Prior to Financial Accounting Standard 94 in 1988, wholly owned finance subsidiaries of major U.S. companies were accounted for by the parent using the equity method. These companies justified the procedure by claiming that the operations of the subsidiaries were so unlike those of the parents that consolidating the subsidiaries’ financial statements would distort those of the parents. At the same time, by using the equity method, the parents were able to avoid including the subsidiaries’ liabilities, which were often quite large, on their consolidated balance sheets. It was estimated, for example, that adding the liabilities of General Motors Acceptance Company, a finance subsidiary, to those of General Motors (GM), the parent, would have quadrupled GM’s debt/equity ratio.

Forbes commented that if the FASB required such companies to consolidate their finance subsidiaries, it “could cause difficulties with bond indenture agreements and loan covenants requiring that certain ratios be maintained.” Others have commented that such problems are of little concern because they can be avoided by writing debt covenants so that all financial ratios are defined in terms of generally accepted accounting principles. Moreover, most financial statement users are reasonably sophisticated and are already aware of the subsidiary’s debt. Credit-rating agencies claim, for example, that as long as the debt of the subsidiary is disclosed, it matters little whether it is consolidated or not.

REQUIRED:

a. Briefly explain the difference between using the equity method and preparing consolidated financial statements, and describe how requiring the consolidation of subsidiary financial statements could “cause difficulties with bond indenture agreements.”

b. How might the fact that most financial statement users are reasonably sophisticated affect the nature of the accounting standards developed by the FASB?