Chapter 3: The Reporting Entity and Consolidated Financial Statements

1
Chapter 3 The Reporting Entity and Consolidated
Financial Statements

• At the end of the chapter students should be able
  to
• Explain which users find consolidated financial
  statements most useful and why
• Explain the limitations of consolidated financial
  statements
• Describe how the concept of control is addressed
  in the accounting literature and how it is
  changing
• Describe the accounting guidance for
  special-purpose entities and variable interest
  entities
• Explain why intercorporate stockholdings,
  intercompany receivables/payables, and
  intercompany sales must be given special
  attention when preparing consolidated financial
  statements
• Noncontrolling interest
• Different approaches to consolidation

2
Usefulness of Consolidated Financial Statements

• Who are the users?
• What decisions do they make? What is their focus?
• Management focus?

3
Limitations of Consolidated Financial Statements

• Aggregation by definition requires that details
  be lost
• Dissimilar companies may be aggregated
• Five important limitations
• Poor performers can be hidden by good performers
  in the aggregation
• Consolidated R/E is not all available to the
  parent for dividends
• Consolidated financial ratios do represent any
  individual companys financial status
• Combined companies may not have comparable
  characteristics
• The only place to get detailed information is in
  voluminous notes

4
Control

• ARB 51
• FASB 94
• Direct and indirect control
• Inability to control when gt 50
• Effective control rather than mere legal control
• Harmonization with international standards

5
SPEs and VIEs

• Special-Purpose Entities
• FASB 140
• Qualifying SPEs
• Not consolidated
• Variable Interest Entities
• FIN 46
• Contractual, ownership, or other money-related
  interest that changes with the entitys net asset
  value
• The primary beneficiary must consolidate
• At date of transaction, the net assets of the VIE
  are transferred to the primary beneficiary at BV
  (just like when a Parent creates a Sub by
  transferring assets)

6
Special-Purpose Entities

• In general, FASB 140 states that SPEs be
  demonstrably distinct from the transferor,
  its activities be significantly limited, and it
  hold only certain types of financial assets.
• If the conditions of FASB 140 are met, this
  type of SPE is not consolidated by the
  transferor of assets to the SPE.

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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
  entitys activities.

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Consolidation Process

• Combine Parent and Sub
• Eliminate
• intercorporate stockholdings
• intercompany receivables/payables
• intercompany sales
• Eliminating entries and consolidation workpaper

9
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.

10
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. 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
• BV Book Value

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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 arms length
  transaction has occurred to justify recognition
  of the profit).
• This also applies to intercompany sales within
  a consolidated entity.

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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.
• With respect to the consolidated balance sheet,
  the following elimination entry is required with
  respect to unrealized profits in ending inventory
  (e.g., 2,000)
• Consolidated Retained Earnings 2,000
  Consolidated Ending Inventory
  2,000

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• Remember
• You cant own yourself.
• You cant owe yourself money.
• You cant make money selling to yourself.

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Noncontrolling Interest

• 100 of Subsidiarys assets, liabilities, and
  earnings are included in consolidated financial
  statements
• The minority or noncontrolling interest in the
  Sub is reported between liabilities and equity
• The FASB favors treating noncontrolling interest
  as an ownership interest (equity) and the
  noncontrolling share of income as an allocation
  of total consolidated income

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Theoretical Approaches to Consolidation

• Proprietary Theory
• Parent Company Theory
• Current practice
• Entity Theory