IPPTChap 003

Chapter 3
The Reporting Entity and

the Consolidation of
Less-than-Wholly-Owned
Subsidiaries with No
Differential
McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 3-1
Understand and explain the

usefulness and limitations of
consolidated
financial statements.
3-2
Consolidation: The Concept
 Parent creates or gains control of the subsidiary.

 The result: a single reporting entity.
S
3-3
Review
How do we report the results of subsidiaries?
Parent
Company
80% 51% 21%
Sub A Sub B Sub C
Consolidation Equity Method

(plus the Equity Method)
3-4
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.
3-5
Benefits of Consolidated Financial Statements
 Presented primarily for those parties having a

long-run interest in the parent company:
 shareholders,
 long-term creditors, or
 other resource providers.
 Provide a means of obtaining a clear picture of the
total resources of the combined entity that are
under the parent's control.
3-6
Limitations of Consolidated Financial Statements
 Results of individual companies not

disclosed (hides poor performance).
 Financial ratios are not necessarily
representative of any single company in the
consolidation.
 Similar accounts of different companies may
not be entirely comparable.
 Information is lost any time data sets are
aggregated.
3-7
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.
3-8
Practice Quiz Question #1
A primary benefit of consolidated

financial statements is that they
a. provide information directly applicable
to the needs of regulators.
b. obscure data of individual companies.
c. present data of two or more entities that
clearly reports their individual
performance.
d. give a picture of the use of resources
under the parent’s control.
e. none of the above.
3-9
Practice Quiz Question #1 Solution
A primary benefit of consolidated

financial statements is that they
a. provide information directly applicable
to the needs of regulators.
b. obscure data of individual companies.
c. present data of two or more entities that
clearly reports their individual
performance.
d. give a picture of the use of resources
under the parent’s control.
3-10
Understand and explain how

direct and indirect control
influence the
consolidation of a
subsidiary.
3-11
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.
3-12
Indirect Control Example
Does X control Y? Yes X Does X control Z? Yes
51% 75%
Y Z
20% 40%
Does Y control K? No Does Z control K? No

K
Does X control K?
Yes, indirectly through Y and Z!
X must consolidate Y, Z, and K. 3-13
X
 Ability to Exercise Control
90%
 Sometimes, majority stockholders may
not be able to exercise control even Y
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.
3-14
 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.
3-15
 Changing Concept of the Reporting Entity

 Guidance in ASC 810-10-55, 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
3-16
 The 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.
3-17
 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.
3-18
P owns 60% of X and 75% of Y. If X

and Y jointly own 100% of Z, under
what circumstance would P not be
deemed to control Z?
a. Z is a bank.
b. Z’s products are largely sold overseas.
c. Z is currently in Chapter 11 bankruptcy.
d. Z has a CEO known to have a bad temper
and a serious gambling habit.
3-19
P owns 60% of X and 75% of Y. If X

and Y jointly own 100% of Z, under
what circumstance would P not be
deemed to control Z?
a. Z is a bank.
b. Z’s products are largely sold overseas.
c. Z is currently in Chapter 11 bankruptcy.
d. Z has a CEO known to have a bad temper
and a serious gambling habit.
3-20
Understand and explain

differences in the
consolidation process when
the subsidiary is not wholly
owned.
3-21
Noncontrolling Interest
 Only a controlling interest is needed for the parent

to consolidate the subsidiary—not 100% interest.
 Shareholders of the subsidiary other than the parent
are referred to as “noncontrolling” shareholders.
 Noncontrolling interest refers to the claim of these
shareholders on the income and net assets of the
subsidiary.
NCI Parent
<50% >50%
Sub
3-22
Noncontrolling Interest (NCI)
 What is a noncontrolling interest (NCI)?

 Voting shares not owned by the parent company
 NCI was formerly called the “Minority Interest”
Two Issues:
NCI Parent (1) Should 100% of the
financial statements
<50% >50% be consolidated?
(2) Where to report NCI
Sub in the financial
statements?
3-23
Issue 1: Should 100% be Consolidated?
Proportional Full
Consolidation Consolidation
Percent
< 100% 100%
Consolidated?
Reports NCI
No Yes
Amounts?
Complies with
No Yes
US GAAP?
Relative
Easy Hard
Complexity?
3-24
Issue 1: Should 100% be Consolidated?
 Full consolidation required by US GAAP

(100%)
 This means two special accounts appear in
consolidated statements:
 NCI in Net Income of Sub
 Like an “expense” in the consolidated income
statement
 “Reported income that doesn’t belong to us.”
 NCI in Net Assets of Sub
 Equity of unrelated owners
 “Net assets on our balance sheet not belonging to us.”
3-25
Issue 2: Where to report NCI in Net Assets?
 Old rules: Could report it in equity,

liabilities, or “no man’s land” between
liabilities and equity.
 New rules: Must report in equity
 ASC 810-10-55 makes clear that the
noncontrolling interest’s claim on net assets is an
element of equity, not a liability.
3-26
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 810-10-50 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.
3-27
The noncontrolling interest in a

corporation can best be describe as
a. a group of disinterested shareholders
who rarely vote on company issues.
b. all employees below the manager level.
c. all shareholders other than the parent
company.
d. a group of investors who plan to sell
their stock within the next twelve
months .
3-28
The noncontrolling interest in a

corporation can best be describe as
a. a group of disinterested shareholders
who rarely vote on company issues.
b. all employees below the manager level.
c. all shareholders other than the parent
company.
d. a group of investors who plan to sell
their stock within the next twelve
months .
3-29
Make calculations and

prepare basic elimination
entries for the consolidation
of a less-than-wholly-owned
subsidiary.
3-30
Summary of differences in consolidation
Wholly Owned Partially Owned

Subsidiary Subsidiary
Investment = No
Book Value Chapter 2 Chapter 3 Differential
Investment >
Book Value Chapter 4 Chapter 5 Differential
No NCI NCI
Shareholders Shareholders
3-31
Consolidation of Less-than-wholly-owned Subs
 The entity theory requires that the entity’s

entire income and value be reported.
 The subsidiary’s income is divided between the parent
(controlling interest) and the NCI shareholders.
 The subsidiary’s net assets are divided between the
parent (controlling interest) and the NCI shareholders.
 Basic elimination entry is modified to split both:
Sub Equity Accounts 100%
Income from Sub XXX
NCI in Net Income of Sub XXX
Dividends Declared by Sub 100%
Investment in Sub XXX
NCI in Net Assets of Sub XXX
3-32
The primary difference in

consolidating a less than wholly
owned subsidiary relative to a wholly
owned subsidiary is
a. income and net assets of the subsidiary
must be divided between the parent and
the NCI shareholders.
b. the title of the worksheet must specify
“Less than wholly owned.”
c. you only consolidate the parent’s %
ownership.
d. There is no difference.
3-33
The primary difference in

consolidating a less than wholly
owned subsidiary relative to a wholly
owned subsidiary is
a. income and net assets of the subsidiary
must be divided between the parent and
the NCI shareholders.
b. the title of the worksheet must specify
“Less than wholly owned.”
c. you only consolidate the parent’s %
ownership.
3-34
Group Exercise 1: Basic Elimination Entry
The following information is given:
1) Photo owns 70% of Snap Photo
2) Snap’s net income for 20X4 is $160,000
3) Photo’s net income for 20X4 from its own separate operations is 70%
$500,000.
4) Snap’s declares dividends of $12,000 during 20X4.
5) Snap has 10,000 shares of $4 par stock outstanding that were Snap
originally issued at $14 per share.
6) Snap’s beginning balance in Retained Earnings for 20X4 is $120,000.
Book Value Calculations
Investment Additional
Account = Common Paid-in Retained
NCI (30%) (70%) Stock Capital Earnings
Beginning Balance
+ Net Income
 Dividends
Ending Balance
3-35
Beginning Balance $78,000 $182,000 $40,000 $100,000 $120,000
+ Net Income 48,000 112,000 160,000
Dividends (3,600) (8,400) (12,000)
Ending Balance $122,400 $285,600 $40,000 $100,000 $268,000
Basic Elimination Entry

Common Stock
Investment in Snap Add PIC – CS
Beg. Bal. 182,000 Retained Earnings, BB
70% NI 112,000 70% Div. 8,400 Income from Snap
End. Bal. 285,600 NCI in Net Income
Dividends Declared
Investment in Snap
NCI in Net Assets
3-36
+ Net Income 48,000 112,000 160,000
Dividends (3,600) (8,400) (12,000)
Ending Balance $122,400 $285,600 $40,000 $100,000 $268,000

Common Stock
Investment in Snap Add PIC – CS
Beg. Bal. 182,000 Retained Earnings, BB
70% NI 112,000 70% Div. 8,400 Income from Snap
End. Bal. 285,600 NCI in Net Income
Dividends Declared
Investment in Snap
NCI in Net Assets
3-37
+ Net Income 48,000 112,000 160,000
Dividends (3,600) (8,400) (12,000)
Ending Balance $122,400 $285,600 $40,000 $100,000 $268,000

Common Stock 40,000
Investment in Snap Add PIC – CS 100,000
Beg. Bal. 182,000 Retained Earnings, BB 120,000
70% NI 112,000 70% Div. 8,400 Income from Snap 112,000
End. Bal. 285,600 NCI in Net Income 48,000
Dividends Declared 12,000
Investment in Snap 285,600
NCI in Net Assets 122,400
3-38
Prepare a consolidation
worksheet for a less-than-
wholly-owned
consolidation.
3-39
Consolidation of < Wholly Owned Subs
 The worksheet is modified when the parent

owns less than 100% of the subsidiary.
 The total “Net Income” is divided between:
 the noncontrolling interest (NCI shareholders) and
 the controlling interest (the parent company)
Elimination Entries
Pinkett, Inc. Smith, Inc. DR CR Consolidated
Income Statement
Sales $ 840,000 $ 300,000
Less: COGS (516,000) (156,000)
Less: Depreciation Expense (12,000) (10,000)
Less: Other Expenses (192,000) (98,000)
Income from Smith, Inc. 32,400 32,400
Net Income $ 152,400 $ 36,000 32,400
NCI in Net Income 3,600
CI In Net Income $ 152,400 $ 36,000 36,000
3-40
The primary difference in the

worksheet when consolidating a less
than wholly owned subsidiary is
a. only the parent’s % is consolidated.
b. extra columns are added to split the
subsidiary into two or more pieces.
c. extra rows are added to divide the net
income and net assets of the sub
between the parent and NCI
shareholders.
3-41
The primary difference in the

worksheet when consolidating a less
than wholly owned subsidiary is
a. only the parent’s % is consolidated.
b. extra columns are added to split the
subsidiary into two or more pieces.
c. extra rows are added to divide the net
income and net assets of the sub
between the parent and NCI
shareholders.
3-42
Group Exercise 2: Consolidation < 100%
Elimination Entries
Income Statement
Sales $ 840,000 $ 300,000
Less: COGS (516,000) (156,000)
Less: Depreciation expense (12,000) (10,000)
Income from Smith, Inc. 32,400
Net Income $ 152,400 $ 36,000
NCI in Net Income
CI in Net Income $ 152,400 $ 36,000 Assume Pinkett only purchases
Statement of Retained Earnings
90% of Smith.
Balances, 1/1/X8 $ 124,800 $ 72,000
Add: Net Income 152,400 36,000
Less: Dividends (108,000) (12,000) REQUIRED
Balances, 12/31/X8 $ 169,200 $ 96,000
Balance Sheet • Prepare an analysis of the

Cash $ 58,800 $ 48,000
Accounts Receivable 114,000 66,000 investment for 20X8.
Inventory 204,000 90,000
Investment in Sub 140,400 • Prepare all consolidation
Property & Equipment
Accumulated Depreciation
336,000
(144,000)
210,000
(30,000)
entries as of 12/31/X8.
Total Assets $ 709,200 $ 384,000
• Prepare a consolidation
Payables & Accruals $ 168,000 84,000 worksheet at 12/31/X8.
Long-term Debt 360,000 144,000
Common Stock 12,000 60,000
Retained Earnings 169,200 96,000
NCI in Net Assets
Total Liabilities & Equity $ 709,200 384,000
3-43
Group Exercise 2: Solution
Parent’s Subsidiary’s Equity Accounts
NCI Investment = Common Retained
(10%) Account (90%) Stock Earnings
Balances, 1/1/X8 NCI (10%) (90%) Stock
Earnings
+ Net Income
 Dividends
Balances, 12/31/X8
3-44
Balances, 1/1/X8 NCI (10%)118,800 (90%)
13,200 Stock
60,000 72,000
Earnings
+ Net Income 3,600 32,400 36,000
 Dividends (1,200) (10,800) (12,000)
Balances, 12/31/X8 15,600 140,400 60,000 96,000

Common Stock
Retained Earnings, BB
Income from Smith
NCI in Net Income
Dividends Declared
Investment in Smith
NCI in Net Assets
3-45
Balances, 1/1/X8 13,200 118,800 60,000 72,000
+ Net Income 3,600 32,400 36,000
 Dividends (1,200) (10,800) (12,000)
Balances, 12/31/X8 15,600 140,400 60,000 96,000

Common Stock
Retained Earnings, BB
Income from Smith
NCI in Net Income
Dividends Declared
Investment in Smith
NCI in Net Assets
3-46
Balances, 1/1/X8 13,200 118,800 60,000 72,000
+ Net Income 3,600 32,400 36,000
 Dividends (1,200) (10,800) (12,000)
Balances, 12/31/X8 15,600 140,400 60,000 96,000

Common Stock 60,000
Retained Earnings, BB 72,000
Income from Smith 32,400
Dividends Declared 12,000
Investment in Smith 140,400
3-47
Don’t forget the accumulated depreciation elimination entry:
Accumulated Depreciation 20,000

Buildings and Equipment 20,000
Property, Plant & Equipment Accumulated Depreciation

210,000 20,000
3-48
Don’t forget the accumulated depreciation elimination entry:
Accumulated Depreciation 20,000

Buildings and Equipment 20,000
Property, Plant & Equipment Accumulated Depreciation

210,000 20,000
20,000 20,000
190,000 0
Shows the Buildings and Equipment “as if” they have been
recorded on the Sub’s books as new assets at book value.
3-49
Elimination Entries
Income Statement
Sales $ 840,000 $ 300,000
Less: COGS (516,000) (156,000)
Less: Depreciation expense (12,000) (10,000)
Income from Smith, Inc. 32,400
Net Income $ 152,400 $ 36,000
NCI in Net Income
CI in Net Income $ 152,400 $ 36,000

Balances, 1/1/X8 $ 124,800 $ 72,000
Add: Net Income 152,400 36,000
Less: Dividends (108,000) (12,000)
Balances, 12/31/X8 $ 169,200 $ 96,000
Balance Sheet
Cash $ 58,800 $ 48,000
Accounts Receivable 114,000 66,000
Inventory 204,000 90,000
Investment in Sub 140,400
Property & Equipment 336,000 210,000
Accumulated Depreciation (144,000) (30,000)
Total Assets $ 709,200 $ 384,000
Payables & Accruals $ 168,000 84,000

Common Stock 12,000 60,000
Retained Earnings 169,200 96,000
NCI in Net Assets
Total Liabilities & Equity $ 709,200 384,000
3-50
Elimination Entries
Income Statement
Sales $ 840,000 $ 300,000
Less: COGS (516,000) (156,000)
Less: Depreciation Expense (12,000) (10,000)
Net Income $ 152,400 $ 36,000 32,400 0
CI in Net Income $ 152,400 $ 36,000 36,000 0

Balances, 1/1/X8 $ 124,800 $ 72,000 72,000
Add: Net Income 152,400 36,000 36,000 0
Less: Dividends (108,000) (12,000) 12,000
Balances, 12/31/X8 $ 169,200 $ 96,000 108,000 12,000
Balance Sheet
Cash $ 58,800 $ 48,000
Accounts Receivable 114,000 66,000
Inventory 204,000 90,000
Investment in Sub 140,400 140,400
Property & Equipment 336,000 210,000 20,000
Accumulated Depreciation (144,000) (30,000) 20,000
Total Assets $ 709,200 $ 384,000 20,000 160,400
Payables & Accruals $ 168,000 84,000

Common Stock 12,000 60,000 60,000
Retained Earnings 169,200 96,000 108,000 12,000
Total Liabilities & Equity $ 709,200 384,000 168,000 27,600
3-51
Elimination Entries
Income Statement
Sales $ 840,000 $ 300,000 $ 1,140,000
Less: COGS (516,000) (156,000) (672,000)
Less: Depreciation Expense (12,000) (10,000) (22,000)
Less: Other Expenses (192,000) (98,000) (290,000)
Net Income $ 152,400 $ 36,000 32,400 0 $ 156,000
NCI in Net Income 3,600 (3,600)
CI in Net Income $ 152,400 $ 36,000 36,000 0 $ 152,400

Balances, 1/1/X8 $ 124,800 $ 72,000 72,000 $ 124,800
Add: Net Income 152,400 36,000 36,000 0 152,400
Less: Dividends (108,000) (12,000) 12,000 (108,000)
Balances, 12/31/X8 $ 169,200 $ 96,000 108,000 12,000 $ 169,200
Balance Sheet
Cash $ 58,800 $ 48,000 $ 106,800
Accounts Receivable 114,000 66,000 180,000
Inventory 204,000 90,000 294,000
Investment in Sub 140,400 140,400
Property & Equipment 336,000 210,000 20,000 526,000
Accumulated Depreciation (144,000) (30,000) 20,000 (154,000)
Total Assets $ 709,200 $ 384,000 140,400 $ 952,800
Payables & Accruals $ 168,000 84,000 $ 252,000

Long-term Debt 360,000 144,000 504,000
Common Stock 12,000 60,000 60,000 12,000
Retained Earnings 169,200 96,000 108,000 12,000 169,200
NCI in Net Assets 15,600 15,600
Total Liabilities & Equity $ 709,200 384,000 168,000 27,600 $ 952,800
3-52

purpose of combined
financial statements and
how they differ from
consolidated financial
statements.
3-53
Combined Financial Statements
 Combined financial statements are sometimes

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, such as when
 an individual, not a corporation, owns or controls
multiple companies.
 a parent company prepares financial statement
that only include its subsidiaries, and not itself.
 a parent company prepares financial statements
for its subsidiaries by operating group.
3-54
Combined Financial Statements
 The procedures used to prepare combined

financial statements are essentially the same
as those used in preparing consolidated
financial statements:
 Eliminate all intercompany receivables, payables,
transactions, unrealized profits and losses,
ownership, and the associated portion of
stockholders’ equity.
 The remaining stockholders’ equity is divided into
the portions accruing to the controlling and non-
controlling interests.
3-55
Which of the following statements is

true regarding combined financial
statements:
a. The parent company is always included in
combined financial statements.
b. Companies included in combined financial
statements simultaneously own a majority of
each others stock.
c. Combined financial statements combine the
financial statements of a group of companies
that have the same owner.
d. All intercompany transactions remain in the
accounts of combined financial statements.
3-56
Which of the following statements is

true regarding combined financial
statements:
a. The parent company is always included in
combined financial statements.
b. Companies included in combined financial
statements simultaneously own a majority of
each others stock.
c. Combined financial statements combine the
financial statements of a group of companies
that have the same owner.
d. All intercompany transactions remain in the
accounts of combined financial statements.
3-57

rules related to the
consolidation of variable
interest entities.
3-58
The Rise and FALL of Enron
Press Release Tuesday, October 16, 2001
ENRON REPORTS NON-RECURRING CHARGES OF $1.01

BILLION AFTER-TAX.
3-59
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.
3-60
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, or
 has equity investors that do not provide sufficient
financial resources to support the entity’s
activities.
3-61
Enron’s Accounting “Sleight of Hand”
Special Purpose Entities (SPEs)

 What is normally the business purpose?
 Bundle peripheral activities and have them
done by an independent, but close, friend.
 Examples:
 Acquire financing for a project
 Package receivables and sell them to third parties
 What was Enron’s purpose?

 Move liabilities off the balance sheet
 Provide favorable terms for some transactions
3-62
“Raptors”
 Established by Enron CFO to provide a quick

buyer for Enron assets.
 Option 1: Find a bona fide third party.
 Can’t find anyone?
 Option 2: Establish a SPE to take the other side
of the transaction.
 Where does the financing come from?
 97% sponsoring institution
 3% third party
3-63
Example: The Chewco Raptor
A diagram of the Chewco transaction is set forth below:
3-64
Raptor’s Impact on Earnings
Raptor’s
Quarter Earnings Raptors
Impact
3Q 2000 $364 $295 $69
4Q 2000 286 (176) 462
1Q 2001 536 281 255
2Q 2001 530 490 40
3Q 2001 (210) (461) 251
Total $1,506 $429 $1,077
3-65
Variable Interest Entities (VIEs)
 As a result of the Enron collapse and other notable
scandals related to SPEs, the FASB issued guidance on
VIEs in 2003 (ASC 810-10-25) and updated this
guidance later the same year (ASC 810-10-38C).
 What is a VIE?
 An entity that either
 does not have equity investors with voting rights and a
percentage of profits and losses, OR
 has equity investors that do not provide sufficient
financial resources to support the entity’s activities.
 What is a variable interest?
 an interest that changes with changes in the VIE’s net assets.
3-66
Variable Interest Entities
 ASC 810-10-25 uses the term variable interest

entities to encompass SPEs and other entities
falling within its conditions.
 ASC 810-10-38C 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.
3-67
Purpose of ASC 810
The main effect of ASC 810-10-

38C is to capture those
investment relationships in
which a controlling financial
interest is not indicated by
voting rights, but is indicated by
residual interests in risks and
benefits, which is the conceptual
definition of ownership in CON6.
3-68
Example: Variable Interest Entities
Senior Debt Junior Debt

($85k) ($12k)
Lease Pmts. $100k

ABC Corp. Leasing Corp. Building Owner
Use of Building Building
Investor ($3k)
How would ABC Corp. typically determine whether to consolidate Leasing Corp.?
 A controlling financial interest through voting rights.
What if ABC Corp. were a related party to Investor?
What if ABC Corp. guaranteed the value of the building at the end of the lease?
What if ABC Corp. received any residual value above $100k when building sold?
3-69
Variable Interest Entities (VIEs)
Variable Interest Relationships

 Situations in which an entity receives benefits
and/or is exposed to risks similar to those
received from having a majority ownership
interest.
 Results from contractual arrangements.
3-70
VIEs: “Contractual Arrangements”
 Contractual Arrangement Types:

 Options
 Leases
 Guarantees of asset recovery values
 Guarantees of debt repayment
 Contractual arrangements may exist
simultaneously with a less than majority
ownership in a VIE.
3-71
VIEs: Potential Variable Interests
 Potential Variable Interests

 Subordinated loans to a VIE.
 Equity interests in a VIE (50% or less).
 Guarantees to a VIE’s lenders or equity
holders (that reduce the true risk of these
parties).
 Written put options on a VIE’s assets held
by a VIE or its lenders or equity holders.
 Forward contracts on purchases and sales.
3-72
VIEs: Most are “SPEs”
 Special Purpose Entities

 Legally structured entities to serve a specific,
predetermined, limited purpose.
 May be a corporation, partnership, trust, or some
other legal entity.
 Creator is called the “sponsor.”
 Usually thinly capitalized.
 Most commonly used for securitizations (of
receivables).
3-73
VIEs: The Primary Beneficiary
 The primary beneficiary of a VIE must consolidate

the VIE.
 The primary beneficiary is the entity that
 has the power to direct the activities of a VIE that most
significantly impact the VIE’s economic performance.
 will absorb losses of the VIE that could potentially be
significant to the VIE or will receive the benefits from
the VIE that could potentially be significant to the VIE.
 Only one primary beneficiary can exist for a VIE
(by definition).
3-74
Group Exercise 3: To Consolidate (or not)?
Parch Inc. and Rees Urch, Parch’s former head of R&D, formed
Sede Inc., which will perform research and development.
Sede issued 10,000 shares of common stock to Urch, who is
now Sede’s president. Parch lent $800,000 to Sede for initial
working capital in return for a note receivable that can be
converted at will into 100,000 shares of Sede’s common stock.
Parch also granted Sede a line of credit of $1,000,000.
REQUIRED
1. Is consolidation appropriate?
2. What would Parch accomplish with this arrangement?
3. If consolidation were not appropriate, what serious
reporting issue exists regarding Parch’s separate
financial statements?
3-75
Group Exercise 3: To Consolidate (or not)?
Parch Inc. and Rees Urch, Parch’s former head of R&D, formed
Sede Inc., which will perform research and development.
Sede issued 10,000 shares of common stock to Urch, who is
now Sede’s president. Parch lent $800,000 to Sede for initial
working capital in return for a note receivable that can be
converted at will into 100,000 shares of Sede’s common stock.
Parch also granted Sede a line of credit of $1,000,000.
Rees Urch
10,000 shares
$1,000,000
Line of credit
Parch Sede
$800,000 loan
Option
100,000 shares 3-76
Requirement 1: Is consolidation appropriate?
Consolidation is appropriate.
1. By having an option exercisable at will, Parch has the exclusive
potential to control Sede.
2. In substance, it is doubtful that Sede would make any decisions not to
Parch’s liking, since Parch could immediately exercise the option and
prevent those decisions from being implemented. Thus it seems that
Parch effectively has control over Sede from a substance versus form
perspective.
3. If conditions had to be met before the option could be exercised,
however, that might change things.
4. Sede’s total dependency on Parch for financing also points toward
consolidation.
Presumably Sede’s president, as sole owner of the company, appointed the
board of directors. Thus technically, Parch did not appoint the board, which
implies that it does not control Sede. It is doubtful, however, that the
president would appoint board members whom Parch did not approve.
3-77
Requirement 2: What would Parch accomplish with this

arrangement?
 Parch avoids recording research and development expense
on its books.
Requirement 3: If consolidation were not appropriate, what

serious reporting issue exists regarding Parch’s separate
financial statements?
 A serious reporting issue for Parch is whether its $800,000
note receivable from Sede is collectible—a problem that
grows as Sede spends the money on research and
development. The arrangement may be a disguised manner
of effectively capitalizing research and development costs.
3-78
On 1/1/X2, Pocahontas, Inc. invested $480,000 in

Smith (80% owned). For 20X2, Smith:
(1) earned $70,000,
(2) declared dividends of $60,000, and
(3) paid dividends of $50,000.
What amounts does Pocahontas report?
Cost Equity
Investment income for 20X2
Investment in Smith at year-end
Retained earnings increase
3-79

Smith (80% owned). For 20X2, Smith:
(1) earned $70,000,
What amounts does Pocahontas report?
Cost Equity
Investment income for 20X2 $48,000 $56,000
Investment in Smith at year-end $480,000 $488,000
Retained earnings increase $48,000 $56,000
3-80

Smith (80% owned) and NCI shareholders invested
$120,000. For 20X2, Smith:
(1) earned $70,000,
What amounts does Pocahontas report for the
following items?
NCI in net income for 20X2
NCI in net assets at 12/31/X2
Parent’s retained earnings increase
3-81

Smith (80% owned) and NCI shareholders invested
$120,000. For 20X2, Smith:
(1) earned $70,000,
What amounts does Pocahontas report for the
following items?
NCI in net income for 20X2 $14,000
NCI in net assets at 12/31/X2 $122,000
Parent’s retained earnings increase $56,000
3-82

differences in consolidation
rules under U.S. GAAP
and IFRS.
3-83
IFRS Differences Related to VIEs and SPEs
 U.S. GAAP and International Financial

Reporting Standards (IFRS) are rapidly
converging.
 The FASB and the IASB are working together to
remove differences in existing standards.
 They are also working jointly on all new
standards so that agreed-upon standards can be
adopted.
 Despite convergence efforts, there are still
some differences related to VIEs and SPEs.
 See Figure 3-5 on p. 124 of the text.
3-84
Key Differences between U.S. GAAP and IFRS
Topic U.S. GAAP IFRS
Determination  Normally, control is  Normally, control is determined
of Control determined by majority by majority ownership of voting
ownership of voting shares. shares.
 However, majority  In addition to voting shares,
ownership may not indicate convertible instruments and
control of a VIE. other contractual rights that
 Thus, VIE rules must be could affect control are
evaluated first in all considered.
situations.  A parent with less than 50
 The primary beneficiary percent of the voting shares
must consolidate a VIE. could have control through
 The majority shareholder contractual arrangements
consolidates most non-VIEs. allowing control of votes of the
 Control is based on direct or board of directors.
indirect voting interests.  Control over SPEs is determined
 An entity with less than 50 based on judgment and relevant
percent ownership may facts.
have “effective control”  Substance over form considered
through other contractual in determining whether 85an SPE
arrangements. should be consolidated. 3-85
Related Parties  Interests held by related  There is no specific provision for
parties and “de facto” agents related parties or de facto agents.
may be considered in
determining control of a VIE.
Definitions of  SPEs can be VIEs.  Considers specific indicators of
VIEs versus  Consolidation rules focus on whether an entity has control of
SPEs whether an entity is a VIE an SPE: (1) whether the SPE
(regardless of whether or conducts activities for the entity,
not it is an SPE). (2) whether the entity has
 This guidance applies only to decision-making power to obtain
legal entities. majority of benefits from the SPE,
(3) whether the entity has the
right to majority of benefits from
the SPE, and (4) whether the
entity has majority of the SPE’s
residual or risks.
 This guidance applies whether or
not conducted by a legal entity.
3-86
Disclosure  Disclosures required for  No SPE-specific disclosure
determining control of a VIE. requirements.
 Entities must disclose  There are specific disclosure
whether or not they are the requirements related to
primary beneficiary of consolidation in general.
related VIEs.
Accounting for  Owners typically share  Joint ventures can be accounted
Joint Ventures control (often with 50-50 for using either proportionate
ownership). consolidation or the equity
 If the joint venture is a VIE, method.
contracts must be  Proportionate consolidation
considered to determine reports the venturer’s share of
whether consolidation is the assets, liabilities, income, and
required. expenses on a line-by-line basis
 If the joint venture is not a based on the venturer’s financial
VIE, venturers use the equity statement line items.
method.
 Proportional consolidation
generally not permitted.
3-87
Which of the following differs

between U.S. GAAP and IFRS in the
determination of control?
a. In U.S. GAAP, control is solely based on
ownership but IFRS considers other
factors.
b. U.S. GAAP ignores direct stock
ownership, while IFRS considers it.
c. In U.S. GAAP, rules related to VIEs must
be followed, but IFRS has not specifically
addressed VIEs (only SPEs).
e. The determination of control is identical
under U.S. GAAP and IFRS.
3-88
Which of the following differs

between U.S. GAAP and IFRS in the
determination of control?
a. In U.S. GAAP, control is solely based on
ownership but IFRS considers other
factors.
b. U.S. GAAP ignores direct stock
ownership, while IFRS considers it.
c. In U.S. GAAP, rules related to VIEs must
be followed, but IFRS has not specifically
addressed VIEs (only SPEs).
e. The determination of control is identical
under U.S. GAAP and IFRS..
3-89
Appendix 3B

differences in theories of
consolidation.
3-90
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 ASC 805, the FASB’s
approach to consolidation now focuses on the
entity theory.
3-91
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.
3-92
Parent Company Theory
 Recognizes that although 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.
3-93
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.
3-94
Recognition of Subsidiary Income
3-95
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.
3-96
Reporting Net Assets of the Subsidiary
3-97
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 ASC 805-50-30, consolidation follows
largely an entity-theory approach.
 Accordingly, the full entity fair value increment
and the full amount of goodwill are recognized.
3-98
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.
3-99
Current consolidation practice in

the U.S. adopts the:
a. proprietary theory.
b. parent company theory.
c. equity theory.
d. entity theory.
e. None of the above.
3-100
Current consolidation practice in

the U.S. adopts the:
a. proprietary theory.
b. parent company theory.
c. equity theory.
d. entity theory.
e. None of the above.
3-101
Conclusion
The End
3-102

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Chapter 3

The Reporting Entity and

Understand and explain the

 Parent creates or gains control of the subsidiary.

How do we report the results of subsidiaries?

80% 51% 21%

Sub A Sub B Sub C

Consolidation Equity Method

Consolidated financial statements present the

 Presented primarily for those parties having a

 Results of individual companies not

 Creditors, preferred stockholders, and

A primary benefit of consolidated

A primary benefit of consolidated

Understand and explain how

 Traditional view of control includes:

Does X control Y? Yes X Does X control Z? Yes

Does Y control K? No Does Z control K? No

 The unconsolidated subsidiary is reported

 Differences in Fiscal Periods

 Changing Concept of the Reporting Entity

 The FASB has been attempting to move

 Defining the accounting entity would help

P owns 60% of X and 75% of Y. If X

P owns 60% of X and 75% of Y. If X

Understand and explain

 Only a controlling interest is needed for the parent

 What is a noncontrolling interest (NCI)?

 Full consolidation required by US GAAP

 Old rules: Could report it in equity,

 Computation of income to the

The noncontrolling interest in a

The noncontrolling interest in a

Make calculations and

Wholly Owned Partially Owned

 The entity theory requires that the entity’s

The primary difference in

The primary difference in

Basic Elimination Entry

Basic Elimination Entry

Basic Elimination Entry

 The worksheet is modified when the parent

The primary difference in the

The primary difference in the

Balance Sheet • Prepare an analysis of the

Basic Elimination Entry

Basic Elimination Entry

Basic Elimination Entry

Accumulated Depreciation 20,000

Property, Plant & Equipment Accumulated Depreciation

Accumulated Depreciation 20,000

Property, Plant & Equipment Accumulated Depreciation

Statement of Retained Earnings

Payables & Accruals $ 168,000 84,000

Statement of Retained Earnings

Payables & Accruals $ 168,000 84,000

Statement of Retained Earnings

Payables & Accruals $ 168,000 84,000 $ 252,000