Editor's Note: In the accounting column of October 1988, we published "On the Usefulness of Consolidated Financial Statements" which challenged the presumption of both ARB 51 and new SFAS 94 that consolidated statements are more meaningful than separate statements. This article reaffirms the need for consolidated financial statements, explains the requirements of SFAS 94, the need for the FASB's continuing project on the reporting entity, and the effect of the new requirements on diversified companies. We would be interested in our readers' comments on both articles.

Consolidated financial statements have been justified on the presumption that such financial statement presentations provide more useful information than separate financial statements. This presumption was acknowledged in ARB No. 51, Consolidated Financial Statements, issued in 1959.

While ARB 51's general rule was to consolidate all majority-owned subsidiaries, it provided several exceptions in which that presumption was overcome. One such exception is when the companies engaged in different lines of business.

In October 1987, the FASB issued SFAS 94, amending ARB 51. Under SFAS 94, consolidated financial statements for a parent company and a majority-owned subsidiary are required even though the subsidiary is involved in a line of business unrelated to the parent company's business. This statement is effective for financial statements for fiscal years ending after December 15, 1988. Application to interim financial statements for the year of adoption is not required at the time of their issuance. Comparative financial statements, however, for earlier periods including those of the year of adoption must be restated.

The Basis for Consolidation

The objective of consolidated financial statements is to report the financial position and results of operations of the parent company and its subsidiaries as if the group were one economic enterprise. Since the parent company is able to control the decision-making processes and resources of the subsidiary, a single economic unit exists. Thus, consolidated financial statements usually provide a more meaningful presentation to stockholders and creditors than separate presentations by parent and each subsidiary.

A controlling financial interest is present when the parent company owns, either directly or indirectly, more than 50% of the outstanding voting shares of a subsidiary. For example, Peterson owns 100% and 49% of the outstanding voting shares of Sampson and Shane, respectively. In addition, Sampson owns 10% of the outstanding voting shares of Shane. Peterson has a controlling financial interest in both Sampson and Shane. Peterson has a direct controlling financial interest in Sampson (100%), but Peterson controls Shane through direct and indirect ownership (49% + 10% = 59%). Shane and Sampson should be included in the consolidated financial statements of Peterson.

In recent years under ARB 51, the line of business exception has become a common justification for excluding a subsidiary from consolidation. A 1979 study of 600 industrial companies surveyed the consolidation policies for majority-owned subsidiaries and their subsidiaries which were not consolidated. Eighty-four percent of the subsidiaries excluded from consolidation, based on the line of business exception, were involved in finance-related or insurance operations.

The line of business exception has only recently become the most prominent reason for excluding majority-owned subsidiaries from consolidations. When ARB 51 was first issued, the most common reasons for exclusion were other restrictive policies of the parent--to consolidate only wholly owned subsidiaries, only subsidiaries owned to a specified degree (e.g., 75%), only domestic subsidiaries, or only North American subsidiaries. These other restrictive policies have become less widely used while the line of business exception has become more widespread.

A major criticism of the line of business exception concerns off- balance sheet financing. When this exception was taken advantage of the liabilities of unconsolidated subsidiaries were excluded from consolidated financial statements. In many cases, these liabilities are significant. Some parent companies have wholly-owned subsidiaries which finance their operations. Chrysler Corporation, for example, owns Chrysler Finance Corporation which is excluded from Chrysler's consolidated financial statements on the basis of the line of business exception. This practice allowed Chrysler Corporation to derive benefits from its controlling interest, yet exclude the obligations of these captive finance companies from its consolidated balance sheet. One result is that the balance sheet of Chrysler Corporation and, more generally, any company with similarly excluded subsidiaries, is not comparable to the balance sheet of an enterprise that finances its own operations.

SFAS 94 has eliminated three exceptions to the general rule that majority-owned subsidiaries should be consolidated: 1) for parent and subsidiary who are engaged in a different line of business; 2) for relatively large minority interests (seldom used in practice); and 3) for other restrictive policies. The statement also amends ARB 43, Chapter 12, Foreign Operations and Foreign Exchange, to narrow the exception for a majority-owned foreign subsidiary from consolidation of any or all foreign subsidiaries to one that effectively eliminates distinctions between foreign and domestic subsidiaries.

The other exceptions--control that is temporary and control that does not rest with majority--have not been considered by SFAS 94. They relate to the concept of control and its place in consolidation policy. Those matters are part of a broader project on the reporting entity, including consolidations and the equity method, that the FASB is considering. Similarly, consolidation of subsidiaries that are controlled by means other than ownership of majority voting interest--by significant minority ownership by contract, lease, or other agreement with stockholders, by court degree, or otherwise--has not been reconsidered because that subject is also a part of the project on the reporting entity.

The FASB project on the reporting entity will also consider what desegregated information should be disclosed with consolidated financial statements. In the meantime the same information now required by APBO 18 for unconsolidated subsidiaries will be disclosed for subsidiaries that are consolidated as a result of this statement. That is, the practice of giving summarized information about the assets, liabilities, and results of operations (or separate statements) should be continued. In addition, a number of enterprises have been providing information about consolidated subsidiaries that goes beyond required disclosure. The FASB encourages continued experimentation that may also provide the board and its constituents with experience on which to draw in considering the broad issues of disclosures of desegregated information.

SFAS 94 also makes several important amendments to APBO 18. APBO 18 is amended to eliminate its requirement to use the equity method to account for unconsolidated subsidiaries in consolidated financial statements. In addition, the statement precludes use of parent-company financial statements prepared for issuance to stockholders as the financial statements of the primary reporting entity.

Research Study to Determine the

Effect of SFAS 94

Choosing the Sample. The computer search was conducted using Compact Disclosure. The objective of the search was to identify the 500 largest manufacturing companies, according to net sales, traded on the New York Stock Exchange. Manufacturing parent companies are emphasized because they frequently own finance-related companies. The search determined the names of the manufacturing companies and the net sales of each company for the survey period. The survey period was defined as fiscal years ending December 1, 1986 through November 30, 1987.

A stratified random sample of 90 companies was chosen from the list of the 500 manufacturing companies. The sample consisted of 30 firms selected from the highest net sales group, 30 firms selected from the middle net sales group, and 30 firms selected from the lowest net sales group. Stratified sampling decreases the chance, for example, of choosing proportionally too many companies in the highest net sales group. In addition, the results of this sample may provide insight into the relationship between the size of a company and the presence of unconsolidated subsidiaries.

Financial Statement Analysis

APB 22 requires a "summary of significant accounting policies" in an enterprise's annual report as an integral part of its financial statements. One such accounting policy is the basis of consolidation. A 1983 survey of annual reports of 100 companies revealed that 98 of the companies disclosed their principles of consolidation in the summary of significant accounting policies.

Identification of parent companies, their unconsolidated subsidiaries, and the line of business for each unconsolidated subsidiary were determined from the summary of significant accounting policies disclosure in each of the annual reports. From these data any subsidiaries that were not included in the parent's consolidated financial statements due to the line of business exception were identified.

Findings of the Study

Examination of annual reports revealed unconsolidated subsidiaries from nine different lines of business. The lines of business were banking, credit, dealership, dissimilar operations, finance, insurance, investing, leasing, and real estate. Each unconsolidated subsidiary was engaged in a line of business different from the parent company.

Table 1 presents a summary of the number and diversity of unconsolidated subsidiaries that were identified in the study. This summary shows that the most frequently occurring unconsolidated subsidiary was in the finance area, which was identified in 20 (41.7%) of the annual reports. The second most frequently occurring unconsolidated subsidiary was in the real estate area, which was identified in eight (16.7%) of the annual reports. In general, the highest net sales group contained the greatest number of unconsolidated real estate subsidiaries.

Table 2 shows the percentage of sample companies which report one or more unconsolidated subsidiaries. The greatest impact of SFAS 94 is on the consolidation policies of the manufacturing companies in the highest net sales group. Sixty-seven percent of the companies in this net sales group excluded majority-owned subsidiaries from consolidation due to the line of business exception. The consolidation policies of the companies in the middle and lowest net sales groups are affected to a lesser extent, 17% and 23%, respectively. Overall, SFAS 94 will affect 36% of the sample companies.

Conclusion

SFAS 94 requires the consolidation of all majority-owned subsidiaries unless control is temporary or does not rest with the majority. This statement eliminates what has been the most common justification for excluding subsidiaries from consolidation--majority-owned subsidiaries engaged in operations significantly different from those of their parent.

SFAS 94 requires the consolidation of significantly more subsidiaries than ARB 51. Thirty-six percent of the companies included in this study are affected by the elimination of the line of business exception. These companies must cope with the problems of meaningful financial statements, balance sheet classifications, loan covenant violations, and decreased credit ratings as a consequence of consolidating previously unconsolidated subsidiaries. Further, SFAS 94 states that its provision is only a first step in its process of evaluating the criterion for preparing consolidated financial statements. The FASB indicated that the concept of control is being reconsidered. The Board may conclude that more than 50% ownership is not a requisite for a controlling financial interest. If the Board reaches this conclusion, there will be an even greater impact on the consolidation policies of diversified companies. This consideration is important because a company may avoid consolidation, particularly for subsidiaries in which control is near 50%, by selling shares to reduce its ownership to 50% or less. Yet, the same benefit of ownership would exist.

Table : UNCONSOLIDATED MAJORITY-OWNED SUBSIDIARIES

Table : MANUFACTURING PARENT COMPANIES