Question

Q 2-45 Indicate the two approaches to presenting con- solidated statements. Q 2-46 Describe how a company could be required to consolidate another company in which it has no or minor voting stock. Q 2-47 Consolidation rules are similar between coun- tries. Comment. Salaries Expense Salaries Payable $1,000 (increase) 1,000 (increase) Explain how the matching concept applies in this situation. Q 2-29 Why are adjusting entries necessary?

Answer 1

Ans : Q2-45

Two apporaches for presenting the consolidated statements are as follows ;

1) Properitory theroy : i.e where the associate or subsidiary company prepare its own financial statments . The proprietary theory of accounting views the firm as an extension of its owners. The assets and liabilities of the firm are considered to be assets and liabilities of the owners themselves.Similarly, revenue of the firm is viewed as increasing the wealth of the owners, while expenses decrease the wealth of the owners

When applied to the preparation of consolidated financial statements, the proprietary concept results in a pro rata consolidation.The parent company consolidates only its proportionate share of the assets and liabilities of the subsidiary.

2) Parent Company Theory : The parent company theory is perhaps better suited to the modern corporation and the preparation of consolidated financial statements than is the proprietary approach.The parent company theory recognizes that although the parent does not have direct ownership of the assets or direct responsibility for the liabilities of the subsidiary, it has the ability to exercise effective control over all of the subsidiary’s assets and liabilities, not simply a proportionate share.

Under parent company theory, separate recognition is given in the consolidated balance sheet to the noncontrolling interest’s claim on the net assets of the subsidiary and in the consolidated income statement to the earnings assigned to the noncontrolling shareholders.

Ans to Q 2-46

Public companies were required to implement the consolidation provisions in Interpretation no. 46(R) in 2003 and 2004. Private companies with an interest in a VIE that was created after December 31, 2003, should have consolidated those entities immediately. Most private companies with VIEs that existed on December 31, 2003, made transition disclosures during calendar year 2004 and were required to consolidate those VIEs no later than calendar year 2005.

WHO SHOULD CONSOLIDATE?
Under Interpretation no. 46(R) a VIE must be consolidated into the financial statements of the primary beneficiary company when either of the following conditions exist:

The VIE does not have sufficient equity investment at risk.

Equity investors in the VIE lack any of three characteristics of controlling financial interest. Investors with such an interest

— Participate in decision-making processes by voting their shares.

— Expect to share in returns generated by the entity.

— Absorb any losses the entity may incur.

To avoid consolidation the total equity investment at risk should be sufficient for the VIE to finance its activities without additional support. CPAs can help reporting entities evaluate the sufficiency of equity at risk using qualitative or quantitative methods. Use the qualitative approach first to make the consolidation vs. nonconsolidation decision; use the quantitative approach if qualitative methods don’t result in a definitive conclusion. Where neither approach provides an answer, use a combination of the two.

Qualitatively, a VIE must be able to demonstrate it can get nonrecourse financing from an unrelated party without additional subordinated financial support from other entities or individuals, including equity investors. Examples of such support include equity investments, loans, guarantees and commitments to fund operations. When provided by related parties, such support is considered provided by the primary reporting entity. In many cases involving private companies, these additional support arrangements exist between and among affiliated entities and indicate there is not sufficient equity at risk for the VIE to operate on a stand-alone basis.

Quantitatively, the general rule is that at least 10% of the fair value of the VIE’s assets must be provided as an equity investment. (A lesser investment does not give the entity sufficient equity to operate alone.) The 10% rule is not a safe harbor—having more equity at risk should not lead CPAs to presume the VIE has sufficient equity at risk to cover any expected losses.

If the equity investors lack any of the three characteristics described above, the VIE’s primary beneficiary must consolidate the entity. Conversely, where equity investors have these characteristics and the other requirements in Interpretation no. 46(R), no investor needs to consolidate the VIE.

A VIE’s primary beneficiary is the entity that will consolidate it in its financial statements. In some cases, it is relatively easy to determine which entity is the primary beneficiary through a qualitative analysis of the entity’s ability to make decisions about the VIE and share in its profits or losses. In those circumstances where one entity receives the majority of expected returns and another absorbs the majority of expected losses, the entity that absorbs the losses is the primary beneficiary. This means the ability to absorb expected losses is a tie-breaker CPAs should use to determine which entity, if any, is a VIE’s primary beneficiary. However, CPAs should base the consolidation vs. nonconsolidation decision on a determination of which entity holds a majority of the variable interests in another entity. Exhibit 1 describes a public company that had already implemented Interpretation no. 46(R). Exhibit 2 includes some practical issues CPAs working with private companies should consider in deciding whether to consolidate.

Exhibit 1 : Consolidation of Variable Interest Entities—Public Company Example

In evaluating whether an affiliated entity needed to be consolidated using the guidance in Interpretation no. 46(R), some reporting entities initially concluded they were not the primary beneficiary of a VIE and later concluded they were the primary beneficiary.

BUSINESS CONSOLIDATIONS
In replacing the original Interpretation no. 46, FASB concluded a primary reporting entity need not evaluate activities deemed to be businesses to determine whether they are VIEs unless certain conditions exist. Excluded entities should use other accounting literature to determine whether consolidation is required. CPAs should consider an entity for consolidation if one or more of these conditions exist:

The reporting entity, its related parties or both participated significantly in the design or redesign of the entity. This condition does not apply if the entity is an operating joint venture under control of the reporting entity and one or more independent parties or a franchisee.

The entity is designed so that substantially all of its activities either involve or are conducted on behalf of the reporting entity and its related parties.

The reporting entity, its related parties or both provide more than half of the total equity, subordinated debt or other forms of subordinated financial support based on an analysis of the fair values of interests in the entity.

The entity’s activities are primarily related to securitizations or other forms of asset-backed financings or single-lessee leasing arrangements.

Exhibit 2 : Consolidation of VIEs by Private Companies

I t’s not uncommon for the owners of private companies to personally own the real estate used in the business and to lease it under an operating lease. In those cases the company must decide whether the real estate and any related mortgage need to be recognized in its financial statements. In the past, only rents paid by the business were reflected in the financial statements. Here’s a three-step decision-making process CPAs should use to determine if this is necessary. Step 1: Is the real estate “housed” in an entity? If the answer is no, there is no consolidation requirement under Interpretation no. 46(R). Entities subject to this provision might be corporations, partnerships, limited liability companies and grantor and other trusts. If the owners of the business own the real estate outside an entity, there is no requirement to consolidate it into the financial statements of the business. Step 2: If the answer in step 1 is yes, the next question would be, Is that entity a VIE? If the answer is no, there is no consolidation requirement under Interpretation no. 46(R). There should be sufficient equity at risk for the VIE to operate on a stand-alone basis. Equity investors should have the characteristics typically associated with a controlling financial interest. There should be no guarantees from other entities or owners. There should be no additional collateral. There should be no subordinated debt outstanding (second mortgages or intercompany loans). There should be no loans from equity investors or related parties to those equity investors. There should be no above-market lease payments or management fees. Step 3: If the answer in step 2 is yes, then which entity, if any, is the primary beneficiary of the VIE? If no entity is the primary beneficiary, there is no consolidation requirement under Interpretation no. 46(R). There can only be one primary beneficiary associated with a VIE. The primary beneficiary may be determined qualitatively without undertaking an exhaustive quantitative analysis. The primary beneficiary provides the majority of the VIE’s financial support. The primary beneficiary receives the majority of expected returns and absorbs the majority of expected losses. If one investor is entitled to the majority of expected returns and another must absorb the majority of expected losses, the latter is the primary beneficiary. Using the guidance in Interpretation no. 46(R), not all VIEs need to be consolidated, paralleling the requirement that not all voting interest entities are consolidated under ARB no. 51. To the extent risk has been effectively disbursed between and among investors, the result might be that no entity is considered a VIE’s primary beneficiary.

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