Chapter 9

Consolidation
Ownership Issues

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Consolidation Ownership Issues

• Only simple ownership situations have been

presented in the preceding chapters.

• In practice, however, relatively complex

ownership structures are often found. For
example, a subsidiary may have preferred
stock outstanding in addition to its common
stock, and in some cases a parent may
acquire shares of both the common and the
preferred stock of the subsidiary.

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Consolidation Ownership Issues

• Additionally, one or more subsidiaries may

acquire stock of the parent or of other related
companies.

• Further, the parent’s ownership claim on a

subsidiary may change through its purchase
or sale of subsidiary shares or through stock
transactions of the subsidiary.

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Consolidation Ownership Issues
• The discussion in this chapter is intended to
provide a basic understanding of some of the
consolidation problems arising from complex
ownership situations commonly encountered
in practice. Specifically, the following topics
are discussed:
• Subsidiary preferred stock outstanding.
• Change in the parent’s ownership
interest in the subsidiary.
• Multiple ownership levels.
• Reciprocal or mutual ownership.
• Subsidiary stock dividends.

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 Subsidiary Preferred Stock Outstanding

• Many companies have more than one type of

stock outstanding.
• Each type of security typically serves a particular
function, and each has a different set of rights
and features.
• Because preferred shareholders of a subsidiary
do have a claim on the net assets of the
subsidiary, special attention must be given to
that claim in the preparation of consolidated
financial statements.
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Subsidiary Preferred Stock Outstanding

• Preferred stockholders normally have

preference over common shareholders with
respect to dividends and the distribution of
assets in a liquidation.

• The right to vote usually is withheld from

preferred shareholders, so that preferred stock
ownership normally does not convey control,
regardless of the number of shares owned.

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 Subsidiary Preferred Stock Outstanding

• Many other features of preferred stocks are

found in practice.

• For example, most preferred stocks are

cumulative, a few are participating, and many
are callable at some price other than par value.

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 Subsidiary Preferred Stock Outstanding

• Occasionally a parent company will hold

preferred stock of a subsidiary in addition to its
investment in the subsidiary’s common stock.

• Because the preferred stock held by the parent

is within the consolidated entity, it must be
eliminated when consolidated financial
statements are prepared.

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 Subsidiary Preferred Stock Outstanding

• Likewise, any income from the preferred stock

recorded by the parent also must be eliminated.

• Any portion of the subsidiary’s preferred stock

interest not held by the parent is assigned to the
noncontrolling interest.

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Subsidiary Preferred Stock Outstanding

• When a subsidiary with preferred stock

outstanding is consolidated, the provisions
of the preferred stock agreement must be
examined to determine the portion of the
subsidiary’s stockholders’ equity to be
assigned to the preferred stock interest.

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 Subsidiary Preferred Stock Outstanding

• A cumulative dividend provision provides some

degree of protection for preferred shareholders
by requiring the company to pay both current
and omitted past preferred dividends before any
dividend can be given to common shareholders.

• If a subsidiary has cumulative preferred stock

outstanding, an amount of income equal to the
current year’s preferred dividend is assigned to
the preferred stock interest in consolidation
whether of not the preferred dividend is
declared.
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Subsidiary Preferred Stock Outstanding

• When there are dividends in arrears on a

subsidiary’s cumulative preferred stock,
recognition is given in consolidation to the
claim of the preferred shareholders by
assigning to the preferred stock interest an
amount of subsidiary retained earnings
equal to the passed dividends.

• No special consolidation procedures are

needed with respect to undeclared dividends
on noncumulative subsidiary preferred stock.
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 Subsidiary Preferred Stock Outstanding

• Preferred stock participation features allow the

preferred stockholders to receive a share of
income distributions that exceed the preferred
stock base dividend rate.
• Although few preferred stocks are participating,
many different types of participation
arrangements are possible. Once the degree of
participation has been determined, the
appropriate share of subsidiary income and net
assets is assigned to the preferred stock interest
in the consolidated financial statements.

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 Subsidiary Preferred Stock Outstanding

• Many preferred stocks are callable, often at

prices that exceed the par value.

• The amount to be paid to retire a subsidiary’s

callable preferred stock under the preferred
stock agreement is viewed as the preferred
stockholders’ claim on the subsidiary’s assets,
and that amount of subsidiary stockholders’
equity is assigned to the preferred stock interest
in preparing the consolidated balance sheet.

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 Changes in Parent Company Ownership

• Although preceding chapters have treated the

parent company’s subsidiary ownership interest
as remaining constant over time, in actuality
ownership levels sometimes vary.

• Changes in ownership levels may result from

actions of either the parent or the subsidiary.

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 Changes in Parent Company Ownership

• The parent company can change ownership

ratios by purchasing or selling shares of the
subsidiary in transactions with unaffiliated
companies.

• A subsidiary can change the ownership

percentage of the parent by selling additional
shared to or repurchasing shares from
unaffiliated parties, or through stock transactions
with the parent (if the subsidiary is less than
wholly owned).
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Parent’s Purchase of Additional
Shares from Nonaffiliate

• A parent company may purchase the common

stock of a subsidiary at different points in time.

• When consolidated statements are prepared,

the cost of each block of stock purchased is
compared with the stock’s book value at the
date of purchase and the difference is treated
as part of the purchase differential to be
assigned.

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 Parent’s Purchase of Additional
Shares from Nonaffiliate

• In the event a purchase of additional shares is

make during the period, the eliminating entries
will be altered so that consolidated net income
will include only the earnings accruing to the
parent company for the portion of period in
which the additional shares are owned by the
parent.

• Consolidation procedures for interim acquisitions

are illustrated in Chapter 10.

9-18
 Parent’s Sale of Subsidiary
Shares to Nonaffiliate

• A gain or loss normally occurs and is recorded

on the books of the seller when a company
disposes of all or part of an investment.

• APB 18 deals explicitly with sales of stock of an

investee, requiring recognition of a gain or loss
on the difference between selling price and the
carrying amount of the stock.

9-19
 Parent’s Sale of Subsidiary
Shares to Nonaffiliate

• A question arises, however, when the shares

sold are those of a subsidiary and the subsidiary
continues to qualify for consolidation.

• When a parent sells some of the shares of a

subsidiary but continues to hold a controlling
interest, the question is whether the gain or loss
on the sale of shares should be carried to the
consolidated income statement or eliminated in
consolidation.

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 Parent’s Sale of Subsidiary
Shares to Nonaffiliate

• Recognizing a gain or loss in the consolidation

income statement on a sale of subsidiary shares
while continuing to consolidate the subsidiary
seems inconsistent with the concept of a single
economic entity.

• From a consolidated viewpoint, the subsidiary

shares become part of the noncontrolling
interest outstanding at the point they are sold to
a nonaffiliate.

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 Parent’s Sale of Subsidiary
Shares to Nonaffiliate

• If recognition of the gain on the sale of the stock

is considered appropriate in the consolidated
income statement, no adjustment is needed in
preparing consolidated statements, or in the
periods that follow.

• On the other hand, excluding the gain from the

consolidated income statement is more
consistent with the view of a single economic
entity. In that case, the gain is eliminated and
additional paid-in capital is established.
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 Subsidiary’s Sale of Additional
Shares to Nonaffiliate

• Additional funds are generated for consolidated

enterprise when a subsidiary sells new shares to
parties outside the economic entity.

• A sale of additional shares to an unaffiliated

party increases the total shares of the subsidiary
outstanding and, consequently, reduces the
percentage ownership held by the parent
company.

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 Subsidiary’s Sale of Additional
Shares to Nonaffiliate

• At the same time, the dollar amount assigned to

the noncontrolling interest in the consolidated
financial statements increases.

• The resulting amounts of the controlling and

noncontrolling interests are affected by two
factors:
• The number of shares sold to nonaffiliates.
• The price at which the shares are sold to
nonaffiliates.
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 Subsidiary’s Sale of Additional
Shares to Parent

• A sale of additional shares directly from a less

than wholly owned subsidiary to its parent
increases the parent’s ownership percentage.

• If the sale is at a price equal to the book value

of the existing shares, the increase in the
investment account of the parent equals the
increase in the stockholders’ equity of the
subsidiary. The net book value assigned to the
noncontrolling interest remains unchanged.

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Subsidiary’s Sale of Additional
Shares to Parent

• In preparing consolidated financial statements,

the normal elimination entries are made based
on the parent’s new ownership percentage.

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 Subsidiary’s Sale of Additional
Shares to Parent

• When the parent purchases shares directly from

a subsidiary at an amount other than the book
value of the subsidiary’s shares already
outstanding, a differential is measured as the
difference between the price paid and resulting
increase in the total underlying book value of all
shares owned by the parent.
• This increase in book value includes both the
amount assigned to the new shares just
acquired from the subsidiary and the increase or
decrease in the book value of shares previously
held by the parent.
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 Subsidiary’s Sale of Additional
Shares to Parent

• Once determined, the differential is treated in

preparing consolidated financial statements in
the same manner as a differential arising on a
purchase from a nonaffiliate.
• However, because the parent may be able to
influence the purchase price of the shares in this
case, the amount of differential may or may not
have an obvious connection to changes in the
value of identifiable assets or liabilities and must
be reviewed carefully in determining how it is to
be assigned.
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 Subsidiary’s Purchases of
Shares from Nonaffiliate

• Treasury shares sometimes are purchased by

a subsidiary from noncontrolling shareholders.
• Noncontrolling shareholders frequently find they
have little opportunity for input into the activities
and operations of the subsidiary and often are
willing sellers.
• The parent company may prefer not to be
concerned with outside shareholders and may
direct the subsidiary to reacquire any of the
noncontrolling shares that become available.
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Subsidiary’s Purchases of
Shares from Nonaffiliate

• Although the parent is not a direct participant

when a subsidiary purchases treasury stock
from noncontrolling shareholders, the parent’s
equity in the net assets of the subsidiary may
change as a result of the transaction.

• When this occurs, the amount of the change

must be recognized in preparing the
consolidated statements.

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 Subsidiary’s Purchases of
Shares from Parent

• A subsidiary can reduce the number of shares it

has outstanding through purchases from the
parent as well as from noncontrolling
shareholders.

• In practice, stock repurchases from the parent

occur infrequently. That is, a parent reducing its
ownership interest in a subsidiary usually does
so by selling some of its holdings to nonaffiliates
to generate additional funds.

9-31
 Subsidiary’s Purchases of
Shares from Parent

• When a subsidiary reacquires some of its shares

from its parent, the parent records a gain or loss
on the difference between the selling price and
the change in the carrying amount of its
investment.

• There is some question as to whether a

transaction of this type between a parent and its
subsidiary can be regarded as arm’s-length, and
consequently the reporting of the gain or loss in
the parent’s income statement can be
questioned.
9-32
Subsidiary’s Purchases of
Shares from Parent

• From a consolidated viewpoint, when a

subsidiary requires its shares from the parent,
the transaction represents an internal transfer
and does not give rise to a gain or loss.

9-33
 Complex Ownership Structures

• Current reporting standards call for the

preparation of consolidated financial statements
whenever one company has direct or indirect
control over another.

• The discussion to this point has focused on a

simple, direct parent-subsidiary relationship.

• Many companies, however, have substantially

more complex organizational schemes.
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 Multilevel Ownership and Control

• In many cases, companies establish multiple

corporate levels through which they carry out
diversified operations.

• For example, a company may have a number

of subsidiaries, one of which is a retailer. The
retail subsidiary may in turn have a finance
subsidiary, a real estate subsidiary, an insurance
subsidiary, and perhaps other subsidiaries.

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 Multilevel Ownership and Control

• This means that when consolidated statements

are prepared, the statements will include
companies in which the parent has only an
indirect investment along with those in which
direct ownership is held.

9-36
Multilevel Ownership and Control

• The amount of income and net assets to be

assigned to the controlling and noncontrolling
shareholders, and the amount of unrealized
profits and losses to be eliminated, must be
determined at each level of ownership.

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 Multilevel Ownership and Control

• Consolidation proceeds from the lowest level to

the highest in these cases. In a relatively few
cases, a subsidiary may own common shares of
its parent. Usually those common shares are
treated as treasury stock in consolidated
financial statements.

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Subsidiary Stock Dividends

• Subsidiary dividends payable in shares of

subsidiary’s common stock require slight
changes in the elimination entries used in
preparing consolidated financial statements.

• Because stock dividends are issued

proportionally to all common stockholders,
the relative interests of the controlling and
noncontrolling stockholders do not change
as a result of the stock dividend.

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 Subsidiary Stock Dividends
• While the carrying amount of the investment on
the books of the parent also is unaffected by a
stock dividend, the stockholders’ equity accounts
of the subsidiary do change, although total
stockholders’ equity does not.

• The stock dividend represents a permanent

capitalization of retained earnings, thus
decreasing retained earnings and increasing
capital stock and, perhaps, additional paid-in
capital.
9-40
 Subsidiary Stock Dividends
• In the preparation of consolidated financial
statements for the period in which a stock
dividend is declared by the subsidiary, the stock
dividend declaration must be eliminated along
with the increased common stock and increased
additional paid-in capital, if any.

• The stock dividend declared cannot appear in

the consolidated retained earnings statement
because only the parent’s dividends are viewed
as dividends of the consolidated entity.
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You Will Survive This Chapter !!!

• Chapter 10 is the last chapter dealing

specifically with consolidation topics.

9-42
 Chapter 9

End of Chapter

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.