Created Subsidiaries

1. Created Subsidiaries Purpose of Setting Up Separate Corporations

2. Subsidiary vs. Branch • Limiting Legal Liability Exposure • Federal income taxes • Patent & Copyright Protection • Meet foreign country local ownership rules • Create a perception of separateness to introduce new product (Saturn) • Break up parent company into separate publicly traded companies (spinoff) • Getting around the “rules” (unions, sanctions)

3. If subsidiaries exist … Consolidation is probably necessary!

4. Consolidation: The Concept A “pro forma” presentation--it means “as if ” the parent and subsidiary were a SINGLE legal entity with one or more branches. • It is a LEGALFICTIONAL PRESENTATION (an accounting mirage).

5. Control, Control, Control! • In determining whether consolidation is appropriate, the three most important considerations are “control,control,and control.” Like real estate’s “location, location, location”

6. Consolidation: The Concept • Remember--the parent has the POWERtoliquidate the subsidiary into a branch (thus shattering the subsidiary’s “protective shell”). • The result: A SINGLE legal entity. 2 - 1 = 1

7. Control: By What Means? • TheUsual Way--Owning more than 50% of the subsidiary’s outstanding voting stock (50% plus only 1 share will do it). • TheUnusual Way--Having contractual agreements or financial arrangements that effectively achieves control.

8. Control: Ways It Can Be Lost Or Lessened • Bankruptcy filing--the judge takes control. • Foreign government interventionin day-to-day operations. • Currency transfer restrictions imposed by a foreign government. • Dividend restrictions imposed by U.S. government regulatory authorities (banking and S&Lindustries).

9. Loss of Control:To What Extent? • SUBSTANTIALor COMPLETELOSS OF CONTROL--stopconsolidating: • Bankruptcy. • Foreign government intervention. • Severe long-term currency transfer or dividend restrictions. • SIGNIFICANT LOSS OF CONTROL--use judgment as to consolidating.

10. FIN 46 – Consolidation of Variable Interest Entities Jim Mountain January 2003

11. TG Determination of Primary Beneficiary • Depends on who has majority of expected losses • If no one, then it depends on who has a majority of the residual gains • A 10% outside equity interest is probably an indication that it is not a VIE but 10% is not a “safe harbor” • The analysis of expected losses & residual returns must still be made to determine primary beneficiary

12. Filling the Buckets Above Average Outcomes Below Average Outcomes + Fees Probability Weighted Scenarios ExpectedResidual Returns ExpectedLosses

13. TG Primary Beneficiary • If a primary beneficiary exists . . . • This entity consolidates the special purpose entity or “variable interest entity” • It is possible that no one will consolidate a particular entity • Certain types of entities are explicitly excluded from scope of FIN46

14. TG Determination of Status • Determination of whether an entity is a VIE is made when the entity is formed • The determination of who is the primary beneficiary is also made then • The classifications are not re-examined unless there is a change in circumstances (triggering event)

15. Reconsideration Triggers

16. Questions? Jmountain@deloitte.com212-436-4742

17. Unconsolidated Subsidiaries Valuation on Parent’s Books

18. Effect of control on accounting for investments Less than 20% Over 50% 20% to 50% Prepare consolidated financial statements Use the equity method Fair value Cost

19. Cost Method • Under GAAP it is permitted only for external reporting in limited circumstances • Stock not publicly traded (no fair value available) AND • Investor does NOT have significant influence or control (equity method not appropriate)

20. Cost Method Write down New “basis” that remains unchanged unless more impairment occurs Never written back up to original cost Equity Method Pretty much happens automatically Value can go up as well as down Never lower than ZERO unless parent has guaranteed the debt of the sub When Subsidiary has Significant Losses – Account for Impaired Value

21. Unconsolidated Subsidiaries – effect of loss of control

22. Cost Method Dividends from sub reported as income on parent’s books Investment remains unchanged (unless impairment occurs) Parent can manipulate reported earnings through acceleration/delay of dividends Equity Method Dividends reduce investment account Investment account increases as sub reports earnings Adjustments for excess value items may be necessary Built-in “check figures” Accounting for Subsidiaries on Parent Company’s Books

23. Consolidation: The Most Important Point of All on Investment Basis The consolidated statement amounts are identical whether the parent usesthe cost method or the equity method This holds true for ALL 3 statements.

24. Types of Entries:How Do They Differ? • Adjusting journal entries (AJEs). • Reclassifying journal entries (RJEs). • Reversing entries. • Proposed journal entries (by auditors) (PJEs). • Consolidation entries. • Posted only to worksheets. • Produce a substitution result.

25. External Reporting Consolidated Entities Partially-owned Consolidated Entities

26. Proportional vs. Full Consolidation

27. Parent Company Concept vs. Economic Unit Concept:

28. Consolidation:Aggregated versus Disaggregated Format • AGGREGATED Presentation: • Sum the parent’s and subsidiary’s accounts. • Makes sense if in the same lines of business.

29. Consolidation:Aggregated Versus Disaggregated Format • DISAGGREGATED Presentation: • Present subsidiary’s accounts separately (“layered,” “tiered,” “stacked,”or “pancake” format). • Makes sense if in different lines of business.

30. PCO Statements • May be presented in the notes to the consolidated financial statements • PCO statements are mandatory for publicly owned banks and S&Ls (SEC rules). • Can ONLY use the equity method.

31. Partially-owned Subsidiaries • Will always need subsidiary only financial statements • Consolidated financial statements are NOT useful for the noncontrolling interest shareholders • If subsidiary is 100% owned, when would separate F/S be needed?

32. Business Combinations No more pooling of interests Always purchase method!

33. The Purchase Method: A Whole New Basis of Accounting is Established • The new basis of accounting is based on the acquirer’s purchase price. • The depreciation cycle for fixed assets begins a new at a higher or lower level. • If cost > CV, goodwill exists. Recognize as an asset--do not amortize. Evaluate periodically for possible impairment. • If cost < CV, an extraordinary gain is recognized at acquisition.

34. Acquiring ASSETS Versus Acquiring COMMON STOCK • Major Decision Factors: • Legal considerations--Buyer must be extremely careful NOT to assume responsibility for (and thus “inherit”)the target company’s: • Unrecorded liabilities. • Contingent liabilities (lawsuits).

35. Acquiring ASSETS Versus Acquiring COMMON STOCK: • Major Decision Factors (continued): • Tax considerations--Often requires major negotiations involving resolution of: • Seller’s tax desires. • Buyer’s tax desires. • Ease of consummation--Acquiring common stock is simple compared with acquiring assets.

36. Major Advantages of Acquiring Assets: Will NOT inherit a target’s contingent liabilities (excluding environmental). Will NOT inherit a target’s unwantedlabor union. Major Disadvantages of Acquiring Assets: Transfers of titles on real estate and other assets can be time-consuming. Transfer of contracts may NOT be possible. Acquiring ASSETS: advantages and disadvantages

37. TOPCO P S 3 legal entities Organizational Forms:Specialized Options • Option #3: HOLDING COMPANY: • Similar to a statutory consolidationexcept that the two subsidiaries are NOT liquidatedinto TOPCO.

38. ”Partial” or “Full “Valuation • Extent of Revaluation of Undervalued Assets and Goodwill: • Parent Company Concept: Partial valuation (could be anywhere from 51% to 99%) • Economic Unit Concept: Full valuation 75% 100%

39. Partial Ownerships: Undervalued Assets • Extent of Revaluation of Subsidiary’s Undervalued Assets: • Parent company concept..... < 100% of CV • Revalued only to the extent of the parent’s OWNERSHIP INTEREST. • Economic unit concept........ 100% of CV • The offsetting credit for the additional valuation increasesthe NCI in the consolidated B/S.

40. Partial Ownerships:Goodwill • Extent of Valuation of Goodwill: • Parent company concept....... < 100% • Valued only to the extent it isbought and paid for by the parent. • Economic unit concept......…. = 100% • The offsetting credit for the additional valuation increasesthe NCI in the consolidated B/S. • Note that the Economic Unit Concept that is currently GAAP does NOT write up goodwill by 100% - only other tangible and intangible assets

41. Postacquisition Subsidiary Earnings • ONLY the subsidiary’s postacquisition earnings are reported in the consolidated financial statements. • The subsidiary’s preacquisition earnings (included in its retained earnings account) are ALWAYS eliminated against the parent’s Investment account in consolidation.

42. #1 Goodwill: What to Do With It? • GOODWILL--Usually Exists When Acquiring a Winner or a Potential Winner : • Must capitalize as an asset. • Cannot amortize to earnings. • Must periodically (at least annually) assess for impairment. • If impaired, must write it down--charge to earnings.

43. Bargain Purchase Element:What to Do With It? • BARGAIN PURCHASE ELEMENT--Usually Exists When Acquiring a Troubled Company: • Extinguish against certain specified assets to extent possible. • Any unextinguished amount is credited to earnings--reported as an extraordinary item. red ink galore

44. Nonpush-Down Accounting:The HARDER Way • Non-Push-Down Accounting: • Don’t touch the subsidiary’s general ledger (treat likea “sacred cow”). • Make fair value adjustments and record goodwill in consolidation (on the worksheets).

45. Push-Down Accounting:The EASIER Way • Push-Down Accounting (an absolute gem): • In the subsidiary’s general ledger: • Adjust assets and liabilities to FVbased on the parent’s purchase price. • This establishes a new basisof accounting. • Record goodwill. • Discussed in depth in Chapter 7.

46. Consolidation Consequences:Push-Down Versus Non-Push-Down • Push-Down Accounting: • Consolidation effort is minimal (has received the “Better Book-keeping” stamp of approval). • Non-Push-Down Accounting: • Consolidation effort is cumber-some (often a headache). Aspirin

47. Push-Down Versus Non-Push-Down Accounting: The Bottom Line • The consolidated financial statement amounts are the SAME whether the parent selects: • Push-down accounting or • Non-push-down accounting. • ONLY the accounting procedures differ.

48. SEC Staff Bulletin No. 54 requires push-down accounting in the separate financial statements of a subsidiary acquired in a purchase transaction

49. Intangible Assets: More of Them Are Recognized under FAS 141 • Record at fair value only if either of the following two criteria are met:#1: Intangible arises from a legal or contractual right.#2: Intangible does not arise from a legal or contractual right but is separable.

50. Goodwill: It Must be Assignedto a “Reporting Unit” • A reporting unit is (1) an “operating segment” (as defined in FAS 131) or (2) one level below an operating segment. • The reporting unit could be: • The acquired business alone (the subsidiary or division). • The acquired business and the parent combined. • The acquired business and one or more of the parent’s other subsidiaries or divisions.