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Copyright University of Florida, Accounting Research Center 1995

1.0 INTRODUCTION

The FASB's Discussion Memorandum, Consolidation Policy and Procedures ( 1991; hereafter, the " DM"), compares and contrasts accounting theory and procedures under three competing concepts: the economic unit concept, the parent company concept, and the proportionate consolidation concept. Currently, any of these three concepts may be followed in preparing consolidated financial statements, although the parent company concept is the one most widely used in practice today. The purpose of the FASB's project is to decide on one of these three approaches for preparing consolidated financial statements in order to eliminate diversity in financial reporting across similar situations.

In conducting its investigation, the FASB has found the theoretical literature in this area to be lacking. They note in the DM [p. 5]

there is a small body of conceptual and theoretical literature on consolidated statements and related matters, but it is not nearly as comprehensive as their significance and pervasiveness seem to warrant, and much of it is 40 to 60 years old.

The American Accounting Association's Financial Accounting Standards Committee (hereafter, the "Committee") also ran into difficulty finding theoretical work in this area when its members constructed a response to the DM. In its response, the Committee expressed a preference for the economic unit concept for two reasons: first because the method best presents the entirety of assets under the parent company's control; second because it is consistent with their preference for current value financial statements in general (see below for the discussion of valuations under the three consolidation options). However, the committee members could not agree on many details of the reporting under this concept. They cited an example in which some members prefer presenting minority interest in stockholders' equity, while others prefer showing total consolidated stockholders' equity equal to parent company stockholders' equity. A proper theoretical framework for consolidated reporting is needed to resolve these inconsistencies.

The purpose of this paper is to develop such a theoretical foundation for consolidation through a review and synthesis of the financial economics literature on corporate control transactions which result in minority ownership interests in subsidiary companies. Understanding the nature of minority interest establishes the foundation for consolidation because there is little difference among the three methods when the parent owns 100 of a subsidiary. As Pacter [DM, p. 24] wrote, "noncontrolling (minority) interests become the focus of the differences between the concepts."' Under the economic unit concept,

unless all subsidiaries are wholly owned, the business enterprise's proprietary interest. . .is divided into the controlling interest (stockholders or other owners of the parent company) and one or more noncontrolling [minority] interests in subsidiaries. Both the controlling and the noncontrolling interests are part of the proprietary group of the consolidated entity, even though the noncontrolling stockholders' ownership interests relate only to the affiliates whose shares they own [DM, p. 24].

Alternatively, under the parent company theory and, by association with it, under proportionate consolidation,

unlike the economic unit concept, . . .the stockholders' equity of the parent company is also the stockholders' equity of the consolidated entity. .The equity in subsidiaries represented by shares owned by their noncontrolling (minority) stockholders is considered to be outside the proprietary

interest in the consolidated entity [DM, p. 24].

Accordingly, this paper reviews research on corporate control transactions which have implications for minority (noncontrolling) interests in consolidated entities. This area of the literature provides strong support for the economic unit concept and little support for either of the other two alternatives presented in the DM. The literature generally supports the view that minority interests are stockholders with interests in the entire consolidated entity. This theoretical framework and the details of the research findings in financial economics also provide guidance for selecting among alternative practices within the concept of the economic unit method itself.

The organization of the paper is as follows. Section 2 presents a brief discussion of the three alternative approaches discussed in the DM. Section 3 presents the review and synthesis of the financial economics literature on corporate restructuring transactions. Section 4 presents research implications.

2.0 THE THREE CONSOLIDATION APPROACHES

The three consolidation approaches presented in the DM stem from two theoretical foundations for consolidated financial reporting: the entity theory and the parent company theory of reporting. Under the entity theory [Moonitz, 1951] (also called the economic unit theory), the consolidated group is considered to be one economic unit for financial reporting purposes. That economic unit holds assets and liabilities in various legal entities associated by one common controlling entity. The economic unit may have more than one class of voting ownership interest: parent company voting shareholders and subsidiary voting shareholders (the minority interest).

The parent company theory holds that only the parent company's shareholders' ownership interest should be presented in the stockholders' equity section of the consolidated balance sheet. Proponents of this theory argue that the minority shareholders are not owners in the sense that they cannot outvote the majority and therefore cannot influence company management. The proportionate consolidation concept simply carries the parent company concept to the extreme, arguing that the parent's financial statements should include only the parent's interest in each asset and liability found on the subsidiary's balance sheet. Table 1 provides a summary of the valuations on consolidated balance sheets under each of these three alternative approaches.2

Generally, the economic unit approach includes in consolidated financial statements the entire fair market value of the subsidiary's assets as of the date the parent obtains control over the subsidiary. Minority interests in subsidiary net assets are considered to be part of consolidated stockholders' equity. Under the parent company approach to consolidations, subsidiary net assets are valued at book value plus an adjustment for the parent's portion of the difference between fair market value and book value of the net assets at the date of acquisition. This measurement is equivalent to valuing the parent's interest in the subsidiary's net assets at fair market value and valuing the minority's interest at book value. Under this approach, minority interest typically is classified between liabilities and stockholders' equity in the consolidated balance sheet. The proportionate consolidation approach includes in the consolidated financial statements only the parent's proportionate interest in the subsidiary's assets and liabilities, measured at fair market value as of the date of acquisition by the consolidated entity. Minority interest is excluded entirely under this alternative.

3.0 FINANCIAL ECONOMICS RESEARCH REGARDING CORPORATE RESTRUCTURING TRANSACTIONS

The financial economics of corporate restructuring transactions provides an understanding of the nature of the ownership interests in consolidated entities. In general, the research indicates that the value derived from corporate takeover transactions stems from the change in control over corporate assets. However, minority interests still maintain influence over the operation of the entire consolidated entity.

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Table 1

Minority interests in consolidated entities arise primarily from two types of corporate restructuring transactions. First, a minority interest may be the residual effect after one company takes over another through a tender offer. This could result from either (1) a tender offer attempt to obtain 100 of the outstanding target shares to which some lesser percentage of shares are tendered; or, (2) an initial attempt to obtain less than 100 of the target firm's outstanding shares. Second, a minority interest may be created when a parent company sells a portion of its interest in a subsidiary in a transaction labelled an "equity carve-out" by Schipper and Smith [1986]. The following discussion on corporate control transactions is organized according to the type of transaction giving rise to minority interest.

3.1 Tendering less than 100 for Any-or-all Tender Offers

Untendered target shares average 12 following tender offers for any-or-all outstanding shares [Comment and Jarrell, 1987, p. 302]. Grossman and Hart [1980] provide a theoretical explanation for this phenomenon. Their model indicates that a shareholder's optimal reaction to a tender offer may be not to tender. This decision can be optimal because the shareholder may "free-ride" on the gains provided by the acquisition and new management. "Free-riding" is a possibility because the tender offer price presumably is less than the value that the acquirer expects to derive from acquisition of the target firm; otherwise, the acquirer would not enter into the transaction. Therefore, tendering shareholders must receive something less than the full gains expected from the business combination. An optimal result for an individual target firm shareholder, then, would be for the takeover to succeed but for the individual stockholder to retain his or her own interest.

3.1.1 Expected Failure of Takeover Transactions

Grossman and Hart conclude that takeovers cannot succeed unless there is some mechanism whereby acquirers can "raid" the target firm to expropriate some wealth from the minority interest. That is, acquirers will not bid to pay out 100 of the gains they expect to achieve from the business combination. Yet any offer which transfers less than 100 of the gains to the target shareholders provides an incentive for those shareholders to free-ride. If target shareholders each act independently, then by attempting to free-ride they will cause the transaction to fail.

In reaching this conclusion, Grossman and Hart make some limiting assumptions which may not hold empirically. First, they assume that target shareholders know which transactions will be successful with certainty. Second, they assume that the firm ownership is diffuse, with each shareholder holding such a small percentage of the target firm's stock that the shareholder will not consider the effect of his decision on the outcome of the offer in deciding whether or not to tender. Finally, Grossman and Hart assume that the acquirer and the target's shareholders know both the maximum value of the firm under current management and the incremental benefit to be

derived from changing to management by the acquirer.

Bebchuk 119891 relaxes one of Grossman and Hart's assumptions and allows for some probability that the takeover transaction could fail. This approach is much more consistent with empirical observations which find significant stock price reactions to announcement of the outcome of the offer, indicating resolution of uncertainty in the market [Baron, 1983, p. 331; Mikkelson and Ruback, 1985, p. 540]. Bebchuk's model demonstrates that tender offers below the maximum value which the acquirer expects to obtain, but above the value of the target firm operating independently, may be successful if the bid is unconditional (i.e., it commits the bidder to purchase tendered shares even if the bid fails). Under these circumstances,

although certain success of the bid is not a rational equilibrium outcome, neither is a certain failure. Nontendering is not an equilibrium strategy for the target's shareholders because, if other shareholders are going to hold out and the bid is going to fail, each atomistic shareholder will prefer to tender and have his share acquired for a price exceeding the target's independent value. Such an unconditional bid has a unique symmetric equilibrium...in which shareholders use mixed strategies and the bid may consequently either succeed or fail.

Bebchuk also demonstrates that bidders are likely to bid at this level. Bebchuk's results therefore provide a theoretical foundation for observing some successful and some failing offers while still maintaining that minority interests develop as Grossman and Hart's theory describes-when shareholders attempt to free ride on an acquirer's value-increasing efforts.

The implication of this literature for consolidation procedure is that it characterizes the minority shareholders as investors sharing in the gains provided by the acquisition and new management. Furthermore, Bebchuk's results expand this model to explain some empirical observations which apparently contradict Grossman and Hart's theory. That is, tender offers may succeed even when "corporate raiding" is not observed; shareholders still can be considered to have behaved according to Grossman and Hart's model. Even though we observe successful tender offers which contradict Grossman and Hart's model, still we may characterize minority interest shareholders as shareholders holding an ownership interest in part of the consolidated entity following the takeover. The consolidation approach which is most consistent with this characterization of minority shareholders is the economic unit approach.

3.1.2 Conditional and Two-Tier Tender Offers

Grossman and Hart conclude that, in order to allow takeovers to occur, target firm shareholders should allow acquirers to expropriate wealth from ("raid") target firms. One mechanism which allows expropriation of shareholder wealth is to use frontend loading through two-tier tender offers. A takeover is front-end loaded when the tender bid exceeds the value of any unpurchased shares....Two-tier offers provide an effective vehicle for frontend loading because they combine a limited tender offer (for voting control only) with a subsequent (unilaterally approved) merger [Comment and Jarrell, 1987, p. 283-284].

In two-tier tender offers, the acquirer will accept only the number of shares necessary to achieve control through the front end portion of the offer. The backend portion of the offer then may be less valuable or may be comprised of a combination of different securities (e.g., cash, debt, and/or stock of the acquirer). Target firm shareholders may 'stampede' to tender first in order to receive the higher, front-end portion of the offer.

These offers can ". . . counter shareholder opportunism by reducing the incentives of individual shareholders to hold out in an attempt to free-ride on the bidder's value-increasing changes" [Comment and Jarrell, 1987, p. 290]. If this 'stampeding' occurs, then bidders have expropriated wealth from target shareholders by paying a smaller value for the back-end portion of the offer. However, though Comment and Jarrell find higher average tendering into the two-tier offers than into the any-or-all offers, they find no significant differences between the bid premiums paid through these two forms of offer.

These results are inconsistent with claims that shareholders are 'stampeded' into tendering into

two-tier and partial offers because of the greater coerciveness of these forms [Comment and Jarrell, 1988, p. 309].

These results are consistent with the argument that competition among bidders must be executed through the overall value of the offer. Competition in the market for corporate control will drive the overall value of any offer at least to the market value of the firm [Jensen and Ruback, 1983, p. 31]. Comment and Jarrell's results indicate that such competition drives the bid price to a level commensurate with that of an any-or-all offer.

These empirical results on tender offers contradict the modelling results deduced by Grossman and Hart. Takeovers by tender offer do succeed and this literature provides evidence that the basis for success is something other than expropriation of minority shareholder wealth. But the empirical findings are consistent with the results expected from Bebchuk's model. Mixed trading strategies produce some successful and some failing tender offers. Bid premiums which may fall somewhat below the maximum value which the acquirer expects to obtain provide the acquirer with sufficient incentive to bid and sufficient tendering incentive for the transaction to succeed. Accordingly, the investment by minority shareholders in the consolidated entity still may be construed as Grossman and Hart describe-as shareholder interests stemming from a desire to share in the gains derived from the combination of the acquirer and the target firm. This interest is characteristic of an ownership interest in the net assets of consolidated entities.

3.1.3 Finance Theories of the Sources of Gains in Corporate Takeovers

For some shareholders to become a minority interest, the benefits derived from the takeover must be the type on which shareholders would like to free-ride. There are at least three types of gains from corporate restructuring transactions which may result in efforts to free-ride. First, synergistic gains from business combinations arise from operating the two companies on a combined basis following the takeover, producing economies of scale or expanded use of existing facilities. These synergistic gains were unavailable to these shareholders prior to the business combination. Second, benefits of corporate takeovers which replace inefficient managements also provide the same basis for shareholders to free-ride. Third, the benefits obtained from combining two firms because of the effect of the information asymmetry problem identified by Myers and Majluf [1984] provide the most clear case wherein target shareholders would want to free-ride.

According to the information asymmetry theory, the takeover of the target firm may allow the combined firm to invest in positive net present value projects previously passed up by the target firm.

lf managers have inside information, then there must be some cases in which that information is so favorable that management, if it acts in the interests of old stockholders, will refuse to issue shares even if it means passing up a good investment opportunity. That is, the cost to old shareholders of issuing shares at a bargain price may outweigh the project's NPV [net present value] [Myers and Majluf, 1984, p. 188].

The information asymmetry theory predicts that bidders with excess financing capacity will buy cash-poor target firms and then finance the projects previously passed up by the target firm [Myers and Majluf, 1984; Bruner, 1988].

This literature provides further evidence behind the reasons that shareholders will attempt to free-ride. Gains on which shareholders attempt to free-ride can only be achieved through the consolidation of the acquiring and target firms. This combination of theories on the sources of takeover gains and Grossman and Hart's free-rider theory therefore further supports the argument that minority interests following tender offer modes of takeover represent an ownership interest in the entire consolidated entity. By extension, this literature therefore supports the use of the economic unit method of consolidation because that method is the one which characterizes minority interest shareholders as owners in the consolidated entity.

3.2 Partial Acquisitions by Tender Offer

Roy [1988] presents a model which explains the phenomenon of partial acquisitions. Assuming that gains from business combinations may be divided between the acquirer and target firm in any fashion desired, the gains will be determined by the acquisition price and the fraction of the target shares purchased. There exists, therefore, an optimal fraction to be acquired in any given takeover transaction. This model therefore implies that it is the change in control of 100 of the target firm's assets which generates the economic gains evident in both acquiring firms' and target firms' stock price reactions to tender offers. As the FASB acknowledges [DM, p. 61], the economic unit approach "provides the most faithful representation of the totality of assets and liabilities that have come under the parent's control."

Roy's modeling results are consistent with empirical observations of higher gains to tendering shareholders than to non-tendering shareholders because there exists a premium associated with the transfer of control at that optimal ownership acquisition level. Bradley [1980] examines 161 successful tender offers between July 1962 and December 1977 and finds that average appreciation of target shares through one month subsequent to the offer execution is 36 relative to the market value two months prior to the offer. But average bid premiums at the time of the offer amount to 49 relative to the same base value. The average reduction in market value of 13 evidences the control value component of the price paid for the target shares [Bradley, 1980, p. 346].

Bradley also finds an increase in the market value of the acquiring and target firms over the time period from two months before the offer to two months after. The average market value of acquiring firms increases by $7.7 million despite an average offer premium of $7.7 million. The average market value of target firms increases by $31 million [p. 346]. These results provide further evidence that "the value of the target shares stems not from their proportional claims to the net cash flows of the target firm but rather from the control of the target resources that they confer" IP. 3671.

Finally, Bradley's findings also indicate that the price of shares traded before the close of the offer may be devoid of a value attributed to the influence available to minority interests following completion of the takeover. Shares traded during the time a tender offer is open are valued through two components: the bid price for the percent of shares demanded by the acquirer and the expected value of minority shares following offer closing. Regression analysis results indicate that the market price of shares traded prior to the offer closing undervalues the second component; the expected value of minority shares following offer closing is not fully incorporated into the trading value during the time the tender offer is open. That is, Bradley finds a regression coefficient of .76 instead of 1 as he expected. These results may indicate that there is another explanatory variable needed in the analysis: an "influence component" may be part of the expected value of the minority shares following closing of the offer.

Bradley's theory emphasizes that the value of control is included in the bid price but is stripped from the untendered shares. On the other hand, minority shareholders have some ability to influence parent and subsidiary company transactions subsequent to the takeover through litigation (see "Clean up" Tender Offers and Influence through Litigation, below). The value of the minority shareholders' influence on the control of the target firm may not be present in the shares traded prior to offer execution but may be included in the trading price after offer expiration. Thus, it appears that this portion of share value supports the argument that minority shareholders can influence parent and subsidiary company transactions after consummation of the tender offer.

Both components of share value, the control premium inherent in the share price prior to transfer of control and the influence component inherent in the minority interest subsequent to the closing of the offer, have implications for consolidation procedure. The control premium paid by the acquirer indicates that the purchase price for the parent's share "should not be used to infer the fair value of the total goodwill" [DM, p. 621 present in the business combination. When the economic unit method is followed, valuing the goodwill at only the portion acquired by the parent is the appropriate approach. The influence component inherent in the minority interest is again consistent with characterizing the minority interest as an ownership interest in the consolidated entity. These shareholders often influence operation of the consolidated entity through the court

system.

3.2.1 "Clean up" Tender Offers and Influence Through Litigation

Tender offers may be undertaken even when an acquirer already has control over the target firm. Dodd and Ruback [1977] find that minority shareholders receive tender offer gains even when an offering party already has majority control.

Since the bidders already had control of the target firm, these abnormal returns cannot reflect synergy, monopoly or internal efficiency gains. . . . In effect, these `clean-up' offers can be interpreted as out-of-court settlements, and the positive abnormal gains reflect the realization of the potential gains by minority stockholders and include the savings in litigation costs to the majority stockholders [p. 371].

The gains paid to minority shareholders provide further evidence of the influence component inherent in the minority shares. Parent firms expect minority shareholders to attempt to influence management of the consolidated entity through the court system. This litigation can be undertaken by minority shareholders holding any level of minority interest, large or small.

In an analysis of litigation by stockholders in general, Jones [1980] examines a sample of 190 firms which were the defendants in 114 suits between 1971 and 1976 involving parent-subsidiary relations. In total, these 114 suits brought by minority shareholders constitute 26 of Jones's sample of 440 shareholder lawsuits against large companies. The suits by minority shareholders claimed mistreatment of the subsidiary in many areas. Common areas for complaint were in transfer pricing, revenue distribution, dividends (either insufficient or excessive), charges for management or staff services, and diversion of subsidiary opportunities.

These complaints cast in bold relief the problems of minority shareholders and large multi-unit (especially multinational) firms. The goal of the parent firm is to optimize the profits of the entire organization. To do so it must allocate resources and opportunities among its subsidiaries to its greatest advantage. Virtually every exploited opportunity for one subsidiary is a lost opportunity for the others, in some sense. Given this situation it is not surprising that minority stockholders file a substantial number of suits making this (parentsubsidiary) type of claim [Jones, 1980, p. 8-9].

Parent firms with more than one subsidiary having minority interest shareholders face even greater dilemmas. For example, two suits included in the sample involved litigation from both minority shareholders to a proposed transfer of an operation from one subsidiary to another.

The existence of a minority interest impacts the overall management of the consolidated entity because of the litigation these shareholders undertake to influence that management process. In contrast to arguments associated with the parent company theory, these shareholders' influence is not limited to the subsidiary alone, although their point of interest may stem from the subsidiary as opposed to the entire economic unit. The fact that the minority shareholders influence corporate management supports the argument that these shareholders are corporate owners; the economic unit approach is the only one which is conceptually consistent with this view of minority interest shareholders. In addition, the litigation undertaken by these shareholders poses a special risk for the corporation with minority interests which differs from the risk inherent in a corporation with only wholly-owned subsidiaries. The existence of a minority interest therefore must be disclosed to financial statement readers. Prominent display on the face of the balance sheet provides the best disclosure. This treatment precludes using proportionate consolidation, but can be achieved under either the economic unit or parent company approaches.

3.3 Equity Carve-out Transactions

Shareholders may purchase a minority interest directly from the parent company by purchasing shares offered in an equity carve-out transaction. Equity carveouts often are associated with subsidiaries having high growth potential and needing external financing. One of the most frequently "stated motives for public offerings of subsidiary stock . . . [is to] enable [the] subsidiary

to obtain its own financing for anticipated growth" [Schipper and Smith, 1986, p. 171]. Other incentives include a desire to (I) provide a direct basis for incentive plans for subsidiary management; and, (2) increase the level of information available to the market about the good performance of a subsidiary which might otherwise be clouded in the consolidated reports.

The desire to obtain separate equity financing for subsidiary activities and to obtain a market-based measure for management performance at the subsidiary level are motivations which relate directly to control over 100 of a subsidiary's assets. Consolidated financial statements should present information in a fashion that is consistent with these motives.

In these transactions, the parent is willing to undertake the costs associated with having a minority interest since sufficient benefits can be obtained from utilizing separate financing for the subsidiary. In such growth situations shareholders may be willing to purchase an investment in a minority interest. In fact, efforts to free-ride also may be present just as Grossman and Hart's [ 1980] theory indicates. That is, shareholders purchasing shares in an equity carve-out anticipate good returns which partly result from the corporate structure involving the parentsubsidiary relationship. Again, the implication from the literature is that the economic unit method is the appropriate choice both before and after an equity carve-out transaction.

The motives for equity carve-out transactions argue strongly against using the proportionate consolidation approach because that method accounts for consolidated net assets differently before and after an equity carve-out. That is, the consolidated financial statements would include 100 of the subsidiary's assets and liabilities before the equity carve-out, but some lesser percentage afterwards. Such an accounting would be inappropriate because there has been no fundamental change in the operation of the subsidiary, the parent, or the economic unit comprised of the two.

Schipper and Smith find positive market reactions to announcements of equity carve-out transactions, in sharp contrast to negative market reactions to equity offerings in stocks already publicly traded. "Thus, equity carve-outs represent the only equity financing arrangement, undertaken by publicly traded firms, for which an average increase in shareholder wealth has been documented" [Schipper and Smith, 1986, p. 153]. Nanda [ 1991, p. 1718] shows "that the Myers and Majluf [19841 framework [of information asymmetry and the use of takeovers to release information about, and invest in, positive net present value projects available to the firm]. . .can be extended in a straightforward manner to provide an explanation for the positive price reactions to equity carve-outs." Nanda models corporate financing behavior when there are three available choices: to undertake an equity carveout; to issue stock in the consolidated entity; or to forego the project. Debt financing is not considered as an alternative.

In this situation we find that some firm types resort to equity carve-outs to fund subsidiary projects, while other types prefer to issue equity in the consolidated corporation. . . Hence, by their financing decisions, firms reveal information not just about the value of assets in place of the subsidiary but also about the value of the assets in place in the rest of the corporation [Nanda, 1991, p. 1719].

Nanda's model indicates that firms undertaking equity carve-outs will choose this option because their shares have been undervalued by the market. These findings further support the contention that minority shareholders are one class of the entire ownership in consolidated net assets and, accordingly, that the economic unit approach should be followed to faithfully present the entity in a set of consolidated financial statements.

3.3.1 Eliminating Minority Interest Holdings

Schipper and Smith [ 1986] find that a large number of the minority interests created by the equity carve-out transactions frequently are eliminated-in as little as two years, up to a maximum of eleven years. Dodd and Ruback 1977, p. 352] also find that minority interests left after tender offer transactions frequently are eliminated by merger. Klein et al. [1991] view equity carve-outs as the first of a two-stage process whereby the subsidiary is either sold off entirely or later re-acquired. Of their sample of 52 equity carve-outs, 25 were later reacquired and 19 were divested

by the parent firm. These authors interpret their results as indicating that the equity carve-out helps to put the subsidiary on the selling block. If no good offers arise, the subsidiary is later reacquired.

The fact that minority interests often are eliminated shortly after takeovers are consumated could be construed as evidence that minority interest should be classified as a liability (following the parent company theory). Classifying minority interest between liabilities and stockholders' equity is commonly done in practice today (following a hybrid approach between the parent company and economic unit approaches). However, the FASB relies heavily on the definitions of financial statement elements presented in Concepts Statement No. 6 [FASB, 1985] in resolving questions of classification such as the one at hand. The minority interest cannot ever require a company to sacrifice economic resources as debtholders can. Minority interest clearly better fits the definition of a residual interest than it does the definition of a liability. Therefore, even if the minority interest is outstanding for only a short period of time, it is an equity interest in the consolidated net assets while it is outstanding.

3.4 Synthesis of the Literature

The DM [p. 24] indicates two conditions which provide theoretical support for using the economic unit method of consolidation. These two conditions are:

(1) Control of the whole subsidiary is held by a single management team (that of the parent company). Accordingly, 100 of the fair market value of the subsidiary's assets and liabilities are included in the consolidation at the date consolidation commences (presently, when legal control via voting ownership interest is obtained); and,

(2) Minority interest shareholders are viewed as stockholders in the entire consolidated entity.

A preponderance of the research into the financial economics of corporate restructuring transactions supports both of these conditions for using the economic unit method when these transactions produce minority interests. Table 2 summarizes the major points from the financial economics literature which support the choice of the economic unit approach.

The research into any-or-all tender offers to which target shareholders tender less than 100 of the outstanding shares indicates that these shareholders hold their interests in order to participate in the gains provided by the acquisition and new management-that is, in order to hold an ownership interest in the new consolidated entity. These findings indicate that minority interest should be viewed as a proprietary interest in the consolidated entity and therefore supports the first of the two conditions for choosing the economic unit method. The research into partial tender offers and into equity carve-out transactions indicates that these transactions arise from management interests which entail retaining control over 100 of the subsidiary's net assets. This intent exists even when managements undertake transactions which they expect will produce minority interests. These findings thus support the second of the conditions above for choosing the economic unit method of consolidation-that 100 of the fair market value of the subsidiary's assets should be included in the consolidation regardless of the percentage ownership held by the controlling parent.

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Table 2

3.5 Consolidation Procedure Implications

The DM indicates several areas in which practices vary even among those methods which are consistent with only one of the three alternative theories of consolidation. For example, the economic unit method may be followed with either a "full goodwill" or a "purchased goodwill" approach. As noted above, the presence of a control premium in the price paid for partial acquisitions indicates that this price should not be used to infer the full amount of goodwill which would be involved in a 100 acquisition and, accordingly, that the "purchased goodwill" approach should be used.

Other problem areas discussed in the DM include questions about how to account for step acquisitions and "bargain purchases" (purchases at an amount below the sum of the fair market values of the subsidiary's identifiable net assets). The following sections of this paper give guidance on these topics which can be derived from the financial economics literature and the framework previously developed. The surprising result for these two issues is that the methods associated with the parent company approach in the DM actually are defensible under the economic unit approach. These methods need not have been characterized as being consistent only with the parent company theory.

3.5.1 Step Acquisitions

There are various possibilities in accounting for the changes in value of controlling interests acquired in a piecemeal fashion. These alternatives all have implications for the underlying net asset values and goodwill presented in the consolidated financial statements. The DM presents the accounting alternatives as they would be used under each of the three theories of consolidation.

Under the economic unit method, the fair market value of the subsidiary's net assets must be included in the consolidation as of the date that control is obtained. To properly associate the investment account balance with the fair market value of the subsidiary's net assets at that date, "a holding gain or loss must be recognized on any previously purchased shares if the current fair value of those shares differs from the amount at which they are carried on the parent's books" [DM, p. 29]. This treatment could be considered to be analogous to the required accounting under Statement of Financial Accounting Standards No. 115 [FASB, 1993). When an investment is transferred from one investment portfolio to another, the transfer is made at market value and holding gain or loss may flow through the income statement. There seems to be no reason to avoid recognizing gain or loss in the case at hand. However, the alternative methods of accounting for step acquisitions are presented in the DM as proposals designed merely to avoid this recognition [p. 31].

Step acquisitions can be recorded under the economic unit concept in a fashion which includes only purchased goodwill. This approach has previously been presented as the best practice for single step acquisitions given that prices paid for control of the subsidiary likely are different from share prices stripped of that control premium [Bradley, 19801. The alternative presented in the DM which is most consistent with the findings in the financial economics literature accounts for all acquired assets and liabilities other than goodwill by the economic unit concept [and therefore recognizes holding gain or loss on the date control is obtained] but accounts for goodwill essentially by the parent company concept in that it recognizes purchases of layers of goodwill relating to each stock acquisition, including one or more layers purchased in steps before the parent obtained control [p. 30].

The discussion in the DM assumes that this valuation is consistent only with the parent company approach, yet it is also consistent with the theories and empirical findings that have been shown to support the economic unit approach. These layers of goodwill probably sum to the best possible estimate of total goodwill based on two factors: (1) the individual purchases would likely contain different premium amounts required to obtain the various levels of ownership interests leading up to the control premium, and (2) there exist changes in the intrinsic value of the goodwill due to changes over time in the business being acquired. This method of recognizing "layers" of goodwill need not be characterized as consistent only with the parent company theory.

3.5.2 Bargain Purchases

Some acquisitions, known as "bargain purchases," are accomplished for amounts less than the total of the estimated fair values of the subsidiary's identifiable net assets-the difference between the estimated fair market value of the net assets and the purchase price is termed "negative goodwill." In current practice, the typical treatment is to reduce the value assigned to all long-lived assets, other than investments, by the negative goodwill, in proportion to the assets' relative fair market values. This treatment is consistent with the treatment used to allocate cost among the acquired assets in any basket purchase in which the estimation process produces an excess of total fair market value over cost. The discussion in the DM (p. 28) indicates that this procedure is considered to be consistent with the parent company approach.

Under the economic unit concept the subsidiary's identifiable net assets are included in consolidation at. . .the sum of the best estimate of their individual fair values. . . . Negative goodwill is viewed as an indicator of the value of the subsidiary as a whole. . .[and] in most cases. . .would be recognized separately as a master valuation account in the consolidated balance sheet [DM, p. 28].

Grossman and Hart's [1980] theory of free-riding by minority shareholders, which has been shown to support the use of the economic unit approach, also addresses the accounting questions surrounding bargain purchases. If the assets are worth more individually than in use, then the likely result is that the acquisition process is being undertaken in order to "raid" the subsidiary as Grossman and Hart describe. If the assets are sold off, then the parent corporation has in fact earned a gain which should show in the consolidated income statement-via separate disclosure outside of income from continuing operations. Perhaps the most convenient way to accomplish this presentation is to have reduced the carrying values of the individual assets by an allocated portion of the "negative goodwill." If the parent company does not sell off these assets to obtain these gains, then the assets should be written down to the value which most appropriately reflects the use of those assets by the consolidated entity and to reflect the actual cost of those assets to the consolidated entity. That is, in this case also the "negative goodwill" should be allocated among long-term assets other than investments. Thus, the treatment presented in the DM as consistent with the parent company theory actually is consistent with arguments that support the economic unit approach.

4.0 RESEARCH IMPLICATIONS

Even after choosing the economic unit approach to preparing consolidated financial statements, some contentious issues and practice implications remain. The discussion in this paper has highlighted some of the choices in the DM which are most consistent with the findings in the financial economics literature and the theoretical framework which supports the economic unit

approach to consolidated financial statements.

The profession will face contentious issues in implementing a change to the economic unit method for consolidations. Facing those difficulties will present research opportunities ( I ) in obtaining further understanding of the use of consolidated financial information and (2) in support of practice efforts to implement the change in consolidation procedure, particularly the FASB's efforts to develop accounting standards that are consistent across many types of parent-subsidiary relationships.

A line of research to obtain further understanding of the use of consolidated financial information could be oriented around the regression of aggregate market value of the consolidated firm (including majority and minority stakeholders) on alternative measures of assets and liabilities. Research in support of practice efforts to implement the economic unit approach would be based on an extension of prior work on consolidation policy and would integrate an analysis of both accounting policy and procedures. Each of these topics will be discussed in turn.

4.1.1 Research to Understand the Use of Consolidated Financial Information

Research to understand the economics of using consolidated financial information is needed and could begin with a regression analysis using the market value of all equity interests in a consolidated firm and the alternative accounting valuations using the economic unit and parent company approaches. This analysis could provide a direct test of the FASB's argument, as well as the theory presented in this paper, that the economic unit method provides the greatest representational faithfulness to the underlying economic reality of the consolidated entity. The expected result would be a higher cross-sectional correlation between the market value for firms and accounting valuations made under the economic unit method than with accounting valuations made under the parent company approach.

The correlation between the market value of equity interests and the accounting valuation under the parent company theory can be expected to decrease as the level of minority interest increases. This result is expected because of the greater loss of representational faithfulness for the amounts presented under the parent company theory as those amounts are influenced to a greater extent by an increasing minority interest. This decrease in correlation is not expected to occur for the valuations under the economic unit approach.

Further understanding of the nature of minority ownership interests could be obtained if the data could be segregated according to the type of transaction giving rise to the minority interest in the consolidated entity as described in this paper. This analysis would be expected to further support the contention that the minority interest represents a similar type of ownership interest regardless of which type of transaction gives rise to minority interest. Failure to reject the null hypothesis of no differences across categories would be consistent with the theory presented in this paper.

The data for this analysis currently are available across different companies: while most firms currently choose to use the parent company approach, some use the economic unit method. If the FASB implements a requirement to use the economic unit method (as they expect to do, as of the date of this writing, according to recent comments by members of the FASB Task Force on Consolidation Policy and Procedures), then comparative information for individual companies also will be available. Presumably, the economic unit method would be applied retroactively when first implemented. Restated information would then be available for comparison to the financial information originally presented under the parent company theory.

4.1.2 Research Integrating Consolidation Policy and Procedure Choices

Mian and Smith [1990] investigate incentives for unconsolidated financial reporting based on the hypothesis that the choice of using consolidated financial information is the "product of purposeful maximizing decisions" [p. 142]. They hypothesize that the choice to consolidate is based on the interdependence of the subsidiary firm with the parent firm. Yet they analyze only finance subsidiaries which generally are created by parent firms and thus do not have minority ownership interests. An extension of their work to other types of consolidated subsidiaries is

needed in order to analyze research questions about consolidation policy which is being implemented across all types of parent-subsidiary relationships.

The nature of the minority interest as described in this paper is relevant to any effort to extend Mian and Smith's work to all types of parent-subsidiary relationships. Minority interest ownership represents another principal in the principal-agent relationship characterized by the contracting theory of the firm and the existence of a "relatively large" minority interest was once considered to be a reason for not consolidating a subsidiary [FASB 1987]. While any research effort to expand the work originally done by Mian and Smith would necessitate using pre-1987 data (because SFAS 94 eliminated virtually all of the accounting policy choice available to firms considering consolidation), there may be greater opportunities to investigate these issues in the future. If the FASB begins to require consolidation under circumstances of effective control, as described in the DM and the Preliminary Views on Consolidation Policy [FASB 1994), then variation in accounting policy choices may arise from firms who must begin to consolidate anew under this standard.

[Footnote]I would like to thank Bill Baber, Marshall Geiger, Alex Hazera. Jun Koo Kang, Ken Kim, Paul Munter, Henry Oppenheimer, Mike Shaub, the editor Bipin B. Ajinkya, an anonymous reviewer, and workshop participants at the 1993 Northeast Regional Meetings of the AAA for their helpful comments on earlier drafts of this paper. Any remaining errors are my own.

[Footnote]Minority interest in the net assets of consolidated subsidiaries currently is defined as the outside ownership held in a subsidiary which is controlled by a parent holding over 50 of the voting stock. The DM uses the term "noncontrolling" interest because it is possible that the above definition could change. Another issue addressed in the DM is whether other definitions of control, besides ownership interest in voting stock, should be used to determine when to consolidate for financial reporting. The issues addressed in this paper may then be of even more concern. If consolidation is expanded, the minority" interest account balance may represent an even larger share of the consolidated net assets.

[Footnote]2 Also see Pacter [ 1992] for a detailed discussion and analysis of consolidation accounting under these three alternatives.

[Footnote]3 Whether the debt/equity classification scheme currently followed in consolidated balance sheets should be maintained is discussed in Clark [19931 and is beyond the scope of this paper.

[Reference]ANNOTATED BIBLIOGRAPHY

[Reference]1. Grossman, S.J. and O.D. Hart. 1980. Takeover bids, the free-rider problem, and the theory of the corporation. The Bell Journal of Economics 11 (Spring): 42-. Takeovers are presumed to curb managerial inefficiencies because inefficient companies may be purchased, run efficiently, and resold at a higher price. These authors argue instead that "shareholders can free-ride on the raider's improvement of the corporation, thereby seriously limiting the raider's profit" so that takeovers will not provide this control. They propose that corporate charters should initially be written to allow a "raider" to benefit through price appreciation of the shares purchased in order to reinstate the threat of takeover as an encouragement to efficient corporate operations.

2. Comment, R. and G.A. Jarrell. 1987. Two-tier and negotiated tender offers: The imprisonment of the free-riding shareholder. Journal of Financial Economics 18 (June): 283-310. These researchers examined 210 cash tender offers between 1981 and 1984 to compare the wealth effects of different forms of offers: two-tier v. any-or-all v. partial and negotiated v. unnegotiated. They found that any-or-all offers are much more frequent than two-tier and partial offers and that 82 of all final offers during

[Reference]the period were negotiated with target firm managements. The bid premiums paid to target shareholders of any-or-all offers averaged 56.6, virtually the same as the average 55.9 paid in two-tier offers; partial offers' bid premiums averaged 22.8. The authors thus concluded that "the average premiums paid provide no evidence that target shareholders are absolutely or relatively disadvantaged by the two-tier form of tender offer" (p. 304) and that the negotiations process results in ensuring cooperative tendering behavior. 3. Myers, S.C. and N.S. Majluf. 1984. Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics 13 (June): 187-221. These authors' model of corporate investing and financing behavior assumes that management acts in the best interests of current firm shareholders and has information that investors do not have. The model explains empirical observations that managements reserve financial slack and do not finance every positive-NPV project, as more traditional theory argues they should. It also is consistent with empirical observations of negative stock price reactions to new stock issues; it is not inconsistent with findings of no stock price reactions to debt issuances; and it predicts certain forms of merger between slack-rich bidding firms and slack-poor target firms.

[Reference]4. Roy, A. 1988. Optimal acquisition fraction and a theory for partial acquisitions. Journal of Business Finance and Accounting 15 (Winter): 543-555. Roy developed a model which demonstrates that it is sometimes optimal from a share-value maximization point of view to acquire a firm only partially because the net gain from the combination of the two firms is a function of the acquisition price and the percent acquired. Roy analyzed cases which require a fixed price to be paid for any acquisition level and a variable price case. In the fixed price case, the optimal acquisition fraction will be either the minimum percent necessary to obtain synergistic benefits or 100. In the variable price case, the optimal acquisition level may fall anywhere between these two points. 5. Bradley, M. 1980. Interfirm tender offers and the market for corporate control. Journal of Business 53 (October): 345-376.

[Reference]Bradley analyzed the components of the price of stocks traded during the time of unexpired tender offers. This price can be modeled as a combination of the expected values of the fraction of shares demanded through the tender offer and the fraction left outstanding after offer execution. A supporting regression analysis indicated that the bid premium is fully valued in the price of the shares traded during the offer period, but that the expected value of the shares outstanding following offer execution is less than fully impounded in this price. Bradley interpreted his results as indicating that there is a control premium associated with the shares traded on the open market prior to offer execution. He concluded that acquiring firms obtain value from takeovers not as a result of capital gains on the shares acquired, but as a result of obtaining subsequent control over the target firm. 6. Schipper, K. and A. Smith. 1986. A comparison of equity carve-outs and seasoned equity offerings: Share price effects and corporate restructuring. Journal of Financial Economics 15 (January/February): 153-186. These researchers found positive parent company stock price reactions for 76 equity carve-outs between 1963 and 1983, in contrast to negative price reactions previously documented for seasoned equity offerings. They explain these results from the differences between these two types of offerings: asset management systems are often restructured simultaneously with the equity carve-out; increased information dissemination about the subsidiary usually occurs; the market value of the subsidiary's net assets becomes directly observable; and a publicly held minority interest is generated. Of their 76 observations, 22 were reacquired by the parent; 36 were subjected to various other restructurings.

[Reference]7. Klein, A., J. Rosenfeld, and W. Beranek. 1991. The two stages of an equity carve-out and the price response of parent and subsidiary stock. Managerial and Decision Economics 12 (December): 449-

460. Klein et al. further analyzed the positive stock price reactions found by Schipper and Smith as dependent upon the ultimate outcome of the two-stage process begun with the equity carve-out. Carve-outs followed by a final sale of the subsidiary result in significant, positive abnormal returns when the two event dates are combined. However, if no sale arises, the subsidiary is reacquired and there is little overall stock price reaction when the two event dates are combined.

[Reference]REFERENCES

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[Reference]FASB. 1985. Statement of Financial Accounting Concepts No. 6: Elements of Financial Statements. Norwalk, CT: FASB. FASB. 1977. Statement of Financial Accounting Concepts No. 2: Qualitative Characteristics of Accounting Information. Norwalk, CT: FASB. Grossman, S. and O. Hart. 1980. Takeover bids, the free-rider problem, and the theory of the corporation. Bell Journal of Economics (Spring): 42-64. Jensen, M. C. and R. Ruback. 1983. The market for corporate control: The scientific evidence. Journal of Financial Economics II: 5-50. Jones, T.M. 1980. What's bothering those shareholder-plaintiffs? California Management Review (Summer): 5-19. Klein, A., J. Rosenfeld, and W. Beranek. 1991. The two stages of an equity carve-out and the price response of parent and subsidiary stock. Managerial and Decision Economics (December): 449460. Mian, S.L. and C.W. Smith, Jr. 1990. Incentives for unconsolidated financial reporting. Journal of Accounting and Economics 12: 141-171. Mikkelson, W.H. and R. Ruback. 1985. An empirical analysis of the interfirm equity investment process. Journal of Financial Economics 14: 523-553. Moonitz, Maurice. 1951. The Entity Theory of Consolidated Financial Statements (American Accounting Association; rpt. Brooklyn: The Foundation Press). Myers, S.C. and N.S. Majluf. 1984. Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics 13: 187-221. Nanda, V. 1991. On the good news in equity carve-outs. The Journal of Finance (December): 1717-1737. Pacter, P. 1992. Revising GAAP for consolidations: Join the debate. The CPA Journal (July): 3847. Roy, A. 1988. Optimal acquisition fraction and a theory for partial acquisitions. Journal of Business Finance and Accounting (Winter): 543-555. Schipper, K. and A. Smith. 1986. A comparison of equity carveouts and seasoned equity offerings: Share price effects and corporate restructuring. Journal of Financial Economics 15: 153-186.