Chapter 3

The Reporting Entity and the

Consolidation of Less-than-Wholly
Owned Subsidiaries with No
Differential

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Consolidated Financial Statements
• Consolidated financial statements present
the financial position and results of
operations for a parent (controlling entity) and
one or more subsidiaries (controlled entities)
as if the individual entities actually were a
single company or entity.

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Consolidated Financial Statements
• Consolidation is required when a corporation owns a
majority of another corporation’s outstanding
common stock and occasionally under other
circumstances.
• Two companies are considered to be related when one
controls the other or both are under the common
control of another entity.
• The same accounting principles should be applied in
preparing consolidated financial statements as in
preparing separate-company financial statements.
• More useful than the separate financial statements of the
individual companies when the companies are related.

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 Benefits of Consolidated Financial
Statements

• Presented primarily for those parties having a long-

run interest in the parent company, including its
management, shareholders, long-term creditors or
other resource providers.

• Often provide the only means of obtaining a clear

picture of the total resources of the combined
entity that are under the parent's control.

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 Limitations of Consolidated Financial
Statements
• 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.

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 Limitations of Consolidated Financial
Statements
• 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.
• Information is lost any time data sets are
aggregated.

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 Subsidiary Financial Statements
• Creditors, preferred stockholders, and
noncontrolling common stockholders of
subsidiaries are most interested in the separate
financial statements of the subsidiaries in which
they have an interest.
• Because subsidiaries are legally separate from
their parents, the creditors and stockholders
of a subsidiary generally have no claim on
the parent, and the stockholders of the
subsidiary do not share in the profits of the
parent.
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 Concepts and Standards
• Traditional view of control
– ASC 810-10-10-10 indicates that consolidated
financial statements normally are appropriate for a
group of companies when one company “has a
controlling financial interest in the other
companies.”
– ASC 810-10-15 requires consolidation of all
majority-owned subsidiaries unless the parent is
unable to exercise control.

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 Concepts and Standards
• Less Than Majority Ownership
– A company may be able to direct the operating and
financing policies of another with less than majority
ownership.
– ASC 810-10-15 does not preclude consolidation with
less than majority ownership, but such consolidations
have seldom been found in practice.
– ASC 810-10-55 indicates that control can be obtained
without majority ownership of a company’s common
stock.

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 Concepts and Standards
• Traditional view of control includes:
– Direct control that occurs when one company
owns a majority of another company’s common
stock.
– Indirect control or pyramiding that occurs
when a company’s common stock is owned by
one or more other companies that are all under
common control.

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Indirect Control

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 Concepts and Standards
• Ability to Exercise Control
– Sometimes, majority stockholders may not be
able to exercise control even though they hold
more than 50 percent of outstanding voting stock.
• Subsidiary is in legal reorganization or
bankruptcy
• Foreign country restricts remittance of
subsidiary profits to domestic parent company
– The unconsolidated subsidiary is reported as an
intercorporate investment.

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 Concepts and Standards
• Differences in Fiscal Periods
– Difference in the fiscal periods of a parent and
subsidiary should not preclude consolidation.
– Often the fiscal period of the subsidiary is
changed to coincide with that of the parent.
– Another alternative is to adjust the financial
statement data of the subsidiary each period
to place the data on a basis consistent with the
fiscal period of the parent.

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 Concepts and Standards
• Changing Concept of the Reporting Entity
– ASC 810-10-15, requiring consolidation of all
majority-owned subsidiaries, was issued to
eliminate the inconsistencies found in practice
until a more comprehensive standard could be
issued.
– Completion of the FASB’s consolidation project
has been hampered by, among other things,
issues related to:
• Control
• Reporting entity
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 Concepts and Standards
• FASB has been attempting to move toward a
consolidation requirement for entities under
effective control.
– Ability to direct the policies of another entity even
though majority ownership is lacking.
– Even though ASC 805-10-55 indicates that control
can be achieved without majority ownership, a
comprehensive consolidation policy has yet to be
achieved.

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 Concepts and Standards
• Defining the accounting entity would help
resolve the issue of when to prepare
consolidated financial statements and what
entities should be included.
• ASC 810 deals only with selected issues related
to consolidated financial statements, leaving a
comprehensive consolidation policy until a later
time.

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 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 Parent

holdings.

Subsidiary
Consolidated Entity

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 Consolidation Process

• Intercorporate 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

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 Consolidation Process

• Intercorporate Stockholdings
– Parent’s retained earnings (less the Parent’s
common
unrealized intercompany profit) remains stock

as the only retained earnings figure

in the consolidated balance sheet.

Parent
Subsidiary’s
common
stock
Subsidiary

Consolidated Entity

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 Consolidation Process
• 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
Parent
payables in preparing the Intercompany

consolidated balance sheet. receivable/

payable

Subsidiary

Consolidated Entity
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 Consolidation Process

• Intercompany Sales
– The sale should be removed from the
combined revenues because it does not
represent a sale to an external party. Cost of
goods
• Remaining inventory must be restated to its
original cost to the consolidated
entity (transferring affiliate).
Parent
Sales

Subsidiary

Consolidated Entity
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 Consolidation Process
• 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.

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 Consolidation Process

• Single-Entity Viewpoint
– To understand the adjustments needed, one
should focus on:
1. identifying the treatment accorded a particular
item by each of the separate companies and
2. 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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 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 workpaper.
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 Mechanics of the Consolidation
Process
• 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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 Noncontrolling Interest
• For the parent to consolidate the subsidiary,
only a controlling interest is needed—not
100% interest.
• Those shareholders of the subsidiary other than
the parent are referred to as “noncontrolling” or
“minority” shareholders.
• Noncontrolling interest or minority interest
refers to the claim of these shareholders on the
income and net assets of the subsidiary.

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 Noncontrolling Interest
• Computation of income to the noncontrolling
interest: In uncomplicated situations, it is a
simple proportionate share of the subsidiary’s
net income.
• Presentation: ASC 805-10-50 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 noncontrolling stockholders
shown.

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 Noncontrolling Interest

• The noncontrolling 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.
• ASC 805-10-55 makes clear that the
noncontrolling interest’s claim on net assets
is an element of equity, not a liability.

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 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.

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 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.

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 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

Under the parent company theory, however, the noncontrolling interest’s

share of income is deducted to arrive at consolidated net income
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 Recognition of Subsidiary Net Assets

The parent company approach includes all of the subsidiary’s assets and
liabilities in the consolidated balance sheet, however, only the parent’s share
of any fair value increment and goodwill is included
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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.

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

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 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 noncontrolling
shareholders viewed as two separate groups,
each having an equity in the consolidated
entity.

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 Entity Theory
• 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
noncontrolling interest.

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 Current Practice
• ASC 805-50-30 has significantly changed the
preparation of consolidated financial
statements subsequent to the acquisition of
less-than-wholly owned subsidiaries.
– Under FASB ASC 805-50-50 consolidation
follows largely an entity-theory approach.
– Accordingly, the full entity fair value increment
and the full amount of goodwill are recognized.

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 Current Practice
• 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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 Effect of a Noncontrolling Interest

• When a subsidiary is less than wholly owned,

the consolidation procedures must be
modified slightly to recognize the
noncontrolling interest

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 Effect of a Noncontrolling Interest

• Consolidated Net Income

– In the absence of transactions between
companies included in the consolidation,
consolidated net income is equal to:
• The parent’s income from its own operations,
excluding any investment income from
consolidated subsidiaries, plus the net income
from each of the consolidated subsidiaries.

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 Effect of a Noncontrolling Interest

• The income attributable to the subsidiary

noncontrolling interest is deducted from
consolidated net income on the face of the
income statement to arrive at consolidated
net income attributable to the controlling
interest
– The income attributable to a noncontrolling
interest in a subsidiary is based on a
proportionate share of that subsidiary’s net
income
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 Effect of a Noncontrolling Interest

• Consolidated retained earnings

– That portion of the consolidated entity’s
undistributed earnings accruing to the
parent’s stockholders
– Calculated by adding the parent’s share of
subsidiary cumulative net income since
acquisition to the parent’s retained earnings
from its own operations and subtracting the
parent’s share of any differential write-off

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 Effect of a Noncontrolling Interest

• Consolidated retained earnings

– Retained earnings related to subsidiary
noncontrolling shareholders is included in the
Noncontrolling Interest amount reported in the
equity section of the consolidated balance
sheet
– More consistent with the parent company
theory rather than the entity approach

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Income recognized by the parent from all consolidated
subsidiaries, therefore, must be eliminated to avoid
double-counting. The subsidiary’s dividends must be
eliminated when consolidated statements are prepared so
that only dividend declarations related to the parent’s
shareholders are treated as dividends of the consolidated
entity. Thus, the basic elimination entry removes both the
investment income reflected in the parent’s income
statement and any dividends declared by the subsidiary
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