2016 McGraw-Hill Education

CHAPTER
4:
Consolidatio
n of NonWholly
Owned
Subsidiaries

Prepared by
Shannon Butler, CPA,
Carleton University

Learning Objectives
LO1 Define non-controlling interest and explain how
it is measured on the consolidated balance sheet.

LO2 Prepare a consolidated balance sheet using the

entity theory.

LO3 Prepare a consolidated balance sheet using

the parent company extension theory.

LO4 Explain the concept of negative goodwill and

describe how it should be treated when it arises
in a business combination.
2

Learning Objectives
LO5 Account for contingent consideration based
on its classification as a liability or equity.

LO6 Analyze and interpret financial statements

involving consolidation of non-wholly
owned subsidiaries.

LO7 (Appendix 4A) Prepare a consolidated balance

sheet using the working paper approach.

Owned
Subsidiaries

LO1

When the parent acquires less than 100% of

the shares, the parents own assets and
liabilities and the parents share of the
subsidiarys assets and liabilities will be
measured at carrying value and fair value,
respectively, on the consolidated balance.

The following example, Exhibit 4.1, will form

the basis of many of the illustrations that will
be used in this chapter.

LO1

Exhibit 4.1
BALANCE SHEET
At June 29, Year 1
P Ltd.
S Ltd.
S Ltd.
Carrying amount Carry amount Fair Value
Cash $100,000
$ 12,000
$ 12,000
Accounts receivable
90,000
7,000
7,000
Inventory 130,000
20,000
22,000
Plant
280,000
50,000
59,000
Patent
-11,000
10,000
Total Assets
$600,000
$100,000
$110,000
Current liabilities $ 60,000
$ 8,000
$ 8,000
Long-term debt
180,000
22,000
25,000
Total liabilities 240,000
30,000
$ 33,000
Common Shares
200,000
40,000
Retained Earnings 160,000
30,000
Total Liabilities and
$600,000
$100,000
Shareholders Equity

Owned
Subsidiaries

LO1

The shares not acquired by the parent are owned by the

other shareholders, referred to as the non-controlling
shareholders.

The value of shares held by the non-controlling

shareholders
appears on the balance sheet as non-controlling interest
(NCI)

Three questions arise when preparing consolidated

financial
statements for less-than-100% subsidiaries:

How should the portion of the subsidiaries net assets not

acquired by the parent be valued on the consolidated
financial statements?
How should NCI be measured?

Introduction to
Consolidation Theories

LO1

Four theories propose a solution to preparing consolidated financial

Statements for non-wholly subsidiaries.
Proprietary Theory
Parent Company Theory
Parent Company Extension Theory
Entity Theory

Proprietary Theory is presently used for consolidating certain

types of joint arrangements and was an option under GAAP prior
to 2013 for consolidating joint ventures.
Parent Company Theory was GAAP in Canada prior to January 1,
2011.
Parent company extension theory and Entity theory are both
acceptable options for consolidating subsidiaries after January 1,
2011.
7

Introduction to
Consolidation Theories

LO1

We will illustrate the preparation of consolidated

financial statements under these theories using
the following example:

We will examine P Ltd. And S Ltd. Both companies

have a June 30 fiscal year-end. On June 30, Year 1, S
Ltd. had 10,000 shares outstanding and P Ltd.
purchased 8,000 shares (80%) of S Ltd. for a total
cost of $72,000. P Ltd.s journal entry to record this
purchase is as follows:
Dr investment in S Ltd.
Cr Cash

$72,000
$72,000
8

LO1

The Proprietary Theory

Views the consolidated entity from the
standpoint
of the shareholders of the parent company.

Therefore the consolidated statements do not

reflect the equity of the non-controlling
shareholders.

Not permitted under GAAP for consolidation of

parent and subsidiary, however is used to
report
joint venture investments where there is no
control relationship.

LO1

The Proprietary Theory

The consolidated balance sheet consists of the
historical values of the parents assets and liabilities
plus the parents share of the fair values of the
subsidiarys net assets.

Only the Parents share of the fair values of the

subsidiary are included on the consolidated balance
sheet (see Exhibits 4.2 and 4.3)

Goodwill is therefore based only on the cost paid by

the parent for the acquisition, and does not include
any portion attributable to the non-controlling
shareholders.
10

LO1

The Parent Company Theory

Similar to the proprietary theory the Parent Company theory
focuses on the parents shareholders, but gives some
recognition
to NCI.

Required by GAAP prior to January 1, 2011 or upon earlier

adoption of IFRS 3.

The fair values of the assets and liabilities acquired in the

consolidation statements, but only to the extent of the parents
proportionate interest acquired. The non-controlling
shareholders portion is reflected at the book values.

Accordingly, the value of subsidiarys assets and liabilities

reflected on the consolidated balance sheet is a hybrid:
book value for non-controlling interest portion and fair value
for the parents share. (see Exhibit 4.4)
11

LO1

The Parent Company Theory

Requires that fair values be recognized only to the extent of the
proportion evidenced by the parents purchase . That is, with
90% purchases of a subsidiary, book value is reflected for each
asset and liability of the subsidiary, plus the parents fair value
increment based on 90% of the acquisition differential
(difference
between fair and book value).

Consolidated balance sheet is the sum of the:

Book value of Parent Companys Net Assets

Book value of Subsidiary Company Net Assets, and
Difference between fair value and book value of Subsidiarys
assets and liabilities (Acquisition Differential), only for the
percentage acquired by the parent. (The non-controlling portion
remains at historical cost).

NCI is presented as a liability.

12

The Entity Theory

LO2

Views the consolidated entity as having two distinct groups of

shareholders the controlling and non-controlling shareholders.

The basis of GAAP for consolidation beginning January 1,

2011 or upon earlier adoption of IFRS 3.

The consolidated balance sheet reflects full fair values of

subsidiarys net assets and goodwill as if the parent had
acquired 100% instead of the lesser amount actually acquired.

For the balance sheet to reflect full fair value of the subsidiary,
the price per share paid by the parent is effectively
extrapolated to the shares not acquired, to establish an implied
fair value for the entire company.

This assumes a linear relationship to calculate the value of NCI.

13

The Entity Theory

LO2

As parents holding moves further away from 100%, or as

parent acquires control through a series of small purchases,
straight-line extrapolation loses validity.

If the subsidiary was a public company and its shares were

actively traded prior to acquisition, an alternative approach to
valuing the non-controlling interest would be to multiply the
number of non-controlling shares by the acquisition date
trading price. (market price of subsidiarys shares)

Another alternative approach for valuing non-controlling

interests would be to perform an independent business
valuation using valuation techniques, which could be costly.

14

The Entity Theory

LO2

The entity theory results in the following:

Assets acquired and liabilities assumed are valued
at their total fair value at the date of acquisition.

Non-controlling interest is valued on the basis of the

market value of the company acquired, not the
underlying book value as in the parent company
theory

NCI is presented in consolidated equity based on

fair values of subsidiarys net assets and goodwill.

15

The Entity Theory

LO2

Example 1:
Fair value of NCI as evidenced by market
trades

P Ltd. acquires 80% of S Ltd. (8,000 of S Ltds

shares) for $72,000 by paying $9 per share.

S Ltd. shares are trading for $7.75 per share at

acquisition date.

16

The Entity Theory

LO2

Acquisition date FV is as follows:

FV of controlling interest ($9 x 8,000 shares) $72,000
FV of NCI ($7.75 x 2,000 shares)
15,500
Total FV of S Ltd. at acquisition date
$87,500
Goodwill is calculated as follows:
Total FV at acquisition date $87,500
FV of net assets acquired per Exhibit 4.1
Goodwill $10,500

77,000

The goodwill component as a % of total value for the

controlling
interest is much higher than NCI when a parent pays a
premium
to obtain control. See Chapter 5 self-study for an example.
17

The Entity Theory

LO2

Example 2:
Fair value of NCI Implied by Parents
purchase paid

P Ltd. Acquires 80% of S Ltd. on June 30, Year 1

for $72,000 paid in cash.

The following two slides Exhibit 4.6 and 4.7 reflect

the calculation and allocation of acquisition
differential, non-controlling interest, and
consolidated balance sheet of P Ltd.
18

Exhibit 4.6

LO2

CALCULATION OF ACQUISITION DIFFERENTIAL (entity theory)

Cost of 80% investment in S Ltd.
$72,000
Implied value of 100% investment
in S Ltd (72,000 / 80%)
$90,000
Carrying amount of S Ltds net assets
Assets
$100,000
Liabilities
30,000
70,000
Implied acquisition differential
20,000
Allocated:
(FV - CA) x 100%
Inventory
+ 2,000 x 100% = + 2,000
(a)
Plant
+ 9,000 x 100% = + 9,000
(b)
Patent
- 1,000 x 100% = - 1,000
(c)
10,000
Long-term debt
+ 3,000 x 100% = + 3,000 7,000 (d)
Balance -- goodwill
$13,000 (e)

CALCULATION OF NCI
Implied value of 100% investment in S Ltd.
NCI ownership
20%
$18,000 (f)

$90,000

19

Exhibit 4.7

LO2

Illustration of the Direct Approach (entity theory)

P LTD.
CONSOLIDATED BALANCE SHEET
At June 30, Year 1

Cash (100,000 72,000* + 12,000) $ 40,000

Accounts receivable (90,000 + 7,000)
97,000
Inventory (130,000 + 20,000 + [5a] 2,000)
152,000
Plant (280,000 + 50,000 + [5b] 9,000)
339,000
Patent (0 + 11,000 [5c] 1,000)
10,000
Goodwill (0 + 0 + [5e] 13,000)
13,000
$651,000
Current liabilities (60,000 + 8,000)
$ 68,000
Long-term debt (180,000 + 22,000 + [5d] 3,000)
205,000
Total liabilities
273,000
Shareholders equity
Controlling interest
Common shares
200,000
Retained earnings 160,000
360,000
Non-controlling interest [5f]
18,000
378,000
$651,000
* Cash paid by P Ltd. to acquire S Ltd.

20

Parent Company ExtensionLO3

Theory
Addresses concern about goodwill valuation
under the entity theory.

Reflects both parents and non-controlling

interests share of identifiable net assets at
full fair values.

However only parents share of subsidiarys

goodwill is reflected on consolidated balance
sheet.

21

Parent Company ExtensionLO3

Theory
NCI is calculated as follows:
Carrying amount of S Ltds net assets:
Assets
$100,000
Liabilities
(30,000)
70,000
Excess of fair value over carrying amount
for identifiable net assets (Exhibit 4.5)
7,000
Fair value of identifiable net assets
77,000
Non-controlling ownership %
20%
Non-controlling interest
$15,400

NCI is reflected in equity.

See Exhibit 4.8 for Consolidated Balance Sheet
22

Bargain Purchases

LO4

Negative goodwill results when the total consideration

(purchase price) is less than the fair value of identifiable
net assets.

Often described as a bargain purchase, this can occur when

share prices are depressed or subsidiary has had recent
operating losses.

IFRS 3 requires that negative goodwill be reduced to zero by

first reducing any goodwill on the subsidiarys books, then
recognizing any remaining negative goodwill as a gain.

Since negative goodwill is very rare, the parent should check

the valuations of the identifiable net assets before recording a
gain on bargain purchase.

23

Bargain Purchases
Illustration

LO4

- Negative Goodwill:

On June 30, year 1 P Ltd. Purchased 100% of the

shares of S Ltd. For $72,000 cash. The carrying
amount of Ss identifiable net assets is $70,000 and
the acquisition differential is $2,000 on that date.

$7,000 of the $2,000 acquisition differential is

allocated to the net assets of S, leaving $5,000
negative goodwill.

The calculation and amortization of the acquisition

differential is shown in Exhibit 4.9 on the next slide.

24

Exhibit 4.9

LO4

CALCULATION AND ALLOCATION OF ACQUISITION DIFFERENTIAL

(negative goodwill, wholly owned subsidiary)
Cost of investment in S Ltd.
$72,000
Carrying amount of S Ltds net assets
Assets $100,000
Liabilities
(30,000) 70,000
Acquisition differential
2,000
Allocated: (FV CA)
Inventory + 2,000
Plant + 9,000
Patent - 1,000
10,000
Long-term debt
+ 3,000
7,000
Balance negative goodwill
$-5,000
(gain on bargain purchase)
The negative goodwill is recognized as a gain on bargain purchase
25

Negative Acquisition
Differential

LO4

Not the same as negative goodwill

Results when the parents interest in the book
values
of the subsidiarys net assets exceed acquisition
cost

Could result in negative goodwill if the fair values

of the subsidiarys net assets also exceed
acquisition cost, otherwise will result in positive
goodwill.

26

LO4

Subsidiary with Goodwill

Any goodwill on the balance sheet of subsidiary on
acquisition date is not carried forward to the
consolidated balance sheet.

That goodwill resulted from a past transaction in which

the subsidiary was the acquirer in a business
combination, reflecting outdated fair values of entity it
acquired.

The parents acquisition differential is now calculated as

if the goodwill has been written off by the subsidiary and
replaced instead by the updated fair values and goodwill
of the entity the subsidiary previously acquired.
27

LO4

Subsidiary with Goodwill

Example:

On June 30, Year 1 P Ltd. purchased 80% of the shares

of S Ltd. For $62,000 cash. The fair value of Ss
identifiable net assets which includes goodwill is
$67,000
on that date.

The balance sheets of both companies is shown in

Exhibit
4.12 on the next slide.

The calculation and amortization of the acquisition

differential is shown in Exhibit 4.13 in the following
slide.

The consolidated balance sheet is shown in Exhibit 4.1428

LO4

Exhibit 4.12
BALANCE SHEET
At June 29, Year 1
P Ltd.
Carrying amount

S Ltd.
S Ltd.
Carrying amount Fair Value

Cash
$100,000 $ 12,000 $12,000
Accounts receivable
90,000
7,000
Inventory
130,000
20,000
22,000
Plant
280,000
50,000
59,000
Goodwill
-11,000
$600,000 $100,000

7,000

Current liabilities $ 60,000 $ 8,000

8,000
Long-term debt
180,000
22,000
25,000
Common shares
200,000
40,000
Retained earnings 160,000
30,000
$600,000 $100,000
29

Exhibit 4.13

LO4

CALCULATION AND ALLOCATION OF ACQUISITION DIFFERENTIAL

(subsidiary with goodwill)
Cost of 80% investment in S Ltd. $62,000
Implied value of 100% investment in S Ltd (62,000 / .80) $77,500
Carrying amount of S Ltds net income
Assets $100,000
Liabilities
(30,000)
70,000
Deduct old goodwill of S Ltd.
11,000
Adjusted net assets
59,000
Acquisition differential
18,500
Allocated: (FV CA)
Inventory
+$ 2,000
Plant
+ 9,000
11,000
Long-term debt + 3,000 (c) 8,000
Balance goodwill $10,500

CALCUALTION OF NCI
Implied value of 100% investment in S Ltd
NCI Ownership
20%
$15,500

$77,500

30

Exhibit 4.14

LO4

Illustration of the Direct Approach (subsidiary with goodwill)

P LTD
CONSOLIDATED BALANCE SHEET
At June 30, Year 1
Cash (100,000 62,000* + 12,000)
$ 50,000
Accounts receivable (90,000 + 7,000)
97,000
Inventory (130,000 + 20,000 + [12a] 2,000)
152,000
Plant (280,000 + 50,000 + [12b] 9,000)
339,000
Goodwill (0 + 11,000 11,000 + [12d] 10,500)
10,500
$648,500
Current liabilities (60,000 + 8,000)
$ 68,000
Long-term debt (180,000 + 22,000 + [12c] 3,000)
Common shares 200,000
Retained earnings
160,000
Non-controlling interest [12e]
15,000
$648,500

205,000

*Cash paid by P Ltd to acquire s Ltd.

The direct approach produces the same results as the working paper
approach but appears to be easier to perform.

31

LO5

Contingent Consideration
What happens when a portion of the total cost of the
acquisition is variable depending on future events, so
the eventual total cost is not known with certainty at
the date of acquisition of the subsidiary?

IFRS 3 requires the contingent consideration to be

recorded at fair value at the acquisition date as part
of the acquisition cost, using assumptions, probabilities,
and other valuation techniques which can be subjective
and require significant amount of judgment.

32

LO5

Contingent Consideration
Classify contingent consideration as either liability or equity
depending on its nature.

If payable in cash or another asset, record as liability.

Revalue liability after acquisition date as circumstances
change.

Record revaluation adjustment in earnings if revaluation

arose as a result of events occurring after acquisition; or

Adjust the purchase price if revaluation arose as a result

of new information about facts and circumstances that
exists as at the date of acquisition.

If payable in additional shares of the parent, record as

equity.
Do not revalue contingent consideration classified as
equity.
33

LO5

Contingent Consideration
Disclosure Requirements:
IFRS 3, paragraph B64, requires that a reporting
entity disclose the following for each business
combination in which the acquirer holds less than
100% of the equity interests in the acquiree at
the acquisition date:
a) The amount of the NCI in the acquiree recognized
at the acquisition date and the measurement basis
for that amount.

b) For each NCI in an acquiree measured at fair value,

the valuation techniques and key model inputs
used for determining that value.
34

LO6

Analysis and Interpretation

of Financial Statements
The key ratios are different under different
reporting methods.

The classification of NCI has a big impact on

the
debt-to-equity ratio.

See Exhibit 4.16 for impact on current and

debtto-equity ratios.
35

Consolidation of Non-Wholly
LO7
Owned Subsidiaries Appendix
4A
Working Paper Approach - Use of the working paper ensures
that the debit and credit adjustments balance each other.

The working paper in Exhibit A4.1 (refer to exhibit in text for

example) reflects three consolidated adjusting entries:
To eliminate the parents share of the subsidiarys shareholders
equity accounts and the parents investment account; the
difference is the acquisition differential.
To eliminate the NCIs share of the subsidiarys equity accounts
and determine NCI for the consolidated balance sheet
To allocate the acquisition differential to revalue the identifiable
assets and liabilities of the subsidiary and record goodwill.

These entries are made only on the working paper, not in the
accounting records of P or S.

36

Consolidation of Non-Wholly
LO7
Owned Subsidiaries Appendix
4A
Working Paper Approach (Contd)

Worksheet entries are made only in the working

paper; they are not entered into the accounting
records of P Ltd. Or S Ltd.

Exhibit A4.2 shows the preparation of the consolidated

balance sheet when P Ltd. Acquires 80% of the common
shares of S Ltd. For $60,000
results in negative goodwill, reported as a gain.

Exhibit A4.3 show the preparation of the consolidated

balance sheet when S Ltd. Has goodwill on its own
balance sheet.
37