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Understanding
Consolidation 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. 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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