsidiary operates under long term restrictions which significantly

impair its ability to transfer funds

What if activities of the subsidiary are totally different

from the parent?

– Not a valid ground for not doing consolidation

Consolidation procedure

Line by line consolidation of assets/liabilities/incomes and expenses of

the subsidiary

– Investment of the parent in the capital of the subsidiary (A), and parent’s portion of

equity of the subsidiary (B) , should be eliminated.

• If is A is more than B, A-B is goodwill

• If B is more than A, B-A is capital reserve

• This determination is done on the date of investment in the subsidiary.

–Minority interest in the net income of the subsidiary should be adjusted against

group income

– Minority interest in the net assets should be identified and reflected separately from

the liabilities and equity of the parent

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– Intra-group balances and intra group transactions, and any unrealised profits should

be eliminated completely

• Unrealised losses are also eliminated, but may reflect impairment

– Financial statements are drawn up to the same date

• However, if it is not practical to prepare on the same date, a gap of not more than 6

months is permissible

– Uniform accounting policies

De-subsidiarisation

• From the date on which the holding-subsidiary relation ceases, the difference

between the relation ceases, the difference between the proceeds of investment, and

the carrying amount of net assets on the balance sheet of

the parent, is recognised as profit/loss

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10 CONSOLIDATION OF FINANCIAL INFORMATION

FINANCIAL ACCOUNTING STANDARDS BOARD allows reporting for businesses

combined using the acquisition method. The acquisition method embraces a fair value

measurement attribute.

* Adoption of this attribute reflects the FINANCIAL ACCOUNTING STANDARDS

BOARD’s increasing emphasis on fair value for measuring and assessing business

activity.

* In the past, reporting standards embraced the cost principle to measure and report the

financial effects of business combinations.

Expansion Through Corporate Takeovers

Reasons for firms to combine:

1. Vertical integration of one firm’s output and another firm’s distribution or further

processing.

2. Cost savings through elimination of duplicate facilities and staff.

3. Quick entry for new and existing products into domestic and foreign markets.

4. Economies of scale allowing greater efficiency and negotiating power.

5. The ability to access financing at more attractive rates. As firm size increases,

negotiating power with financial institutions can increase also.

6. Diversification of business risk.

7. Continuous expansion of the organization, often into diversified areas (creating

conglomerates).

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11 TYPES OF CONSOLIDATION

The consolidation of financial information into a single set of statements become

necessary when the business combination of two or more companies creates a single

economic entity – FASB ASC (810-10-10-1)

* “There is a presumption that consolidated financial statements are more meaningful

than separate financial statements and that they are usually necessary for a fair

presentation when one of the entities in the consolidated group directly or indirectly has

a controlling financial interest in the other entities.”

* Business combination: refers to a transaction or other event in which an acquirer

obtains control over one or more businesses.

Business combinations are formed by a wide variety of transactions or events with

various formats:

1. Statutory merger – Any business combination in which only one of the original

companies continues to exist.

a. One company obtains the assets, and often the liabilities, of another company in

exchange for cash, other assets, liabilities, stock, or a combination of these.

b. The second organization normally dissolves itself as a legal corporation.

c. One company obtains all of the capital stock of another in exchange for cash, other

assets, liabilities, stock, or a combination of these. After gaining control, the acquiring

company can decide to transfer all assets and liabilities to its own financial records.

d. The second company dissolves. However, because stock is obtained, the acquiring

company must gain 100% control of all shares before legally dissolving the

subsidiary.

2. Statutory Consolidation – Business combination that has united two or more

existing companies under the ownership of a newly created company.

e. Two or more companies transfer either their assets or their capital stock to a newly

formed corporation.

f. Both original companies are dissolved, leaving only the new organization in

existence.

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3. Acquisition of more than 50% of voting stock

g. One company achieves legal control over another by acquiring a majority of voting

stock. Although control is present, no dissolution takes place; each company remains

in existence as an incorporated operation.

Separate incorporation is frequently preferred to take full advantage of any

intangible benefits accruing to the acquired company as a going concern.

h. Because the assets and liability account balances are not physically combined as in

statutory mergers and consolidations, each company continues to maintain an

independent accounting system.

Maintaining an independent information system for a subsidiary often enhances

its market value for an eventual sale or IPO as a stand-alone entity.

To reflect the combination, the acquiring company enters the takeover transaction

into its own records by establishing a single investment asset account. The newly

acquired subsidiary omits any recording of this event; its stock is just simply

transferred to the parent firm the subsidiary’s shareholders (no direct effect of the

takeover).

4. Control of variable interest entity (VIE) – Establishes contractual control over a VIE

to engage in a specific activity.

i. Does not involve a majority voting stock interest or direct ownership or assets.

j. Sponsoring the firm and becomes its “primary beneficiary” with rights to its

residual profits.

k. Can take the form of leases, participation rights, guarantees, or other interests.

Control

The definition of control is central to determining when two or more entities become

one economic entity and therefore one reporting entity.

* Control of one firm by another is most often achieved through the acquisition of

voting shares. Accordingly, GAAP traditionally has pointed to a majority voting share

ownership as a controlling financial interest that requires consolidation.

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12 CONSOLIDATION PROCESS

Consolidation Process- Overview

Starting point: Separate financial statements of the companies involved.

Separate statements are added together, after some adjustments and eliminations, to

generate consolidated statements.

– Adjustments and eliminations relate to intercompany transactions and

holdings.

.

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Parent

Subsidiary

Consolidation of Financial statements

Inter corporate Stockholdings

– Common stock of the parent is held by those outside the consolidated entity and is

viewed as the common stock of the entire entity.

– Common stock of the subsidiary is held entirely within the consolidated entity and is

not stock outstanding from a consolidated viewpoint.

– Note: A company cannot report in its financial statements an investment in itself

– Parent’s retained earnings (less the unrealized intercompany profit) remain as the only

retained earnings figure in the consolidated balance sheet.

Intercompany Receivables and Payables

– A single company cannot owe itself money, that is, a company cannot report (in its

financial statements) a receivable to itself and a payable to itself.

– Therefore, an intercompany receivable/payable is eliminated from both receivables

and payables in preparing the consolidated balance sheet

Intercompany Sales

– The sale should be removed from the combined revenues because it does not

represent a sale to an external party.

Difference between Fair Value and Book Value

Fair value of the consideration given usually reflects the fair value of the acquired

company and differs from its book value.

An acquiree’s assets and liabilities must be valued based on their acquisition-date fair

values, and any excess of the consideration given over the fair values of the net assets

is considered goodwill.

Single-Entity Viewpoint

• To understand the adjustments needed, one should focus on:

• identifying the treatment accorded a particular item by each of the separate companies

and

• identifying the amount that would appear in the financial statements with respect to

that item if the consolidated entity were actually a single company.

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13 Mechanics of the Consolidation Process

A worksheet is used to facilitate the process of combining and adjusting

the account balances involved in a consolidation.

While the parent company and the subsidiary each maintain their own

books, there are no books for the consolidated entity.

The balances of the accounts are taken at the end of each period from the

books of the parent and the subsidiary and entered in the consolidation

work paper.

Where the simple adding of the amounts from the two companies leads to

a consolidated figure different from the amount that would appear if the

two companies were actually one, the combined amount must be adjusted

to the desired figure.

This is done through the preparation of eliminating entries.

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14 Objective of consolidation

To report the financial position, results or operations, and cash flows from the

combined entity.

For statutory merger or statutory consolidation, when the acquired

company (or companies) is (are) legally dissolved, only one accounting

consolidation ever occurs.

On the data of the combination, the surviving company simply records

the various account balances from each of the dissolving companies.

After this, the financial records of the acquired companies are closed

out as part of the dissolution.

When all companies retain incorporation, a different set of

consolidation procedures is appropriate.

They maintain their own independent accounting systems. Thus, no

permanent consolidation of the account balances is ever made. Rather,

the consolidation process must be carried out anew each time the

reporting entity prepares financial statements for external reporting

purposes.

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15 What is to be consolidated?

If dissolution takes place, appropriate account balances are physically

consolidated in the surviving company’s financial records.

If separate incorporation is maintained, only the financial statement information

(not the actual records) is consolidated.

16 When does the consolidation take place?

If dissolution takes place, a permanent consolidation occurs at the date of the

combination.

If separate incorporation is maintained, the consolidated process is carried out at

regular intervals whenever financial statements are to be prepared.

17 How are the accounting records affected?

If dissolution takes place, the surviving company’s accounts are adjusted to

include appropriate balances of the dissolved company. The dissolved company’s

records are closed out.

If separate incorporation is maintained, each company continues to retain its own

records. Using worksheets facilitates the periodic consolidation process without

disturbing the individual accounting system.

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18 Non-controlling Interest

For the parent to consolidate the subsidiary, only a controlling interest is needed not be

100% interest

Non controlling interest or minority interest refers to the claim of these shareholders on

the income and net assets of the subsidiary

Computation of income to the non controlling interest: In uncomplicated situations, it is a

simple proportionate share of the subsidiary’s net income.

Those shareholders of the subsidiary other than the parent are referred to as “non -

controlling” or “minority” shareholders.

Presentation: FINANCIAL ACCOUNTING STANDARDS BOARD 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 non controlling

stockholders shown.

The non controlling interest’s claim on the net assets of the subsidiary was previously

shown between liabilities and stockholders’ equity in the consolidated balance sheet.

-Some firms reported minority interest as a liability, although it did not meet the

definition of a liability

FINANCIAL ACCOUNTING STANDARDS BOARD 160 makes clear that the

non controlling interest’s claim on net assets is an element of equity, not a liability

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19 Combined Financial Statements

Financial statements are also prepared for a group of companies when no one

company in the group owns a majority of the common stock of any other company

in the group.

Combined financial statements are those that include a group of related companies

without including the parent company or other owner.

– Procedures are essentially the same as those used in preparing consolidated

financial statements.

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

Qualifying SPEs

– Types of SPEs widely used for servicing financial assets and meet very

restrictive conditions established by financial accounting standards board 140.

– Conditions generally require that the SPE be “demonstrably distinct from the

transferor,” its activities be significantly limited, and it hold only certain types

of financial assets.

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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

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.

22 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 has

moved very much toward the entity theory.

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Recognition of Subsidiary Income

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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.

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 non

controlling interest’s claim on the net assets and earnings of the subsidiary.

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 non

controlling shareholders viewed as two separate groups, each having an equity

in the consolidated entity.

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 non controlling interest.

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.

• 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.

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23 Financial Reporting for Business Combinations

> Current financial reporting standards require the acquisition method to account for business

combinations. Appling the acquisition method typically involves recognizing and measuring:

1. The consideration transferred for the acquired business and any non controlling interest.

a. Measured at FV and is equal to the sum of the acquisition-date FV or the assets transferred

by the acquirer, the liabilities incurred by the acquirer to former owners of the acquire, and

the equity interest issued by the acquirer (FASB ASC 805-30-30-7).

2. The separately identified assets acquired and liabilities assumed.

3 Goodwill, or a gain from a bargain purchase.

* FV is defined as the price that would be received to sell an asset to pay to transfer a liability

in an orderly transaction between market participants at the measurement date (market value).

* Contingent consideration is an additional element of consideration transferred. Can be

useful in negotiations when two parties disagree on each other’s estimates of future cash

flows for the target firm or when valuation uncertainty is high.

> Fundamental principle of the acquisition is that the acquirer must identify the assets

acquired and the liabilities assumed in the business combination (then the acquirer must

measure them).

 To estimate the FV, 3 sets of valuation techniques are typically employed:

1. Market approach – recognizes that FV can be estimated using other market transactions

involving similar assets or liabilities.

2. Income approach – relies on multi-period estimates of future cash flows that are projected

to be generated by an asset.

a. Projected cash flows are then discounted at a required rate of return that reflects the time

value of money and the risk associated with realizing the future estimated cash flows.

b. Useful for obtaining FV estimates of intangible assets and acquired in-process R&D

3. Cost approach – estimates fair values by reference to the current cost of replacing an asset

with another of comparable economic utility.

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c. The cost to replace a particular asset reflects both its estimated replacement cost and the

effects of obsolescence

d. Widely used to estimate FV from many tangible assets acquired in business combinations

such as PP&E.

Goodwill, and gains on bargain purchases

* For combinations resulting in complete ownership by the acquirer, the acquirer recognizes

the asset goodwill as the excess of the consideration transferred over the collective FV of the

net identified assets acquired and liabilities assumed.

* Conversely, if the collective FV of the net identified assets acquired and liabilities assumed

exceeds the consideration transferred, the acquirer recognizes a “gain on bargain purchase.”

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24 Procedures for Consolidating Financial Information

✪ Acquisition Method When Dissolution Takes Place

* Typically records the combination recognizing:

* The FV of the consideration transferred by the acquiring firm to the former owners of the

acquire

* The identified assets acquired and liabilities assumed at their individual FV

Consideration Transferred Equals Net FV of Identified Assets Acquired and Liabilities

Assumed:

* The book values are ignored and the acquiring firm records a consolidation entry in its

financial records at FV

Acquisition Method: Considering Transferred Equals Net Identified Asset FV – Subsidiary

Dissolved:

* Under the acquisition method, only the subsidiary’s revenues, expenses, dividends, and

equity transactions that occur subsequent to the takeover affect the business combination.

Consideration Transferred Exceeds Net Amount of FV of Identified Assets Acquired and Liabilities Assumed:

* The excess is allocated to an unidentifiable asset known as “goodwill”

Bargain Purchase – Consideration Transferred Is Less Than Net Amount of FV of Identified

Assets Acquired and Liabilities Assumed:

* Occurs most often in forced or distressed sales

* The acquisition method records the identified assets acquired and liabilities assumed at

their individual FV.

Acquisition Method: Consideration Transferred Is Less Than Net Identified Asset FV,

Subsidiary dissolved:

* In a bargain purchase, the FV of the assets received and all liabilities assumed in a business

combination are considered more relevant for asset valuation that the consideration

transferred.

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Relevant costs of business acquisition (regardless of whether dissolution takes place):

1. Firms often engage attorneys, accountants, IB, and other professionals from combination-

related services. The acquisition method does not consider such expenditures as part of the

FV received by the acquirer.

a. Professional service fees are expenses in the period they are incurred

2. Acquiring a firm’s internal costs (example: secretaries, etc.)

b. These indirect costs are also reported as current year expenses.

3. Amounts incurred to register and issue securities in connection with a business

combination simply reduce the otherwise determinable FV of the securities

✪ The acquisition method when separate incorporation is maintained

Many aspects of the consolidation process remain the same when each company retains

separate incorporation

* FV remains the basis for initially consolidating the subsidiary’s assets and liabilities

7 Steps to prepare a worksheet on the date of acquisition to arrive at consolidated totals for the combination:

1. Prior to the construction of the worksheet, the parent prepares a formal allocation of the

acquisition-date FV similar to the equity method procedures (chapter 1).

2. The first two columns of the worksheet show the separate companies’ acquisition-date

financial figures. The company’s revenue, expense, and dividend accounts have been closed

into its RE account.

3. Remove Common Stock, APIC, and RE balances so the company’s assets and liabilities

remain to be combined with the parent company figures.

4. Remove the $ component of the investment of the subsidiary company account that

equates to the BV of the subsidiary’s net assets.

5. Remove the excess payment in the investment of the subsidiary company and assign it to

the specific accounts indicated by the FV allocation schedule.

6. All accounts are extended into the Consolidated Total column

7. Subtract consolidated expenses from revenues to arrive at net income.

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Acquisition-Date Fair-Value Allocation – Additional Issues

1. Intangibles

a. Include current and noncurrent assets (not including financial instruments) that lack

physical substance.

b. Determining whether to recognize an intangible asset in a business combination, two

criteria:

i. Does the intangible asset arise from contractual or other legal rights? Most common

ii. Is the intangible asset capable of being sold or otherwise separated from the acquired

enterprise?

2. Preexisting Goodwill on Subsidiary’s Books

c. By its very nature, such goodwill is not considered identifiable by the parent. Therefore,

the new owner simply ignores it in allocating the acquisition-date FV.

3. Acquired In-Process R&D

d. Measured at acquisition-date FV and recognized in consolidated financial statements as an

asset.

e. R&D expenditures incurred subsequent to the date of acquisition will continue to be

expensed

f. Acquired IPR&D assets initially should be considered indefinite-lived until the project is

completed or abandoned.

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25 Convergence Between U.S. and International Accounting Standards

* The two standards are identical in most important aspects of accounting for business

consolidations although differences can result in non controlling interest valuation and some

other limited applications.

* The joint project on business combinations represent one of the first successful

implementations of the agreement between the two standard-setting groups to coordinate

efforts on future work with the goal of developing high-quality comparable standards for both

domestic and cross-border financial accounting.

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