Consolidation, translation, and the equity method are related sets of accounting practices used mainly in the preparation of consolidated financial statements. In this Tutorial we will discuss Consolidation Method for preparing financial statements of consolidated entities.
CONSOLIDATION. Consolidated financial statements present the financial position, results of operations, and cash flows of a consolidated group of companies essentially as if the group were a single enterprise with one or more branches or divisions. With limited exceptions, a consolidated group of companies includes a parent company and all subsidiaries in which the parent company has a direct or indirect controlling financial interest. Because the reporting entity for consolidated financial statements transcends the legal boundaries of single companies, consolidated financial statements have special features, which require consideration in preparing and interpreting them.
(i) Control. Consolidation is required when one company, the parent, owns—directly or indirectly—more than 50 percent of the outstanding voting shares of another company, unless control is likely to be temporary or does not rest with the parent. For instance, a majority-owned subsidiary is not consolidated if it (1) is in legal reorganization or bankruptcy or (2) operates under foreign exchange restrictions, controls, or other governmentally imposed uncertainties so severe that they cast doubt on the parent’s ability to control the subsidiary. Majority-owned subsidiaries excluded from consolidation because control is likely to be temporary or does not rest with the parent are called unconsolidated subsidiaries.
Investments in unconsolidated subsidiaries, like other investments that give an investor the ability to exercise significant influence over the investee’s operating and financial activities, are accounted for by the equity method, which is discussed below.
(ii) Irrelevant Factors. The fact that a particular subsidiary is located in a foreign country, has a large minority interest, or engages in principal activities substantially different from those of its parent is irrelevant to the consolidation requirement. That was not always the case, however. Until 1988, those factors were quite relevant and, indeed, were considered to be legitimate reasons for excluding a particular subsidiary from consolidation. The rules were changed by the issuance of Statements of Financial Accounting (SFAS) No. 94, “Consolidation of All Majority-Owned Subsidiaries,” and that no longer is the case. The SFAS No. 94 requires consolidation of all majority-owned subsidiaries unless control is temporary or does not rest with the majority owners. A difference in fiscal periods of a parent and a majority-owned subsidiary does not in itself justify the subsidiary’s exclusion from consolidation. In that case, the subsidiary has to prepare, for consolidation purposes, financial statements for a period that corresponds with or closely approaches the parent’s fiscal period. If, however, the difference between the parent’s and the subsidiary’s fiscal periods does not exceed about three months, the subsidiary’s financial statements may be consolidated with those of the parent even though they cover different periods. In that case, recognition has to be given in the consolidated financial statements by disclosure or otherwise of this fact and the effect of any intervening events that materially affect consolidated financial position or results of operations.
(iii) Intercompany Amounts. Only legal entities can own assets, owe liabilities, issue capital stock, earn revenues, enjoy gains, and incur expenses and losses. A group of companies as such cannot do those things. So the elements of consolidated financial statements are the elements of the financial statements of the members of the consolidated group of companies—the parent company and its consolidated subsidiaries. They are the assets owned by the member companies, the liabilities owed by the member companies, the equity of the member companies, and the revenues, expenses, gains, and losses of the member companies. Some elements of the financial statements of member companies are not elements of the consolidated financial statements, however. The elements of the financial statements of a reporting entity are relationships and changes in relationships between the reporting entity and outside entities. But some elements of the financial statements of members of a consolidated group are relationships and changes in relationships between member companies, called intercompany amounts. (They would more accurately be described as intragroup amounts.) Intercompany amounts are excluded from consolidated financial statements.
It is convenient to prepare consolidated financial statements by starting with the financial statements of the member companies, which include intercompany amounts. The intercompany amounts are removed by adjustments and eliminations in consolidation. The items are:
• Intercompany stockholdings. Ownership by the parent company of capital stock of the subsidiaries and ownership, if any, by subsidiaries of capital stock of other subsidiaries or of the parent company.
• Intercompany receivables and payables. Debts of member companies to other member companies.
• Intercompany sales, purchases, fees, rents, interest, and the like. Sales of goods or provision of services from member companies to other member companies.
• Intercompany profits. Profits recorded by member companies in transactions with other member companies reflected in recorded amounts of assets of member companies at the reporting date.
• Intercompany dividends. Dividends from members of the consolidated group to other members of the consolidated group.
After the intercompany amounts are eliminated, the consolidated financial statements present solely relationships and changes in relationships with entities outside the consolidated reporting entity. They present:
• Amounts receivable from and amounts payable to outside entities
• Investments in outside entities
• Other assets helpful in carrying out activities with outside entities
• Consolidated equity equal to the excess of those assets over those liabilities
• Changes in those assets, liabilities, and equity, including profits realized or losses incurred by dealings with outside entities
Consolidated financial statements present the financial affairs of a consolidated group of companies united for economic activity by common control.
(iv) Variable Interest Entities. In 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation (FIN) No. 46 (Revised December 2003), “Consolidation of Variable Interest Entities (VIEs)—An Interpretation of Accounting Research Bulletin (ARB) No. 51”, to clarify the circumstances where and how VIEs should be consolidated. As defined in paragraph 2c of FIN 46R, interests in a VIE are contractual, ownership, or other interests in an entity that change with changes in the fair value of the entity’s net assets, thus the term variable interest entity. VIEs are often are created for a specific purpose (e.g., to facilitate the securitization of receivables). In FIN No. 46 R, VIEs are defined by the nature and amount of their equity investment and the rights and obligations of their equity investors
FIN 46 defines a VIE as a legal entity whose equity, by design, has any of the following characteristics:
• The equity investors do not have an obligation to absorb the expected losses of the entity,
• The equity investors do not have the right to receive the expected returns,
• The total equity at risk is not sufficient to finance the entity’s activities without additional financial support,
• The equity investors do not have the ability to make decisions through voting rights, or,
• The voting rights of equity investors are not proportional to their expected share of losses or residual returns and substantially all of the entity’s activities are on behalf of an entity with few voting rights.
In general, VIEs should be consolidated by their primary beneficiaries (e.g., the party that will absorb the majority of the losses or receive the majority of the benefits), even when the primary beneficiary is not the majority owner.
The issue of accounting for such entities received considerable public attention and accounting focus after revelations about the role of certain unconsolidated entities in possibly obscuring the underlying economic effect of certain transactions relating to Enron’s financial statements. FIN 46 will make it harder to exclude debt from the balance sheet via specialized finance affiliates, and likely will require more entities to be consolidated.
Entities holding a majority of voting stock will still follow the ownership-based guidelines for consolidation in ARB No. 51, Consolidated Financial Statements.
Variable interests may include:
• Investments in common or preferred stock
• Loans or notes
• Certain insurance contracts and derivative contracts
• Leases, and service or management contracts.
Not all entities that qualify as VIEs are consolidated. For example, when a VIE has sufficient equity at risk such that the VIE can operate on a stand-alone basis, there may be no need for another entity to consolidate the VIE.
This topic continues to be a complex area of practice. Familiarity with the Interpretation’s concepts and requirements is evolving, but FIN 46 provides much needed guidance to shore up perceived weaknesses in the consolidation requirements when VIEs exist. FIN 46 also identifies certain required disclosures for primary beneficiaries as well as for unconsolidated VIEs.
(v) Disclosures. Consolidation policy, that is, the composition of the consolidated group, needs to be disclosed in the notes to the consolidated financial statements. Also, a member of a consolidated group that files a consolidated tax return discloses the following information related to income taxes in its own separately issued financial statements:
• The amount of current and deferred tax expense for each statement of earnings presented and any tax-related balances due to or from other group members as of each balance sheet date
• The principal provisions of the method by which the consolidated amount of current and deferred tax expense is allocated to members of the consolidated group and the nature and effect of any changes in that method