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Understanding
Consolidation
A
Comparison of the Proprietary, Parent, Entity, and IASB Views
By Rebecca
Toppe Shortridge and Pamela A. Smith
APRIL 2007 -
FASB’s June 30, 2005 exposure draft, Consolidated Financial
Statements, proposes changing the presentation of consolidated
financial statements from the parent view to the entity view. This
has reignited the debate over how to represent subsidiary financial
information in consolidated financial statements. There are three
perspectives from which to view the parent’s share of the
subsidiary upon consolidation, and each has its merits. Each view
reflects how the parent’s ownership and the noncontrolling
shareholders’ interest (NCI) in the subsidiary are represented
on the consolidated financial statements. The differences stem from
the treatment of the following: the subsidiaries’ net assets
(or net book value, NBV), the fair market value (FMV) increment
assigned to the subsidiaries’ assets and liabilities, and
the purchase price differential assigned to goodwill. The three
perspectives are the proprietary view, the parent view, and the
entity view. In addition, the IASB’s view combines attributes
of both the parent and entity views. FASB currently requires the
use of the parent view, but the exposure draft proposes a change
to the entity view. In order to evalutate the proposed change, the
four perspectives are described below, with examples of their effect
on the accounting. The authors conclude by comparing the treatment
of the FMV increment and goodwill and discussing the merits of each.
[On June 30, 2005, the
IASB and FASB also issued an ED, Business Combinations,
which addresses accounting on the date of acquisition. For further
discussion of this draft, please see “Implications of the
Joint FASB and IASB Proposal on Accounting for Business Combinations,”
by Pamela A. Smith and Georgia Saemann, accessible by clicking
here.]
Examples
Exhibit
1 provides an example of the amounts consolidated on the financial
statements under each of the three consolidation perspectives
and the current treatment under the IASB standards. The example
assumes that the parent corporation purchases a 75% interest in
a subsidiary that has net book value of $100. The FMV of the subsidiary’s
net assets is $60 greater than the NBV; therefore, the FMV increment
is $60 and the total FMV of the net identifiable assets is $160
(identifiable net assets include tangible and intangible assets;
the only unidentifiable asset is goodwill). The FMV of the subsidiary
as a whole is $200, resulting in goodwill of $40. The parent’s
share of the subsidiary is 75%, and the noncontrolling interest
is 25%.
Proprietary
view. The proprietary view focuses on the parent’s
ownership percentage of the subsidiary. The view assumes that
the parent purchases only a portion of the company and only
that portion should be shown on the consolidated financial statements.
Therefore, the consolidated financial statements recognize only
the price paid by the parent to purchase the interest in the subsidiary.
This implies that the parent consolidates its percentage of the
subsidiary NBV, its percentage of the FMV increment, and its percentage
of goodwill. This is often referred to as proportionate consolidation.
The resulting consolidated entity does not include any portion
of the noncontrolling shareholder’s interest in the financial
statements.
Under the
proprietary view, 75% of the subsidiary’s NBV, FMV increment,
and goodwill is allocated to the parent. Nothing is allocated
to the noncontrolling interest. Therefore, the consolidated financial
statements would include 75% of the value of the subsidiary, and
the remaining 25% is not presented. Exhibit
2 graphically presents the allocation of the subsidiary’s
NBV, the FMV increment, and goodwill under the proprietary view.
Parent
view. U.S. GAAP currently requires the parent view
of consolidation. The parent consolidates the book value of all
of the subsidiary’s assets and liabilities and then allocates
a portion of the subsidiary’s NBV to the noncontrolling
interest. The parent’s percentage of the FMV increment and
goodwill is recognized. The FMV increment is not allocated to
the noncontrolling interest.
Under the
parent view, as shown in Exhibit
1, 75% of the subsidiary’s NBV is allocated to the parent,
as well as 75% of the FMV increment and goodwill. Twenty-five
percent of the subsidiary’s NBV is allocated to the noncontrolling
interest. Therefore, the consolidated financial statements include
100% of the subsidiary’s NBV (allocated to the controlling
and noncontrolling interest) and 75% of the FMV increment and
goodwill. Exhibit
3 shows a graphical representation of the parent view. Twenty-five
percent of the FMV increment and goodwill are not allocated to
the NCI and are not presented on the consolidated financial statements.
Entity
view. The entity view focuses on the economic entity
as a whole. The view recognizes that the parent, while not owning
100% of the assets, has effective control of the entire subsidiary.
In the entity view, the parent includes the full fair value of
the subsidiary in its consolidated financial statements and then
allocates to the noncontrolling interest the percentage not owned
by the parent. The key difference between the parent view and
the entity view is that in the entity view, all of the FMV increment
and all of the goodwill is recognized, including the portion attributable
to the noncontrolling interest.
Under the
entity view, as shown in Exhibit
1, the parent is allocated 75% of the subsidiary’s NBV,
the FMV increment, and goodwill. In addition, the noncontrolling
interest is allocated 25% of the subsidiary’s NBV, 25% of
the FMV increment, and 25% of goodwill. The total amount represented
on the consolidated financial statements is “100%”
of the subsidiary’s FMV. Exhibit
4 graphically shows that the 100% is fully allocated to the
controlling and noncontrolling interest.
IASB
view. The IASB currently utilizes a perspective
that combines attributes from the parent and entity views. Specifically,
the IASB requires consolidation of all the subsidiary’s
NBV and all of the FMV increment. These amounts are allocated
proportionately to the parent and the noncontrolling interest
on the financial statements. However, the consolidated financial
statements present only the parent’s portion of goodwill;
therefore, goodwill is not allocated to the noncontrolling interest.
As with the
three alternatives previously shown in Exhibit
1, under the IASB’s position, 75% of the subsidiary’s
NBV, the FMV increment, and goodwill is allocated to the parent
and included on the consolidated financial statements. In addition,
25% of the FMV increment is allocated to the noncontrolling interest.
However, only 75% of the goodwill is recognized by the consolidated
entity; therefore, no goodwill is allocated to the noncontrolling
interest. Exhibit
5 depicts the allocation under the current IASB requirements.
The differences
between the four views of the consolidated entity stem from the
treatment of the FMV increment and goodwill. There are arguments
to be made for and against the different treatments. Because the
proprietary view is not used by either the IASB or FASB, the discussion
below focuses on the other three views.
Treatment
of the FMV Increment
Both the
entity and IASB views support recording 100% of the FMV increment
and allocating it between the controlling and noncontrolling interests.
The entity and IASB views recognize that the parent has effective
control of all the economic resources and obligations of the subsidiary,
even absent 100% ownership. Therefore, the entity and IASB views
portray the parent and the subsidiary as one economic unit by
recognizing the entire fair value of the identifiable net assets
under the parent’s control.
Recognizing
the full FMV increment also supports the perspective of the FASB/IASB
joint exposure draft Business Combinations, which advocates
that the parent record the full fair value of the net assets acquired
on the date of acquisition. Recognizing the full fair value of
a subsidiary’s assets avoids representing these assets partially
at book value and partially at FMV. Full FMV presents the most
transparent information to financial statement users. Readers
of the financial statements can more easily interpret the economic
resources and obligations of the entity without having to discern
how much of the value is recorded at the subsidiaries’ original
cost and how much of the value is recorded at the parent’s
share of the FMV that existed at the date of acquisition.
The parent
view opposes the recognition of full FMV for the identifiable
net assets of the subsidiary. Current GAAP follows the parent
view. The reasoning behind the parent view is that the parent
should recognize only what it paid for: its portion of FMV of
the identifiable net assets. If the parent purchased only 75%
of the subsidiary, then the net assets should be revalued only
to the extent of that arm’s-length transaction. To record
100% of the full FMV requires an allocation to the NCI, which
mechanically means the NCI would be represented at full FMV. Many
believe that this allocation does not have any theoretical merit
because there was no transaction between the NCI holders at the
date of acquisition.
This concern
can be answered in two ways. One is that the allocation of the
FMV increment to the NCI on the consolidated financial statements
is just mechanics for financial reporting purposes. The NCI shareholders
are not recording any FMV increment on their financial statements.
The second is that FASB and the IASB propose to report NCI in
equity rather than as a liability (or in the mezzanine). Reporting
NCI in the equity section, at full FMV, can provide useful information
about minority ownership to the financial statement user. The
NCI value will represent the percentage of net identifiable assets,
at FMV, that the parent does not own. Since the parent’s
share of the net identifiable assets of the subsidiary is at FMV,
it would be consistent and comparable to also report the NCI’s
share at FMV.
Treatment
of Goodwill
The IASB
view is consistent with the parent view with respect to the recognition
of goodwill. Both advocate recognizing only the goodwill that
is attributed to the parent. This is also consistent with current
practice. These views support the notion that goodwill can only
be determined via an arm’s-length transaction in which the
acquirer paid more than FMV for the identifiable net assets of
the acquiree. Supporters argue that goodwill is such a dubious
value that extrapolation to full value is irrelevant and unreliable.
Current practice measures goodwill only when there is a transaction
to provide evidence of its value. The very nature of goodwill
as an unidentifiable asset makes measurement difficult.
The entity
view supports measurement of goodwill at 100% and allocation between
the parent and NCI. In Exhibit
1, this would mean that even though the parent paid $30 above
the FMV of the identifiable net assets, the full $40 of goodwill
is recognized by the consolidated entity. Many have expressed
concern about extrapolating the value of goodwill based upon the
value observable via the parent’s purchase. Using current
purchase method accounting, extrapolation would be the only way
to get the 100% value of goodwill. This concern should be lessened
because of the “acquisition method” accounting proposed
in the joint exposure draft Business Combinations.
Under acquisition
method accounting, the full fair value of the acquiree will be
determined whenever circumstances indicate that the acquisition
price may not be representative of FMV (e.g., when there is a
control premium). Independent valuation of the acquiree will add
support to the measurement of the FMV of the acquiree as a whole.
In Exhibit
1, the acquirer paid $150 for 75% of the acquiree. If circumstances
warranted, the full FMV of the acquiree would be determined by
appraisal to arrive at the $200 full value of the acquiree. Goodwill
would be measured as the difference between the appraised value
of the acquiree as a whole ($200) and the appraised value of the
identifiable net assets ($160). The $40 is presumed to be a reliable
measure of 100% of the value of goodwill.
While there may be conceptual merit to the recognition of 100%
of the goodwill under the entity method, there are many practical
issues to be addressed. Determining the full FMV of every business
acquisition may be overwhelming to some acquirers. There are many
questions concerning the reliability of this measure, as well
as the valuation of goodwill. However, this type of measurement
is currently done on an annual basis to complete goodwill impairment
testing. Under the joint IASB/FASB proposal, goodwill allocated
to NCI will also be subject to impairment testing.
Another
Step Toward Fair Value
The move
to full fair valuation is the most prominent change proposed in
the IASB and FASB’s business combinations and consolidation
exposure drafts. The steps toward fair value have been in motion
for many years, as evidenced by FASB Concepts Statement 7, SFAS
157, Fair Value Measurements, SFAS 159, The Value
Option for Financial Assets and Financial Liabilities, and
the integration of fair valuation in many other recently promulgated
standards. The entity view is conceptually consistent with full
fair valuation and has already been embraced in FASB Interpretation
46(R), Consolidation of Variable Interest Entities. FIN
46(R) requires full valuation and consolidation of 100% of the
FMV increment and goodwill once an entity is determined to be
the primary beneficiary of a variable interest entity. The reintroduction
of the entity view for purposes of consolidation is another step
in standards setters’ progression toward full
fair value.
Rebecca
Toppe Shortridge, PhD, CPA, is an assistant professor of
accountancy at Northern Illinois University, DeKalb, Ill. Pamela
A. Smith, PhD, CPA, is the KPMG Professor of Accountancy,
also at Northern Illinois University. |
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