Chapter 11: Consolidation Theories, Push-Down Accounting, and Corporate Joint Ventures by Jeanne M David, Ph.D., Univ of Detroit Mercy to accompany Advanced Accounting, 10th edition by Floyd A Beams, Robin P Clement, Joseph H Anthony, and Suzanne Lowensohn © Pearson Education, Inc publishing as Prentice 11-1 Theories, Push-Down Accounting, and Joint Ventures: Objectives Compare and contrast the elements of consolidation approaches under traditional theory, parent-company theory, and contemporary entity theory Adjust subsidiary assets and liabilities to fair values using push-down accounting Account for corporate and unincorporated joint ventures Identify variable interest entities Consolidate a variable interest entity © Pearson Education, Inc publishing as Prentice 11-2 Consolidation Theories, Push-Down Accounting and Corporate Joint Ventures 1: Consolidation Theories © Pearson Education, Inc publishing as Prentice 11-3 Parent Company Theory Consolidated financial statements are • Extension of parent company statement • Viewpoint of parent company shareholders Prepare consolidated statements • To benefit parent company shareholders Noncontrolling interests • Have the separate (subsidiary) statements © Pearson Education, Inc publishing as Prentice 11-4 Entity Theory Consolidated financial statements • Viewpoint of the total business entity • All resources of the entity are valued consistently – Impute the value of the firm from the acquisition price • Income of noncontrolling interests is a distribution of the total business income © Pearson Education, Inc publishing as Prentice 11-5 Income Reporting • Parent company theory and traditional theory – Consolidated net income is income to the parent company shareholders • Entity theory – Total consolidated income is to be shared between the controlling and noncontrolling interests © Pearson Education, Inc publishing as Prentice 11-6 Asset Valuation • Parent company theory and traditional theory – Assets and liabilities are adjusted to market value at acquisition, but only to the extent of the parent's ownership share • Land with a book value of $50 and fair value of $80 would be consolidated at $80 if the parent owned 100%, but at $71 (including only 70% of the $30 appreciation in value) if the parent owned 70% • Entity theory – Assets and liabilities are consolidated at fair value • Land would be consolidated at $80 regardless of ownership percentage © Pearson Education, Inc publishing as Prentice 11-7 Unrealized Gains and Losses • Parent company theory – Unrealized gains and losses attributable to the subsidiary are only eliminated to the extent of the parent's ownership • 80% of the $10 unrealized profits on upstream sales would be eliminated if the parent owned 80% of the subsidiary • Entity theory and traditional theory – Unrealized gains and losses are eliminated • All theories treat downstream gains and losses the same © Pearson Education, Inc publishing as Prentice 11-8 Consolidated Stockholders' Equity • Contemporary theory – Noncontrolling interest is a single amount and a part of stockholders' equity • Entity theory – Noncontrolling interest is also part of stockholders' equity – It would be decomposed into paid in capital, retained earnings, etc • Other ideas being promoted – Use footnote disclosure for CI and NCI shares of consolidated income – Use proportional consolidation, excluding NCI from the statements © Pearson Education, Inc publishing as Prentice 11-9 Consolidation Theories, Push-Down Accounting and Corporate Joint Ventures 2: Push-Down Accounting © Pearson Education, Inc publishing as Prentice 11-10 Push-Down Example • Paly buys 90% of Sim Sim's book and fair values are: BV FV BV FV Cash 5 Liabilities 25 30 Inventory 10 15 Capital stock 100 Plant assets 200 300 Retained earnings 90 50 Total 215revalue • IfGoodwill Sim applies push-down accounting, it would Total 215 370assets, liabilities, and record its inventories, fixed goodwill © Pearson Education, Inc publishing as Prentice 11-13 Sim Uses Parent Company Theory • Sim revalues assets and liabilities only to the extent of Paly's ownership Only 90% of the increases/decreases are recorded Inventory 4.5 Plant assets 90.0 Goodwill 45.0 Retained earnings 90.0 Liabilities 4.5 Push-down capital 225.0 © Pearson Education, Inc publishing as Prentice 11-14 Sim Uses Entity Theory • Sim fully revalues assets and liabilities 100% of the increases/decreases are recorded Inventory Plant assets 100 Goodwill 50 Retained earnings 90 Liabilities Push-down capital 240 © Pearson Education, Inc publishing as Prentice 11-15 Push-Down Differences • The example used 90% ownership by the parent • SEC requires push-down accounting when the firm is substantially owned… 97% – Differences between the methods of application will be considerably less • Leveraged Buyouts with a change in controlling interest – Changing accounting basis may be appropriate © Pearson Education, Inc publishing as Prentice 11-16 Consolidation Theories, Push-Down Accounting and Corporate Joint Ventures 3: Joint Ventures © Pearson Education, Inc publishing as Prentice 11-17 Joint Ventures (def.) • Form – Partnership or corporate – Domestic or foreign – Temporary or relatively permanent • It is a business entity that is owned, operated and jointly controlled by a small group of investors for the conduct of a specific business undertaking that provides mutual benefit for each of the venturers © Pearson Education, Inc publishing as Prentice 11-18 Corporate Joint Ventures • Investors who participate in the overall management of the joint venture (APB Opinion No 18) – Use equity method for the joint venture – If significant influence is not present, use the cost method • Investors with more than 50% of the voting stock have a subsidiary, not a joint venture – Consolidate the subsidiary © Pearson Education, Inc publishing as Prentice 11-19 Unincorporated Joint Ventures • Although not specifically addressed by APB Opinion No 18, application of the equity method to unincorporated joint ventures is appropriate • Industry specific practice – Proportional consolidation in oil & gas and undivided interests in real estate ventures © Pearson Education, Inc publishing as Prentice 11-20 Consolidation Theories, Push-Down Accounting and Corporate Joint Ventures 4: Identify Variable Interest Entities © Pearson Education, Inc publishing as Prentice 11-21 Variable Interest (def.) "Variable interests in a variable interest entity are contractual, ownership, or other pecuniary interests in an entity that change with changes in the fair value of the entity's net assets exclusive of variable interests." (FIN 46(R), para.2c) The primary beneficiary of the variable interest entity (VIE) must consolidate the VIE © Pearson Education, Inc publishing as Prentice 11-22 Primary Beneficiary • The entity that will – Absorb the majority of the expected losses, receive a majority of the expected gains or both – If separate entities are expected to absorb the profits and losses, the entity expected to absorb the losses is the primary beneficiary • The primary beneficiary may be an equity holder and/or creditor of the VIE © Pearson Education, Inc publishing as Prentice 11-23 VIE Example • Get Rich Quick is a VIE with equity contributed equally by 10 parties, including Corrine • The VIE will borrow additional amounts equal to twice the equity The bank is the major creditor/investor! • Corrine agrees to absorb 75% of the losses and will take 28% of the profits The other nine investors will share equally – Corrine is the primary beneficiary and consolidates the VIE – All 10 equity investors will have to make detailed disclosures about their interests in this VIE © Pearson Education, Inc publishing as Prentice 11-24 Consolidation Theories, Push-Down Accounting and Corporate Joint Ventures 5: Consolidate Variable Interest Entities © Pearson Education, Inc publishing as Prentice 11-25 Special Consolidation Considerations • VIEs are consolidated like other subsidiaries – FASB Statement No 141 • Exception – Goodwill can only be recorded if the VIE is a "business" FIN 46(R) – If the VIE is not a "business," the excess paid is an extraordinary loss • "business" "Self-sustaining, integrated set of activities and assets conducted and managed for providing a return to investors." © Pearson Education, Inc publishing as Prentice 11-26 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher Printed in the United States of America Copyright © 2009 Pearson Education, Inc Publishing as Prentice Hall © Pearson Education, Inc publishing as Prentice 11-27 ... Parent company theory and traditional theory – Assets and liabilities are adjusted to market value at acquisition, but only to the extent of the parent's ownership share • Land with a book value... subsidiary assets and liabilities to fair values using push-down accounting Account for corporate and unincorporated joint ventures Identify variable interest entities Consolidate a variable interest... Assets and liabilities are consolidated at fair value • Land would be consolidated at $80 regardless of ownership percentage © Pearson Education, Inc publishing as Prentice 11-7 Unrealized Gains and