The consolidation debate has begun, thanks to publication by the FASB of Discussion Memorandum (DM), Consolidation Policy and Procedures. The DM is the first step in a comprehensive reconsideration of existing guidance on consolidations, most of which was adopted 30 years ago, and is expressed as broad preferences and presumptions rather than as specific requirements. The comment period ends this month. At that point, serious discussions will begin and the debate will heat up.

KEY ISSUES IN THE DM

The overriding issues in the DM are whether and how the separate financial statements of two or more affiliated legal entities should combine into a single set of consolidated financial statements.

Deciding whether to consolidate involves:

* Assessing the relative importance of control and ownership as conditions for consolidation; and

* Defining control and ownership. in fact, whether to consolidate a controlled company that is less than majority owned is probably the single most difficult issue in the DM.

Determining how to consolidate involves answering questions of consolidation procedure. Examples include:

* How to measure a subsidiary's identifiable assets and liabilities at acquisition date.

* How to measure goodwill.

* What to do if an investee becomes a subsidiary through a series of purchases of small blocks of stock - a step acquisition.

* How to account for subsequent increases and decreases in a parent's proportionate interest in a subsidiary.

* How to eliminate intercompany transactions.

* How to structure the information for the most meaningful financial- statement display.

* Whether and how to conform parent and subsidiary accounting practices and fiscal periods.

The scope of the DM is limited to consolidating the financial statements of business corporations. Consolidation of joint ventures, partnerships, and not-for-profit organizations will be examined by the FASB in separate future phases of the consolidations project.

ACCOUNTING RESEARCH

BULLETIN 51

Current accounting standards for consolidation are set forth primarily in Accounting Research Bulletin (ARB) 51, Consolidated Financial Statements, issued in 1959 by the Committee on Accounting Procedure. Paragraphs 1 and 2 state:

1. The purpose of consolidated statements is to present, primarily for the benefit of the shareholders and creditors of the parent company, the results of operations and the financial position of a parent company and its subsidiaries essentially as if the group were a single company with one or more branches or divisions. There is a presumption that consolidated statements are more meaningful than separate statements and that they are usually necessary for a fair presentation when one of the companies in the group directly or indirectly has a controlling financial interest in the other companies. 2. The usual condition for a controlling financial interest is ownership of a majority voting interest. Therefore, as a rule ownership by one company, directly or indirectly, of over 50% of the outstanding voting shares of another company are a condition pointing toward consolidation ....

Those paragraphs make several important points:

* Consolidated financial statements are intended for stockholders and creditors of the parent company. They have little relevance to minority stockholders in a consolidated subsidiary, who are served by the subsidiary's separate financial statements.

* Consolidation is appropriate if one company has a controlling financial interest in another company. Although controlling financial interest is not defined, the implication in paragraph 1 is that the primary consolidation criterion is control. However, paragraph 2 suggests that a controlling financial interest is usually conferred by owning a majority voting interest. Consequently, control versus ownership as the basis for consolidation remains unsettled today.

* Consolidation procedures should result in a financial statement presentation as if two or more legal entities were a single company. Some people read into that principle such consolidation procedures as eliminating 100% of the profit on intercompany transactions rather than only the parent's percentage and accounting for purchases and sales of the subsidiary's stock after the parent has acquired control as treasury stock transactions with no gain or loss. Those issues are examined in the DM.

Need to Reconsider ARB 51

The FASB undertook its project on consolidation policy and procedures primarily because of perceived shortcomings of the existing standards. For instance:

Incomplete Standards. ARB 51 is more descriptive of consolidation practices in the 1950s than prescriptive of what practice ought to be in the 1990s. Moreover, because it is not very detailed, some important questions are not addressed, particularly with regard to measuring assets, liabilities, and goodwill in consolidation. In some cases, alternatives are sanctioned.

Outdated Standards. Because existing standards were written 30 years ago, they did not contemplate the complex securities and techniques used today in mergers and takeovers.

AICPA Concerns. Over the years, the AICPA has published a number of "issues papers" calling to the FASB'S attention practice problems in the area of consolidations. Topics covered in the issues papers have included:

* Accounting for minority interests in consolidation;

* Accounting for a "consolidated portfolio" of marketable securities;

* Capitalizing interest cost on a consolidated basis;

* Accounting for the issuing of a subsidiary's stock other than to its parent. Should a gain or loss be recognized, or are the issuances adjustments of consolidated paid-in capital?

* Whether the carrying amounts of a subsidiary in consolidated financial statements following a business combination accounted for by the purchase method should be "pushed down" to the subsidiary's own separately issued financial statements. This is being covered in a separate FASB DM.

SEC Concerns. The SEC has identified such problems as control versus ownership and accounting for issuances of stock by a subsidiary.

International Changes. Australia, Canada, New Zealand, United Kingdom, International Accounting Standards Committee, and the European Community have recently issued new accounting standards for consolidated statements, all moving toward control and away, from majority ownership as the primary basis for consolidation.

THE THREE CONCEPTS

There are three alternative concepts of consolidated financial statements examined in the DM: economic unit, parent company, and proportionate consolidation.

Economic Unit Concept

The economic unit concept emphasizes control of a group of legal entities by single management. Under this concept, sometimes called the entity theory in the accounting literature, consolidated financial statements are intended to provide information about the group as a whole - a parent company and its subsidiaries operating as a single unit.

Observations:

* The reporting entity is the combined economic unit.

* All of a subsidiary's assets and liabilities belong to the consolidated entity, not just the parent's portion.

* The consolidated entity's ownership equity is divided into:

- Controlling interest (stockholders of the parent); and

- One or more non-controlling (minority) interests in those subsidiaries less than wholly owned.

* Control is the basis for consolidation. Ownership is an indicator of control, but not a separate criterion.

* Consolidated net income is the income earned on all assets controlled by the management of the parent company.

Parent Company Concept

The parent company concept emphasizes the interests of the parent's shareholders. Under this concept, the consolidated financial statements reflect those stockholders' interests in the parent itself, plus their undivided interests in the net assets of the parent's subsidiaries.

Observations:

* The consolidated balance sheet is essentially a modification of the parent's balance sheet with the assets and liabilities of subsidiaries substituted for a single-line presentation of the parent's investment in subsidiaries.

* The consolidated income statement is essentially a modification of the parent's income statement with the revenues, expenses, gains, and losses of subsidiaries substituted for a single-line presentation of the parent's income from investment in the subsidiaries.

* The multi-line substitutions for single lines in the parent's balance sheet and income statement are intended to make the parent's financial statements more informative about the parent's total ownership holdings, not to broaden the reporting entity, which continues to be the parent itself.

* The stockholders' equity of the parent company is also the stockholders' equity of the consolidated entity. The portion of the equity in a subsidiary represented by shares owned by its non- controlling (minority) stockholders is considered to be outside consolidated stockholders' equity. Whether it should be classified as a liability or in a separate category between liabilities and stock- holders' equity is one of the issues in the DM.

* Ownership and control are two necessary and distinct conditions for consolidation.

* Consolidated net income represents earnings attributable to capital provided by investors in the parent - the same as net income reported in a parent-only income statement using the equity method. The only difference is in financial statement presentation.

Proportionate Consolidation

Concept

Under the proportionate consolidation concept, only the parent's share of a subsidiary's assets, liabilities, revenues, and expenses is included in consolidated financial statements. The non-controlling (minority) interest's share is excluded from both the balance sheet and the income statement.

Observations:

* Proportionate consolidation nets out the non-controlling interest in individual assets, liabilities, revenues, expenses, gains, and losses in the consolidated financial statements line by little. The parent company concept, in contrast, includes 100% of the individual items and nets out the non-controlling interest on a single line in the balance sheet and on a single line in the income statement.

* Non-controlling (minority) interest is excluded entirely because the parent's stockholders have no beneficial interest in the portion of the subsidiary's assets from which the subsidiary,'s other owners will derive their direct benefits.

* Ownership is an essential and distinct condition for consolidation, as it is to the parent company concept.

* Consolidated net income is the same as under the parent company concept, namely earnings attributable to capital provided by investors in the parent.

* Some view proportionate consolidation as a conceptually pure version of the parent company concept, taking the parent company stockholder perspective literally by reporting only the amounts of assets, liabilities, revenues, and expenses in which the parent's shareholders have a direct financial interest.

CONTROL

AND

OWNERSHIP

Control, as the term is used in the DM, is the power of one entity to direct or cause the direction of the management and operating and financing policies of another entity. If one company controls another, it can manage the subsidiary entity's resources in the same way that it manages its own directly owned resources - for its own (the parent's) benefit.

Does control, by itself, justify consolidation - with ownership an indicator of control - or is ownership a separate and necessary condition for consolidation?

Under the parent company and proportionate consolidation concepts. control and ownership are two separate and necessary conditions for consolidation. A parent's ability to control its subsidiary is essential, but that is not enough. The parent must be able to derive specific kinds of benefits from the power to control - the kinds of benefits that come from owning an equity interest such as the right to share in profits and dividends, and the ability to recover the investment through liquidation of assets or resale of stock.

The economic unit concept, on the other hand, holds that control is a sufficient basis for consolidation. It regards the right to obtain the benefits of ownership as an indicator of control, not as a separate condition for consolidation. If a parent company has the power to direct the operating and financing policies of its subsidiary, the parent automatically will benefit. To the economic unit concept, the benefits of ownership are inherent in the definition of control.

Proponents of both points of view would draw a line at some minimum level of ownership for consolidation purposes - no matter whether ownership is a separate condition for consolidation (parent company and proportionate consolidation concepts) or is an indicator of control (economic unit concept). Current practice in the U.S. tends to draw the line at majority ownership.

Proponents of the parent company concept are more likely to take a strict majority-ownership approach than their economic unit counterparts, who look to ownership as evidence of the ability to control rather than as a separate condition for consolidation. Those who are willing to consolidate at levels of voting ownership below a majority point out, for example, that the owner of a large minority, interest can have effective control by forming an alliance with one or a few other owners. Or the owner of a large minority can have effective control simply because the remaining shares are widely held and no other shareholder has been more than a passive investor. They note that companies often are controlled at ownership levels of 20% or 30% or even lower.

The further below the majority threshold, the more in both camps who jump off the consolidation bandwagon. Parent company proponents are likely to jump off sooner because the ownership benefits diminish as ownership levels drop, even if the minority owner is still in control.

Interestingly, a majority ownership cutoff or some other relatively fixed division between consolidation and non-consolidation is not as important to proportionate consolidation as it is to either the parent company or economic unit concepts. When it comes to consolidation, the economic unit and parent company concepts are "all or nothing." If the defined ownership threshold is crossed - majority or otherwise - 100% of a subsidiary's individual assets, liabilities, revenues, and expenses are included in consolidated statements. If the threshold is not crossed, none of those individual items are included; instead, the equity method is used, resulting in financial statements that differ significant. from consolidated statements. Proportionate consolidation, on the other hand, includes only the parent's portion of the subsidiary's assets, liabilities, revenues, and expenses, minimizing the impact of a dividing line, and the necessity even to draw such a line.

The DM examines a number of other circumstances that have been brought to the FASB's attention regarding whether control exists for purposes of consolidation. Examples include the following: * Does the power of one company to obtain a majority voting interest in another company through conversion of a convertible security or through exercise of an option justify consolidation? * Should a subsidiary be consolidated if control by its parent is expected to be temporary, for example, if the parent is required by law or court order to sell the subsidiary or if the parent has announced an intention to dispose of the subsidiary? * Is consolidation appropriate if a company is controlled through a management contract, a lease, or other contractual arrangement even if a majority or a large minority voting interest is not owned? * Sometimes, one entity (known as a "sponsor") creates another entity (known as a "special-purpose entity") to serve the sponsor's purposes. Nominal ownership of the special-purpose entity is held by a party other than the sponsor. However, the special-purpose entity is required to operate for the benefit of the sponsor under the terms of a contract entered into when the special purpose entity was created. A typical example is that the special-purpose entity serves as a financing vehicle for the sponsor by buying the sponsor's receivables. in such circumstance, should control of the created entity by the creating entity be presumed, and therefore consolidation be required, until the creating entity has clearly divested itself of control, even in the absence of majority or significant minority ownership?

MEASURING NET ASSETS,

GOODWILL, AND NON-CONTROLLING

INTEREST

Each of the three concepts results in different measurements in consolidation for the subsidiary's identifiable assets and liabilities, goodwill, and the non-controlling interest. Exhibit 1 summarizes the measurement procedures pursuant to the three concepts if a subsidiary is acquired in a single transaction. Exhibit 2 provides a simple numerical example.

EXHIBIT2

EXAMPLE:SUBACQUIREDINA

SINGLETRANSACTION

FAIRVALUEBOOKVALUE

OFSUB'SOFSUB'S

STOCKAMOUNTIDENTIFIABLEIDENTIFIABLE

PURCHASEDPAIDNETASSETSNETASSETS

80%$1,600$1,500$900

InConsolidation:

ParentCompany:

Sub'sidentifiablenetassetsincludedat

$1,380(80%x$1,500)+(20%x$900)

Goodwill=$400$1,600-(80%x$1,500)

Non-controllinginterest=$18020%x$900

EconomicUnit:

Sub'sidentifiablenetassetsincludedat$1,500

PurchasedGoodwillInterpretation:

Goodwill=$400$1,600-(80%x$1,500)

Non-controllinginterest=$30020%x$1,500

FullGoodwillInterpretation:

Goodwill=$500$1,600/.80=$2,000

$2,000-$1,500=$500.

With respect to identifiable assets and liabilities, the differences among the methods concern whether to recognize in consolidation 100% of fair values (economic unit) or only the parent's share of fair values (parent company and proportionate consolidation). Of course, proportionate consolidation excludes the non-controlling interest's share completely, whereas the parent company concept records that share at book value.

Exhibit 1 describes two interpretations for measuring goodwill under the economic unit concept. The "purchased goodwill" interpretation recognizes only the parent's purchased goodwill and excludes any goodwill pertaining to the non-controlling (minority) interest. The "full goodwill" interpretation recognizes 100% of the subsidiary's goodwill either based on an appraisal or inferred from the price paid to purchase the controlling shares and the fair values of all identifiable assets on that date.

As for measuring the non-controlling interest in the subsidiary's identifiable net assets, under the parent company concept, it is based strictly on the subsidiary's book value, whereas under the economic unit concept it is based on the subsidiary's fair values, including the fair value of the non-controlling interest's share of goodwill under the "full goodwill" interpretation.

SUBSIDIARY ACQUIRED IN A

STEP ACQUISITION

Exhibit 3 summarizes consolidation measurement procedures under the three concepts if a subsidiary is acquired by purchasing a series of smaller blocks of stock until control is finally obtained, known as a step acquisition. Exhibit 4 is the corresponding example.

EXHIBIT 3

MEASUREMENTS IN CONSOLIDATION:

SUB ACQUIRED N STEP ACQUISITION

Parent Company Concept:

* Each step purchase is separate acquisition layer of identifiable assets and goodwill. Aggregate layers in consolidation. * For each layer: Include sub's identifiable net assets at sum of parent's shares of their fair values at various acquisition plus non-controlling interest's share at sub's current book values. * For each layer: Goodwill = Parent's cost minus its share of fair values of identifiable net assets. * For each layer: Non-controlling interest = its share of sub's book values.

Proportionate Consolidation: * Same layering as parent company for identifiable assets and goodwill. * For each layer: Exclude non- controlling interest's share of identifiable net assets entirely.

Economic Unit Concept:

* Sub's identifiable net assets included in consolidation at 100% of fair value (parent's and non-controlling share) on date control is obtained. * Goodwill = Two interpretations:

Purchased Goodwill Interpretation: Recognize only the amount of goodwill purchased on the date control is attained.

Full Goodwill Interpretation: Recognize 100% of goodwill based on price paid by parent or appraisal. * Recognize holding gain or loss on previously owned shares. * Non-controlling interest = its share of sub's fair values (including its share of goodwill under "full goodwill" interpretation).

Perhaps the three most important observations about step acquisitions relate to 1) the layering under the parent company and proportionate consolidation concepts, 2) recognizing a holding gain or loss under the economic unit concept, and 3) measuring goodwill under the "purchased goodwill" interpretation.

Layering

Under both the parent company and proportionate consolidation concepts, each purchase by the parent of an investee's stock is accounted for as a separate acquisition. Those separate acquisitions aggregate after control is obtained to determine the amounts of the acquired identifiable assets and liabilities included in consolidated financial statements. Consolidated statements thus contain layers corresponding to each asset and liability of the subsidiary, including goodwill, at the various times the parent purchased the subsidiary's stock. Under the parent company concept, the identifiable assets and liabilities also include the non-controlling interest's share of book values at balance sheet date, not individual layers on the various acquisition dates. Proportionate consolidation excludes the non- controlling interest's share entirely.

Holding Gain or Loss

Since the economic unit concept recognizes 100% of the fair values of the subsidiary's identifiable net assets as of the date control is attained in a step acquisition, a holding gain or loss must be recognized on any previously purchased ownership shares if the current fair value of those shares differs from the amount at which they are carried on the parent's books. The underlying net assets represented by the shares purchased earlier are accounted for as having the same carrying amount (fair value at the date control is attained) as those purchased later, requiring the parent's investment account to be increased or decreased to reflect fair value at the date control is attained, and leading to gain or loss.

Purchased

Goodwill

Exhibit 3 indicates that in a step acquisition under the "purchased goodwill" interpretation of the economic unit concept, only the amount of goodwill purchased on the date control is attained is recognized. Goodwill implicit in the purchase of the preconsolidation blocks of stock (while the equity method was being followed) is not recognized. That is a debatable point among economic unit proponents. An alternative school of thought says the preconsolidation goodwill should be recognized. If that approach to the "purchased goodwill" interpretation were followed, $308 of goodwill would be recognized in Exhibit 4 (the same $58 and $250 layers as the parent company concept) and the holding gain would have been $90 (30% of the $500 increase in fair value of the subsidiary's assets minus $60 of income previously recognized under the equity method). The DM discusses this and several other possible alternatives.

SUBSEQUENT PURCHASES

AND SALES OF STOCKS

Under the economic unit concept, since the non-controlling (minority) interest is deemed part of consolidated ownership equity, purchases and sales of the subsidiary's stock after control is obtained are transactions with owners, that is, treasury stock transactions. To illustrate, if the parent buys additional shares in the subsidiary, from the perspective of the consolidated entity, cash has been paid to owners to reacquire outstanding ownership interests (treasury stock purchases). Conversely, if the parent sells some of its shares while maintaining a controlling interest, from the perspective of the consolidated entity cash has been received in exchange for issuing shares of equity ownership in the entity (treasury stock sales).

The parent company and proportionate consolidation concepts handle the transactions differently. Even after control is attained, additional purchases of the subsidiary's stock result in acquisition of added layers of identifiable net assets and added layers of goodwill. Sales of shares of the subsidiary's stock while maintaining a controlling interest results in a realized gain or loss because transactions with non-controlling interests are regarded as transactions with outsiders, not with owners. To measure that gain or loss, the layers must be peeled away using a method such as FIFO, LIFO, or average to determine the carrying amounts of the subsidiary's assets and liabilities in the consolidated financial statements and the parent's gain or loss on the sale of the stock.

A related issue in the DM is whether to recognize gain or loss if the subsidiary issues additional shares rather than if the parent sells some of its holding. From a consolidated perspective, the result is the same - the consolidated entity has more cash and a larger outstanding ownership interest. In current practice, some companies recognize gain or loss if the subsidiary issues additional shares while others treat the transaction as a capital transaction.

BALANCE SHEET DISPLAY

The major display issue in a consolidated balance sheet is where to present the non-controlling (minority) interest in the subsidiary's net assets. Under the economic unit concept, the non-controlling interest conceptually is a part of the ownership of the entire economic unit. Accordingly, non-controlling interest is displayed on the balance sheet as a component of stockholders' equity.

It is more difficult to articulate the nature and classification of a non-controlling interest under the parent company concept. That concept views the consolidated financial statements as those of the parent, with the assets and liabilities of the subsidiary merely substituting for the parent's investment on the balance sheet. Consolidated ownership equity represents the interests of the parent's stockholders. Non-controlling interest is not part of consolidated stockholders' equity because the non-controlling investors in a subsidiary do not have an ownership interest in the subsidiary's parent. On the other hand,, non-controlling interest is not a liability, because the parent does not owe anything to the minority stockholders. FASB Concepts Statement 6 states that minority interest does not satisfy the conditions for a liability. Nonetheless, minority interest has to be presented somewhere. The alternatives include: * Show non-controlling interest as a liability and include it in a subtotal of total liabilities; or * Show non-controlling interest as a separate classification between liabilities and stockholders' equity; This tends to be current practice. Some who support this view would present a subtotal total liabilities that excludes the non-controlling interest. Others would omit any subtotal of total liabilities.

Of course, the issue goes away under proportionate consolidation, because non-controlling (minority) interest is excluded entirely.

INCOME STATEMENT DISPLAY

Under the economic unit concept, consolidated net income comprises the earnings on all net assets controlled by the parent company's management, including the subsidiary's net assets. Part of that net income belongs to the minority stockholders in consolidated subsidiaries; the rest belongs to the stockholders of the parent company. Thus, under the economic unit concept, consolidated net income represents income attributable to both the controlling and non- controlling interests. It is allocated between the two stockholder groups "below the bottom line" or maybe even in a note.

Under the parent company concept, consolidated net income is the earnings on capital invested by the stockholders of the parent entity. Consequently, income attributable to the non-controlling interest in consolidated subsidiaries is deducted before arriving at consolidated net income. Consolidated net income is the remainder attributable only to the controlling interest. This is practice today.

How to deduct or display income attributable to the non-controlling interest in the subsidiary is not an issue under proportionate consolidation.

RIPE FOR CHANGE

Admittedly, consolidations may not be the easiest accounting subject to get into. But it's a pervasive issue that, after 32 years, is ripe for comprehensive review by FASB.

Paul Pacter, PhD, CPA, is a Professor of Accounting at the University of Connecticut at Stanford. He is the author of the Discussion Memorandum, Consolidation Policy and Procedures, for the FASB. The views expressed in this article are his own, not necessarily those of the FASB. Official positions of the FASB are determined only after extensive due process and deliberations.