Question

There are several theories to application accounting for combination and consolidation of business and there are many methods to measure the consolidation, explain these theories and measurement methods?

Answer 1

CONSOLIDATION THEORIES
The evolution of the consolidation parent, entity, and traditional/hybrid theories of
consolidation is outlined below.
Parent Company Theory
This theory assumes that consolidated financial statements are an extension of
parent company statements and should be prepared from the viewpoint of the parent
company stockholders (Beams, et al, 2009). Advocates of this theory believe that
consolidated financial statements do not provide any value to the non-controlling
stockholders of the acquired subsidiary.

Exhibit 1. Evolution of Accounting for Business Combinations (FASB, 2007b):
1944: American Accounting Association publishes “The Entity Theory of
Consolidated Statements” by Professor Maurice Moonitz. Consolidation focus is
the total business entity.
1959: ARB No. 51 is published - Consolidated Financial Statements.
Consolidation focus is a hybrid between parent only and total business entity
theories. Describes an ambiguous definition of control and therefore is not
definitive under which circumstances consolidation is necessary. Led to the
evolution of the traditional theory used in consolidation procedures.
1970: APB Opinion 16 is published - Business Combinations. Dictated business
combinations be accounted for using one of two methods, the pooling-of-interests
method or the purchase method. The consolidation focus is the parent with the
traditional or hybrid approach used in its implementation.
1987: FAS 94 is issued - Consolidation of All Majority-Owned Subsidiaries.
Amends ARB No. 51 to require consolidation of all majority-owned subsidiaries
unless control is temporary or does not rest with the majority owner. Focuses on
the traditional hybrid accounting approach.
2001: FAS 141 is issued - Business Combinations. Requires all business
combinations be accounted for using the purchase method. Recommends
continued use of the traditional/hybrid method of implementation.
2007: FAS 141R is issued - Business Combinations. Replaces FAS 141 and
requires the acquisition method of accounting be used for business combinations.
Also, prescribes the identification of an acquirer for each business combination.
Uses the entity theory and fair value measurements for implementation.
2007: FAS 160 is issued – Non-controlling Interests in Consolidated Financial
Statements. Amends ARB 51 to establish accounting and reporting standards for
the non-controlling interest in a subsidiary and for the deconsolidation of a
subsidiary. Uses the entity theory and fair value measurements for
implementation.
The parent company theory has unique characteristics in the way certain elements
of the consolidated financial statements are disclosed when a non-controlling interest is
present. When net income for the consolidated entity is reported, the parent company
theory only takes into account the parent company’s share of subsidiary income. If a noncontrolling interest exists, the non-controlling interest share of net income is deemed to
be an expense. The non-controlling interest in the subsidiary is reported as a liability on
the consolidated financial statements. Unrealized gains and losses from upstream sales
are eliminated to the extent of the parent company’s ownership percentage in the
subsidiary (Davis and Largay, 2008)

Contemporary/Entity Theory
The contemporary/entity theory differs from the parent-company theory in that
the consolidated financial statements prepared under this approach take into account the
total entity created by the parent company and the subsidiary. This theory creates
consolidated financial statements that will provide value to various groups including the
parent company shareholders, non-controlling shareholders of the subsidiary, and
creditors. Under the entity theory, the controlling shareholders, non-controlling
shareholders, and consolidated entity are considered equal, with no preference or
emphasis given to group (Beams, et al, 2009).
The reporting of consolidated net income under the entity theory includes total net
income of the parent company and the subsidiary and then allocates the controlling and
non-controlling share of subsidiary net income accordingly. The non-controlling interest
in the subsidiary is designated by a separate line item in the stockholders’ equity section
of the consolidated balance sheet. In the case of unrealized gains and losses from
upstream sales, the total unrealized gain or loss is eliminated. The amount eliminated is
then assigned to income to non-controlling and controlling stockholders according to
their respective ownership percentages (Walsh, 2006-7).
There are additional differences between the parent company theory and the entity
theory in the manner in which assets of the subsidiary are valued. The entity theory
consolidates subsidiary assets and liabilities at their fair values, and it accounts for the
controlling and non-controlling interests in those net assets consistently. The fair value of
the subsidiary’s assets is derived from the purchase price paid for a given percentage of
ownership in the subsidiary (Walsh, 2006-7).

While the entity theory provides more relevant and representationally faithful
information to decision makers when compared to the parent company theory, there are
critics who believe that the price paid by the parent company for its controlling interest is
not a valid basis for valuation of non-controlling interests (Chen and Chen, 2009). This is
due to the fact that once the parent is able to exercise absolute control over the subsidiary,
the shares held by non-controlling stockholders do not represent equity ownership in the
usual sense

Traditional/Hybrid Theory
The traditional theory of consolidation incorporates characteristics of the parent
company theory and the contemporary/entity theory. The consolidated statements
prepared using the traditional theory are intended to benefit the parent company
shareholders, as is the case with the parent company theory, and a wider audience that
includes the parent company’s creditors. However, the non-controlling interest of the
subsidiary that is highlighted by the entity theory is still lost (Beams, et al, 2009).
The traditional theory improves on the parent company theory’s accounting for
the non-controlling interest. While the traditional theory calculates consolidated net
income using a similar process as used in the parent company theory, it avoids reporting
the non-controlling interest as an expense and a liability. The preferred accounting
practices under traditional theory report non-controlling interest as a reduction of
consolidated net income and an increase to equity that is essentially a wash to overall
equity (Davis and Largay, 2008).
The traditional theory also implements characteristics of both parent company
theory and entity theory in its approach to valuing assets of the acquired subsidiary and
the elimination of unrealized gains and losses from upstream sales. When the assets of
the acquired subsidiary are consolidated, the traditional theory follows the same process
as the parent company theory and consolidates subsidiary assets at their book values, plus
the parent company’s share of any excess fair value over book values. However,
elimination of unrealized gains and losses arising from upstream sales under the
traditional theory follows a process similar to that used under the entity theory

METHODS:

There are three consolidation methods, which are used depending on the strength of the Parent company's control or influence (see also Significant influence): Full consolidation, Proportionate consolidation, and the Equity method.

Full consolidation :

Full Consolidation consists in transferring all the Subsidiary's Assets, Liabilities and Equity to the Parent company's Balance sheet and all the Revenues and Expenses to the Parent company's Income statement. The accounts of a Subsidiary are fully consolidated if it is controlled by its parent.

Proportionate consolidation :

The proportional consolidation method of accounting records the assets and liabilities of a joint venture on a company's balance sheet in proportion to the percentage of participation a company maintains in the venture

Equity method:

Equity accounting is an accounting process for recording investments in associated companies or entities. Companies sometimes have ownership interests in other companies. Typically, equity accounting–also called the equity method–is applied when an investor or holding entity owns 20–50% of the voting stock of the associate company. The equity method of accounting is used only when an investor or investing company can exert a significant influence over the investee or owned company.