Accounting for majority-owned finance subsidiaries under SFAS No. 94: Motivations and consequences

What constitutes the reporting entity in accounting has been under debate for decades. The accounting profession has been using the legal control (ownership of more than 50%) with some exceptions in defining the reporting entity. One important exception was the nonhomogeneity of the subsidiary's business with that of the parent. Under the nonhomogeneity exception, manufacturing and merchandising parents were allowed to use the equity method in accounting for their majority-owned fiance subsidiaries (MOFS) because, it was believed that, consolidating MOFS would distort the content of the parent's financial statements. This practice was criticized for omitting relevant information about the MOFS. Mainly, it was claimed that creating a MOFS and accounting for it under the equity method is a form of off-balance sheet financing.;In response, the Financial Accounting Standards Board (FASB) issued SFAS No. 94 mandating the consolidation of MOFS. Firms that were required to change their accounting for MOFS expressed great concern about the economic consequences of consolidating their MOFS. They claimed that consolidating MOFS may cause violation of existing debt covenants and reduce their accounting-based performance indicators. In addition, some analysts argued that consolidating MOFS would cause loss of disaggregated information and, thus, making it difficult for the user to make accurate interpretations of financial statements.;This dissertation examines the economics of accounting for MOFS. It examines: (i) firms motivations for the use of the equity method, and (ii) the effect of the method used on the users' inferences from financial statements. The results suggest that firms choose the equity method to enhance their ability to borrow and to avoid near violation debt covenants. Other motivations such as firm's desire to report higher performance measures and the information and operation dependencies are partially supported. In terms of users inferences from financial statements, the results indicate that users were, in general, affected by the accounting method used. Fewer subjects adjusted the financial statement numbers to undo the accounting method effect.;The results of this research has direct implications for the FASB's current exposure draft that expands the consolidation and defining the reporting entity beyond the legal control.