Financial 4 - Basic Consolidation Concepts

Question 1

Criteria for Consolidating Financial Statements when a Company has Controlling Interest

Answer 1

FS are consolidated when:

1. 2 companies are in unrelated industries (ex. manufacturing and real estate)
2. Consolidation of Finance companies are usually required
3. A difference in fiscal periods of a parent and subsidiary will not stop the consolidation of Financial Statements

Exception: When the subsidiary is in legal reorganization or bankruptcy and/or the subsidiary operates under severe foreign currency exchange restrictions, controls, or other governmentally imposed uncertainties so severe that they cast significant doubt on the parent’s ability to control the subsidiary

Question 2

Parent-Subsidiary Relationship

Answer 2

• Consolidated FS are prepared in recognition of the accounting concept of Economic Entity. This means that the economic entity can be identified with a unit of accountability
• Consolidated FS are prepared when a parent-subsidiary relationship has been formed
• An investor is considered to have parent status when control over an investee is established or more than 50% of the voting stock of the investee has been acquired

Question 3

Consolidation Accounting Application

Answer 3

RULE: In a vertical chain, where a parent company owns more than 50% of subsidiary company and subsidiary owns more than 50% of a third company, consolidate:

1. Third Company into Subsidiary
2. Subsidiary (now consolidated with third company) into parent company

Question 4

Variable Interest Entity Characteristics

Answer 4

Determining the Primary Beneficiary

1. Has power to direct the activities of a VIE
2. Has obligation to absorb expected VIE losses
3. Has right to receive expected VIE returns

The primary beneficiary is NOT required to have greater than 50% ownership of the VIE

Variable Interest in an Entity

1. Option to acquire a leased asset at fair value at the end of the lease term
2. Forward contract to sell assets owned by the entity
3. Explicit guarantee of the entity’s debt

Most liabilities, EXCLUDING short-term payables (AP) are variable interest

** An entity has insufficient equity investment at risk if the entity’s equity investment is less than the equity investment of similar non-VIE entities