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ANSWERS TO QUESTIONS
Q3-1 Underlying the preparation of consolidated financial statements is the notion that the
consolidated financial statements present the financial position and the results of operations
of a parent and its subsidiaries as if the related companies actually were a single company.
Q3-2 Without consolidated statements it often is very difficult for an investor to gain an
understanding of the total resources controlled by a company. A consolidated balance sheet
provides a much better picture of both the total assets under the control of the parent
company and the financing used in providing those resources. Similarly, the consolidated
income statement provides a better picture of the total revenue generated and the costs
incurred in generating the revenue. Estimates of future profit potential and the ability to meet
anticipated funds flows often can be more easily assessed by analyzing the consolidated
statements.
Q3-3 Parent company shareholders are likely to find consolidated statements more useful.
Noncontrolling shareholders may gain some understanding of the basic strength of the
overall economic entity by examining the consolidated statements; however, they have no
control over the parent company or other subsidiaries and therefore must rely on the assets
and earning power of the subsidiary in which they hold ownership. The separate statements
of the subsidiary are more likely to provide useful information to the noncontrolling
shareholders.
Q3-4 A parent company has the ability to exercise control over one or more other entities.
Under existing standards, a company is considered to be a parent company when it has
direct or indirect control over a majority of the common stock of another company. The
FASB has proposed adoption of a broader definition of control that would not be based
exclusively on stock ownership.
Q3-5 Creditors of the parent company have primary claim to the assets held directly by the
parent. Short-term creditors of the parent are likely to look only at those assets. Because
the parent has control of the subsidiaries, the assets held by the subsidiaries are potentially
available to satisfy parent company debts. Long-term creditors of the parent generally must
rely on the soundness and operating efficiency of the overall entity, which normally is best
seen by examining the consolidated statements. On the other hand, creditors of a
subsidiary typically have a priority claim to the assets of that subsidiary and generally
cannot lay claim to the assets of the other companies. Consolidated statements therefore
are not particularly useful to them.
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Chapter 3
Q3-6 When one company holds a majority of the voting shares of another company, the
investor should have the power to elect a majority of the board of directors of that company
and control its actions. Unless the investor holds controlling interest, there is always a
chance that another party may acquire a sufficient number of shares to gain control of the
company, or that the other shareholders may join together to take control.
Q3-7 The primary criterion for consolidation is the ability to directly or indirectly exercise
control. Control normally has been based on ownership of a majority of the voting common
stock of another company. The Financial Accounting Standards Board is currently working
on a broader definition of control. At present, consolidation should occur whenever majority
ownership is held unless other circumstances indicate that control is temporary or does not
rest with the parent.
Q3-8 Consolidation is not appropriate when control is temporary or when the parent cannot
exercise control. For example, if the parent has agreed to sell a subsidiary or plans to
reduce its ownership below 50 percent shortly after year-end, the subsidiary should not be
consolidated. Control generally cannot be exercised when a subsidiary is under the control
of the courts in bankruptcy or reorganization. While most foreign subsidiaries should be
consolidated, subsidiaries in countries with unstable governments or those in which there
are stringent barriers to funds transfers generally should not be consolidated.
Q3-10 Special purpose entities generally have been created by companies to acquire
certain types of financial assets from the companies and hold them to maturity. The special
purpose entity typically purchases the financial assets from the company with money
received from issuing some form of collateralized obligation. If the company had borrowed
the money directly, its debt ratio would be substantially increased.
Q3-11 A variable purpose entity normally is not involved in general business activity such
as producing products and selling them to customers. They often are used to acquire
financial assets from other companies or to borrow money and channel it other companies.
A very large portion of the assets held by variable purpose entities typically is financed by
debt and a small portion financed by equity holders. Contractual agreements often give
effective control of the activities of the special purpose entity to someone other than the
equity holders.
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Chapter 3
Q3-13 Indirect control occurs when the parent controls one or more subsidiaries that, in
turn, hold controlling interest in another company. Company A would indirectly control
Company Z if Company A held 80 percent ownership of Company M and that company held
70 percent of the ownership of Company Z.
Q3-14 It is possible for a company to exercise control over another company without
holding a majority of the voting common stock. Contractual agreements, for example, may
provide a company with complete control of both the operating and financing decisions of
another company. In other cases, ownership of a substantial portion of a company's shares
and a broad based ownership of the other shares may give effective control to a company
even though it does not have majority ownership. There is no prohibition to consolidation
with less than majority ownership; however, few companies have elected to consolidate with
less than majority control.
Q3-16 The consolidated statements are prepared from the viewpoint of the parent company
shareholders and only the amounts assignable to parent company shareholders are
included in the consolidated stockholders' equity balances. Subsidiary shares held by the
parent are not owned by an outside party and therefore cannot be reported as shares
outstanding. Those held by the noncontrolling shareholders are included in the balance
assigned to noncontrolling shareholders in the consolidated balance sheet rather than being
shown as stock outstanding.
Q3-17 While it is not considered appropriate to consolidate if the fiscal periods of the parent
and subsidiary differ by more than 3 months, a difference in time periods cannot be used as
a means of avoiding consolidation. The fiscal period of one of the companies must be
adjusted to fall within an acceptable time period and consolidated statement prepared.
Q3-18 The noncontrolling interest, or minority interest, represents the claim on the net
assets of the subsidiary assigned to the shares not controlled by the parent company.
Q3-19 The procedures used in preparing consolidated and combined financial statements
may be virtually identical. In general, consolidated statements are prepared when a parent
company either directly or indirectly controls one or more subsidiaries. Combined financial
statements are prepared for a group of companies or business entities when there is no
parent-subsidiary relationship. For example, an individual who controls several companies
may gain a clearer picture of the financial position and operating results of the overall
operations under his or her control by preparing combined financial statements.
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Chapter 3
Q3-20* Under the proprietary theory the parent company includes only a proportionate
share of the assets and liabilities and income statement items of a subsidiary in its financial
statements. Thus, if a subsidiary is 60 percent owned, the parent will include only 60
percent of the cash and accounts receivable of the subsidiary in its consolidated balance
sheet. Under current practice the full amount of the balance sheet and income statement
items of the subsidiary are included in the consolidated statements.
Q3-21* Under the entity theory the consolidated statements are not prepared from the
viewpoint of the parent company shareholders. The parent and subsidiary are viewed as a
single economic entity with a shareholder group that includes both controlling and
noncontrolling shareholders, each with an equity interest in the consolidated entity. As a
result, the assets and liabilities of the subsidiary are included in the consolidated statements
at 100 percent of their fair value at the date of acquisition and consolidated net income
includes the earnings to both controlling and noncontrolling shareholders. Current
accounting practice does not recognize the noncontrolling shareholders' portion of fair
value, nor is income assigned to noncontrolling shareholders included in consolidated net
income.
Q3-22* The parent company theory is closest to the procedures used in current practice.
The parent company theory reflects all assets under the control of the combined entity, yet
presents the net operating results and stockholders' equity portion of the consolidated
balance sheet from the viewpoint of the parent company shareholders.
Q3-23* Consolidated net income will include income to noncontrolling shareholders under
the FASB proposal.
Q3-24* The balance assigned to the noncontrolling interest will include its share of both
goodwill and the fair value increment related to identifiable net assets. Under current
standards only a proportionate share of the book value of the subsidiarys net assets is
assigned to the noncontrolling interest.
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Chapter 3
SOLUTIONS TO CASES
The relationship observed should always be true. Assets reported by the parent company
include its investment in the net assets of the subsidiaries. These totals must be eliminated
in the consolidation process to avoid double counting. There also may be intercompany
receivables and payables between the companies that must be eliminated when
consolidated statements are prepared. In addition, inventory or other assets reported by the
individual companies may be overstated as a result of unrealized profits on intercorporate
purchases and sales. The carrying value of the assets must be adjusted and the unrealized
profits eliminated in the consolidation process.
a. (1) The conventional or traditional approach has been to define the accounting entity
in terms of a specific firm or enterprise unit that is separate and apart from the owner
or owners and from other enterprises. For example, partnerships and sole
proprietorships are accounted for separately from the owners although such a
distinction might not exist legally. Thus, it was recognized that the transactions of the
enterprise should be accounted for and reported on separately from those of the
owners.
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Chapter 3
C3-2 (continued)
(2) The way in which an accounting entity is defined establishes the boundaries of the
possible objects, attributes, or activities that will be included in the accounting records
and reports. Knowledge as to the nature of the entity may aid in determining (1) what
information to include in reports of the entity and (2) how to best present information
about the entity so that relevant features are disclosed and irrelevant features do not
cloud the presentation.
The applicability of all other generally accepted concepts (or principles or postulates)
of accounting (for example, continuity, money measurement, and time periods)
depends on the established boundaries and nature of the accounting entity. The other
accounting concepts lack significance without reference to an entity. The entity must
be defined before the balance of the accounting model can be applied and the
accounting can begin. Thus, the accounting entity concept is so fundamental that it
pervades all accounting.
(3) Most large corporations issue consolidated financial reports. These statements
often include the financial statements of a number of separate legal entities that are
considered to constitute a single economic entity for financial reporting purposes.
(4) Although the accounting entity often is defined in terms of a business enterprise
that is separate and distinct from other activities of the owner or owners, it also is
possible for an accounting entity to embrace all the activities of an owner or a group of
owners. Examples include financial statements for an individual (personal financial
statements) and the financial report of a person's estate.
(5) The entire economy of Indonesia also can be viewed as an accounting entity.
Consistent with this view, national income accounts are compiled by the Indonesian
Department of Commerce and regularly reported.
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Chapter 3
c. The usual first necessary condition for consolidation is control. Under current accounting
standards, control is assumed to exist when one company, directly or indirectly, owns over
fifty percent of the outstanding voting shares of another company. Consolidated financial
statements should be prepared whether a business combination is accounted for as a
purchase or a pooling of interests. The critical test is whether or not control exists and is
independent of the method of accounting used in recording the business combination.
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Chapter 3
Most of the information needed to answer this case can be obtained from articles available
in libraries, on the Internet, or through various online databases. Some of the information is
available in filings with the SEC (www.sec.gov).
a. General Electric was never able to turn Kidder, Peabody into a profitable subsidiary. In
fact, Kidder became such a drain on the resources of General Electric, that GE decided to
get rid of Kidder. Unfortunately, GE was unable to sell the company as a whole and
ultimately broke the company into pieces and sold the pieces that it could. GE suffered large
losses from its venture into the brokerage business.
b. Sears, Roebuck and Co. has been a major retailer for many decades. For a while, Sears
attempted to provide virtually all consumer needs so that customers could purchase
financial and related services at Sears in addition to goods. It owned more than 200 other
companies. During that time, Sears sold insurance (Allstate Insurance Group, consisting of
many subsidiaries), real estate (Coldwell Banker Real Estate Group, consisting of many
subsidiaries), brokerage and investment advisor services (Dean Witter), credit cards (Sears
and Discover Card), and various other related services through many different subsidiaries.
During the mid-nineties, Sears sold or spun off most of its subsidiaries that were unrelated
to its core business, including Allstate, Coldwell Banker, Dean Witter, and Discover. On
March 24, 2005, Sears Holding Corporation was established and became the parent
company for Sears, Roebuck and Co. and K Mart Holding Corporation. From an accounting
perspective, the merger was treated as a purchases business combination with Kmart
acquiring Sears, even though Kmart had just emerged from bankruptcy proceedings.
Following the merger the company now has approximately 2,300 full-line and 1,100
specialty retain stores in the United States and approximately 370 full-line and specialty
retail stores in Canada.
c. PepsiCo entered the restaurant business in 1977 with the purchase of Pizza Hut. By
1986, PepsiCo also owned Taco Bell and KFC (Kentucky Fried Chicken). In 1997, these
subsidiaries were spun off to a new company, Tricon Global Restaurants, with Tricon's
stock distributed to PepsiCo's shareholders. Tricon Global Restaurants changed its name to
YUM! Brands, Inc., in 2002. Although PepsiCo exited the restaurant business, it continued
in the snack-food business with its Frito-Lay subsidiary, the world's largest maker of salty
snacks.
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Chapter 3
C3-4 (continued)
d. When consolidated financial statements are presented, financial statement users are
provided with information about the company's overall operations. Assessments can be
made about how the company as a whole has fared as a result of all its operations.
However, comparisons with other companies may be difficult because the operations of
other companies may not be similar. If a company operates in a number of different
industries, consolidated financial statements may not permit detailed comparisons with
other companies unless the other companies operate in all of the same industries, with
about the same relative mix. Thus, standard measures used in manufacturing and
merchandising, such as gross margin percentage, inventory and receivables turnover,
and the debt-to-asset ratio, may be useless or even misleading when significant
financial-services operations are included in the financial statements. Similarly, standard
measures used in comparing financial institutions might be distorted when financial
statement information includes data relating to manufacturing or merchandising
operations. A partial solution to the problem results from providing disaggregated
(segment or line-of-business) information along with the consolidated financial
statements, as required by the FASB.
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Chapter 3
a. Parent companies must prepare consolidated financial statements that include all
subsidiaries. However, if the parent itself is wholly owned by another entity, the company
may be exempt from this requirement. For the company to be exempt, the owners of the
minority interest must have been informed and they must indicate that they do not object to
omitting the consolidated statements. Additionally, the parents securities must not be
publicly traded and the parent must not be in the process of issuing such securities. Further,
the immediate or ultimate parent must still publish consolidated financial statements that
comply with IFRS.
b. According to IFRS, if any excess of fair value over the purchase price arises, the
acquiring company must reassess the acquired identifiable assets, liabilities and contingent
liabilities to determine that they have been properly identified and valued. The acquiring
company must also reassess the cost of the combination. If there is still a differential after
reassessment, this amount is recognized immediately in the income statement. This
treatment is consistent with the FASBs proposed standard on business combinations.
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Chapter 3
a. Off-balance sheet financing refers to techniques that allow companies to borrow while
keeping the debt, and related assets, from being reported in the companys balance sheet.
b. (1) Funds to acquire new assets for a company may be borrowed by a third party such
as a SPE, with the acquired assets then leased to the company.
(2) A company may sell assets such as accounts receivable instead of using them as
collateral.
(3) A company may create a new SPE and transfer assets to the new entity in exchange
for cash.
c. SPEs may serve a genuine business purpose, such as risk sharing among investors and
isolation of project risk from company risk.
d. SPEs may be structured to avoid consolidation. To the extent that standards for
consolidation are rule-based, it is possible to structure a SPE so that it is not consolidated
even if the underlying economic substance of the entity would indicate that it should be
consolidated. By artificially removing debt, assets, and expenses from the financial reports
of the sponsoring company, the financial position of a company and the results of its
operations can be distorted. The FASB has been working to ensure that rule-based
consolidation standards result in financial statements that reflect the underlying economic
substance.
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Chapter 3
SOLUTIONS TO EXERCISES
1. d
2. c
3. b
4. a
5. b
1. c
2. d
3. a
4. b
5. b
1. a
2. b
3. b
4. c
5. a
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Chapter 3
1. d
2. b
3. b
4. d
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Chapter 3
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Chapter 3
a. PT Berlian Motor apparently owns 100 percent of the stock of PT Premium since the
balance in the investment account reported by PT Berlian Motor is equal to the net book
value of PT Premium.
Rp1,120,000,000
a. The total noncontrolling interest reported in the consolidated balance sheet at January
1, 20X7, is Rp126,000,000 (Rp420,000,000 x .30).
b. The stockholders' equity section of the subsidiary is eliminated when the consolidated
balance sheet is prepared. Thus, the stockholders' equity section of the consolidated
balance sheet is that of the parent company:
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Chapter 3
c. Consolidated net income of Rp65,000 should be reported for 20X4, computed as follows:
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Chapter 3
a. Proprietary theory:
c. Entity theory:
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Chapter 3
a. Entity theory:
Book Value (Rp240,000,000 x 1.00) Rp240,000,000
Fair Value Increase (Rp50,000,000 x 1.00) 50,000,000
Rp290,000,000
c. Proprietary theory:
Book Value (Rp240,000,000 x .75) Rp180,000,000
Fair Value Increase (Rp50,000,000 x .75) 37,500,000
Rp217,500,000
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Chapter 3
a. Entity theory:
c. Proprietary theory:
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Chapter 3
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Chapter 3
SOLUTIONS TO PROBLEMS
1. d
2. c
3. b
4. c
5. c
b.
PT Kintamani and Subsidiary
Consolidated Income Statement
Year Ended December 31, 20X6
Sales Rp300,000,000
Cost of goods sold (200,000,000)
Consolidated net income Rp100,000,000
c.
PT Kintamani and Subsidiary
Consolidated Income Statement
Year Ended December 31, 20X6
Sales Rp250,000,000
Cost of goods sold (180,000,000)
Consolidated net income Rp 70,000,000
d. Each of the three income statement items is changed when the effects of the
intercompany sale are eliminated.
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Chapter 3
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Chapter 3
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Chapter 3
b. As shown in the investment account balance, PT Berdikari paid Rp110,000,000 for the
ownership of PT Mantili. The amount paid was Rp30,000,000 greater than the book value
of the net assets of PT Mantili and is reported as goodwill in the consolidated balance
sheet at January 1, 20X5.
c. In determining the amount to be reported for land in the consolidated balance sheet,
Rp15,000,000 (Rp70,000,000 + Rp50,000,000 - Rp105,000,000) was eliminated. PT
Berdikari apparently sold the land to PT Mantili for Rp25,000,000 (Rp10,000,000 +
Rp15,000,000).
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Chapter 3
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Chapter 3
c. Consolidated net income is Rp143,000,000. None of the 20X5 net income of PT Timika
was earned after the date of purchase and, therefore, none can be included in
consolidated net income.
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Chapter 3
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Chapter 3
Ungu
.7
Hijau
.40 .1
Kuning Oranye
.60
Biru
The earnings of PT Biru and PT Oranye are included under cost method reporting due to
the 10 percent ownership level of PT Oranye.
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Chapter 3
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Chapter 3
a. Proprietary theory:
c. Entity theory:
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Chapter 3
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