Lecture 07 Consolidation

Question 1

What is consolidation?

Answer 1

Consolidation is the process of merging the accounts of the parent with those of its subsidiaries for financial statement presentation purposes.

In broad outline, consolidation means
adding the parent’s and subsidiaries’ balance sheets and income statements together, line by line; and
canceling any redundant balances.

The equity investment account (equity-method income) gets replaced by the subsidiaries’ assets and liabilities (revenues and expenses).

Question 2

When do companies get consolidated?

Answer 2

The investor (parent) must have not only significant influence but also control over the investees.

An investor has control over an investee if

• the investor owns more than 50 percent of the equity (voting rights) of the investee; or
• the investor has the power to direct the investee’s activities by other means, such as contractual arrangements or potential voting rights.

Question 3

How is consolidation done?

Answer 3

1. Align the balance sheets of the parent and of all controlled investees (subsidiaries) next to each other, account by account.
2. Replace the ending equity (retained earnings) balance by the beginning-of-period balance and the income statement items (and dividends, if any).
3. Leave an extra column (or several columns) on the right, for the elimination of redundant amounts.
4. The consolidated financial statement line items will be the sum of all entities’ balances, plus or minus any eliminations.
5. The parent’s investment in the subsidiary corresponds to the subsidiary’s equity capital (with adjustments).
6. The equity capital of the subsidiary equals the net balance of its assets and liabilities.
7. Since we are adding these assets and liabilities directly in our worksheet, the investment balance has become redundant.
8. Cancel the equity-method investment against the subsidiary’s equity.
9. Recall that the purchase cost of the equity investment usually exceeds the book equity value of the investee.
10. This excess purchase price is allocated to the fair value of the investee’s assets and liabilities, with the residual booked as goodwill.
11. The excess fair value is not included in the subsidiary’s own records.
12. Add all excess fair value balances, including goodwill, to the respective subsidiary’s balance sheet and increase its equity accordingly.
13. Then cancel the parent’s investment against the subsidiary’s equity.
14. After the acquisition, the parent recognizes equity-method investment income each period, equal to its share of the subsidiary’s net income.
15. Consolidation brings in the subsidiary’s full income statement, making the parent’s investment income redundant.
16. Remove the parent’s equity-method investment income when eliminating the equity-method investment account.
17. Some of the excess purchase price may have been allocated to assets with a finite useful life.
18. The depreciation or amortization of these excess balances does not show up in the subsidiary’s accounting.
19. When adding excess fair value balances, use the carrying value at the beginning of the period.
20. Then record the current-period amortization (including impairments) on the excess balance as an additional expense of the subsidiary.
21. Parent and subsidiary often have transactions with each other (transferring intermediate products; intrafirm lending; etc.).
22. From the consolidated entity’s perspective, these transactions are redundant, since the entity is effectively doing business with itself.
23. Eliminate the revenues from all intercompany transactions against the corresponding expenses.
24. Eliminate all intercompany receivables against the corresponding payables.
25. If an intercompany sale involves the transfer of goods, the buying entity recognizes expenses only when it sells the goods to a third party in turn.
26. Unsold goods remain in assets (usually inventory) at their transfer value.
27. The excess of this transfer value over the seller’s cost basis is a fictitious profit created because the consolidated entity did business with itself.
28. Eliminate the profit left in unsold goods from intercompany transfers, by decreasing income and reducing the appropriate asset balance.
    (And reverse the reduction later when the goods are sold externally.)
29. Consolidation brings in 100% of the subsidiary’s balance sheets and income statements, but the parent might own less than 100% of its equity.
30. The subsidiary equity not owned by the parent is recognized as non-controlling (or minority) interest, a (non-parent-owners’) equity account.
31. Remove any subsidiary equity remaining after the cancellation of the parent’s investment account, and add the amount to minority interest.
32. Create an expense for the minority share of the subsidiary’s income, and add the amount to the minority interest balance in equity.

Question 4

What is included in non-controlling owners’ value basis?

Answer 4

Non-controlling (or minority) interest includes

• the share of the subsidiary’s book value not owned by the parent;
• the share of the excess fair value of all identifiable assets and liabilities that is not owned by the parent; and
• goodwill, equal to the share of the subsidiary’s total fair value not owned by the parent, minus the two items above.

The inclusion of non-controlling owners’ goodwill on the balance sheet is called the full goodwill method. We will use it in our exercises.

IFRS (but not US GAAP) also permits the partial goodwill method, by which non-controlling owners’ goodwill is omitted from the balance sheet.

Question 5

How are transactions between investor and investee treated in consolidation?

Answer 5

In downstream transactions (sales from parent to subsidiary), the full amount of eliminated transfer profit is attributed to the parent.

In upstream transactions (sales from subsidiary to parent), the transfer profit elimination can either

• be attributed to the parent in full; or
• be allocated between parent and non-controlling owners.

Question 6

What are the effects of income tax during consolidation?

Answer 6

• Depending on the tax law and the terms of the deal, acquisitions may or may not change the tax basis of the assets and liabilities of the investee.
• If the tax basis is carried over (remains unchanged), the excess fair value of identifiable assets and liabilities creates deferred tax positions.
• These deferred taxes are recognized as part of the purchase price allocation and subsequently reversed as the excess fair value is amortized.
• No deferred taxes are recognized for goodwill.
• No deferred taxes arise if the tax basis is stepped up to the purchase price.