CHAPTER 16 ACCOUNTING FOR MULTIPLE ENTITIES. Introduction Businesses find it useful to combine operations for efficiencies of scale Accounting issues.

CHAPTER 16

ACCOUNTING FOR MULTIPLE ENTITIES

Introduction

Businesses find it useful to combine operations for efficiencies of scale

Accounting issues for multiple entities:

Business combinations

Consolidations and segment reporting

Foreign currency translation

Business Combinations

Wyatt’s classifications1. Classical era

2. Second wave

3. Third era Why do businesses combine?

1. Tax consequences2. Growth and diversification3. Financial considerations4. Competitive pressure5. Profit and retirement

Business Combinations

Two methods of acquisition 1. cash

2. exchange of stock

Accounting Method

Purchase

Pooling of Interests

Accounting Treatment

Fair Market Value& Goodwill

Book Value

Criticisms of the Pooling of Interests Method

Accounting is distortedInvestment is not disclosed

Assets undervalued

Income overstated in subsequent years

FASB decisionEconomic consequences arguments

The Fresh Start Method

Some combinations are a merger of equals in which none of the combined companies survive

Revalue all assets as if it were a newly formed entity

The Purchase Method

Must be used when one company acquires the net assets of a business

and also obtains control over that business

SFAS No. 141 applies to both incorporated and unincorporated businesses

The Purchase Method

When a business combination is created by an exchange of stock, SFAS No. 141 requires that the following “pertinent facts and circumstances” be taken into consideration:

a. The relative voting rights b. The existence of a large minority voting interest c. The composition of the governing body d. The composition of senior management e. The terms of exchange of equity securities.

Subsequently allocate cost to all identifiable assets with remainder to goodwill

Consolidation

When one business organization has control over another they should report as a unified wholeNow required by SFAS No. 94ARB No. 51 criteria

Parent-subsidiary relationshipControlMaintenance of controlOperate as integrated unitApproximate fiscal years

PrinciplesCannot own or owe itselfCannot make a profit by selling to itself

The Concept of Control

The power of one entity to direct or cause the direction of the management and operating and financing policies of another entity

Control is presumed when the parent Owns the majority of the subsidiary’s outstanding common stockHas the ability to dominate the subsidiary’s board of directorsHas the ability to dissolve the entity

Should control be presumed in cases of less than 50% ownership?

The Modified Approach to Control

FASB Exposure Draft Asks the question: Is consolidation required?

1. Is the entity a special purpose entity and is it a transferor or its affiliate?

(Use SFAS No 140 criteria)2. Are the permitted activities and powers of the entity

significantly linked? If not the presumption of control exists

3. Are powers limited? Can the party change the entity’s purpose?

If so consolidate Also consolidate if no new cash outlay or benefits exceed new cash

outlay4. If step 3 does not require consolidation, assess whether

variable interests are significant

Theories of Consolidation

Entity theory

Parent company theory

Emphasis is on control of a group of legal entities operating as a single unit

Purpose of consolidated statements is to provide information for parent company stockholders

Minority Interest

Definition

PlacementLiability

Separately presented

Stockholder equity

Minority interest and theories of consolidation

Doesn’t meet SFAC definition of liability

FASB ED suggests “non-controlling interest in subsidiaries”

Additional Issues

Proportionate consolidation ignore minority interest

Goodwill

Drawbacks to consolidation loss of information

Should it be attributed to minority interest?

Special Purpose Entities

Partnership, corporation, trust, or joint venture

created for a limited purposelimited life and limited activitiesdesigned to benefit a single company

Primary motive for most SPEs off-balance sheet financingoften to avoid reporting capital leases under SFAS No. 13.

Companies are able to avoid consolidation of SPEs in which they do not have a majority voting interest SPE is created by an asset transfer

The assets are sold to the SPE

To achieve off-balance sheet treatmentminimum (previously 3%, now 10%) investment from an independent third party investor is required

Special Purpose Entities

SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”

Outlines requirements to qualify an SPE for non-consolidationTransferor company, has surrendered control over the transferred assets (and thus has a sale) when all of the following conditions are met:a. The transferred assets have been put beyond the reach of the transferor

and its creditorsb. Each transferee (SPE) has the right to pledge or exchange the assets and

no conditions constrain the transferee from taking advantage of its right to pledge or exchange

c. The transferor does not maintain effective control over the transferred assets through either 1. an agreement that entitles and obligates the transferor to

repurchase or redeem the transferred assets before maturity or

2. the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call

New FASB exposure draft

Segmental Reporting

How it became a factorSEC line-of-business reporting

NYSE recommendations

Why important?Various operations may have differing prospects for growth rate of profitability and degrees of risk

Assessment of decentralized management

What to discloseOperations in different industries

Foreign operations

Major customers

SFAS No 14 Criteria

DefinitionIdentity segment

Reportable segment

Revenue

Operating profit or loss

Identifiable assets

Reporting guidelinesReportable segments

Information to be disclosed

Where to disclose

SFAS No. 131

Operating segment

Report balance sheet and income statement information about each operating segment

Include other specified information if it is included in the measurement of segment profit

Include other geographic information

Include reliance on major customers

Foreign Currency Translation

Foreign currency translation issues Increase of foreign operations

Allowing dollar to float on world market

Necessary to state financial statements in a common measuring unit

Problems: When do you measure difference?

How do you translate specific assets and liabilities

Methods of translationCurrent – Noncurrent

Monetary – Nonmonetary

Current

Temporal

The FASB and Foreign Currency Translation

SFAS No. 8Closely follows the temporal method

Measure in conformity with US GAAP

Record transactions at initial exchange rate

Use balance sheet date or measurement date as basis for translation of balance sheet items

Use transaction date for revenues and expenses

Exchange gains and losses in income

Gains and losses from foreign exchange contracts in income

The FASB and Foreign Currency Translation

SFAS No. 52SFAS No. 8 produced distortions

SFAS No. 52 adopted functional currency approach

Record transactions in functional currency

Adjust, if necessary to comply with GAAP

Translate into currency of reporting company

Transaction gains and losses reported in OCI

If local currency is not functional currency - gains and losses in income

The FASB and Foreign Currency Translation

SFAS No. 52Foreign exchange contract

One transaction

Two transactions

How viewed

International Accounting Standards

The IASC has issued standards dealing with the following issues:

IAS No. 27

(Revised)

Consolidated

Financial

Statements and

Accounting for

Investments in

Subsidiaries

IAS No. 14

Reporting Financial

Information by Segment

exposure draft E51

(same title)

IAS No 21

(revised)

The Effects of

Changes in

Foreign

Exchange

Rates

IFRS No 3

Business Combinations

(replaces

IAS No. 22)

IAS No. 27: Consolidated Financial Statements and Accounting for Investments in Subsidiaries

Revised statement does not change the fundamental approach to accounting for business combinations

Parent companies should present consolidated financial statements

when it has the ability to control its subsidiaries which is similar to U. S. GAAP.

Concept of control is defined somewhat differently.

IAS No. 27 defines control as the power to govern a subsidiary

U. S. GAAP focuses on ownership of a majority voting interest

Major Revisions to IAS No. 27

1. IAS No. 27 permits wholly owned (and virtually wholly-owned) subsidiaries to be excluded from consolidation

2. If the exemption is applied, an entity should disclose:a. the reason for not

publishing consolidated financial statements

b. the name of the parent that publishes consolidated financial statements that comply with IFRS.

3. Minority interests should be presented in equity, separately from parent shareholders' equity.

4. The exemptions from consolidation are tightened

IAS No. 14: Reporting Financial Information by Segment

Revised IAS No. 14 issued 7/97 Requires companies to report information

along product and service lines

and along geographical lines.

The two bases of segmentation termed primary

secondary

Segments defined:organizational units

for which information is reported to the board of directors

IAS No. 14: Reporting Financial Information by Segment

Contains 10% materiality thresholds similar to U. S. GAAP

Standard requires reported segments to equal at lease 75% of consolidated revenue

FASB Review of IAS No. 14

Noted three significant differences from SFAS No. 131:

1 The process for identifying reportable segments

2 The treatment for vertically integrated segments

3 The basis of accounting

IAS No 21: The Effects of Changes in Foreign Exchange Rates

Initially record transactions at historical costUse monetary - nonmonetary method for subsequent transactions

Translate monetary items at current rateTranslate nonmonetary items at either historical or current rate depending upon when they were measuredExchange gains and losses reported as a component of stockholders’ equity

IAS No 21: The Effects of Changes in Foreign Exchange Rates

Major revisions

FASB staff review noted requirements similar to U. S. GAAP except for treatments of hedge accounting and goodwill

expressed concern that these differences might impair interfirm comparability

IFRS No 3: Business Combinations

Requires all business combinations to be accounted for using the purchase method

The pooling of interests method is prohibited

Acquirer must be identified for all business combinations

IFRS No 3: Business Combinations

The acquirer measures the cost of a business combination

at the sum of the fair values, at the date of exchange, of

assets given,

liabilities incurred or assumed,

and equity instruments issued by the acquirer

The acquirer recognizes separately, at the acquisition date,

the acquiree's identifiable assets,

liabilities

and contingent liabilities that satisfy specified recognition criteria

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Prepared by Richard Schroeder, DBAKathryn Yarbrough, MBA