Corporate structures have become increasingly complex since the last decade. Some companies have diversified into additional lines of business through internal growth and acquisitions while others have consolidated, concentrating on their core and more profitable businesses. Many companies of all sizes have expanded into foreign markets, frequently by establishing subsidiaries and invest significant amount of capital in it. Accounting rule makers and regulators are more and more focused on how to account for the investments in subsidiaries.
This post discusses the accounting for investment in subsidiaries, with international overview. Enjoy!
Definitions of Control in Subsidiary Relationships
A subsidiary is defined as an entity that is controlled by another entity. Therefore, the definition of control is of primary concern in determining whether or not consolidated financial statements should be prepared. The definitions of control fall into two categories: legal control and economic control.
Definitions of control based on legal control look to specific objective conditions that demonstrate the ability of the parent to control the subsidiary. Examples of legal control include:
- Ownership of a majority voting interest in the subsidiary
- Ownership of a majority of the equity securities of the subsidiary
- Ability by contract, proxy, or otherwise, to appoint a majority of the subsidiary’s board of directors
Economic control is a more subjective concept than legal control. Some examples of economic control are:
- The control of legally independent entities by a mutually agreed system of central and unified management
- The right to direct the operating and financial policies of the enterprise through either a controls contract or provisions in the enterprises’ Articles
This concept relies on a subjective determination of when the operation of a group of entities is sufficiently unified to constitute economic control.
The full consolidation has emerged throughout the world as the predominant method of accounting for investments in subsidiaries in the primary financial statements. Accounting rule makers and regulators have come to accept that the financial statements of a parent and its subsidiaries should report the financial position, results of operations, and cash flows as if they were one legal entity. Multiple subsidiaries may be formed for tax, legal, or other reasons, but they function as a single economic unit and should report as one.
Proponents of full consolidation recognize that members of the group may operate in a decentralized manner and that management of the various subsidiaries may be given broad authority to run their business with minimum supervision by the parent. The subsidiaries, however, operate for the benefit of the group and will be able to continue to operate in a decentralized manner only as long as they serve the needs of the group. The parent retains the power to control the subsidiaries whether they exercise it or not.
Note: The alternatives to full consolidation, the equity method and the cost method have become less acceptable over time, because they potentially obscure the nature and extent of operations conducted by the subsidiaries and the parent’s control over them. If the equity method is used, the parent reports its share of the subsidiary income or losses but does not display the subsidiary assets or liabilities.
In the United States, the equity method is acceptable only when a company has significant influence over another company but does not have control. When the cost method is used, the parent does not report its share of the undistributed income and, of even greater concern, does not report its share of subsidiary losses. The cost method thus provides a means to conceal losses by transferring loss operations to existing or newly created subsidiaries.
In the United States, the cost method is generally accepted accounting principles (GAAP) only when a company invests in another company but neither has control or significant influence. It is true that footnote disclosures can partially compensate for the deficiencies of the equity or cost method; however, information in the footnotes commands less attention than the information contained on the face of the financial statements. Further information in the footnotes generally is excluded from financial statement databases.
Full consolidation, however, does not solve all of the problems. Creditors in the individual entities in the consolidated group need separated financial statements to reveal the resources that are available for the repayment of their loans. Consolidated financial statements may also need footnote disclosure to explain restrictions on the transfer of cash or other assets between the members of the group.
Accounting Requirements for Investment in Subsidiaries
What is required for the accounting for investment in subsidiaries? It varies from one country to another country. This section describes the accounting requirement in the United States, Canada, the European Union, the United Kingdom, Japan, and the requirements of International Accounting Standards. Follow on…
In the United States
The primary guidance in the United States is FASB Statement No. 94, “Consolidation of All Majority-Owned Subsidiaries.” Statement No. 94 requires the parent to fully consolidate all companies in which it “has a controlling financial interest through direct or indirect ownership of a majority voting interest.” SFAS 94 contains two exceptions to this rule:
- if control is likely to be temporary, or a long-term investment position is not contemplated, such as when a majority interest is acquired for the purpose of facilitating other business deals and not with a meaningful commitment to the acquired company; and
- if the control does not rest with the majority shareholders.
If the subsidiary is in legal reorganization or in bankruptcy, control may not rest with the parent company management, but with fiduciaries, such as bankruptcy trustees or creditors. Similarly, effective control of foreign subsidiaries may rest with the foreign government, in cases where foreign exchange restrictions, controls, or other governmentally imposed restrictions are so severe that they cast significant doubt on the parent’s true ability to control the subsidiary. If the subsidiary were not consolidated because control does not rest with the majority shareholders, it would generally be accounted for by the cost method.
Rule 3A-02 of SEC Regulation S-X is substantially similar to Statement No. 94. Rule 3A-02 differs in two respects:
- It requires full consolidation of majority-owned “entities,” which includes non-incorporated entities.
- It notes that, in certain rare circumstances, it may be necessary to consolidate an entity fully notwithstanding the lack of majority ownership, “because of the existence of a parent-subsidiary relationship by means other than record ownership of voting stock.”
In 1989, the SEC staff became increasingly concerned about special-purpose entities (SPEs):
“Certain characteristics of those transactions raise questions about whether SPEs should be consolidated (notwithstanding the lack of majority ownership). . . . Generally, the SEC staff believes that for nonconsolidation . . . to be appropriate, the majority owner (or owners) of the SPE must be an independent third party who has made a substantive capital investment in the SPE, has control of the SPE, and has made a substantive capital investment in the SPE, and has substantive risks and rewards of ownership of the assets of the SPE (including residuals). Conversely, the SEC staff believes that non-consolidation. . . [is] not appropriate . . . when the majority owner of the SPE makes only a nominal capital investment, the activities of the SPE are virtually all on the sponsor’s or transferor’s behalf, and the substantive risks and rewards of the assets or the debt of the SPE, rest directly or indirectly with the sponsor or transferor.”
In 1995, the FASB issued an Exposure Draft, “Consolidated Financial Statements: Policy and Procedures” and in 1999 issued a revision, “Consolidated Financial Statements: Purpose and Policy.” The revision draft addresses only consolidation policy issues while the initial deals with both consolidation policy and procedures. According to the 1999 Exposure Draft:
“The purpose of consolidated financial statements is to report the financial position, results of operations, and cash flows of a reporting entity that comprises a parent and its affiliates essentially as if all of their assets, liabilities, and activities were held, incurred and conducted by a single entity with one or more branches or divisions. What binds separate legal entities into a single reporting entity is the parent’s decision-making authority, direct or indirect, over each of the entities in the group and the parent’s consequent ability to direct their activities, including the use of their assets.”
The 1999 Exposure Draft would still require the consolidation of all controlled companies but it would change the definition of control. Control would no longer be defined as the majority ownership of the voting stock of the entity. The draft provides the following definition of control:
“Control—the ability of an entity to direct the policies and management that guide the ongoing activities of another entity so as to increase its benefits and limit its losses from that other entity’s activities, For purposes of consolidated financial statement, control involves decision-making ability not shared with others.”
This definition and the ensuing discussion in the 1999 ED recognize two versions of control, legal control and effective control. Legal control involves the unconditional ability to select a majority of an entity’s governing board, and is typically indicated by direct or indirect control of a majority of the entity’s voting shares. Effective control achieves the needed decision-making ability by other means, typically a large minority ownership position and other factors that enable the parent to dominate the entity’s governing board and, accordingly its decision-making process.
Determining whether effective control exists is largely a matter of judgment. The Exposure Draft provides implementation guidance consisting of presumptions of effective control in business organizations and ten specific examples of applying the notion of effective control when the conclusion is not obvious. The Exposure Draft suggests that the presumptions of effective control exists when an entity (including its subsidiaries):
- Possesses a large minority voting interest that produces a majority of the votes typically cast in the election of a corporation’s governing board with other voting interests being generally dispersed
- Possesses the unilateral ability to obtain a majority voting interest in a corporation’s governing board, such as the ownership of options, including those embedded in convertible securities, which if exercised produce such a majority voting interest.
- Is the general partner in a limited partnership in which no other group of limited partners can remove the general partner or dissolve the limited partnership
The primary guidance in Canada is Section 1590 of the CICA Handbook. Section 1590 defines a subsidiary as:
“an enterprise controlled by another enterprise (the parent) that has the rights and ability to obtain future economic benefits from the resources of the enterprise and is exposed to related risks.“
Control of the enterprise is defined as:
“The continuing power to determine its strategic operating, investing and financing policies without the co-operation of others . . . An enterprise is presumed to control another when it owns, directly or indirectly, an equity interest that carries the right to elect the majority of the members of the other enterprise’s board of directors, and is presumed not to control the other enterprise without such ownership.
Control does not exist if an enterprise is acquired “with the clearly demonstrated intention that it be disposed of in the foreseeable future.” In addition, control does not exist, even when one enterprise has majority voting rights in a second enterprise, if a statute or agreement imposes “severe” long-term restrictions” on the ability of the second enterprise to distribute earnings to the first enterprise or undertake other transactions with the first enterprise. “For example, the imposition of severe foreign exchange or currency export restrictions over a foreign subsidiary may indicate that control has been lost.”
A parent is required to fully consolidate all subsidiaries. Certain disclosures are required if an enterprise concludes that it does not control another enterprise despite ownership of majority voting rights or concludes that it does control another enterprise despite not owning majority-voting rights.
In the European Union
Guidance on the preparation of consolidated financial statements in the European Union is found in the Seventh Directive. These requirements are legally enforceable for all EU member countries once they have been introduced into each country’s national laws. As of 1992 all of the member countries have adopted the Directive.
The Directive generally requires parents to prepare financial statements that account for investments in subsidiaries by the full consolidation method. The Directive provides a framework for the preparation of these statements with numerous options in two areas: which parent undertakings are required to present consolidated financial statements and what constitutes a parent–subsidiary relationship.
Consolidation is required under Article 1 of the Directive when any of the following circumstances apply:
- The investor corporation holds a majority of the shares with voting rights.
- The investor corporation has a shareholding and the right to appoint a majority of the board of directors.
- The corporation has a dominant influence as a result of a contract.
The Directive permits the following parent relationships not to be reported in consolidated financial statements:
- Parent undertakings that are not companies incorporated with limited liability
- Parent undertakings that are themselves subsidiaries of a higher-level parent, if the higher-level parent prepares financial statements that fully consolidate the intermediate parent
- Parent undertakings that are purely passive holding companies, that is, are not involved directly or indirectly in the management of their subsidiaries and are not represented on the subsidiaries’ boards of directors
- Small parent undertakings that fall below certain size thresholds
The Seventh Directive permits member states some flexibility in defining control, and thus in defining the subsidiaries that are to be fully consolidated. The first four relationships listed below are defined by the Directive as constituting control and thereby creating a parent–subsidiary relationship. Relationships five and six may be defined by member states as constituting control:
- The parent has majority voting rights in the subsidiary.
- The parent is a shareholder and has the right to appoint or to remove a majority of the subsidiary’s directors.
- The parent has the right to exercise a dominant influence over the subsidiary under a contract or pursuant to the subsidiary’s bylaws, and local law permits such a contract or bylaw provision. Member states may prescribe that the parent also must be a shareholder. (These contract or bylaw provisions may not be permitted in some member states.)
- The parent is a shareholder but controls alone, by agreement with the other shareholders, a majority of the voting rights of the subsidiary. (Member states may enact more detailed provisions concerning the form and content of the agreement.)
- The parent is a shareholder, and a majority of the subsidiary’s directors holding office since the beginning of the preceding year have been appointed solely by the parent’s exercise of its voting rights. This condition would not result in a parent–subsidiary relationship if another entity were parent under relationship 1, 2, or 3 above. A member state electing this option may require that the parent hold at least 20% of the subsidiary’s shares.
- A parent holds a “participating interest” (long-term equity interest of 20% or more), and either exercises dominant influence over the subsidiary or manages the subsidiary on a unified basis with itself. (A member state could define a “participating interest” to exist at a lower level of ownership.)
Furthermore, consolidation may be required by individual member states where there is a shareholding and a dominant influence or unified management in practice. Some of the options available to the EU member states are:
- Group corporations may include those managed on a unified basis or dominantly influenced.
- Requirements to consolidate may be restricted to parents that are corporations.
- Financial holding corporations may be exempted.
- “Small groups” may be exempted from consolidation, except listed corporations.
- EU groups may be exempted if owned by non-EU parents that prepare “equivalent” accounts.
- Exclusion of subsidiaries from consolidation is permitted on the basis of immateriality, long-term restrictions, expense, or delay.
- Pooling of interests accounting is permitted.
- Proportional consolidation is permitted.
In The United Kingdom (UK)
Requirements for consolidated financial statements in the United Kingdom conform to the Seventh Directive. The statutory requirements are contained in the Companies Act of 1985 as amended by Companies Act of 1989. The accounting requirements are contained in the Accounting Standards Committee SSAP1, “Accounting for Associated Companies,” as amended by the Accounting Standards Board Interim Statement “consolidated Accounts” and by the Accounting Standards Board Financial Reporting Standard FRS2, “Accounting for Subsidiary Undertakings.
The Securities and Exchange Law requires listed companies, over-thecounter traded companies, and companies that have filed registration statements in the past under the Securities and Exchange Law to prepare both parent-company only statements and consolidated financial statements. A subsidiary is defined as,
“a corporation in which a parent has direct or indirect ownership of a majority voting interest by standards issued by the Business Accounting Deliberation Council.“
Subsidiaries are not to be consolidated if:
- control does not rest with the majority owner,
- the subsidiary is not a going-concern enterprise, or
- control is temporary.
Subsidiaries would also be excluded from consolidation if the result would mislead readers of the consolidated financial statements. Subsidiaries could also be excluded from consolidation if they are so immaterial that exclusion for the consolidated statements would not prevent reasonable judgement on financial position or operating results of the group of consolidated companies. This excluded subsidiary would generally be accounted for by the use of the equity method.
The International Accounting Standards
International Accounting Standards Committee IAS No. 27, “Consolidated Financial Statements and Accounting for Investments in Subsidiaries,” requires full consolidation of all subsidiaries, with the following exceptions:
A parent is exempted from presenting consolidated financial statements if it is itself a wholly or virtually wholly owned subsidiary of a parent that presents consolidated financial statements.
A subsidiary should be excluded from consolidation if (a) Control is intended to be temporary because the subsidiary is acquired and held exclusively with a view to its subsequent disposal in the near future; or (b) The subsidiary operates under severe long-term restrictions that significantly impair its ability to transfer funds to the parent.
Subsidiaries excluded from consolidation should be accounted for in accordance with IAS No. 25, “Accounting for Investments.” This pronouncement permits long-term investments to be accounted for at cost, lower of cost or market, or fair value. IAS No. 27 defines control as “the power to govern the financial and operating policies of an enterprise so as to obtain benefit from its activities.”
Exclusion of Subsidiaries From Full Consolidation
While the predominant method of accounting for investments in subsidiaries is full consolidation, under certain circumstances subsidiaries should be excluded from consolidation. The most common reasons for exclusion from consolidation are:
- Reason-1. Control Not Resting With Legal Owners – If a subsidiary is in bankruptcy, control might not rest with the legal owners but with a bankruptcy trustee; in this situation, the legal owners should not consolidate the subsidiary. Likewise, if a foreign subsidiary is severely restricted in terms of its business operations or its distribution of earnings by government restrictions or foreign currency controls, the parent should not consolidate the subsidiary. If consolidation is inappropriate for these reasons, the parent in all probability also does not have significant influence and therefore the subsidiary should be accounted for by the cost method.
- Reason-2. Control Is Temporary – This exemption would generally apply to newly acquired subsidiaries. Most authorities believe that if a parent has consolidated a subsidiary in the past, it should continue to do so until the subsidiary is sold or otherwise disposed of. The subsidiary continues to be controlled until the sale and consolidation aids in comparability with past periods. However, if a subsidiary has been purchased with the intention of reselling, there are good arguments for the nonconsolidation of the subsidiary.
- Reason-3. Significantly Different (Nonhomogeneous) Lines of Business – This is still a controversial topic. The trend is toward full consolidation. The United States, Canada, the United Kingdom, and the IASC rules require consolidation regardless of the lines of business. However, many accountants argue that the issuance of parent financial statements that account for subsidiaries in significantly different lines of business by the use of the equity method and the issuance of separate financial statements of the nonconsolidated subsidiaries is more meaningful.
Those opposed to the consolidation of businesses in nonhomogeneous lines of business may be confusing and also may obscure important information. Companies in financial businesses have different assets, liabilities, revenues, expenses, and financial ratios than those in manufacturing and commercial business. The users of financial statements could have a better understanding of the financial conditions of the group if the parent’s financial statements consolidate only the subsidiaries with similar financial and accounting characteristics and present separate financial statements for entities with significantly different financial and accounting characteristics.
Proponents of the full consolidation of all controlled subsidiaries believe that full consolidation presents more meaningful financial information. They agree that users of financial statements are interested in the performance of individual business units, but they believe that the appropriate response is to issue consolidated statements that include all controlled subsidiaries along with either segment information or separate financial statements for the various business units.
Sub-issues in Accounting for Subsidiaries
A number of subissues exist concerning accounting for subsidiaries. Some of these subissues are:
Issue#1. Conceptual Approach to Consolidation
The first issue is the selection of a conceptual approach to consolidation. The question is essentially one of entity definition: Should the focus of consolidation reporting be on the parent, the total business entity, or on some other construct? Here are some fundamental concepts available to be observed:
Parent Theory Of Consolidation – Currently, the generally accepted consolidation practices have followed the parent theory of consolidated statements. This approach considers the consolidated statements to be no more than an extension of the parent company financial statements. The consolidated statements are not intended to be of a significant benefit to the minority interest. The cost principle is followed in that only the parent’s share of the assets acquired and the liabilities assumed is reported in the fair value evidenced by the parent’s cost. The minority interest continues to be carried at book value, since no transaction occurred, and hence no cost incurred for this portion. Minority interest is treated basically as creditors. Major characteristics of the parent theory can be summarized as follows:
- Fair values are assigned only to the portion of the assets and liabilities acquired by the parent. The minority interest share of the assets and liabilities is continued to be carried at their book value.
- Goodwill reported on the consolidated statements relates only to the parent’s interest.
- Minority interest in the subsidiary reflects the minority interest’s share of the book value of the stockholders’ equity.
- Minority interest in the subsidiary generally appears in the noncurrent liability section of the consolidated statement of financial position. The consolidated stockholders’ equity relates only to the controlling interest.
Entity Theory Of Consolidated Financial Statements – The entity theory of consolidated financial statements is referred to by the FASB as the economic unit approach full consolidation method. The is the principal alternative to the parent company approach. The viewpoint of this theory is that consolidated financial statements should reflect the total business entity. The resources of the subsidiary controlled by the consolidated entity relate to both the controlling and to the minority shareholders. All of the assets acquired and liabilities acquired in the purchase transaction are valued at their values. Major characteristics of the entity theory of consolidated financial statements may be summarized as follows:
- Fair values are assigned to all of the subsidiary’s assets and liabilities including the portion attributed to the minority (noncontrolling) interest.
- Goodwill is derived from the total fair value that is inferred from the price paid by the parent for its fractional interests, and pertains to both the controlling and noncontrolling shareholders.
- Minority interest in the subsidiary reflects the minority’s share of the total fair value of the subsidiary’s stockholders’ equity.
- Minority interest in the subsidiary is separately disclosed and is included within the consolidated stockholders’ equity.
Modified Entity Theory – This theory is also known as the economic unit approach/purchased goodwill method. Under this theory, the identifiable assets and liabilities of the subsidiary are recorded at their fair value in the consolidated statement of financial position, and the appropriate portion is reflected in the minority interest.
Goodwill, however, is viewed as a premium paid by the parent for the value of the control over the subsidiary. When viewed in this way, goodwill accrues only to the parent, not to the noncontrolling shareholders, thus no goodwill is attributed to the minority interest. The goodwill calculated under this theory would be the same as the goodwill calculated under the parent company approach.
Issue#2. Elimination of Intercompany Profits – Under both the parent company and economic entity approaches, all intergroup transactions and related profits are eliminated in consolidation. If the subsidiary is not wholly owned, the profit elimination may be allocated between the majority and minority shareholders. There is, however, controversy over when the allocation of the profit elimination is appropriate. Most accountants believe that in the sale from the parent to the subsidiary (downstream sale), all of the eliminated profit should be charged to the majority owners and that allocation is appropriate only in sales from the subsidiary to the parent (upstream sales).
Issue#3. Push-Down Accounting – Controversy also exists over how purchased subsidiaries should report in their separate financial statements. The general rule is that the adjustments to the fair value of assets and liabilities are made only on consolidated working papers and are not recorded on the books of the subsidiary. If separate financial statements are issued by the subsidiary, they report the subsidiary’s original book values.
The Push-Down Accounting practice is now being questioned in the United States, especially with reports that have to be made to the Securities and Exchange Commission (SEC). Under Staff Accounting Bulletin (SAB) No. 54, “Application of `Push Down’ Basis of Accounting in Financial Statements of Subsidiaries, Acquired by Purchase,” when a change in ownership involving substantially all (generally at least 95%) of an acquired company’s stock occurs, it establishes a new basis of accountability for the acquired company, equal to the cost of the acquisition. Under push-down accounting, the new owner’s cost of the acquired company is “pushed down” to the acquired company by recording the fair value of the assets and liabilities on the acquired company’s books. This procedure assures that the acquired company’s separate financial statements report the same valuation reflected in the consolidated financial statement. This procedure is criticized by some, however, because it permits an entity to revalue its assets and liabilities based on an ownership change rather than on a purchase transaction made by the entity.
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