Chap5 - Baker Adaptation

4-1
Baker / Lembke / King
The Reporting
Entity and
Consolidated
Financial
3
Electronic Presentation
by Douglas Cloud
Pepperdine University
Statements
McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
3-2
Consolidated Financial Statements
• Many corporations are composed of

numerous separate companies and,
in turn, prepare consolidated financial
statements.
3-3
• 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.
3-4
• Consolidation is required when a corporation

owns a majority of another corporation’s
outstanding common stock.
3-5
• The accounting principles applied in the

preparation of the consolidated financial
statements are the same accounting
principles applied in preparing separate-
company financial statements.
3-6
• Two companies are considered to be

related companies when one controls
the other company.
3-7
• Consolidated financial statements are

generally considered to be more useful
than the separate financial statements
of the individual companies when the
companies are related.
3-8
• Whether the subsidiary is acquired or

created, each individual company maintains
its own accounting records, but consolidated
financial statements are needed to present
the companies together as a single economic
entity for general-purpose financial reporting.
3-9
• Two companies are considered to be related

or affiliate companies when one controls the
other or both are under the common control
of another entity.
3-10
Benefits
• Consolidated financial statements are

presented primarily for those parties having a
long-run interest in the parent company,
including the parent’s shareholders, creditors
or other resource providers.
• Consolidated financial statements 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.
3-11
Limitations
• While consolidated financial statements are

useful, their limitations also must be kept in
mind.
• Some information is lost any time data sets
are aggregated; this is particularly true when
the information involves an aggregation
across companies that have substantially
different operating characteristics.
3-12
Subsidiary Financial Statements
• 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.
3-13
Subsidiary Financial Statements
• Therefore, consolidated financial statements

usually are of little use to those interested in
obtaining information about the assets,
capital, or income of individual subsidiaries.
3-14
The Tradition View of Control
• The professional guidance regarding

consolidated financial statements is provided
in PSAK 4.
• Under current standards, consolidated

financial statements must be prepared if one
corporation owns a majority of another
corporation’s outstanding common stock.
3-15
The Tradition View of Control
• PSAK 4 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.”
3-16
Less Than Majority Ownership
• Although majority ownership is the most

common means of acquiring control, a
company may be able to direct the operating
and financing policies of another with less
than majority ownership, such as when the
remainder of the stock is widely held.
3-17
Less Than Majority Ownership
• PSAK 4 does not preclude consolidation

with less than majority ownership, but such
consolidations have seldom been found in
practice.
3-18
Indirect Control
• The traditional view of control includes

both direct and indirect control.
• Direct control typically occurs when one

company owns a majority of another
company’s common stock.
3-19
Indirect Control
• Indirect control (or pyramiding) occurs

when a company’s common stock is
owned by one or more other companies
that are all under common control.
3-20
Indirect Control
P owns 80 percent of X
X owns 60 percent of Z
P indirectly controls Z
3-21
Indirect Control
.90 .70
X Y
.40 .30
3-22
Indirect Control
.80
.90
.80
W X Y
.30
.15 .15
3-23
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:
• Subsidiary is in legal reorganization or
bankruptcy
• Foreign country restricts remittance of
subsidiary profits to domestic parent company
3-24
Ability to Exercise Control
• When consolidation is not appropriate,

the unconsolidated subsidiary is reported
as an intercorporate investment.
3-25
Differences in Fiscal Periods
• A difference in the fiscal periods of a parent

and subsidiary should not preclude
consolidation of that subsidiary.
• Often the fiscal period of the subsidiary, if
different from the parent’s, is changed to
coincide with that of the parent.
3-26
Differences in Fiscal Periods
• 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.
3-27
Overview of the Consolidation Process
• Several items need to be given special

attention to ensure that the consolidated
financial statements appear as if they
are the statements of a single company:
• Intercorporate stockholdings.
• Intercompany receivables and
payables.
• Intercompany sales (i.e., unrealized
profits)
3-28
Balance Sheets --December 31, 20X1
On January 1, 20X1, PT Indah purchased at book value all
the common stock of PT Andika.
PT Indah PT Andika
Assets
Cash Rp 5,000,000 Rp 3,000,000
Receivable (net) 84,000,000 30,000,000
Inventory 95,000,000 60,000,000
Fixed Assets (net) 375,000,000 250,000,000
Other Assets 25,000,000 15,000,000
Investment in Sun Stock 300,000,000 .
Total Assets Rp 884,000,000 Rp 358,000,000
Liabilities and Equities
Short-Term Payables Rp 60,000,000 Rp 8,000,000
Long-Term Payables 200,000,000 50,000,000
Common Stock 500,000,000 200,000,000
Retained Earnings 124,000,000 100,000,000
Total Liabilities and Equities Rp 884,000,000 Rp 358,000,000
3-29
The Consolidation Process Illustrated
Additional data:
1. PT Indah uses the basic equity method to
account for its investments in PT Andika. The
investment account is carried at the book value
of PT Andika’s net assets and is adjusted for PT
Indah’s share of PT Andika’s earnings and
dividends.
2. PT Andika owes PT Indah Rp1,000 on account
at the end of the year.
3. PT Andika purchases Rp6,000 of inventory
from PT Indah during 20X1. The inventory
originally cost PT Indah Rp4,000. PT Andika still
holds all the inventory at the end of the year.
3-30
The Consolidated Entity
Parent
Subsidiary
3-31
The Consolidated Entity
PT Indah’s
common
stock
PT Indah
PT Andika’s
common
stock Intercorporate
Stockholdings
PT Andika
3-32
Consolidated Balance Sheet
PT Indah
December 31, 20X1
(in ‘000)
Assets Liabilities and Equities
Cash Rp 8,000 Short-Term Payables
Rp5,000 Rp 67,000
+ Rp3,000
Rp84,000 + Rp30,000
Receivables (net) 113,000 Long-Term Payables
-Rp95,000
Rp1,000 250,000
+ Rp60,000
Inventory 153,000
- Rp2,000
Fixed Assets (net) 625,000 Common Stock + Rp250,000
Rp375,000 500,000
Other Assets 40,000 Retained Rp25,000
Earnings+ Rp15,000 122,000
Total Assets Rp939,000 Total Liab and Equities Rp939,000
3-33
PT Indah
December 31, 20X1
Assets
Rp60,000 + Rp8,000 Liabilities and Equities
Cash
- Rp1,000 Rp 8,000 Short-Term Payables Rp 67,000
Receivables
Rp200,000 +(net)
Rp50,000 113,000 Long-Term Payables 250,000
Inventory 153,000
Rp500,000 + Rp200,000
Fixed Assets (net)
- Rp200,000 625,000 Common Stock 500,000
Rp124,000 + Rp100,000
Other Assets - Rp2,000
- Rp100,000 40,000 Retained Earnings 122,000
Total Assets Rp939,000 Total Liab. and EquitiesRp939,000
3-34
Intercompany Receivable and Payable
PT Indah
Intercompany
receivable/payable
Rp1,000,000
PT Andika
3-35
Profits on Intercompany Sales
Cost of goods
Rp4,000,000
PT Indah
Sales
Rp6,000,000
PT Andika
3-36
Noncontrolling Interest
Those shareholders of the subsidiary other than

the parent are referred to as “noncontrolling” or
“minority” shareholders.
Their interests must be included in the consolidated

statements. Most commonly this interest is shown with
liabilities or between liabilities and stockholders’ equity
in the balance sheet.
3-37
Consolidated Balance Sheet Workpaper (in ‘000)
Item PT Indah PT Andika Debit Credit
Consolidated
Cash 5,000 3,000

Receivables (net) 84,000 30,000 (a)1,000
Inventory 95,000 60,000
Fixed Assets (net) 375,000 250,000
Other Assets 25,000 15,000
Investment in PT Andika 300,000
884,000 358,000
Short-Term Pay. 60,000 8,000 (a) 1,000
Long-Term Pay. 200,000 50,000
Common Stock 500,000 200,000
Retained Earnings 124,000 100,000
884,000 358,000
3-38
Consolidated
Cash 5,000 3,000

Receivables (net) 84,000 30,000 (a)1,000
Inventory 95,000 60,000 (b) 2,000
Fixed Assets (net) 375,000 250,000
Other Assets 25,000 15,000
884,000 358,000
Short-Term Pay. 60,000 8,000
Long-Term Pay. 200,000 50,000 (a) 1,000
Common Stock 500,000 200,000
Retained Earnings 124,000 100,000
(b) 2,000
884,000 358,000
3-39
Consolidated
Cash 5,000 3,000 8,000

Receivables (net) 84,000 30,000 (a)1,000 113,000
Inventory 95,000 60,000 (b) 2,000 153,000
Fixed Assets (net) 375,000 250,000 625,000
Other Assets 25,000 15,000 40,000
884,000 358,000 (c) 300,000 939,000
Short-Term Pay. 60,000 8,000 67,000
Long-Term Pay. 200,000 50,000 (a) 1,000 250,000
Common Stock 500,000 200,000 500,000
Retained Earnings 124,000 100,000 (c)200,000
122,000
(b) 2,000
884,000 358,000 (c)100,000 939,000
3-40
Difference between Cost and Book Value

• The elimination entry related to “intercorporate
stockholdings” was prepared under the assumption that
the parent purchased the subsidiary at book value.
• In reality, the purchase price of a subsidiary usually differs
from the book value of the shares acquired.
• This differential is treated in the same way in preparing
consolidated financial statements as for a merger,
discussed in Chapter 1.
• Generally speaking, if the parent paid more for the
subsidiary than book value of the shares acquired (a net
debit differential), the excess would be allocated (during
the consolidation process) to specific assets and liabilities
of the subsidiary, or to goodwill.
3-41
• 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.
• The claim of these shareholders on the income and net
assets of the subsidiary is referred to as the noncontrolling
interest or the minority interest.
• The noncontrolling interest’s claim on subsidiary assets
reported in consolidated stockholders’ equity and the claim
on subsidiary net income reported as an allocation of
consolidated net income.
3-42
• The noncontrolling shareholders’ claim on the net

assets of the subsidiary is shown most commonly
between liabilities and stockholders’ equity in the
consolidated balance sheet.
• The portion of the subsidiary net income assigned
to the noncontrolling interest normally is deducted
from earnings available to all shareholders to
arrive at consolidated net income in the
consolidated income statement.
3-43
Intercorporate Stockholdings
• The common stock of the parent is held by

those outside the consolidated entity and is
properly viewed as the common stock of the
entire entity.
• In contrast, the common stock of the

subsidiary is held entirely within the
consolidated entity and is not stock
outstanding from a consolidated viewpoint.
3-44
• Because a company cannot report (in its

financial statements) an investment in itself,
the investment, as well as the equity
underlying that investment, is eliminated as
follows:
3-45
Common Stock-Subsidiary BV *
Additional Paid-In Capital-Subsidiary BV
Retained Earnings-Subsidiary BV
Investment in Common
Stock of Subsidiary BV
* BV = Book Value
3-46
• NOTE: The equity accounts of the parent

represent the equity accounts disclosed on
the financial statements of the consolidated
entity.
3-47
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.
3-48
Intercompany Receivables and

Payables
• Thus, with respect to the consolidated
balance sheet, the following entry is made to
eliminate intercompany receivables and
payables between the parent and the
subsidiary:
Consolidated Accounts Payable BV *
Consolidated Accounts Receivable BV
3-49
Intercompany Sales (Unrealized

Profits)
• A single company may not recognize a profit
and write up its inventory simply because the
inventory is transferred from one department
or division to another (since no arm’s length
transaction has occurred to justify recognition
of the profit).
• This also applies to intercompany sales
within a consolidated entity.
3-50
Intercompany Sales (Continued)
• Since unrealized profits (in ending inventory)

overstate ending inventory and understate
cost of goods sold, consolidated net income
as well as consolidated retained earnings
are overstated.
3-51
Intercompany Sales (Continued)
• With respect to the consolidated balance

sheet, the following elimination entry is
required with respect to unrealized profits
in ending inventory (e.g., Rp2,000,000):
Consolidated Retained Earnings Rp2,000,000

Consolidated Ending Inventory Rp2,000,000
3-52
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.
3-53

Value
• In reality, the purchase price of a subsidiary
usually differs from the book value of the
shares acquired.
• This differential is treated in the same way in
preparing consolidated financial statements
as for a merger, discussed in Chapter 1.
3-54

Value
• Typical Situation: Generally speaking, if the

parent paid more for the subsidiary than book
value of the shares acquired (a net debit
differential),
3-55

Value
• The excess would be allocated (during the

consolidation process) to specific assets and
liabilities of the subsidiary, or to goodwill.
• Allocation of differentials is extensively
discussed in Chapter 4.
3-56
Single-Entity Viewpoint
• In understanding each of the adjustments

needed in preparing consolidated
statements, the focus should be on both:
3-57
Single-Entity Viewpoint
• Identifying the treatment accorded a

particular item by each of the separate
companies.
• Identifying the amount that would appear

in the financial statements with respect
to that item if the consolidated entity
were actually a single company.
3-58
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.
3-59

Process
• Instead, 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.
3-60

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.
3-61

Process
• This is done through the preparation of

eliminating entries.
• Consolidation workpapers and eliminating
entries are discussed in more detail in
Chapters 4 to 10.
3-62
• 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.
3-63
• The claim of these shareholders on the

income and net assets of the subsidiary is
referred to as the noncontrolling interest or
the minority interest.
3-64
• The noncontrolling shareholders’ claim on the

net assets of the subsidiary is shown most
commonly between liabilities and
stockholders’ equity in the consolidated
balance sheet.
3-65
• The portion of the subsidiary net income

assigned to the noncontrolling interest
normally is deducted from earnings available
to all shareholders to arrive at consolidated
net income in the consolidated income
statement.
3-66
• Although this assignment of income does not

meet the definition of an expense, it normally
is accorded this expense-type treatment.
3-67
Combined Financial Statements
• Financial statements sometimes are

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.
3-68
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.
3-69
Special Purpose/Variable Interest

Entities
• Special-purpose entities (SPEs) are
corporations, trusts, or partnerships created
for a single specified purpose.
• They have no substantive operations and are
used only for financing purposes.
3-70
Special Purpose/Variable Interest

Entities
• Special-purpose entities have been used for

several decades for asset securitization, risk
sharing, and to take advantage of tax
statutes.
3-71
Special-Purpose Entities
• In general, ISAK 7 states that SPEs be

“demonstrably distinct from the transferor,”
its activities be significantly limited, and it
hold only certain types of financial assets.
3-72
Special-Purpose Entities
• If the conditions of ISAK 7 are met, this

type of SPE is not consolidated by the
transferor of assets to the SPE.
3-73
Variable Interest Entities
• A variable interest entity is 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.
• Has equity investors that do not provide
sufficient financial resources to support the
entity’s activities.
3-74
Variable Interest Entities
• In a variable interest entity, specific

agreements may be limit the extent to which
the equity investors, if any, share in the
profits or losses (etc.) of the entity.
3-75
Different Approaches to
Consolidation
• Several different theories exist that might

serve as a basis for preparing consolidated
financial statements.
3-76
Consolidation
• The choice of consolidation theory can have

a significant impact on the consolidated
financial statements in those cases where the
parent company owns less than 100 percent
of the subsidiary’s common stock.
3-77
Consolidation
• The remaining slides focus on the following

alternative theories of consolidation:
• Proprietary
• Parent company
• Entity
3-78
Proprietary Theory
• The proprietary theory of accounting views

the firm as an extension of its owners.
• The assets and liabilities of the firm are
considered to be assets and liabilities of the
owners themselves.
3-79
Proprietary Theory
• Similarly, revenue of the firm is viewed as

increasing the wealth of the owners, while
expenses decrease the wealth of the owners.
• When applied to the preparation of
consolidated financial statements, the
proprietary concept results in a pro rata
consolidation.
3-80
Proprietary Theory
• The parent company consolidates only its

proportionate share of the assets and
liabilities of the subsidiary.
3-81
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.
3-82
• The parent company theory recognizes that

although the parent does not have direct
ownership of the assets or direct
responsibility for the liabilities of the
subsidiary, it has the ability to exercise
effective control over all of the subsidiary’s
assets and liabilities, not simply a
proportionate share.
3-83
• Under parent company theory, separate

recognition is given in the consolidated
balance sheet to the noncontrolling interest’s
claim on the net assets of the subsidiary and
in the consolidated income statement to the
earnings assigned to the noncontrolling
shareholders.
3-84
Entity Theory
• As a general rule, the entity theory focuses

on the firm as a separate economic entity,
rather than on the ownership rights of the
shareholders of the parent or subsidiary.
3-85
Entity Theory
• Emphasis under the entity approach 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.
• Neither of the two groups is emphasized over
the other or over the consolidated entity.
3-86
Entity Theory
• Because the parent and subsidiary together

are viewed as a single entity (under the entity
approach), all the assets and liabilities of the
subsidiary and any goodwill are reflected in
the consolidated balance sheet at their full
values on the date of combination regardless
of the actual percentage of ownership
acquired.
3-87
Entity Theory
• Additionally, consolidated net income is a

combined figure that is allocated between the
controlling and noncontrolling ownership
groups.
3-88
Proprietary Theory
Noncon-
Parent’s trolling share
share
Goodwill
Fair value
Portion included in increment
consolidated
financial
statements Book value
Recognition of
Subsidiary Net Assets
3-89
Proprietary Theory
Noncon-
share
Revenue
Portion included in
consolidated Expenses
financial
statements
Net income
Recognition of
Subsidiary Net Income
3-90
Noncon-
share
Goodwill
Fair value
Portion included in Increment
consolidated
financial
Recognition of
3-91
Noncon-
share
Revenue
Portion included in
financial
statements
Net income
Recognition of
3-92
Entity Theory
Noncon-
share
Goodwill
Fair value
Portion included in increment
consolidated
financial
Recognition of
3-93
Entity Theory
Noncon-
share
Revenue
Portion included in
financial
statements
Net income
Recognition of
3-94
Current Practice
• The procedures used in practice represent a

blending of the parent company and entity
approaches.
3-95
Current Practice
• The amount of subsidiary net assets

recognized in the consolidated balance sheet
at acquisition is the same in practice as under
the parent company approach.
• On the other hand, the determination of
consolidated net income is a combination of
the entity and parent company approaches.
3-96
Future Practice
• In the future, there could be a change to an

entity approach in practice.
3-97
Future Practice
• This would result in classifying the

noncontrolling interest in the stockholders’
equity section of the consolidated balance
sheet and labeling the total income of the
consolidated entity as consolidated net
income, with an allocation of consolidated
net income between the controlling and
noncontrolling interests in the income
statement.
3-98
You Will Survive This Chapter !!!
• Remember:
• “You can’t own yourself.”

• “You can’t owe yourself money.”
• “You can’t make money selling to yourself.”
3-99
You Will Survive This Chapter !!!
• NOTE: Elimination entries tend to reduce

balances—not increase them.
• EXCEPTION: Entries relating to the

allocation of the difference between
investment cost and book value,
that is, the differential.
3
End of Chapter
The Reporting Entity and Consolidated Financial Statements
McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc. All rights reserved.

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4-1

Baker / Lembke / King

Consolidated Financial Statements

• Many corporations are composed of

Consolidated Financial Statements

• Consolidated financial statements present

Consolidated Financial Statements

• Consolidation is required when a corporation

Consolidated Financial Statements

• The accounting principles applied in the

Consolidated Financial Statements

• Two companies are considered to be

Consolidated Financial Statements

• Consolidated financial statements are

Consolidated Financial Statements

• Whether the subsidiary is acquired or

Consolidated Financial Statements

• Two companies are considered to be related

• Consolidated financial statements are

• While consolidated financial statements are

Subsidiary Financial Statements

• Because subsidiaries are legally separate

Subsidiary Financial Statements

• Therefore, consolidated financial statements

The Tradition View of Control

• The professional guidance regarding

• Under current standards, consolidated

The Tradition View of Control

• PSAK 4 indicates that consolidated financial

Less Than Majority Ownership

• Although majority ownership is the most

Less Than Majority Ownership

• PSAK 4 does not preclude consolidation

• The traditional view of control includes

• Direct control typically occurs when one

• Indirect control (or pyramiding) occurs

Ability to Exercise Control

• Under certain circumstances, the majority

Ability to Exercise Control

• When consolidation is not appropriate,

Differences in Fiscal Periods

• A difference in the fiscal periods of a parent

Differences in Fiscal Periods

• Another alternative is to adjust the financial

Overview of the Consolidation Process

• Several items need to be given special

Those shareholders of the subsidiary other than

Their interests must be included in the consolidated

Cash 5,000 3,000

Cash 5,000 3,000

Cash 5,000 3,000 8,000

Difference between Cost and Book Value

• The noncontrolling shareholders’ claim on the net

• The common stock of the parent is held by

• In contrast, the common stock of the

• Because a company cannot report (in its

• NOTE: The equity accounts of the parent

Intercompany Receivables and

• A single company cannot owe itself money,

Intercompany Receivables and

Intercompany Sales (Unrealized

Intercompany Sales (Continued)

• Since unrealized profits (in ending inventory)