Chapter 3 Consolidated Financial Statements

1
Chapter 3 Consolidated Financial Statements

• FASB Statement No. 94, Consolidation of all
  Majority-owned Subsidiary requires that all
  subsidiaries must be consolidated unless the
  parent is precluded from exercising control or
  unless control is likely temporary.

2
Overview of the Consolidation Process

• The consolidation is to present the financial
  condition and the results of the operations for
  the parent and subsidiary as if they were one
  economic entity.
• Investment account is eliminated against the
  subsidiarys stockholders equity and to
  recognize the differential and allocation to the
  appropriate accounts
• Eliminate intercompany receivable payables

3
Consolidation Process (continued)

• To eliminate profits on inter-company sales

4
Combined Financial Statements

• Financial statements that include a group of
  related companies without including the parent
  company or other owner are referred to as
  combined financial statements
• Combined financial statements are typically
  prepared when an individual owns a number of
  companies and wishes to include them all in a
  single set of financial statements

5
Special-purpose entities (SPEs)

• SPEs are corporations, trusts, or partnerships
  created for a single specified purpose. They
  usually have no substantive operations and are
  used only for financing purposes.
• Qualifying SPEs as specified in FASB 140
• Demonstrably distinct from the transferor
• Its activities be significantly limited
• It hold only certain types of financial assets

6
SPEs (continued)

• If the conditions of FASB 140 are met, this type
  of SPE is not consolidated by the transferor of
  assets to the SPE

7
Variable interest entities(FASB Interpretation
46, issued in 2003)

• A variable interest entity is a legal structure
  used for business purposes, usually a
  corporation, trust, or partnership, that either
  (1) does not have equity investors that have
  voting rights and share in all of the entitys
  profits and losses, or (2) has equity investors
  that do not provide sufficient financial
  resources to support the entitys activities.

8
Variable interest entity (continued)

• The nature of each partys variable interest
  determines whether consolidation by that party is
  appropriate. An enterprise that will absorb a
  majority of the VIEs expected losses, receive a
  majority of the VIEs expected residual returns,
  or both, is called the primary beneficiary of the
  variable interest entity.
• The primary beneficiary must consolidate the VIE.
• If the entitys profits and losses are divided
  differently, the enterprise absorbing a majority
  of the losses will consolidate the variable
  interest entity.

9
Consolidation Theories

• Proprietary Theory- To include only parents
  proportionate share of the assets, liabilities,
  revenues, and expenses. Minority interest
  portion is excluded.
• Parent Company Theory Minority interest portion
  is included, but only at book value. Income to
  minority interest is considered as expense. The
  consolidated net income is only income to the
  majority interest.

10
Consolidation Therories (continued)

• The entity theory-- The full amounts of the
  assets and liabilities of both the parent and
  subsidiary are combined in the consolidated
  balance sheet. The minority interest portion is
  also based on fair values. The consolidated net
  income includes both income to majority as well
  as minority interest.

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Example Net asset valuation

• Suppose that P Company acquires 80 of the voting
  stock of S Company. One of the assets, Land,
  has a book value of 100,000 and fair market
  value of 120,000 at the time of acquisition.
• What amount of land of the S Company would be
  included in the consolidated balance sheet?
• (1) Proprietary Theory 120,000 x 80 96,000
• (2) Parent Company Theory 120,000 x 80
  100,000 x 20 116,000
• (3) Entity Theory 120,000 x 80 120,000 x 20
  120,000
• (4) Current practice same as the parent company
  theory, 116,000

12
Example Inter-company profit elimination

• Suppose that S Company, an 80-owned subsidiary
  of the P Corporation sold inventory to P and
  there is 10,000 unrealized profit in ending
  inventory.
• What amount of profit is to be eliminated in the
  consolidated financial statements?
• (1) Proprietary theory 10,000 x 80 8,000
• (2) Parent company theory 10,000 x 80 8,000
• (3) Entity theory 10,000 x 100 10,000
• (4) Current practice same as the entity theory,
  10,000

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E3-1

• 1. d
• 2. c
• 3. b
• 4. a
• 5. b

14
E3-3

• 1. a
• 2. b
• 3. b
• 4. c
• 5. a

15
E3-4

• 1. d
• 2. b
• 3. b
• 4. d

16
P3-23

• 1. d
• 2. c
• 3. b
• 4. c
• 5. c

17
P3-37

• a. Proprietary theory
• Cash and inventory 360,000
• Building and equipment (net)
  535,000
• Goodwill
  15,000
• B. Parent company theory
• Cash and inventory
  380,000
• Building and equipment
  565,000
• Goodwill
  15,000

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P3-37 (continued)

• C. Entity theory
• Cash and inventory
  380,000
• Building and equipment (net)
  580,000
• Goodwill
  20,000
• D. Current accounting practice
• Cash and inventory
  380,000
• Buildings and equipment (net)
  565,000
• Goodwill
  15,000