CHAPTER 3

THE REPORTING ENTITY AND CONSOLIDATED FINANCIAL STATEMENTS

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.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
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.
Q3-9 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.
Q3-10 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.
Q3-11 Unless intercorporate receivables and payables are eliminated, there is an
overstatement of the true balances. The result is a distortion of the current
asset ratio and other ratios such as those that relate current assets to
noncurrent assets or current liabilities to noncurrent liabilities or to
stockholders' equity balances.
Q3-12 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.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
Q3-13 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.
Q3-14 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.
Q3-15 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.
Q3-16* 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.
Q3-17* 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.
Q3-18* 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.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
SOLUTIONS TO CASES
C3-1 Computation of Total Asset Values
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.
C3-2 Accounting Entity [AICPA Adapted]
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.
An extension of this approach is to define the accounting entity in terms of an
economic unit that controls resources, makes and carries out commitments, and
conducts economic activity. In the broadest sense an accounting entity could be
established in any situation where there is an input-output relationship. Such
an accounting entity may be an individual, a profit-seeking or not-for-profit
enterprise, or a subdivision of a profit-seeking or not-for-profit enterprise
for which a system of accounts is maintained. This approach is oriented toward
providing information to the economic entity which it can use in evaluating its
operating results and financial position.
An alternative approach is to define the accounting entity in terms of an area
of economic interest to a particular individual, group, or institution. The
boundaries of such an economic entity would be identified by determining (a) the
interested individual, group, or institution and (b) the nature of that
individual's, group's, or institution's interest. In theory a number of separate
legal entities or economic units could be included in a single accounting
entity. Thus, this approach is oriented to the external users of financial
reports.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
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.
b. (1) Units created by or under law, such as corporations, partner-
ships, and, occasionally, sole proprietorships, probably are the most common
types of accounting entities.
(2) Product lines or other segments of an enterprise, such as a division,
department, profit center, branch, or cost center, can be treated as accounting
entities. For example, financial reporting by segment was supported by
investors, the Securities and Exchange Commission, financial executives, and
members of the accounting profession.
(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 the United States also can be viewed as an accounting
entity. Consistent with this view, national income accounts are compiled by the
U. S. Department of Commerce and regularly reported.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
C3-3 Consolidation Effects
a. When the finance subsidiary is consolidated, total receivables and the
associated allowance for uncollectibles undoubtedly will increase substantially.
Because finance companies normally generate a large portion of their capital
through borrowing, both current and intermediate term debt will be likely to
increase significantly also. Consolidating an auto leasing subsidiary will result
in a number of leases, probably both capital and operating leases, being included
in the consolidated financial statements. A higher portion of the assets of a
leasing company tend to be supported through borrowing than in a manufacturing
company, and, thus, debt ratios are likely to increase further. Leasing revenue,
interest income, interest expense, and perhaps other items (e.g., depreciation)
are likely to increase significantly when the subsidiaries are consolidated.
Overall, the reported debt situation, including both the amounts of debt reported
and ratios such as the debt-equity and the times-interest-earned ratios, can be
expected to worsen.
b. Some would argue that finance subsidiaries should not be consolidated with
manufacturing, distribution, or merchandising types of companies because of the
lack of homogeneity of operations. The parent's primary mission is to produce and
sell automobiles and including these additional ventures only makes it more
difficult for the financial statement reader to see what the parent is doing. In
addition, the financial statements obtained by adding those of a financing
subsidiary and a leasing subsidiary to those of a manufacturing parent may be
meaningless or misleading because of the significant differences in their
financial structures and operating characteristics.
On the other hand, some would argue that all subsidiaries should be consolidated
with the parent, as is now required by FASB Statement No. 94. Those taking this
point of view argue that all resources and operations under common control should
be reflected in the consolidated financial statements because all subsidiaries
impact the well-being of the parent company shareholders. Others take the view
that, even if all subsidiaries are not consolidated, subsidiaries with operations
closely related to those of the parent should be consolidated in spite of those
operations being different in nature from those of the parent. Crumple Car
Corporation's financing subsidiary clearly supports the operations of the parent.
If the subsidiary did not provide the financing operations, the parent would have
to assume the function itself to survive. One could argue, therefore, that this
financing operation is really an integral part of the overall operations of the
parent and should be reflected fully in the financial statements. Similarly, the
operations of the leasing subsidiary are closely related to those of the parent,
providing another means of distributing the parent's product and financing the
acquisition of that product by customers.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
C3-4 Need for Consolidation [AICPA Adapted]
a. (1) Goodwill does not arise and, therefore, should not be reported if
the business combination is accounted for as a pooling of interests. The book
values of assets and liabilities of the separate companies generally are added
together in determining the amounts reported by the combined corporation in a
pooling of interests. On the other hand, goodwill generally is reported if the
business combination is accounted for as a purchase.
(2) All identifiable assets acquired, either individually or by type, and
liabilities assumed in a business combination, whether or not shown in the
financial statements of Moore, should be assigned a portion of the cost of
Moore, normally equal to their fair values at date of acquisition. Then, the
excess of the cost of acquiring ownership of Moore over the sum of the amounts
assigned to identifiable assets acquired less liabilities assumed should be
recorded as goodwill.
(3) Whenever a noncontrolling interest exists it should be reported whether the
business combination is accounted for as a purchase or a pooling of interests.
Under current generally accepted accounting standards, the amount assigned to
the noncontrolling interest will be the same whether the business combination is
accounted for as a purchase or a pooling of interests.
b. (1) Consolidated financial statements should be prepared in order to
present the financial position and operating results for an economic entity in a
manner more meaningful than if separate statements are prepared.
(2) The usual first necessary condition for consolidation is control. Under
current accounting standards, ownership by one company, directly or indirectly,
of over fifty percent of the outstanding voting shares of another company is a
condition necessary for consolidation.
(3) 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.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
C3-5 What Company is That?
Information for answering this case can be obtained from the SEC's EDGAR database
(www.sec.gov) and from the home pages for Viacom (www.viacom.com) and Seagram
(www.seagram.com).
a. Well known brand names from Viacom's subsidiaries include CBS, Blockbuster
Video, Paramount Pictures, Paramount Home Video, Paramount Television, Paramount
Parks, Spelling Entertainment, Republic Entertainment, MTV, Nickelodeon, Nick at
Nite, Showtime, The Movie Channel, Famous Players Theaters, and Simon & Schuster
(publishers). Viacom's parent company is National Amusements, Inc., which owns
about two-thirds of Viacom's common stock. National Amusements is closely held.
Sumner Redstone is the controlling shareholder of National Amusements and the
Chairman of the Board and Chief Executive Officer of Viacom.
b. Seagram's non-beverage-related subsidiaries include Universal Studios (motion
pictures and home videos, theme parks, and gift stores), Universal Music
(recorded music, including Motown and PolyGram), and Universal City Hollywood
(theme park). In 2001, Seagram combined with Vivendi and Canal Plus to form
Vivendi Universal. As part of the merger plan, the company took steps to sell its
spirits and wine business.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
C3-6 Subsidiaries and Core Businesses
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. Today, Sears continues to own about 100 other companies,
including Sears Canada; Sears, Roebuck de Mexico; Sears, Roebuck de Puerto Rico;
Sears Receivables Financing Group; Sears Roebuck Acceptance; Orchard Supply
Hardware; Western Auto Supply; and Tire America. The company has focused almost
entirely on its core retail business.
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. 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.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
C3-6 (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.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
C3-7 Alternative Accounting Methods
a. Amerada Hesss interests in oil and gas exploration and production ventures
are proportionately consolidated (pro rata consolidation). Investments in
affiliated companies, 20 to 50 percent owned, are reported using the equity
method. A 50 percent interest in a trading partnership over which the company
exercises control is consolidated.
b. Although Alberta Energy Company reports investments in companies over which
it has significant influence using the equity method, investments in jointly
controlled companies and ventures are accounted for using proportionate
consolidation. Alberta Energy is a Canadian company. Proportionate consolidation
is found more frequently outside of the United States. Although not considered
generally accepted in the United States, proportionate (pro rata) consolidation
is nevertheless sometimes found in the oil and gas exploration and transmission
industries.
c. Benton Oil and Gas Company uses the equity method to account for companies
and other investments in which the company has significant influence. Prior to
1999, Benton accounted for its investment in Geoilbent using proportionate
consolidation. Based on a new release from the Emerging Issues Task Force dealing
with accounting for investments in partnerships and joint ventures, however,
Benton changed to the equity method of accounting for Geoilbent.
d. Centex Corporation consolidates its subsidiaries and reports its investments
in joint ventures using the equity method. However, it accounts for the 50
percent joint ventures of one of its subsidiaries, Centex Construction Products,
using proportionate consolidation. This treatment might be justified either
because the amounts are immaterial or because the venture is not incorporated.
e. If a joint venture is not incorporated, its treatment is less clear than for
corporations. Generally, the equity method should be used, but companies
sometimes use proportionate consolidated citing joint control as the reason.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
SOLUTIONS TO EXERCISES
E3-1 Multiple-Choice Questions on Consolidation Overview
[AICPA Adapted]
1. d
2. c
3. b
4. a
5. b
E3-2 Multiple-Choice Questions on Consolidated Balances [AICPA Adapted]
1. a
2. b
3. b
4. c
5. a
E3-3 Multiple-Choice Questions on Consolidation Overview
[AICPA Adapted]
1. d
2. d
3. b
4. b
5. a
6. d
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
E3-4 Balance Sheet Consolidation
a. $470,000 = $470,000 - $55,000 + $55,000
b. $605,000 = ($470,000 - $55,000) + $190,000
c. $405,000 = $270,000 + $135,000
d. $200,000 (as reported by Guild Corporation)
E3-5 Balance Sheet Consolidation with Intercompany Transfer
a. $645,000 = $510,000 + $135,000
b. $845,000 = $510,000 + $350,000 - $15,000
c. $655,000 = ($320,000 + $135,000) + $215,000 - $15,000
d. $190,000 (as reported by Potter Company)
E3-6 Intercompany Transfers
a. Consolidated current assets will be overstated by $37,000 if no eliminations
are made. Inventory will be overstated by $25,000 and accounts receivable will
be overstated by $12,000.
b. Net working capital will be overstated by $25,000 due to unrealized
intercompany inventory profits. The overstatement of accounts payable and
accounts receivable will offset.
c. Net income of the period following will be understated by $25,000 as a result
of overstating cost of goods sold by that amount.
E3-7 Subsidiary Acquired for Cash
Fineline Pencil Company and Subsidiary
Consolidated Balance Sheet
January 2, 20X3
Cash ($200,000 - $150,000 + $50,000) $100,000
Other Assets ($400,000 + $180,000) 580,000
Total Assets $680,000
Current Liabilities ($100,000 + $80,000) $180,000
Common Stock 300,000
Retained Earnings 200,000
Total Liabilities and Stockholders' Equity $680,000
E3-8 Subsidiary Acquired with Bonds
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
Byte Computer Corporation and Subsidiary
Consolidated Balance Sheet
January 2, 20X3
Cash ($200,000 + $50,000) $250,000
Other Assets ($400,000 + $180,000) 580,000
Total Assets $830,000
Current Liabilities $180,000
Bonds Payable $140,000
Bond Premium 10,000 150,000
Common Stock 300,000
Retained Earnings 200,000
Total Liabilities and Stockholders' Equity $830,000
E3-9 Subsidiary Acquired by Issuing Preferred Stock
Byte Computer Corporation and Subsidiary
Consolidated Balance Sheet
January 2, 20X3
Cash ($200,000 + $50,000) $250,000
Other Assets ($400,000 + $180,000) 580,000
Total Assets $830,000
Current Liabilities ($100,000 + $80,000) $180,000
Preferred Stock ($6 x 15,000) 90,000
Additional Paid-In Capital ($4 x 15,000) 60,000
Common Stock 300,000
Retained Earnings 200,000
Total Liabilities and Stockholders' Equity $830,000
E3-10 Computation of Subsidiary Net Income
Messer Company reported net income of $60,000 ($18,000 / .30) for 20X9.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
E3-11 Incomplete Consolidation
a. Belchfire apparently owns 100 percent of the stock of Premium Body Shop since
the balance in the investment account reported by Belchfire is equal to the net
book value of Premium Body Shop.
b. Accounts Payable
Bonds Payable
Common Stock
Retained Earnings

$ 60,000
600,000
200,000
260,000

$1,120,000
Accounts receivable were reduced by
$10,000, presumably as a reduction of
receivables and payables.
There is no indication of intercor-
porate ownership.
Common stock of Premium must be
eliminated.
Retained earnings of Premium also must
be eliminated in preparing
consolidated statements.
E3-12 Noncontrolling Interest
a. The total noncontrolling interest reported in the consolidated balance sheet at
January 1, 20X7, is $126,000 ($420,000 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:
Common Stock $400,000
Additional Paid-In Capital 222,000
Retained Earnings 358,000
Total Stockholders' Equity $980,000
c. Sanderson is mainly interested in assuring a steady supply of electronic switches.
It can control the operations of Kline with 70 percent ownership and can use the
money that would be needed to purchase the remaining shares of Kline to finance
additional operations or purchase other investments.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
E3-13 Computation of Consolidated Net Income
a. Ambrose should report income from its subsidiary of $15,000 ($20,000 x .75) rather
than dividend income of $9,000.
b A total of $5,000 ($20,000 x .25) should be assigned to the noncontrolling interest
in the 20X4 consolidated income statement.
c. Consolidated net income of $65,0000 should be reported for 20X4, computed as
follows:
Reported net income of Ambrose $59,000
Less: Dividend income from Kroop (9,000)
Operating income of Ambrose $50,000
Net income of Kroop 20,000
Total income $70,000
Income assigned to noncontrolling interest (5,000)
Consolidated net income $65,000
d. Income of $79,000 would be attained by adding the income reported by Ambrose
($59,000) to the income reported by Kroop ($20,000). However, the dividend
income from Kroop recorded by Ambrose must be deleted and a proportionate share
of Kroop's net income ($5,000) needs to be set aside for the noncontrolling
shareholders and excluded from consolidated net income.
E3-14 Computation of Subsidiary Balances
a. Light's net income for 20X2 was $32,000 ($8,000 / .25).
b. Common Stock Outstanding (1) $120,000
Additional Paid-In Capital (given) 40,000
Retained Earnings ($70,000 + $32,000) 102,000
Total Stockholders' Equity $262,000
(1) Computation of common stock outstanding:
Total stockholders' equity ($65,500 / .25) $262,000
Additional paid-in Capital (40,000)
Retained earnings (102,000)
Common stock outstanding $120,000
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
E3-15 Subsidiary Acquired at Net Book Value
Banner Corporation and Subsidiary
Consolidated Balance Sheet
December 31, 20X8
Cash ($40,000 + $20,000) $ 60,000
Accounts Receivable ($120,000 + $70,000) 190,000
Inventory ($180,000 + $90,000) 270,000
Fixed Assets (net) ($350,000 + $240,000) 590,000
Total Assets $1,110,000
Accounts Payable ($65,000 + $30,000) $ 95,000
Notes Payable ($350,000 + $220,000) 570,000
Common Stock 150,000
Retained Earnings 295,000
Total Liabilities and Stockholders' Equity $1,110,000
E3-16 Subsidiary Acquired in Pooling of Interests
Snapwell Corporation and Subsidiary
Consolidated Balance Sheet
January 1, 20X1
Cash ($90,000 + $15,000) $105,000
Accounts Receivable ($100,000 + $30,000 - $5,500) 124,500
Inventory ($160,000 + $70,000) 230,000
Land ($50,000 + $18,000) 68,000
Buildings and Equipment (net) ($230,000 + $180,000) 410,000
Goodwill ($40,000 + $17,000) 57,000
Total Assets $994,500
Accounts Payable ($55,000 + $20,000 - $5,500) $ 69,500
Bonds Payable ($200,000 + $140,000) 340,000
Common Stock ($155,000 + $32,000) 187,000
Additional Paid-In Capital ($80,000 + $15,000 - $7,000) 88,000
Retained Earnings ($180,000 + $130,00) 310,000
Total Liabilities and Stockholders' Equity $994,500
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
E3-17* Applying Alternative Accounting Theories
a. Proprietary theory:
Total revenue [$400,000 + ($200,000 x .75)] $550,000
Total expenses [$280,000 + ($160,000 x .75)] 400,000
Consolidated net income [$120,000 + ($40,000 x .75)] 150,000
b. Parent company theory:
Total revenue ($400,000 + $200,000) $600,000
Total expenses ($280,000 + $160,000) 440,000
Consolidated net income [$120,000 + ($40,000 x .75)] 150,000
c. Entity theory:
Total revenue ($400,000 + $200,000) $600,000
Total expenses ($280,000 + $160,000) 440,000
Consolidated net income ($120,000 + $40,000) 160,000
d. Current accounting practice:
Total revenue ($400,000 + $200,000) $600,000
Total expenses ($280,000 + $160,000) 440,000
Consolidated net income [$120,000 + ($40,000 x .75)] 150,000
E3-18* Measurement of Goodwill
a. $240,000 = computed in the same manner as under the parent company
approach.
b. $400,000 = $240,000 / .60
c. $240,000 = computed in the same manner as under the parent company
approach.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
E3-19* Valuation of Assets under Alternative Accounting Theories
a. Entity theory:
Book Value ($240,000 x 1.00) $240,000
Fair Value Increase ($50,000 x 1.00) 50,000
$290,000
b. Parent company theory:
Book Value ($240,000 x 1.00) $240,000
Fair Value Increase ($50,000 x .75) 37,500
$277,500
c. Proprietary theory:
Book Value ($240,000 x .75) $180,000
Fair Value Increase ($50,000 x .75) 37,500
$217,500
d. Current accounting practice:
Book Value ($240,000 x 1.00) $240,000
Fair Value Increase ($50,000 x .75) 37,500
$277,500
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
E3-20* Reported Income under Alternative Accounting Theories
a. Entity theory:
Total revenue ($410,000 + $200,000) $610,000
Total expenses ($320,000 + $150,000) 470,000
Consolidated net income [$90,000 + ($50,000 x 1.00)] 140,000
b. Parent company theory:
Total revenue ($410,000 + $200,000) $610,000
Total expenses ($320,000 + $150,000) 470,000
Consolidated net income [$90,000 + ($50,000 x .80)] 130,000
c. Proprietary theory:
Total revenue [$410,000 + ($200,000 x .80)] $570,000
Total expenses [$320,000 + ($150,000 x .80)] 440,000
Consolidated net income [$90,000 + ($50,000 x .80)] 130,000
d. Current accounting practice:
Total revenue ($410,000 + $200,000) $610,000
Total expenses ($320,000 + $150,000) 470,000
Consolidated net income [$90,000 + ($50,000 x .80)] 130,000
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
SOLUTIONS TO PROBLEMS
P3-21 Multiple-Choice Questions on Consolidated and Combined Financial
Statements [AICPA Adapted]
1. d
2. c
3. b
4. b
5. c
6. c
P3-22 Intercompany Sales
a. Net income will be overstated by $30,000 ($50,000 - $20,000) if no adjustment is
made to eliminate the effects of the intercompany transfer.
b. Knight Corporation and Subsidiary
Consolidated Income Statement
Year Ended December 31, 20X6
Sales $300,000
Cost of goods sold (200,000)
Consolidated net income $100,000
c. Knight Corporation and Subsidiary
Consolidated Income Statement
Year Ended December 31, 20X6
Sales $250,000
Cost of goods sold (180,000)
Consolidated net income $ 70,000
d. Each of the three income statement items are changed when the effects of the
intercompany sale are eliminated.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
P3-23 Intercompany Inventory Transfer
a. Inventory on January 1, 20X3:
Balance reported by River Products $25,000
Unrealized profits recognized by Clayborn (15,000)
Consolidated inventory $10,000
b. Cost of Goods Sold for 20X2:
Cost of goods sold recorded by Clayborn $10,000
Cost of goods sold recorded on intercompany sale (10,000)
Cost of goods sold recorded on sales to outsiders $ -0-

c. Cost of Goods Sold for 20X3:
Cost of goods sold recorded by River Products $25,000
Profit recorded on intercompany sale by Clayborn (15,000)
Consolidated cost of goods sold $10,000
d. Sales for 20X2:
Sales recognized by Clayborn $25,000
Intercompany sale recorded by Clayborn (25,000)
Consolidated sales $ -0-
e. Sales for 20X3:
Sales recognized by River Products $55,000
Intercompany sales during 20X3 (-0-)
Consolidated sales $55,000
P3-24 Determining Net Income of Consolidated Entity
Net income reported by Placer Corporation $110,000
Dividend income from Placer Corporation ($14,000 x .75) (10,500)
Operating income of Placer Corporation $ 99,500
Placer's share of Murdokk's income ($24,000 x .75) 18,000
Amortization of purchase differential ($20,000 / 8 years) (2,500)
Consolidated net income (equal to Placer Corporation's
net income computed on equity-method basis) $115,000
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
P3-25 Determining Net Income of Parent Company
Consolidated net income $164,300
Tally's share of subsidiary income:
Income of subsidiary ($15,200 / .40) $38,000
Proportion of stock held by Tally x .60
Subsidiary income included in consolidated
net income (22,800)
Income from Tally's operations $141,500
P3-26 Consolidated Income Statement Data
a. Sales: ($300,000 + $200,000 - $50,000) $450,000
b. Investment income from LoCal Bakeries: $-0-
c. Cost of goods sold: ($200,000 + $130,000 - $35,000) $295,000
d. Depreciation expense: ($40,000 + $30,000 + $5,000) $75,000
P3-27 Incomplete Company and Consolidated Data
a. A total of $210,000 ($120,000 + $90,000) should be reported.
b. As shown in the investment account balance, Beryl paid $110,000 for the ownership
of Stargel. The amount paid was $30,000 greater than the book value of the net
assets of Stargel 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, $15,000 ($70,000 + $50,000 - $105,000) was eliminated. Beryl apparently
sold the land to Stargel for $25,000 ($10,000 + $15,000).
d. Accounts payable of $120,000 ($75,000 + $55,000 - $10,00) will be reported in the
consolidated balance sheet. A total of $10,000 was deducted in determining the
balance reported for accounts receivable ($90,000 + $50,000 - $130,000). The
elimination of an intercompany receivable must be offset by the elimination of
an intercompany payable.
e. The par value of Beryl's stock outstanding is $100,000.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
P3-28 Consolidation Following Intercompany Sale of Equipment
Potash Company and Subsidiary
Consolidated Balance Sheet
January 1, 20X7
Cash ($50,000 + $35,000) $ 85,000
Accounts Receivable ($110,000 + $60,000 - $17,000) 153,000
Merchandise Inventory ($95,000 + $75,000) 170,000
Equipment (net) ($230,000 + $105,000 - $25,000) 310,000
Total Assets $718,000
Accounts Payable ($82,000 + $28,000 - $17,000) $ 93,000
Notes Payable ($200,000 + $107,000) 307,000
Common Stock 180,000
Retained Earnings ($163,000 - $25,000) 138,000
Total Liabilities and Stockholders' Equity $718,000
Note: The $25,000 ($110,000 - $85,000) profit recorded by Potash on the sale of
equipment to Bortz must be eliminated by reducing the amount reported as
equipment and the retained earnings balance reported by Potash.
A total of $17,000 ($110,000 - $93,000) remains as an account receivable on
the books of Potash and a payable on the books of Bortz at January 1, 20X7.
These amounts must be eliminated in preparing the consolidated balance sheet.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
P3-29 Parent Company and Consolidated Amounts
a. Common stock of Tempro Corporation
on December 31, 20X5 $ 90,000
Retained earnings of Tempro Corporation:
January 1, 20X5 $130,000
Sales for 20X5 195,000
Less: Expenses (160,000)
Dividends paid (15,000)
Retained earnings of Tempro Corporation
on December 31, 20X5 150,000
Net book value on December 31, 20X5 $240,000
Proportion of stock acquired by Quoton x .80
Purchase price $192,000
b. Net book value on December 31, 20X5 $240,000
Proportion of stock held by
noncontrolling interest x .20
Balance assigned to noncontrolling interest $ 48,000
c. Consolidated net income is $143,000. None of the 20X5 net income of Tempro
Corporation was earned after the date of purchase and, therefore, none can be
included in consolidated net income.
d. Consolidate net income would be $171,000 [$143,000 + ($195,000 - $160,000) x .80]
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
P3-30 Purchase versus Pooling of Interests
a. Pooling of interests treatment:
(1) Total Assets: Book value of Smart assets $ 800,000
Book value of Wisner assets 400,000
$1,200,000
(2) Total Liabilities: Book value of Smart bonds $ 200,000
Book value of Wisner bonds 100,000
$ 300,000
(3) Total Equity: Stockholders' equity of Smart $ 600,000
Stockholders' equity of Wisner 300,000
$ 900,000
b. Purchase treatment:
(1) Total Assets: Book value of Smart assets $ 800,000
Book value of Wisner assets 400,000
Fair value increase in Wisner
identifiable assets 210,000
Goodwill on purchase:
Value of stock issued $550,000
Fair value of net assets
($610,000 - $110,000) (500,000) 50,000
$1,460,000
(2) Total Liabilities: Book value of Smart bonds $ 200,000
Fair value of Wisner bonds 110,000
$ 310,000
(3) Total Equity: Stockholders' equity of Smart $ 600,000
Fair value of additional stock
issued ($11 x 50,000) 550,000
$1,150,000
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
P3-31 Parent Company and Consolidated Balances
a. Exacto net assets on date of acquisition $260,000
Cumulative earnings since acquisition $110,000
Cumulative dividends since acquisition (46,000)
Increase in net assets since acquisition 64,000
Net assets on December 31, 20X7 $324,000
Proportion of stock held by True Corporation x .75
Book value of claim by True Corporation $243,000
Balance in investment account, December 31, 20X7 259,800
Unamortized differential December 31, 20X7 $ 16,800
Number of years remaining for amortization 7
Annual amortization $ 2,400
Total years of amortization x 10
Amount paid in excess of book value $ 24,000
b. $24,000 will be added to buildings and equipment each year.
i. $7,200 ($2,400 x 3 years) will be added to accumulated depreciation at December 31,
20X7.
a. $81,000 ($324,000 x .25) will be assigned to noncontrolling interest in the
consolidated balance sheet prepared at December 31, 20X7.
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
P3-32 Fair Value Greater than Cost
a. Balance sheet following a pooling of interests:
Delkart Products Company and Subsidiary
Consolidated Balance Sheet
January 1, 20X2
Assets: Liabilities:
Cash and Receivables $ 130,000 Current Payables $ 80,000
Inventory 365,000 Notes Payable 275,000
Equipment (net) 780,000 Stockholders' Equity:
Common Stock 360,000
Additional Capital 140,000
Retained Earnings 420,000
Total $1,275,000 Total $1,275,000
Cash and Receivables: $80,000 + $75,000 - $25,000 = $130,000
Notes Payable: $200,000 + $100,000 - $25,000 = $275,000
Common Stock: $300,000 + ($10 x 6,000 shares) = $360,000
Additional Capital: $200,000 - $60,000 = $140,000
Retained Earnings: $250,000 + $170,000 = $420,000
b. Balance sheet following a purchase:
Delkart Products Company and Subsidiary
Consolidated Balance Sheet
January 1, 20X2
Assets: Liabilities:
Cash and Receivables $ 130,000 Current Payables $ 80,000
Inventory 385,000 Notes Payable 275,000
Equipment (net) 810,000 Stockholders' Equity:
Common Stock 360,000
Additional Capital 360,000
Retained Earnings 250,000
Total $1,325,000 Total $1,325,000
Cash and Receivables: $80,000 + $75,000 - $25,000 = $130,000
Equipment: $480,000 + $340,000 - $10,000* = $810,000
Notes Payable: $200,000 + $100,000 - $25,000 = $275,000
Common Stock: $300,000 + ($10 x 6,000 shares) = $360,000
Additional Capital: ($70 - $10) x 6,000 shares = $360,000
*Excess of fair value over cost (negative goodwill), allocated against noncurrent
assets
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
P3-33 Indirect Ownership
The following ownership chain exists:
Purple

.70
Green
.40 .10
Yellow Orange
.60
Blue
The earnings of Blue Company and Orange Corporation are included under cost method
reporting due to the 10 percent ownership level of Orange Corporation.
Net income of Green Company:

Reported operating income $ 20,000
Dividend income from Orange ($30,000 x .10) 3,000
Equity-method income from Yellow ($60,000 x .40) 24,000
Green Company net income $ 47,000
Consolidated net income:
Operating income of Purple $ 90,000
Purple's share of Green's net income ($47,000 x .70) 32,900
Consolidated net income $122,900
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
P3-34 Comprehensive Problem: Consolidated Financial Statements
a. Cash: $71,000 + $33,000 = $104,000
b. Receivables (net): $431,000 + $122,000 - $45,000 = $508,000
c. Inventory: $909,000 + $370,000 - ($45,000 - $34,000) = $1,268,000
d. Investment in Mangle Stock: Not reported in consolidated statements
e. Equipment (net): $1,528,000 + $475,000 + $25,000 - $5,000 = $2,023,000
f. Goodwill: ($55,000 - $25,000) = $30,000
g. Current Payables: $227,000 + $95,000 - $45,000 = $277,000
h. Common Stock (par): $1,000,000
i. Sales Revenue: $8,325,000 + $2,980,000 - $45,000 = $11,260,000
j. Cost of Goods Sold: $5,150,000 + $2,010,000 - $34,000 = $7,126,000
k. Depreciation Expense: $302,000 + $85,000 + $5,000 = $392,000
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
P3-35* Balance Sheet Amounts under Alternative Accounting Theories
a. Proprietary theory:
Cash and inventory [$300,000 + ($80,000 x .75)] $360,000
Buildings and Equipment (net)
[$400,000 + ($180,000 x .75)] 535,000
Goodwill [$210,000 - ($260,000 x .75)] 15,000
b. Parent company theory:
Cash and inventory ($300,000 + $80,000) $380,000
Buildings and Equipment (net)
[$400,000 + $120,000 + ($60,000 x .75)] 565,000
Goodwill [$210,000 - ($260,000 x .75)] 15,000
c. Entity theory:
Cash and inventory ($300,000 + $80,000) $380,000
Buildings and Equipment (net)
($400,000 + $180,000) 580,000
Goodwill [$210,000 - ($260,000 x .75)] / .75 20,000
d. Current accounting practice:
Cash and inventory ($300,000 + $80,000) $380,000
Buildings and Equipment (net)
[$400,000 + $120,000 + ($60,000 x .75)] 565,000
Goodwill [$210,000 - ($260,000 x .75)] 15,000
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002
(Page Intentionally Left Blank)
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2002