Discussion Paper on Consolidation Techniques

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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 incen...


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