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ch003 PDF
ch003 PDF
Chapter 3
The Reporting
Entity and • Many corporations are composed of
Consolidated numerous separate companies and,
in turn, prepare consolidated financial
Financial statements.
Statements
McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
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Benefits Limitations
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Ability to Exercise Control Ability to Exercise Control
• Under certain circumstances, the majority
stockholders of a subsidiary may not be able to
exercise control even though they hold more
than 50 percent of its outstanding voting stock.
Examples:
• When consolidation is not appropriate,
• Subsidiary is in legal reorganization or
bankruptcy the unconsolidated subsidiary is reported
as an intercorporate investment.
• Foreign country restricts remittance of
subsidiary profits to domestic parent
company
• Parent is unable to control important
aspects of the subsidiary’s operations.
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Inadequate Standards Special Purpose/Variable Interest Entities
• Although many companies have used special
entities for legitimate purposes, companies • Special-purpose entities (SPEs) are
such as Enron took advantage of the lack of corporations, trusts, or partnerships created
standards to avoid reporting debt or losses by for a single specified purpose.
hiding them in special entities that were not
consolidated.
• They have no substantive operations and are
used only for financing purposes.
• Only in the past few years have consolidation
standards for these special entities started to
provide some uniformity in the financial • Special-purpose entities have been used for
reporting for corporations having relationships several decades for asset securitization, risk
with such entities. sharing, and to take advantage of tax statutes.
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Overview of the Consolidation Process Overview of the Consolidation Process
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Intercorporate Stockholdings Difference between Cost and Book Value
• The elimination entry related to “intercorporate
stockholdings” (in the previous slide) was
prepared under the assumption that the parent
purchased the subsidiary at book value.
• NOTE: The equity accounts of the parent • In reality, the purchase price of a subsidiary
represent the equity accounts disclosed on usually differs from the book value of the shares
the financial statements of the consolidated acquired.
entity.
• This differential is treated in the same way in
preparing consolidated financial statements as
for a merger, discussed in Chapter 1.
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Difference between Cost and Book Value Intercompany Receivables and Payables
• Typical Situation: Generally speaking, if the • A single company cannot owe itself money,
parent paid more for the subsidiary than book that is, a company cannot report (in its
value of the shares acquired (a net debit financial statements) a receivable to itself
differential), the excess would be allocated and a payable to itself. Thus, with respect
(during the consolidation process) to specific to the consolidated balance sheet, the
assets and liabilities of the subsidiary, or to following entry is made to eliminate
goodwill. intercompany receivables and payables
between the parent and the subsidiary:
• Allocation of differentials is extensively Consolidated Accounts Payable BV *
discussed in Chapter 4. Consolidated Accounts Receivable BV
* BV = Book Value
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Single-Entity Viewpoint Mechanics of the Consolidation Process
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Noncontrolling Interest Combined Financial Statements
• The portion of the subsidiary net income • Financial statements sometimes are prepared
assigned to the noncontrolling interest normally for a group of companies when no one company
is deducted from earnings available to all in the group owns a majority of the common
shareholders to arrive at consolidated net stock of any other company in the group.
income in the consolidated income statement.
• Financial statements that include a group of
• Although this assignment of income does not related companies without including the parent
meet the definition of an expense, it normally is company or other owner are referred to as
accorded this expense-type treatment. combined financial statements.
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Parent Company Theory Parent Company Theory
• The parent company theory is perhaps better
suited to the modern corporation and the
preparation of consolidated financial statements
than is the proprietary approach. • Under parent company theory, separate
recognition is given in the consolidated balance
• The parent company theory recognizes that sheet to the noncontrolling interest’s claim on
although the parent does not have direct the net assets of the subsidiary and in the
ownership of the assets or direct responsibility consolidated income statement to the earnings
for the liabilities of the subsidiary, it has the assigned to the noncontrolling shareholders.
ability to exercise effective control over all of the
subsidiary’s assets and liabilities, not simply a
proportionate share.
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You Will Survive This Chapter !!!
• Remember: Chapter 3
• “You can’t own yourself.”
• “You can’t owe yourself money.”
• “You can’t make money selling to yourself.”
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