Accounting for Controlled Entities

(1) power over the other entity;

(2) exposure to, or rights over, the variable returns from

involvement in the other entity; and

(3) the ability to use the power over the other entity
to affect the amount of the investor’s returns—must be considered when determining
whether or not control exists.

The two general types of controlled entities are subsidiaries and structured entities

The most common type of controlled entity is a subsidiary.

A subsidiary is a corporation (or an unincorporated entity such as a partnership or trust)

that is controlled by a parent company that owns, usually, a majority of the voting
shares/rights of the subsidiary.

A parent corporation will establish subsidiaries for three principal reasons:

1. To isolate risk; if one subsidiary fails, it does not jeopardize the overall corporate
structure and functioning.
2. To develop different management teams for essentially different functions or types of
business, such as manufacturing vs. sales.
3. To comply with local legal requirements, including tax compliance

To the public the most “famous” subsidiaries are those that are the result of
one corporation buying another, known as a business combination.

The difference between a subsidiary and an SE is that an

 SE is not controlled through voting power. Indeed, an SE may not even be a

corporation but could instead be a partnership
 Three examples of SEs are: corporation ,not-for-profit organization, “lending agency”

 With consolidated statements, all of the assets and all of the liabilities are reported as a
single economic entity, as though the combined companies were a single legal entity.

 Consolidated financial statements are designed to report on the economic entity

formed by the parent and all of its controlled entities (both subsidiaries and SEs).

 There is no legal entity that corresponds with a consolidated economic entity, and
therefore consolidated statements are sometimes referred to as an accounting
fiction.
  it merely is intended to convey the fact that the statements do not portray a “real”
corporation but instead include the assets and liabilities of many separate controlled
entities

. Significant influence is the ability to participate in the operating and financial policy decisions of the
investee without being able to control them.

Holding , either directly or indirectly through subsidiaries, of 20% or more of the voting
shares of another entity is taken as evidence that significant influence exists, unless
evidence exists to prove otherwise.

Likewise, a holding of less than 20% of the voting shares is indicative of lack of significant
influence unless evidence exists to prove otherwise.

The following additional evidence

should be considered for deciding whether or not significant evidence exists:
■ representation on the board of directors or other equivalent governing body
of the investee;
■ participation in the policy-making process of the investee;
■ significant and essential transactions between the investor and the investee;
■ interchange of managerial personnel between the investor and investee; or
■ provision of essential technical information by the investor to the investee.

Additionally, potential voting rights are a factor to be considered in deciding

whether significant influence exists.

Significant influence gives the investor the power to play a major role in the investee’s
earnings process.

Since the investor is a participant in the investee’s earnings process, under IAS 28, the
investor’s proportionate share of the investee’s earnings should be reported in the
investor’s SCI. This is known as the equity method of reporting.
 Under the equity method, the investor doesn’t report
dividends as income.

 Instead, the investor calculates its share of the associate’s net income (or loss), and
then adds that amount to the investment account and includes it in determining the
investor’s net income.
 Consolidated amounts never appear on the parent company’s books
 Similarly, investments reported on the equity basis are usually recorded on the cost
basis on the investor’s books.
ILLUSTRATION OF CONSOLIDATION
 Consolidated statements are prepared from the point of view of the shareholders of
the parent company.
 Consolidation adds the elements in the financial statements of subsidiaries and
structured entities to those of the parent
 The effects of any and all intercompany transactions will be eliminated
to avoid double-counting.
Eliminations and Adjustments
 To prepare its consolidated financial statements, a parent will add together the
financial statement amounts for itself and its controlled entities.
 In the process, however, some changes to the pre-consolidation reported balances
must be made.
 There are two types of changes that are made when statements are consolidated:
(1) eliminations and (2) adjustments:
 Eliminations are changes that prevent certain amounts on the
separate-entity statements from appearing on the consolidated
statements.
 Eliminations are necessary to avoid double-counting (such as
intercompany sales) and to cancel out offsetting balances (such as
intercompany receivables and payables).
 Adjustments, on the other hand, are made to alter reported
amounts to reflect the economic substance of transactions rather
than their nominal amount.
 Direct Versus Worksheet Approach to Consolidation

 There are two general approaches to preparing consolidated financial

statements, the direct approach and the worksheet approach
The direct approach
 prepares the consolidated statements by setting up the SCI and SFP formats
and computing each consolidated balance directly.
 Each asset, liability, revenue, and expense is separately calculated and
entered into the consolidated statement.
 The direct approach works from the separate-entity financial statements of
the parent and the subsidiary.
Worksheet Approach
 worksheet (or spreadsheet) approach uses a multi-columnar worksheet to
enter the trial balances of the parent and each subsidiary.
 Then eliminations and adjustments are entered onto the worksheet, and the
accounts are cross-added to determine the consolidated balances.
 The finished consolidated statements are then prepared from the
consolidated trial balance.
 The worksheet approach is less intuitive, but is more methodical and keeps
better track of the eliminations and adjustments, some of which get very
complicated.
 In complex situations, therefore, accountants in practice find it easier to use
a worksheet (usually computerized) to summarize the necessary eliminations
and adjustments.
 The investment account is really just an aggregate that represents
the net assets of the subsidiary; instead of showing the net
investment in the subsidiary as an asset, the consolidated
statements show all of the assets and liabilities of the subsidiary
that underlie the investment.

The consolidated financial statements are obtained by

(1) adding together the individual amounts on the parent and
subsidiaries’ financial statements;
(2) subtracting amounts as necessary for eliminations; and then
(3) entering the resulting amounts directly into consolidated
financial statements.
  The trial balances of the parent and the subsidiary (or subsidiaries)
are listed in the first columns of the worksheet, and
 The eliminations and adjustments are inserted in the next column.
 Cross-adding the rows yields the amounts that will be used to
prepare the consolidated statements.

 Consolidation elimination “entries” are entered only on working

papers to prepare the consolidated statements, and

 They are never entered on the formal books of account of either the
parent or the subsidiary.

 The preparation of consolidated financial statements does not

eliminate the need for each separate legal entity to prepare its own
financial statements.

 Each corporation is taxed individually, and unconsolidated

statements are necessary for income tax reporting if for no
other purpose.

 Consolidated statements may not be adequate for the needs

of creditors or other users of financial statements.

 Creditors have claims on the resources of specific

corporations, not on the resources of other corporations
within a consolidated group of companies. Therefore it may
be of little benefit to a creditor to see the consolidated assets
and liabilities when the credit risk is associated with the
financial position of a single company.

A parent company will choose to record its investment in a subsidiary using

the cost method even if it reports unconsolidated subsidiaries on the equity
method.
 A parent company almost invariably carries its subsidiaries’ investment accounts on
thecost basis, even if the investments will be reported on the equity method for
unconsolidated reporting.
 The reason is that the process of consolidation is much simpler if the investments
are carried at cost instead of equity.
 It is vital to remember that, with strategic investments, an investor’s recording
usually does not coincide with its reporting.
 Adjustments and eliminations appear only on working papers for preparing
financial statements and are not recorded in the investor corporation’s accounts.
 It is possible, but rare, for a parent company to carry a subsidiary’s investment
account on its books by using the equity basis.

COMPARISON OF COST, EQUITY, AND CONSOLIDATION

METHODS
 The equity method is frequently referred to as single-line consolidation
because the equity method and consolidation both result in the same net
income and shareholders’ equity for the parent.
 A basic and important attribute of the equity method is that the parent’s reported
net income and net assets (shareholders’ equity) will be the same as when the
subsidiaries are consolidated.

 A basic and important attribute of the equity method is that the parent’s
reported net income and net assets (shareholders’ equity) will be the same as
when the subsidiaries are consolidated.

 Under the cost method, only the original cost of the investment is included in
the investment account, and the only elimination necessary is to offset the
cost of the investment against the common share account of the subsidiary.

 Under the equity method, however, the investment account includes both the
original cost of the investment and the unremitted earnings of the subsidiary.
Both of these amounts must be eliminated.

 The parent’s retained earnings under the equity method also include the
earnings of the subsidiary, since the subsidiary’s earnings are taken into the
parent’s income each year.
EQUITY METHOD: A CONCEPTUAL
ELABORATION

 Under the equity method, the investor records the investment initially at its cost
or purchase price.
 Usually, the purchase price equals the fair or market value of the investment at the
time of the purchase.
 The purchase price rarely is equal to the carrying value of the investment in the
books of the investee.
 The difference between the carrying value of the investment in the books of the
investee and the purchase price or cost paid by the investor is known as the
purchase price discrepancy (PPD) or fair value adjustment (FVA).
 The investor makes two major types of adjustments to the investee’s earnings before
calculating its share of such earnings:
 (1) amortization of the PPD/FVA; and (2) elimination by reducing
unrealized gains/losses on intercompany transactions.
 The adjustments to the investee’s earnings are similar to the adjustments required
when consolidating the financial statements of subsidiaries with the financial
statement of the parent; therefore, these adjustments are called consolidating
adjustments.
 The carrying value of the investment is also reduced by any distributions, such as
dividends, made by the investee.
 equity method, focusing on the most common adjustments
 (1) at time of acquisition,
 (2)in prior years, and
 (3) in the current year.
 The equity method is also known as single-line consolidation.
while determining the presence or absence of control:
■ Does the investor have a contractual agreement with other investors that guarantees
control?
■ Does the investor have the ability to appoint, hire, transfer, or fire key members of
the investee’s management?
■ Do the investor and investee corporation have interlocking boards, wherein a majority of
the board members are on both companies’ boards?
■ Does the investor provide retractable debt financing to the investee that is crucial to
the investee’s financial health?

 If an investor owns a majority of the voting shares, the investor normally will
possess the power to elect a majority of the board of directors and thus will have the
power of control.
 Note also that having a majority of the votes does not always ensure control.
 An investor’s ability to elect a majority of an investee’s board of directors may be
restricted by contractual agreements, regulatory requirements, or legal restrictions.

Indirect Control
Control need not be direct.
 Indirect control exists when a subsidiary is controlled by one or more other
subsidiaries rather than by the parent company.
 Voting control is a yes–no matter, not multiplicative.

The sum of one corporation’s direct and indirect interest in another corporation is
known as the beneficial interest.
 Private enterprises are not required to prepare consolidated
statements
 For significant-influence investments, it is not necessary to use the equity
method. The cost method may be used instead.
 However, the investor cannot use the cost method, but instead has to use the
fair value method when the investee’s shares are quoted in an active
market.
  For joint ventures, the investor can use proportionate consolidation,
the cost method, or the equity method.

 All joint ventures must be reported on the same basis.

 Joint ventures are reported using the equity method. Equity-basis

reporting is sometimes called one-line consolidation.

 Significant influence may exist if the investor holds less than voting control
but more than a nominal amount.

 Significant influence may exist if the investor holds less than voting control
but more than a nominal amount.

 The general guideline is that ownership of between 20% and 50% of the
voting shares gives the investor significant influence.

 Equity-basis reporting is normally used to report investments in

significantly influenced companies.

 Parent companies should prepare consolidated statements that report on

the total economic entity that is controlled by the parent.

 All controlled entities should be consolidated.

Consolidated financial statements are always prepared on working papers.

The working papers may use either a direct approach or a worksheet approach.

 Control can be either direct or indirect.

 Indirect control exists when the parent company controls an intermediate company
that controls another company.
 Control does not imply absolute control.
 The parent company can have complete control over the subsidiary only by owning
100% of the subsidiary’s shares.
Date-of-acquisition consolidation happens only once, and then only for internal reporting.

We will illustrate the following aspects of consolidation for the first

and second years after acquisition:
■ eliminating transactions that occur between a parent and its subsidiaries;
■ eliminating unrealized profit on intercompany sales of inventory;
■ recognizing profit realized in the current year on upstream sales of inventory in the
previous year;
■ amortizing fair value adjustments; and
■ reporting non-consolidated subsidiaries on the equity basis.

In summary, two adjustments are necessary:

1. eliminate the intercompany sale transaction; and
2. eliminate the unrealized profit.

The Eliminate step requires us to:

a. identify and eliminate all intercompany transactions and balances; and
b. calculate and eliminate any unrealized profit (or loss) relating to the intercompany
sale of inventory and other assets in the current period.
2. The Amortize step requires us to:
a. amortize the FVA allocated to the various identifable assets and liabilities, as
appropriate;
b. write off any impairment of goodwill and other intangible assets with indeterminate
useful lives; and
c. determine the balance of the FVA allocated that remains unamortized or unimpaired at
the end of the period.

In general, consolidation adjustments fall into three categories:

(1) acquisition adjustments;

(2) cumulative operations adjustments; and

(3) current operations adjustments.