Consolidation approaches

In the previous section, we discussed how U.S. GAAP determines whether one entity controls another entity using the voting interest entity model and the variable interest entity (VIE) model. When control exists, the reporting entity must include the other entity in its financial reporting.

However, not all investments in other entities result in full consolidation. Companies may have different types of relationships with other entities, ranging from complete control to significant influence but not control. Because of these different relationships, financial reporting standards provide different accounting approaches to reflect these investments.

Definitions

Consolidation accounting approaches

Methods used to reflect investments in other entities in financial statements depending on the level of control or influence.

In practice, three primary accounting approaches are used to reflect investments in other entities:

• Full consolidation
• Proportionate consolidation
• Equity method

Each method reflects a different level of involvement or influence over the investee.

Comparison of the consolidation approaches

The three accounting approaches differ primarily in how the investee’s financial information is incorporated into the investor’s financial statements.

Feature	Full consolidation	Proportionate consolidation	Equity method
Level of relationship	Control	Joint control / shared control	Significant influence
Assets and liabilities	100% included	Investor’s percentage share included	Not included
Revenues and expenses	100% included	Investor’s percentage share included	Investor reports share of income
Investment account	Eliminated in consolidation	Typically replaced by proportional balances	Remains as an investment account

Understanding these differences is important because they determine how the investor’s financial statements reflect its relationship with other entities.

As the level of control or influence decreases, the reporting entity includes less of the investee’s financial information directly in its financial statements.

Full consolidation

Full consolidation is the accounting approach used when the reporting entity controls another entity. This situation typically arises when a parent company owns a majority of the voting shares of a subsidiary or otherwise has control under the consolidation models discussed earlier.

Definitions

Full consolidation

A method in which the parent includes 100% of the subsidiary’s assets, liabilities, revenues, and expenses in the consolidated financial statements.

Under full consolidation, the financial statements of the parent and the subsidiary are combined as if the two entities were a single economic entity. This means that the consolidated financial statements include:

• All of the subsidiary’s assets and liabilities
• All of the subsidiary’s revenues and expenses
• All of the subsidiary’s gains and losses

Even if the parent does not own 100% of the subsidiary, the consolidated financial statements still include 100% of the subsidiary’s financial information. The portion not owned by the parent is presented as noncontrolling interest.

Full consolidation also requires several consolidation procedures, including:

• Elimination of the parent’s investment account
• Recognition of noncontrolling interest
• Elimination of intercompany transactions and balances

These adjustments ensure that the consolidated financial statements reflect the activities of the entire corporate group as a single reporting entity. The various elimination adjustments are discussed in the subsequent section.

Noncontrolling interest

When a parent company owns less than 100% of a subsidiary but still controls the entity, a portion of the subsidiary belongs to other shareholders. This ownership interest is referred to as noncontrolling interest.

Definitions

Noncontrolling interest (NCI)

The portion of a subsidiary’s equity that is owned by shareholders other than the parent company.

Although the parent may own only part of the subsidiary, the consolidated financial statements still include 100% of the subsidiary’s assets, liabilities, revenues, and expenses. The portion attributable to the other shareholders is reported separately as noncontrolling interest.

Noncontrolling interest typically appears:

• In the equity section of the consolidated balance sheet, and
• As a separate allocation of net income in the consolidated income statement

This presentation allows financial statement users to distinguish between the portion of income attributable to the parent company and the portion attributable to other shareholders.

Common misconception: reporting a noncontrolling interest does not shrink the consolidated balance sheet down to the parent’s ownership percentage. The consolidated totals for assets, liabilities, revenues, and expenses always reflect 100% of the subsidiary, regardless of how much of it the parent actually owns. Noncontrolling interest only changes how consolidated equity and net income are split between the parent and the other shareholders - it doesn’t reduce the 100% figures that were combined.

Proportionate consolidation

Proportionate consolidation is an accounting approach in which an investor reports its proportionate share of an investee’s financial statement items rather than including the entire entity.

Definitions

Proportionate consolidation

A method in which an investor includes its proportionate share of an investee’s assets, liabilities, revenues, and expenses in its financial statements.

Under this method, the investor does not include the full financial statements of the investee. Instead, the investor reports only its ownership percentage of each financial statement element.

For example, assume an investor owns 40% of a joint arrangement that reports the following financial information:

• Assets: $1,000,000
• Liabilities: $600,000
• Revenues: $800,000
• Expenses: $500,000

Under proportionate consolidation, the investor would report:

• 40% of assets = $400,000
• 40% of liabilities = $240,000
• 40% of revenues = $320,000
• 40% of expenses = $200,000

This method reflects the idea that the investor shares joint control of the entity with other parties.

GAAP vs. IFRS trap: under U.S. GAAP, proportionate consolidation is largely disallowed for joint ventures. An investor in an incorporated joint venture (or an LLC with corporate governance characteristics) uses the equity method instead. Proportionate consolidation remains permitted only in narrow cases: undivided interests (where the investor owns a direct share of each asset and is proportionately liable for each liability), and unincorporated joint ventures in the construction or extractive industries. IFRS historically allowed broader use of proportionate consolidation, so don’t assume the two frameworks treat joint ventures the same way.

Equity method

The equity method is used when the investor has significant influence over another entity but does not control it.

Definitions

Equity method

An accounting method in which an investment is initially recorded at cost and subsequently adjusted for the investor’s share of the investee’s net income or loss.

Significant influence typically exists when the investor owns between 20% and 50% of the voting shares of another company. At this level of ownership, the investor may be able to participate in policy decisions without having full control.

Under the equity method, the investor does not combine the investee’s assets, liabilities, revenues, or expenses with its own financial statements. Instead, the investment is reported as a single line item on the balance sheet.

The accounting process generally follows these steps:

1. The investment is initially recorded at cost.
2. The investment balance is increased by the investor’s share of the investee’s net income (and decreased by its share of a net loss).
3. The investment balance is decreased by dividends received from the investee.

For example, assume an investor owns 30% of company Gamma. If Gamma reports net income of $100,000 during the year, the investor recognizes income equal to:

30% × $100,000 = $30,000

This amount increases both the investor’s income statement earnings and the investment account on the balance sheet.

Now suppose Gamma also pays $20,000 in dividends during the year. The investor receives its 30% share:

30% × $20,000 = $6,000

This $6,000 decreases the investment account, because dividends received are treated as a return of the investment, not as income. The investor does not report dividend income under the equity method - the dividend only reduces the investment balance. Combining both effects, the investment account rises $30,000 for the share of income and falls $6,000 for dividends received, for a net increase of $24,000. If Gamma had instead reported a net loss, the investor’s share of that loss would decrease the investment account in the same way that a share of net income increases it.

This method is discussed further in the section on investments.