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Copyright University of Florida, Accounting Research Center 1995

1.0 INTRODUCTION

The FASB's Discussion Memorandum, Consolidation Policy and Procedures ( 1991; hereafter, the
" DM"), compares and contrasts accounting theory and procedures under three competing
concepts: the economic unit concept, the parent company concept, and the proportionate
consolidation concept. Currently, any of these three concepts may be followed in preparing
consolidated financial statements, although the parent company concept is the one most widely
used in practice today. The purpose of the FASB's project is to decide on one of these three
approaches for preparing consolidated financial statements in order to eliminate diversity in
financial reporting across similar situations.

In conducting its investigation, the FASB has found the theoretical literature in this area to be
lacking. They note in the DM [p. 5]

there is a small body of conceptual and theoretical literature on consolidated statements and
related matters, but it is not nearly as comprehensive as their significance and pervasiveness
seem to warrant, and much of it is 40 to 60 years old.

The American Accounting Association's Financial Accounting Standards Committee (hereafter, the
"Committee") also ran into difficulty finding theoretical work in this area when its members
constructed a response to the DM. In its response, the Committee expressed a preference for the
economic unit concept for two reasons: first because the method best presents the entirety of
assets under the parent company's control; second because it is consistent with their preference
for current value financial statements in general (see below for the discussion of valuations under
the three consolidation options). However, the committee members could not agree on many
details of the reporting under this concept. They cited an example in which some members prefer
presenting minority interest in stockholders' equity, while others prefer showing total consolidated
stockholders' equity equal to parent company stockholders' equity. A proper theoretical framework
for consolidated reporting is needed to resolve these inconsistencies.

The purpose of this paper is to develop such a theoretical foundation for consolidation through a
review and synthesis of the financial economics literature on corporate control transactions which
result in minority ownership interests in subsidiary companies. Understanding the nature of
minority interest establishes the foundation for consolidation because there is little difference
among the three methods when the parent owns 100 of a subsidiary. As Pacter [DM, p. 24] wrote,
"noncontrolling (minority) interests become the focus of the differences between the concepts."'
Under the economic unit concept,

unless all subsidiaries are wholly owned, the business enterprise's proprietary interest. . .is divided
into the controlling interest (stockholders or other owners of the parent company) and one or more
noncontrolling [minority] interests in subsidiaries. Both the controlling and the noncontrolling
interests are part of the proprietary group of the consolidated entity, even though the
noncontrolling stockholders' ownership interests relate only to the affiliates whose shares they own
[DM, p. 24].

Alternatively, under the parent company theory and, by association with it, under proportionate
consolidation,

unlike the economic unit concept, . . .the stockholders' equity of the parent company is also the
stockholders' equity of the consolidated entity. .The equity in subsidiaries represented by shares
owned by their noncontrolling (minority) stockholders is considered to be outside the proprietary
interest in the consolidated entity [DM, p. 24].

Accordingly, this paper reviews research on corporate control transactions which have implications
for minority (noncontrolling) interests in consolidated entities. This area of the literature provides
strong support for the economic unit concept and little support for either of the other two
alternatives presented in the DM. The literature generally supports the view that minority interests
are stockholders with interests in the entire consolidated entity. This theoretical framework and the
details of the research findings in financial economics also provide guidance for selecting among
alternative practices within the concept of the economic unit method itself.

The organization of the paper is as follows. Section 2 presents a brief discussion of the three
alternative approaches discussed in the DM. Section 3 presents the review and synthesis of the
financial economics literature on corporate restructuring transactions. Section 4 presents research
implications.

2.0 THE THREE CONSOLIDATION APPROACHES

The three consolidation approaches presented in the DM stem from two theoretical foundations for
consolidated financial reporting: the entity theory and the parent company theory of reporting.
Under the entity theory [Moonitz, 1951] (also called the economic unit theory), the consolidated
group is considered to be one economic unit for financial reporting purposes. That economic unit
holds assets and liabilities in various legal entities associated by one common controlling entity.
The economic unit may have more than one class of voting ownership interest: parent company
voting shareholders and subsidiary voting shareholders (the minority interest).

The parent company theory holds that only the parent company's shareholders' ownership interest
should be presented in the stockholders' equity section of the consolidated balance sheet.
Proponents of this theory argue that the minority shareholders are not owners in the sense that
they cannot outvote the majority and therefore cannot influence company management. The
proportionate consolidation concept simply carries the parent company concept to the extreme,
arguing that the parent's financial statements should include only the parent's interest in each
asset and liability found on the subsidiary's balance sheet. Table 1 provides a summary of the
valuations on consolidated balance sheets under each of these three alternative approaches.2

Generally, the economic unit approach includes in consolidated financial statements the entire fair
market value of the subsidiary's assets as of the date the parent obtains control over the
subsidiary. Minority interests in subsidiary net assets are considered to be part of consolidated
stockholders' equity. Under the parent company approach to consolidations, subsidiary net assets
are valued at book value plus an adjustment for the parent's portion of the difference between fair
market value and book value of the net assets at the date of acquisition. This measurement is
equivalent to valuing the parent's interest in the subsidiary's net assets at fair market value and
valuing the minority's interest at book value. Under this approach, minority interest typically is
classified between liabilities and stockholders' equity in the consolidated balance sheet. The
proportionate consolidation approach includes in the consolidated financial statements only the
parent's proportionate interest in the subsidiary's assets and liabilities, measured at fair market
value as of the date of acquisition by the consolidated entity. Minority interest is excluded entirely
under this alternative.

3.0 FINANCIAL ECONOMICS RESEARCH REGARDING CORPORATE RESTRUCTURING


TRANSACTIONS

The financial economics of corporate restructuring transactions provides an understanding of the


nature of the ownership interests in consolidated entities. In general, the research indicates that
the value derived from corporate takeover transactions stems from the change in control over
corporate assets. However, minority interests still maintain influence over the operation of the
entire consolidated entity.
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Table 1

Minority interests in consolidated entities arise primarily from two types of corporate restructuring
transactions. First, a minority interest may be the residual effect after one company takes over
another through a tender offer. This could result from either (1) a tender offer attempt to obtain 100
of the outstanding target shares to which some lesser percentage of shares are tendered; or, (2)
an initial attempt to obtain less than 100 of the target firm's outstanding shares. Second, a minority
interest may be created when a parent company sells a portion of its interest in a subsidiary in a
transaction labelled an "equity carve-out" by Schipper and Smith [1986]. The following discussion
on corporate control transactions is organized according to the type of transaction giving rise to
minority interest.

3.1 Tendering less than 100 for Any-or-all Tender Offers

Untendered target shares average 12 following tender offers for any-or-all outstanding shares
[Comment and Jarrell, 1987, p. 302]. Grossman and Hart [1980] provide a theoretical explanation
for this phenomenon. Their model indicates that a shareholder's optimal reaction to a tender offer
may be not to tender. This decision can be optimal because the shareholder may "free-ride" on the
gains provided by the acquisition and new management. "Free-riding" is a possibility because the
tender offer price presumably is less than the value that the acquirer expects to derive from
acquisition of the target firm; otherwise, the acquirer would not enter into the transaction.
Therefore, tendering shareholders must receive something less than the full gains expected from
the business combination. An optimal result for an individual target firm shareholder, then, would
be for the takeover to succeed but for the individual stockholder to retain his or her own interest.

3.1.1 Expected Failure of Takeover Transactions

Grossman and Hart conclude that takeovers cannot succeed unless there is some mechanism
whereby acquirers can "raid" the target firm to expropriate some wealth from the minority interest.
That is, acquirers will not bid to pay out 100 of the gains they expect to achieve from the business
combination. Yet any offer which transfers less than 100 of the gains to the target shareholders
provides an incentive for those shareholders to free-ride. If target shareholders each act
independently, then by attempting to free-ride they will cause the transaction to fail.

In reaching this conclusion, Grossman and Hart make some limiting assumptions which may not
hold empirically. First, they assume that target shareholders know which transactions will be
successful with certainty. Second, they assume that the firm ownership is diffuse, with each
shareholder holding such a small percentage of the target firm's stock that the shareholder will not
consider the effect of his decision on the outcome of the offer in deciding whether or not to tender.
Finally, Grossman and Hart assume that the acquirer and the target's shareholders know both the
maximum value of the firm under current management and the incremental benefit to be derived
from changing to management by the acquirer.
Bebchuk 119891 relaxes one of Grossman and Hart's assumptions and allows for some probability
that the takeover transaction could fail. This approach is much more consistent with empirical
observations which find significant stock price reactions to announcement of the outcome of the
offer, indicating resolution of uncertainty in the market [Baron, 1983, p. 331; Mikkelson and
Ruback, 1985, p. 540]. Bebchuk's model demonstrates that tender offers below the maximum
value which the acquirer expects to obtain, but above the value of the target firm operating
independently, may be successful if the bid is unconditional (i.e., it commits the bidder to purchase
tendered shares even if the bid fails). Under these circumstances,

although certain success of the bid is not a rational equilibrium outcome, neither is a certain failure.
Nontendering is not an equilibrium strategy for the target's shareholders because, if other
shareholders are going to hold out and the bid is going to fail, each atomistic shareholder will
prefer to tender and have his share acquired for a price exceeding the target's independent value.
Such an unconditional bid has a unique symmetric equilibrium...in which shareholders use mixed
strategies and the bid may consequently either succeed or fail.

Bebchuk also demonstrates that bidders are likely to bid at this level. Bebchuk's results therefore
provide a theoretical foundation for observing some successful and some failing offers while still
maintaining that minority interests develop as Grossman and Hart's theory describes-when
shareholders attempt to free ride on an acquirer's value-increasing efforts.

The implication of this literature for consolidation procedure is that it characterizes the minority
shareholders as investors sharing in the gains provided by the acquisition and new management.
Furthermore, Bebchuk's results expand this model to explain some empirical observations which
apparently contradict Grossman and Hart's theory. That is, tender offers may succeed even when
"corporate raiding" is not observed; shareholders still can be considered to have behaved
according to Grossman and Hart's model. Even though we observe successful tender offers which
contradict Grossman and Hart's model, still we may characterize minority interest shareholders as
shareholders holding an ownership interest in part of the consolidated entity following the takeover.
The consolidation approach which is most consistent with this characterization of minority
shareholders is the economic unit approach.

3.1.2 Conditional and Two-Tier Tender Offers

Grossman and Hart conclude that, in order to allow takeovers to occur, target firm shareholders
should allow acquirers to expropriate wealth from ("raid") target firms. One mechanism which
allows expropriation of shareholder wealth is to use frontend loading through two-tier tender offers.
A takeover is front-end loaded when the tender bid exceeds the value of any unpurchased
shares....Two-tier offers provide an effective vehicle for frontend loading because they combine a
limited tender offer (for voting control only) with a subsequent (unilaterally approved) merger
[Comment and Jarrell, 1987, p. 283-284].

In two-tier tender offers, the acquirer will accept only the number of shares necessary to achieve
control through the front end portion of the offer. The backend portion of the offer then may be less
valuable or may be comprised of a combination of different securities (e.g., cash, debt, and/or
stock of the acquirer). Target firm shareholders may 'stampede' to tender first in order to receive
the higher, front-end portion of the offer.

These offers can ". . . counter shareholder opportunism by reducing the incentives of individual
shareholders to hold out in an attempt to free-ride on the bidder's value-increasing changes"
[Comment and Jarrell, 1987, p. 290]. If this 'stampeding' occurs, then bidders have expropriated
wealth from target shareholders by paying a smaller value for the back-end portion of the offer.
However, though Comment and Jarrell find higher average tendering into the two-tier offers than
into the any-or-all offers, they find no significant differences between the bid premiums paid
through these two forms of offer.

These results are inconsistent with claims that shareholders are 'stampeded' into tendering into
two-tier and partial offers because of the greater coerciveness of these forms [Comment and
Jarrell, 1988, p. 309].

These results are consistent with the argument that competition among bidders must be executed
through the overall value of the offer. Competition in the market for corporate control will drive the
overall value of any offer at least to the market value of the firm [Jensen and Ruback, 1983, p. 31].
Comment and Jarrell's results indicate that such competition drives the bid price to a level
commensurate with that of an any-or-all offer.

These empirical results on tender offers contradict the modelling results deduced by Grossman
and Hart. Takeovers by tender offer do succeed and this literature provides evidence that the basis
for success is something other than expropriation of minority shareholder wealth. But the empirical
findings are consistent with the results expected from Bebchuk's model. Mixed trading strategies
produce some successful and some failing tender offers. Bid premiums which may fall somewhat
below the maximum value which the acquirer expects to obtain provide the acquirer with sufficient
incentive to bid and sufficient tendering incentive for the transaction to succeed. Accordingly, the
investment by minority shareholders in the consolidated entity still may be construed as Grossman
and Hart describe-as shareholder interests stemming from a desire to share in the gains derived
from the combination of the acquirer and the target firm. This interest is characteristic of an
ownership interest in the net assets of consolidated entities.

3.1.3 Finance Theories of the Sources of Gains in Corporate Takeovers

For some shareholders to become a minority interest, the benefits derived from the takeover must
be the type on which shareholders would like to free-ride. There are at least three types of gains
from corporate restructuring transactions which may result in efforts to free-ride. First, synergistic
gains from business combinations arise from operating the two companies on a combined basis
following the takeover, producing economies of scale or expanded use of existing facilities. These
synergistic gains were unavailable to these shareholders prior to the business combination.
Second, benefits of corporate takeovers which replace inefficient managements also provide the
same basis for shareholders to free-ride. Third, the benefits obtained from combining two firms
because of the effect of the information asymmetry problem identified by Myers and Majluf [1984]
provide the most clear case wherein target shareholders would want to free-ride.

According to the information asymmetry theory, the takeover of the target firm may allow the
combined firm to invest in positive net present value projects previously passed up by the target
firm.

lf managers have inside information, then there must be some cases in which that information is so
favorable that management, if it acts in the interests of old stockholders, will refuse to issue shares
even if it means passing up a good investment opportunity. That is, the cost to old shareholders of
issuing shares at a bargain price may outweigh the project's NPV [net present value] [Myers and
Majluf, 1984, p. 188].

The information asymmetry theory predicts that bidders with excess financing capacity will buy
cash-poor target firms and then finance the projects previously passed up by the target firm [Myers
and Majluf, 1984; Bruner, 1988].

This literature provides further evidence behind the reasons that shareholders will attempt to free-
ride. Gains on which shareholders attempt to free-ride can only be achieved through the
consolidation of the acquiring and target firms. This combination of theories on the sources of
takeover gains and Grossman and Hart's free-rider theory therefore further supports the argument
that minority interests following tender offer modes of takeover represent an ownership interest in
the entire consolidated entity. By extension, this literature therefore supports the use of the
economic unit method of consolidation because that method is the one which characterizes
minority interest shareholders as owners in the consolidated entity.

3.2 Partial Acquisitions by Tender Offer

Roy [1988] presents a model which explains the phenomenon of partial acquisitions. Assuming
that gains from business combinations may be divided between the acquirer and target firm in any
fashion desired, the gains will be determined by the acquisition price and the fraction of the target
shares purchased. There exists, therefore, an optimal fraction to be acquired in any given takeover
transaction. This model therefore implies that it is the change in control of 100 of the target firm's
assets which generates the economic gains evident in both acquiring firms' and target firms' stock
price reactions to tender offers. As the FASB acknowledges [DM, p. 61], the economic unit
approach "provides the most faithful representation of the totality of assets and liabilities that have
come under the parent's control."

Roy's modeling results are consistent with empirical observations of higher gains to tendering
shareholders than to non-tendering shareholders because there exists a premium associated with
the transfer of control at that optimal ownership acquisition level. Bradley [1980] examines 161
successful tender offers between July 1962 and December 1977 and finds that average
appreciation of target shares through one month subsequent to the offer execution is 36 relative to
the market value two months prior to the offer. But average bid premiums at the time of the offer
amount to 49 relative to the same base value. The average reduction in market value of 13
evidences the control value component of the price paid for the target shares [Bradley, 1980, p.
346].

Bradley also finds an increase in the market value of the acquiring and target firms over the time
period from two months before the offer to two months after. The average market value of
acquiring firms increases by $7.7 million despite an average offer premium of $7.7 million. The
average market value of target firms increases by $31 million [p. 346]. These results provide
further evidence that "the value of the target shares stems not from their proportional claims to the
net cash flows of the target firm but rather from the control of the target resources that they confer"
IP. 3671.

Finally, Bradley's findings also indicate that the price of shares traded before the close of the offer
may be devoid of a value attributed to the influence available to minority interests following
completion of the takeover. Shares traded during the time a tender offer is open are valued
through two components: the bid price for the percent of shares demanded by the acquirer and the
expected value of minority shares following offer closing. Regression analysis results indicate that
the market price of shares traded prior to the offer closing undervalues the second component; the
expected value of minority shares following offer closing is not fully incorporated into the trading
value during the time the tender offer is open. That is, Bradley finds a regression coefficient of .76
instead of 1 as he expected. These results may indicate that there is another explanatory variable
needed in the analysis: an "influence component" may be part of the expected value of the
minority shares following closing of the offer.

Bradley's theory emphasizes that the value of control is included in the bid price but is stripped
from the untendered shares. On the other hand, minority shareholders have some ability to
influence parent and subsidiary company transactions subsequent to the takeover through
litigation (see "Clean up" Tender Offers and Influence through Litigation, below). The value of the
minority shareholders' influence on the control of the target firm may not be present in the shares
traded prior to offer execution but may be included in the trading price after offer expiration. Thus,
it appears that this portion of share value supports the argument that minority shareholders can
influence parent and subsidiary company transactions after consummation of the tender offer.

Both components of share value, the control premium inherent in the share price prior to transfer
of control and the influence component inherent in the minority interest subsequent to the closing
of the offer, have implications for consolidation procedure. The control premium paid by the
acquirer indicates that the purchase price for the parent's share "should not be used to infer the
fair value of the total goodwill" [DM, p. 621 present in the business combination. When the
economic unit method is followed, valuing the goodwill at only the portion acquired by the parent is
the appropriate approach. The influence component inherent in the minority interest is again
consistent with characterizing the minority interest as an ownership interest in the consolidated
entity. These shareholders often influence operation of the consolidated entity through the court
system.
3.2.1 "Clean up" Tender Offers and Influence Through Litigation

Tender offers may be undertaken even when an acquirer already has control over the target firm.
Dodd and Ruback [1977] find that minority shareholders receive tender offer gains even when an
offering party already has majority control.

Since the bidders already had control of the target firm, these abnormal returns cannot reflect
synergy, monopoly or internal efficiency gains. . . . In effect, these `clean-up' offers can be
interpreted as out-of-court settlements, and the positive abnormal gains reflect the realization of
the potential gains by minority stockholders and include the savings in litigation costs to the
majority stockholders [p. 371].

The gains paid to minority shareholders provide further evidence of the influence component
inherent in the minority shares. Parent firms expect minority shareholders to attempt to influence
management of the consolidated entity through the court system. This litigation can be undertaken
by minority shareholders holding any level of minority interest, large or small.

In an analysis of litigation by stockholders in general, Jones [1980] examines a sample of 190


firms which were the defendants in 114 suits between 1971 and 1976 involving parent-subsidiary
relations. In total, these 114 suits brought by minority shareholders constitute 26 of Jones's sample
of 440 shareholder lawsuits against large companies. The suits by minority shareholders claimed
mistreatment of the subsidiary in many areas. Common areas for complaint were in transfer
pricing, revenue distribution, dividends (either insufficient or excessive), charges for management
or staff services, and diversion of subsidiary opportunities.

These complaints cast in bold relief the problems of minority shareholders and large multi-unit
(especially multinational) firms. The goal of the parent firm is to optimize the profits of the entire
organization. To do so it must allocate resources and opportunities among its subsidiaries to its
greatest advantage. Virtually every exploited opportunity for one subsidiary is a lost opportunity for
the others, in some sense. Given this situation it is not surprising that minority stockholders file a
substantial number of suits making this (parentsubsidiary) type of claim [Jones, 1980, p. 8-9].

Parent firms with more than one subsidiary having minority interest shareholders face even greater
dilemmas. For example, two suits included in the sample involved litigation from both minority
shareholders to a proposed transfer of an operation from one subsidiary to another.

The existence of a minority interest impacts the overall management of the consolidated entity
because of the litigation these shareholders undertake to influence that management process. In
contrast to arguments associated with the parent company theory, these shareholders' influence is
not limited to the subsidiary alone, although their point of interest may stem from the subsidiary as
opposed to the entire economic unit. The fact that the minority shareholders influence corporate
management supports the argument that these shareholders are corporate owners; the economic
unit approach is the only one which is conceptually consistent with this view of minority interest
shareholders. In addition, the litigation undertaken by these shareholders poses a special risk for
the corporation with minority interests which differs from the risk inherent in a corporation with only
wholly-owned subsidiaries. The existence of a minority interest therefore must be disclosed to
financial statement readers. Prominent display on the face of the balance sheet provides the best
disclosure. This treatment precludes using proportionate consolidation, but can be achieved under
either the economic unit or parent company approaches.

3.3 Equity Carve-out Transactions

Shareholders may purchase a minority interest directly from the parent company by purchasing
shares offered in an equity carve-out transaction. Equity carveouts often are associated with
subsidiaries having high growth potential and needing external financing. One of the most
frequently "stated motives for public offerings of subsidiary stock . . . [is to] enable [the] subsidiary
to obtain its own financing for anticipated growth" [Schipper and Smith, 1986, p. 171]. Other
incentives include a desire to (I) provide a direct basis for incentive plans for subsidiary
management; and, (2) increase the level of information available to the market about the good
performance of a subsidiary which might otherwise be clouded in the consolidated reports.

The desire to obtain separate equity financing for subsidiary activities and to obtain a market-
based measure for management performance at the subsidiary level are motivations which relate
directly to control over 100 of a subsidiary's assets. Consolidated financial statements should
present information in a fashion that is consistent with these motives.

In these transactions, the parent is willing to undertake the costs associated with having a minority
interest since sufficient benefits can be obtained from utilizing separate financing for the
subsidiary. In such growth situations shareholders may be willing to purchase an investment in a
minority interest. In fact, efforts to free-ride also may be present just as Grossman and Hart's
[ 1980] theory indicates. That is, shareholders purchasing shares in an equity carve-out anticipate
good returns which partly result from the corporate structure involving the parentsubsidiary
relationship. Again, the implication from the literature is that the economic unit method is the
appropriate choice both before and after an equity carve-out transaction.

The motives for equity carve-out transactions argue strongly against using the proportionate
consolidation approach because that method accounts for consolidated net assets differently
before and after an equity carve-out. That is, the consolidated financial statements would include
100 of the subsidiary's assets and liabilities before the equity carve-out, but some lesser
percentage afterwards. Such an accounting would be inappropriate because there has been no
fundamental change in the operation of the subsidiary, the parent, or the economic unit comprised
of the two.

Schipper and Smith find positive market reactions to announcements of equity carve-out
transactions, in sharp contrast to negative market reactions to equity offerings in stocks already
publicly traded. "Thus, equity carve-outs represent the only equity financing arrangement,
undertaken by publicly traded firms, for which an average increase in shareholder wealth has been
documented" [Schipper and Smith, 1986, p. 153]. Nanda [ 1991, p. 1718] shows "that the Myers
and Majluf [19841 framework [of information asymmetry and the use of takeovers to release
information about, and invest in, positive net present value projects available to the firm]. . .can be
extended in a straightforward manner to provide an explanation for the positive price reactions to
equity carve-outs." Nanda models corporate financing behavior when there are three available
choices: to undertake an equity carveout; to issue stock in the consolidated entity; or to forego the
project. Debt financing is not considered as an alternative.

In this situation we find that some firm types resort to equity carve-outs to fund subsidiary projects,
while other types prefer to issue equity in the consolidated corporation. . . Hence, by their financing
decisions, firms reveal information not just about the value of assets in place of the subsidiary but
also about the value of the assets in place in the rest of the corporation [Nanda, 1991, p. 1719].

Nanda's model indicates that firms undertaking equity carve-outs will choose this option because
their shares have been undervalued by the market. These findings further support the contention
that minority shareholders are one class of the entire ownership in consolidated net assets and,
accordingly, that the economic unit approach should be followed to faithfully present the entity in a
set of consolidated financial statements.

3.3.1 Eliminating Minority Interest Holdings

Schipper and Smith [ 1986] find that a large number of the minority interests created by the equity
carve-out transactions frequently are eliminated-in as little as two years, up to a maximum of
eleven years. Dodd and Ruback 1977, p. 352] also find that minority interests left after tender offer
transactions frequently are eliminated by merger. Klein et al. [1991] view equity carve-outs as the
first of a two-stage process whereby the subsidiary is either sold off entirely or later re-acquired. Of
their sample of 52 equity carve-outs, 25 were later reacquired and 19 were divested by the parent
firm. These authors interpret their results as indicating that the equity carve-out helps to put the
subsidiary on the selling block. If no good offers arise, the subsidiary is later reacquired.

The fact that minority interests often are eliminated shortly after takeovers are consumated could
be construed as evidence that minority interest should be classified as a liability (following the
parent company theory). Classifying minority interest between liabilities and stockholders' equity is
commonly done in practice today (following a hybrid approach between the parent company and
economic unit approaches). However, the FASB relies heavily on the definitions of financial
statement elements presented in Concepts Statement No. 6 [FASB, 1985] in resolving questions
of classification such as the one at hand. The minority interest cannot ever require a company to
sacrifice economic resources as debtholders can. Minority interest clearly better fits the definition
of a residual interest than it does the definition of a liability. Therefore, even if the minority interest
is outstanding for only a short period of time, it is an equity interest in the consolidated net assets
while it is outstanding.

3.4 Synthesis of the Literature

The DM [p. 24] indicates two conditions which provide theoretical support for using the economic
unit method of consolidation. These two conditions are:

(1) Control of the whole subsidiary is held by a single management team (that of the parent
company). Accordingly, 100 of the fair market value of the subsidiary's assets and liabilities are
included in the consolidation at the date consolidation commences (presently, when legal control
via voting ownership interest is obtained); and,

(2) Minority interest shareholders are viewed as stockholders in the entire consolidated entity.

A preponderance of the research into the financial economics of corporate restructuring


transactions supports both of these conditions for using the economic unit method when these
transactions produce minority interests. Table 2 summarizes the major points from the financial
economics literature which support the choice of the economic unit approach.

The research into any-or-all tender offers to which target shareholders tender less than 100 of the
outstanding shares indicates that these shareholders hold their interests in order to participate in
the gains provided by the acquisition and new management-that is, in order to hold an ownership
interest in the new consolidated entity. These findings indicate that minority interest should be
viewed as a proprietary interest in the consolidated entity and therefore supports the first of the two
conditions for choosing the economic unit method. The research into partial tender offers and into
equity carve-out transactions indicates that these transactions arise from management interests
which entail retaining control over 100 of the subsidiary's net assets. This intent exists even when
managements undertake transactions which they expect will produce minority interests. These
findings thus support the second of the conditions above for choosing the economic unit method of
consolidation-that 100 of the fair market value of the subsidiary's assets should be included in the
consolidation regardless of the percentage ownership held by the controlling parent.

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Table 2
3.5 Consolidation Procedure Implications

The DM indicates several areas in which practices vary even among those methods which are
consistent with only one of the three alternative theories of consolidation. For example, the
economic unit method may be followed with either a "full goodwill" or a "purchased goodwill"
approach. As noted above, the presence of a control premium in the price paid for partial
acquisitions indicates that this price should not be used to infer the full amount of goodwill which
would be involved in a 100 acquisition and, accordingly, that the "purchased goodwill" approach
should be used.

Other problem areas discussed in the DM include questions about how to account for step
acquisitions and "bargain purchases" (purchases at an amount below the sum of the fair market
values of the subsidiary's identifiable net assets). The following sections of this paper give
guidance on these topics which can be derived from the financial economics literature and the
framework previously developed. The surprising result for these two issues is that the methods
associated with the parent company approach in the DM actually are defensible under the
economic unit approach. These methods need not have been characterized as being consistent
only with the parent company theory.

3.5.1 Step Acquisitions

There are various possibilities in accounting for the changes in value of controlling interests
acquired in a piecemeal fashion. These alternatives all have implications for the underlying net
asset values and goodwill presented in the consolidated financial statements. The DM presents
the accounting alternatives as they would be used under each of the three theories of
consolidation.

Under the economic unit method, the fair market value of the subsidiary's net assets must be
included in the consolidation as of the date that control is obtained. To properly associate the
investment account balance with the fair market value of the subsidiary's net assets at that date, "a
holding gain or loss must be recognized on any previously purchased shares if the current fair
value of those shares differs from the amount at which they are carried on the parent's books"
[DM, p. 29]. This treatment could be considered to be analogous to the required accounting under
Statement of Financial Accounting Standards No. 115 [FASB, 1993). When an investment is
transferred from one investment portfolio to another, the transfer is made at market value and
holding gain or loss may flow through the income statement. There seems to be no reason to
avoid recognizing gain or loss in the case at hand. However, the alternative methods of accounting
for step acquisitions are presented in the DM as proposals designed merely to avoid this
recognition [p. 31].

Step acquisitions can be recorded under the economic unit concept in a fashion which includes
only purchased goodwill. This approach has previously been presented as the best practice for
single step acquisitions given that prices paid for control of the subsidiary likely are different from
share prices stripped of that control premium [Bradley, 19801. The alternative presented in the DM
which is most consistent with the findings in the financial economics literature accounts for all
acquired assets and liabilities other than goodwill by the economic unit concept [and therefore
recognizes holding gain or loss on the date control is obtained] but accounts for goodwill
essentially by the parent company concept in that it recognizes purchases of layers of goodwill
relating to each stock acquisition, including one or more layers purchased in steps before the
parent obtained control [p. 30].

The discussion in the DM assumes that this valuation is consistent only with the parent company
approach, yet it is also consistent with the theories and empirical findings that have been shown to
support the economic unit approach. These layers of goodwill probably sum to the best possible
estimate of total goodwill based on two factors: (1) the individual purchases would likely contain
different premium amounts required to obtain the various levels of ownership interests leading up
to the control premium, and (2) there exist changes in the intrinsic value of the goodwill due to
changes over time in the business being acquired. This method of recognizing "layers" of goodwill
need not be characterized as consistent only with the parent company theory.

3.5.2 Bargain Purchases

Some acquisitions, known as "bargain purchases," are accomplished for amounts less than the
total of the estimated fair values of the subsidiary's identifiable net assets-the difference between
the estimated fair market value of the net assets and the purchase price is termed "negative
goodwill." In current practice, the typical treatment is to reduce the value assigned to all long-lived
assets, other than investments, by the negative goodwill, in proportion to the assets' relative fair
market values. This treatment is consistent with the treatment used to allocate cost among the
acquired assets in any basket purchase in which the estimation process produces an excess of
total fair market value over cost. The discussion in the DM (p. 28) indicates that this procedure is
considered to be consistent with the parent company approach.

Under the economic unit concept the subsidiary's identifiable net assets are included in
consolidation at. . .the sum of the best estimate of their individual fair values. . . . Negative goodwill
is viewed as an indicator of the value of the subsidiary as a whole. . .[and] in most cases. . .would
be recognized separately as a master valuation account in the consolidated balance sheet [DM, p.
28].

Grossman and Hart's [1980] theory of free-riding by minority shareholders, which has been shown
to support the use of the economic unit approach, also addresses the accounting questions
surrounding bargain purchases. If the assets are worth more individually than in use, then the
likely result is that the acquisition process is being undertaken in order to "raid" the subsidiary as
Grossman and Hart describe. If the assets are sold off, then the parent corporation has in fact
earned a gain which should show in the consolidated income statement-via separate disclosure
outside of income from continuing operations. Perhaps the most convenient way to accomplish this
presentation is to have reduced the carrying values of the individual assets by an allocated portion
of the "negative goodwill." If the parent company does not sell off these assets to obtain these
gains, then the assets should be written down to the value which most appropriately reflects the
use of those assets by the consolidated entity and to reflect the actual cost of those assets to the
consolidated entity. That is, in this case also the "negative goodwill" should be allocated among
long-term assets other than investments. Thus, the treatment presented in the DM as consistent
with the parent company theory actually is consistent with arguments that support the economic
unit approach.

4.0 RESEARCH IMPLICATIONS

Even after choosing the economic unit approach to preparing consolidated financial statements,
some contentious issues and practice implications remain. The discussion in this paper has
highlighted some of the choices in the DM which are most consistent with the findings in the
financial economics literature and the theoretical framework which supports the economic unit
approach to consolidated financial statements.

The profession will face contentious issues in implementing a change to the economic unit method
for consolidations. Facing those difficulties will present research opportunities ( I ) in obtaining
further understanding of the use of consolidated financial information and (2) in support of practice
efforts to implement the change in consolidation procedure, particularly the FASB's efforts to
develop accounting standards that are consistent across many types of parent-subsidiary
relationships.

A line of research to obtain further understanding of the use of consolidated financial information
could be oriented around the regression of aggregate market value of the consolidated firm
(including majority and minority stakeholders) on alternative measures of assets and liabilities.
Research in support of practice efforts to implement the economic unit approach would be based
on an extension of prior work on consolidation policy and would integrate an analysis of both
accounting policy and procedures. Each of these topics will be discussed in turn.
4.1.1 Research to Understand the Use of Consolidated Financial Information

Research to understand the economics of using consolidated financial information is needed and
could begin with a regression analysis using the market value of all equity interests in a
consolidated firm and the alternative accounting valuations using the economic unit and parent
company approaches. This analysis could provide a direct test of the FASB's argument, as well as
the theory presented in this paper, that the economic unit method provides the greatest
representational faithfulness to the underlying economic reality of the consolidated entity. The
expected result would be a higher cross-sectional correlation between the market value for firms
and accounting valuations made under the economic unit method than with accounting valuations
made under the parent company approach.

The correlation between the market value of equity interests and the accounting valuation under
the parent company theory can be expected to decrease as the level of minority interest increases.
This result is expected because of the greater loss of representational faithfulness for the amounts
presented under the parent company theory as those amounts are influenced to a greater extent
by an increasing minority interest. This decrease in correlation is not expected to occur for the
valuations under the economic unit approach.

Further understanding of the nature of minority ownership interests could be obtained if the data
could be segregated according to the type of transaction giving rise to the minority interest in the
consolidated entity as described in this paper. This analysis would be expected to further support
the contention that the minority interest represents a similar type of ownership interest regardless
of which type of transaction gives rise to minority interest. Failure to reject the null hypothesis of no
differences across categories would be consistent with the theory presented in this paper.

The data for this analysis currently are available across different companies: while most firms
currently choose to use the parent company approach, some use the economic unit method. If the
FASB implements a requirement to use the economic unit method (as they expect to do, as of the
date of this writing, according to recent comments by members of the FASB Task Force on
Consolidation Policy and Procedures), then comparative information for individual companies also
will be available. Presumably, the economic unit method would be applied retroactively when first
implemented. Restated information would then be available for comparison to the financial
information originally presented under the parent company theory.

4.1.2 Research Integrating Consolidation Policy and Procedure Choices

Mian and Smith [1990] investigate incentives for unconsolidated financial reporting based on the
hypothesis that the choice of using consolidated financial information is the "product of purposeful
maximizing decisions" [p. 142]. They hypothesize that the choice to consolidate is based on the
interdependence of the subsidiary firm with the parent firm. Yet they analyze only finance
subsidiaries which generally are created by parent firms and thus do not have minority ownership
interests. An extension of their work to other types of consolidated subsidiaries is needed in order
to analyze research questions about consolidation policy which is being implemented across all
types of parent-subsidiary relationships.

The nature of the minority interest as described in this paper is relevant to any effort to extend
Mian and Smith's work to all types of parent-subsidiary relationships. Minority interest ownership
represents another principal in the principal-agent relationship characterized by the contracting
theory of the firm and the existence of a "relatively large" minority interest was once considered to
be a reason for not consolidating a subsidiary [FASB 1987]. While any research effort to expand
the work originally done by Mian and Smith would necessitate using pre-1987 data (because
SFAS 94 eliminated virtually all of the accounting policy choice available to firms considering
consolidation), there may be greater opportunities to investigate these issues in the future. If the
FASB begins to require consolidation under circumstances of effective control, as described in the
DM and the Preliminary Views on Consolidation Policy [FASB 1994), then variation in accounting
policy choices may arise from firms who must begin to consolidate anew under this standard.

[Footnote]
I would like to thank Bill Baber, Marshall Geiger, Alex Hazera. Jun Koo Kang, Ken Kim, Paul Munter,
Henry Oppenheimer, Mike Shaub, the editor Bipin B. Ajinkya, an anonymous reviewer, and workshop
participants at the 1993 Northeast Regional Meetings of the AAA for their helpful comments on earlier
drafts of this paper. Any remaining errors are my own.

[Footnote]
Minority interest in the net assets of consolidated subsidiaries currently is defined as the outside
ownership held in a subsidiary which is controlled by a parent holding over 50 of the voting stock. The
DM uses the term "noncontrolling" interest because it is possible that the above definition could change.
Another issue addressed in the DM is whether other definitions of control, besides ownership interest in
voting stock, should be used to determine when to consolidate for financial reporting. The issues
addressed in this paper may then be of even more concern. If consolidation is expanded, the minority"
interest account balance may represent an even larger share of the consolidated net assets.

[Footnote]
2 Also see Pacter [ 1992] for a detailed discussion and analysis of consolidation accounting under these
three alternatives.

[Footnote]
3 Whether the debt/equity classification scheme currently followed in consolidated balance sheets
should be maintained is discussed in Clark [19931 and is beyond the scope of this paper.

[Reference]
ANNOTATED BIBLIOGRAPHY

[Reference]
1. Grossman, S.J. and O.D. Hart. 1980. Takeover bids, the free-rider problem, and the theory of the
corporation. The Bell Journal of Economics 11 (Spring): 42-.
Takeovers are presumed to curb managerial inefficiencies because inefficient companies may be
purchased, run efficiently, and resold at a higher price. These authors argue instead that "shareholders
can free-ride on the raider's improvement of the corporation, thereby seriously limiting the raider's profit"
so that takeovers will not provide this control. They propose that corporate charters should initially be
written to allow a "raider" to benefit through price appreciation of the shares purchased in order to
reinstate the threat of takeover as an encouragement to efficient corporate operations.
2. Comment, R. and G.A. Jarrell. 1987. Two-tier and negotiated tender offers: The imprisonment of the
free-riding shareholder. Journal of Financial Economics 18 (June): 283-310.
These researchers examined 210 cash tender offers between 1981 and 1984 to compare the wealth
effects of different forms of offers: two-tier v. any-or-all v. partial and negotiated v. unnegotiated. They
found that any-or-all offers are much more frequent than two-tier and partial offers and that 82 of all final
offers during

[Reference]
the period were negotiated with target firm managements. The bid premiums paid to target shareholders
of any-or-all offers averaged 56.6, virtually the same as the average 55.9 paid in two-tier offers; partial
offers' bid premiums averaged 22.8. The authors thus concluded that "the average premiums paid
provide no evidence that target shareholders are absolutely or relatively disadvantaged by the two-tier
form of tender offer" (p. 304) and that the negotiations process results in ensuring cooperative tendering
behavior.
3. Myers, S.C. and N.S. Majluf. 1984. Corporate financing and investment decisions when firms have
information that investors do not have. Journal of Financial Economics 13 (June): 187-221.
These authors' model of corporate investing and financing behavior assumes that management acts in
the best interests of current firm shareholders and has information that investors do not have. The
model explains empirical observations that managements reserve financial slack and do not finance
every positive-NPV project, as more traditional theory argues they should. It also is consistent with
empirical observations of negative stock price reactions to new stock issues; it is not inconsistent with
findings of no stock price reactions to debt issuances; and it predicts certain forms of merger between
slack-rich bidding firms and slack-poor target firms.
[Reference]
4. Roy, A. 1988. Optimal acquisition fraction and a theory for partial acquisitions. Journal of Business
Finance and Accounting 15 (Winter): 543-555.
Roy developed a model which demonstrates that it is sometimes optimal from a share-value
maximization point of view to acquire a firm only partially because the net gain from the combination of
the two firms is a function of the acquisition price and the percent acquired. Roy analyzed cases which
require a fixed price to be paid for any acquisition level and a variable price case. In the fixed price case,
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[Reference]
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the offer period, but that the expected value of the shares outstanding following offer execution is less
than fully impounded in this price. Bradley interpreted his results as indicating that there is a control
premium associated with the shares traded on the open market prior to offer execution. He concluded
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but as a result of obtaining subsequent control over the target firm.
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153-186.
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equity offerings. They explain these results from the differences between these two types of offerings:
asset management systems are often restructured simultaneously with the equity carve-out; increased
information dissemination about the subsidiary usually occurs; the market value of the subsidiary's net
assets becomes directly observable; and a publicly held minority interest is generated. Of their 76
observations, 22 were reacquired by the parent; 36 were subjected to various other restructurings.

[Reference]
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outs followed by a final sale of the subsidiary result in significant, positive abnormal returns when the
two event dates are combined. However, if no sale arises, the subsidiary is reacquired and there is little
overall stock price reaction when the two event dates are combined.

[Reference]
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