1 ACCOUNTING FOR MULTIPLE ENTITIESCHAPTER 16 ACCOUNTING FOR MULTIPLE ENTITIES 17
2 Introduction Businesses find it useful to combine operations for efficiencies of scale Accounting issues for multiple entities: Business combinations Consolidations and segment reporting Foreign currency translation 18
3 Business CombinationsWyatt’s classifications Classical era Second wave Third era Why do businesses combine? Tax consequences Growth and diversification Financial considerations Competitive pressure Profit and retirement 19
4 Business CombinationsTwo methods of acquisition cash exchange of stock Accounting Method Accounting Treatment Purchase Fair Market Value & Goodwill Pooling of Interests Book Value 20
5 Criticisms of the Pooling of Interests MethodAccounting is distorted Investment is not disclosed Assets undervalued Income overstated in subsequent years FASB decision Economic consequences arguments
6 The Fresh Start Method Some combinations are a merger of equals in which none of the combined companies survive Revalue all assets as if it were a newly formed entity
7 The Purchase Method Must be usedwhen one company acquires the net assets of a business and also obtains control over that business SFAS No. 141 applies to both incorporated and unincorporated businesses
8 The Purchase Method When a business combination is created by an exchange of stock, SFAS No. 141 requires that the following “pertinent facts and circumstances” be taken into consideration: The relative voting rights The existence of a large minority voting interest The composition of the governing body The composition of senior management The terms of exchange of equity securities. Subsequently allocate cost to all identifiable assets with remainder to goodwill
9 Business Combinations IIFASB – IASB project on business combinations Phase 1- Valuation of intangibles Phase 2 – Develop a common set of principles intended to improve the completeness, relevance and comparability of financial information about business combinations. Tentative conclusion that business combinations should be recorded at fair value as defined is SFAS No. 157
10 Consolidation When one business organization has control over another they should report as a unified whole Now required by SFAS No. 94 ARB No. 51 criteria Parent-subsidiary relationship Control Maintenance of control Operate as integrated unit Approximate fiscal years Principles Cannot own or owe itself Cannot make a profit by selling to itself 21
11 Should control be presumed in cases of less than 50% ownership?The Concept of Control The power of one entity to direct or cause the direction of the management and operating and financing policies of another entity Control is presumed when the parent Owns the majority of the subsidiary’s outstanding common stock Has the ability to dominate the subsidiary’s board of directors Has the ability to dissolve the entity Should control be presumed in cases of less than 50% ownership? 22
12 The Modified Approach to ControlFASB Exposure Draft Asks the question: Is consolidation required? Is the entity a special purpose entity and is it a transferor or its affiliate? (Use SFAS No 140 criteria) Are the permitted activities and powers of the entity significantly linked? If not the presumption of control exists Are powers limited? Can the party change the entity’s purpose? If so consolidate Also consolidate if no new cash outlay or benefits exceed new cash outlay If step 3 does not require consolidation, assess whether variable interests are significant
13 Theories of ConsolidationEntity theory Parent company theory Emphasis is on control of a group of legal entities operating as a single unit Purpose of consolidated statements is to provide information for parent company stockholders 23
14 Noncontrolling InterestDefinition Placement Liability Separately presented Stockholder equity Noncontrolling interest and theories of consolidation Doesn’t meet SFAC definition of liability FASB ED suggests “non-controlling interest in subsidiaries” Report as separate component of stockholders’ equity 24
15 Should it be attributed to minority interest?Additional Issues Proportionate consolidation ignore minority interest Goodwill Drawbacks to consolidation loss of information Should it be attributed to minority interest? 25
16 Special Purpose EntitiesPartnership, corporation, trust, or joint venture created for a limited purpose limited life and limited activities designed to benefit a single company Primary motive for most SPEs off-balance sheet financing often to avoid reporting capital leases under SFAS No. 13. Companies are able to avoid consolidation of SPEs in which they do not have a majority voting interest SPE is created by an asset transfer The assets are sold to the SPE To achieve off-balance sheet treatment minimum (previously 3%, now 10%) investment from an independent third party investor is required
17 Special Purpose EntitiesSFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” Outlines requirements to qualify an SPE for non-consolidation Transferor company, has surrendered control over the transferred assets (and thus has a sale) when all of the following conditions are met: The transferred assets have been put beyond the reach of the transferor and its creditors Each transferee (SPE) has the right to pledge or exchange the assets and no conditions constrain the transferee from taking advantage of its right to pledge or exchange The transferor does not maintain effective control over the transferred assets through either an agreement that entitles and obligates the transferor to repurchase or redeem the transferred assets before maturity or the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call New FASB exposure draft
18 Segmental Reporting How it became a factor Why important?SEC line-of-business reporting NYSE recommendations Why important? Various operations may have differing prospects for growth rate of profitability and degrees of risk Assessment of decentralized management What to disclose Operations in different industries Foreign operations Major customers 26
19 SFAS No 14 Criteria Definition Reporting guidelines Identity segmentReportable segment Revenue Operating profit or loss Identifiable assets Reporting guidelines Reportable segments Information to be disclosed Where to disclose 27
20 SFAS No. 131 Operating segmentReport balance sheet and income statement information about each operating segment Include other specified information if it is included in the measurement of segment profit Include other geographic information Include reliance on major customers
21 Foreign Currency TranslationForeign currency translation issues Increase of foreign operations Allowing dollar to float on world market Necessary to state financial statements in a common measuring unit Problems: When do you measure difference? How do you translate specific assets and liabilities Methods of translation Current – Noncurrent Monetary – Nonmonetary Current Temporal 31
22 FASB and Foreign Currency TranslationSFAS No. 8 Closely follows the temporal method Measure in conformity with US GAAP Record transactions at initial exchange rate Use balance sheet date or measurement date as basis for translation of balance sheet items Use transaction date for revenues and expenses Exchange gains and losses in income Gains and losses from foreign exchange contracts in income 32
23 FASB and Foreign Currency TranslationSFAS No. 52 SFAS No. 8 produced distortions SFAS No. 52 adopted functional currency approach Record transactions in functional currency Adjust, if necessary to comply with GAAP Translate into currency of reporting company Transaction gains and losses reported in OCI If local currency is not functional currency - gains and losses in income 33
24 Foreign Currency Translation – Additional IssuesTranslation vs. Remeasurement Translation – expressing amounts denominated or measured in a different currency Remeasurement – measuring transactions originally denominated in a different unit of currency (use temporal method Foreign currency hedges Fair value hedge Cash flow hedge Hedge of net investment in foreign operations 34
25 International Accounting StandardsThe IASC has issued standards dealing with the following issues: IFRS No 3 Business Combinations (replaces IAS No. 22) IAS No 21 (revised) The Effects of Changes in Foreign Exchange Rates IAS No. 27 (Revised) Consolidated Financial Statements and Accounting for Investments in Subsidiaries IFRS No 8 Operating Segments (Replaces IAS No. 14)
26 IAS No. 27: Consolidated Financial Statements and Accounting for Investments in SubsidiariesRevised statement does not change the fundamental approach to accounting for business combinations Parent companies should present consolidated financial statements when it has the ability to control its subsidiaries which is similar to U. S. GAAP. Concept of control is defined somewhat differently. IAS No. 27 defines control as the power to govern a subsidiary U. S. GAAP focuses on ownership of a majority voting interest
27 Major Revisions to IAS No. 27IAS No. 27 permits wholly owned (and virtually wholly-owned) subsidiaries to be excluded from consolidation If the exemption is applied, an entity should disclose: the reason for not publishing consolidated financial statements the name of the parent that publishes consolidated financial statements that comply with IFRS. Minority interests should be presented in equity, separately from parent shareholders' equity. The exemptions from consolidation are tightened
28 IAS No 21: The Effects of Changes in Foreign Exchange RatesInitially record transactions at historical cost Use monetary - nonmonetary method for subsequent transactions Translate monetary items at current rate Translate nonmonetary items at either historical or current rate depending upon when they were measured Exchange gains and losses reported as a component of stockholders’ equity
29 IFRS No 3: Business CombinationsRequires all business combinations to be accounted for using the purchase method The pooling of interests method is prohibited Acquirer must be identified for all business combinations
30 IFRS No 3: Business CombinationsThe acquirer measures the cost of a business combination at the sum of the fair values, at the date of exchange, of assets given, liabilities incurred or assumed, and equity instruments issued by the acquirer The acquirer recognizes separately, at the acquisition date, the acquiree's identifiable assets, liabilities and contingent liabilities that satisfy specified recognition criteria
31 ISRS No. 8: Operating SegmentsAdopts requirements of SFRS No. 131 except for some terminology “Management Approach” Operating segments become reportable based on threshold tests related to Revenues Results Assets Requires disclosure of “measure” of profit or loss and total assets
32 Prepared by Kathryn Yarbrough, MBAEnd of Chapter 16 Prepared by Kathryn Yarbrough, MBA Copyright © 2009 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.