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CHAPTER

Paper F7 (INT) Financial reporting

18

Consolidated accounts

Contents 1

The nature of a group and consolidated accounts

2

Consolidated statement of financial position: the basic rules

3

Consolidated statement of financial position: purchased goodwill

4

Consolidated statement of financial position: non-controlling interests

5

Consolidated statement of financial position: fair value adjustments

6

Consolidated statement of comprehensive income

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Paper F7: Financial reporting (International)

The nature of a group and consolidated accounts 

A group of companies: parent and subsidiaries



Statement of financial position of the parent: accounting for a subsidiary



Purpose and nature of consolidated financial statements



The effect of the parent/subsidiary relationship on the financial statements



International accounting standards and consolidated accounts



The requirement to prepare consolidated accounts



The requirement to include all subsidiaries



Common reporting date



Uniform accounting policies

1

The nature of a group and consolidated accounts

1.1

A group of companies: parent and subsidiaries A group consists of a parent entity and one or more subsidiary entities. (There may also be ‘associates’ in a group: these are described in a later chapter). 

An entity is a subsidiary of another entity if it is controlled by that other entity. ‘Control’ usually means that more than 50% of its equity shares are owned by that other entity.



Within a group, Company C might be a subsidiary of Company B, which is a subsidiary of Company A. Company C is then a sub-subsidiary of Company A. Group structures with sub-subsidiaries are not examinable.



The entity that ultimately controls all the entities in the group is called the parent.

A parent is defined as ‘an entity that has one or more subsidiaries’ (IAS27). Definition of ‘control’ Control is assumed to exist when the parent owns directly, or indirectly through other subsidiaries, more than half of the voting power of the entity, unless in exceptional circumstances it can be clearly demonstrated that such control does not exist. Control also exists when the entity (= parent) owns half or less than half of the voting power of the entity but any of the following circumstances also applies:

354



The entity has power over more than half of the voting rights in the subsidiary by virtue of an agreement with other investors.



The entity has power to govern the financial and operating policies of the subsidiary entity under a statute or agreement.

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Chapter 18: Consolidated accounts

1.2



The entity has power to appoint or remove a majority of the members of the board of directors of the subsidiary, and the board of directors has control over the entity.



The entity has power to cast a majority of votes at meetings of the board of directors of the subsidiary, and the board of directors has control over the entity.

Statement of financial position of the parent: accounting for a subsidiary A subsidiary is acquired by purchasing a controlling interest in its equity. The parent makes a long-term investment in the subsidiary. In the statement of financial position of the parent, there is a non-current asset: ‘Investment in subsidiary, at cost’ In some groups, the parent company has no assets at all except shares in the subsidiaries in the group. A parent whose main assets (or only assets) are shares in subsidiaries is sometimes called a holding company. You might see both terms, ‘parent’ and ‘holding company’: treat them as meaning the same.

1.3

Purpose and nature of consolidated financial statements When a large part of the assets of the parent consists of investments in subsidiaries, it is difficult for the users of the financial statements of the parent to understand anything about its financial position or financial performance. If a parent company only reported to its shareholders about the financial performance and position of the parent itself, the statement of financial information might contain little more than ‘investments in subsidiaries at cost’ and the profit for the year might consist of little more than ‘dividends received’ from the investments. To find out meaningful information about their investment, users of the parent’s financial statements need to know about the financial position and performance of the operating subsidiaries in the entire group of companies. The purpose of consolidated financial statements is to provide financial statements that have meaning and relevance to users. When a parent acquires a subsidiary, both the parent and the subsidiary remain legally separate entities. However, in practice they operate as if they were one organisation. Consolidated financial statements reflect the reality (or substance) of the situation: the group is a single economic unit. In preparing consolidated financial statements: 

the profits of the parent and its subsidiaries, and their other comprehensive income, are combined into a single in a consolidated statement of comprehensive income



the assets and liabilities of the parent and its subsidiaries are combined in a single consolidated statement of financial position. (However, the share capital and reserves for the consolidated balance sheet are not calculated simply by adding the capital and reserves of all the companies in the group!).

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Paper F7: Financial reporting (International)

1.4

The effect of the parent/subsidiary relationship on the financial statements A parent and a subsidiary are related parties of each other, because the parent controls the subsidiary. This relationship often has an effect on the profit or loss, or on the financial position of both entities, because they may enter into transactions with each other on terms that other entities or individuals (unrelated parties) would not. For example: 

an entity might sell goods to its parent or fellow-subsidiaries on more favourable terms than it would sell to other customers



a parent company may make supplies to a struggling subsidiary on more favourable terms than it would to other companies. This would boost the apparent profitability of that subsidiary.



the only or main reason for a subsidiary’s existence might be to produce goods or to provide services for the parent to use in its own operations.

In all these situations, the financial performance and financial position reported by the separate financial statements of the subsidiary is affected, so that: 

the information could be misleading to users who not aware of the existence and effect of the related party relationship; and



it may not be possible to make meaningful comparisons between the subsidiary’s financial statements and those of a similar entity that (for example) makes all its sales to third parties on normal commercial terms (at ‘arm’s length’).

The consolidated financial statements are also affected. Because they present the activities of the group as a single entity, transactions between the subsidiary and the parent are eliminated (not included). Amounts owed by one entity to another are also eliminated.

1.5

International accounting standards and group accounts There are three relevant IASs and IFRSs relating to the financial statements of groups of companies: 

IAS27: Consolidated and separate financial statements



IAS28: Investments in associates



IFRS3: Business combinations. (IFRS 3 was revised in January 2008 and applies to business combinations that occur in financial periods starting on or after 1 July 2009. However, the revised IFRS became examinable from December 2008.)

IFRS3 defines a business combination as ‘a transaction … in which an acquirer obtains control of one or more businesses.’ The effect of business combinations is to bring together separate entities or businesses into one reporting entity, which produces consolidated financial statements for the group of entities as a whole.

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Chapter 18: Consolidated accounts

The examination paper will include a question on preparing consolidated financial statements. The question will involve a parent company, one subsidiary and possibly also an associate.

1.6

The requirement to prepare consolidated accounts IAS27 states that, with certain exceptions, a parent must present consolidated financial statements in which it consolidates its investments in subsidiaries. In other words, a parent must prepare consolidated financial statements for the group as a whole. Exception to this rule There is an exception to this rule. A parent need not present consolidated financial statements if (and only if) all the following conditions apply:

1.7



The parent itself (X) is a wholly-owned subsidiary, with its own parent (Y). Alternatively, the parent (X) is a partially-owned subsidiary, with its own parent (Y), and the other owners of X are prepared to allow it to avoid preparing consolidated financial statements.



The parent’s debt or equity instruments are not traded in a public market.



The parent does not file its financial statements with a securities commission for the purpose of issuing financial instruments in a public market.



The parent’s own parent, or the ultimate parent company (for example, the parent of the parent’s parent), does produce consolidated financial statements for public use that comply with International Financial Reporting Standards.

The requirement to include all subsidiaries Consolidated financial statements should include all the subsidiaries of the parent (IAS27). There are several reasons why a parent may not wish to consolidate a particular subsidiary, for example: 

The subsidiary’s activities are dissimilar from those of the parent, so that the consolidated financial statements might not present the group’s financial performance and position fairly.



The subsidiary has been acquired only so that it can be resold within a short time.



Obtaining the information needed would be expensive and time consuming and might delay the preparation of the consolidated financial statements.



The subsidiary operates under severe long term restrictions, so that the parent is unable to manage it properly. For example, a subsidiary might be located in a country badly disrupted by a war or a revolution.

None of these is allowed as a reason for excluding a subsidiary from consolidation. However:

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Paper F7: Financial reporting (International)

1.8



Where a subsidiary is acquired exclusively with a view to subsequent resale, it is accounted for in accordance with IFRS 5 Non-current assets held for sale and discontinued operations.



If a parent actually loses control over an entity which has been a subsidiary, it is no longer a subsidiary, even if the parent still holds more than 50% of its equity shares. This means that it does not have to be ‘consolidated’ (i.e. included within the consolidated financial statements).

Common reporting date Consolidated accounts combine the assets, liabilities, income and expenses of all the entities in the group. IAS27 therefore requires that the financial statements of the parent and its subsidiaries that are used to prepare the consolidated financial statements should all be prepared with the same reporting date (the same financial year-end date), unless it is impracticable to do so. If it is impracticable for a subsidiary to prepare its financial statements with the same reporting date as its parent, adjustments must be made for the effects of significant transactions or events that occur between the dates of the subsidiary's and the parent's financial statements. In addition, the reporting date of the parent and the subsidiary must not differ by more than three months.

1.9

Uniform accounting policies Since the consolidated accounts combine the assets, liabilities, income and expenses of all the entities in the group, it is important that the methods used for recognition and measurement of all these items should be the same for all the entities in the group. IAS27 therefore states that consolidated financial statements must be prepared using uniform accounting policies. The policies used to prepare the financial statements in all the entities in the group must be the same.

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Chapter 18: Consolidated accounts

Consolidated statement of financial position: the basic rules 

The basic rules



Acquiring a subsidiary after incorporation: pre- and post-acquisition profits



Directly-related acquisition costs

2

Consolidated statement of financial position: the basic rules

2.1

The basic rules A consolidated statement of financial position brings together the assets and liabilities of the parent company and all its subsidiaries. Some adjustments are made to the assets and liabilities for the purpose of consolidation, but the assets of the group minus its liabilities are the group’s equity. The basic rules for preparing a consolidated statement of financial position can be illustrated with a simple example. In this example: 

the parent owns 100% of the equity of the subsidiary



the parent acquired its investment in the subsidiary when the subsidiary was first established (so the acquisition date was the date that the subsidiary was created)



the cost of the investment in the subsidiary is exactly equal to the fair value of the net assets in the subsidiary, as at the date of acquisition.

When all these conditions apply, a consolidated statement of financial position can be prepared as at the acquisition date of the subsidiary by: 

adding the assets of the parent and the subsidiary, line by line



however, excluding the item ‘investment in subsidiary’ in the statement of financial position of the parent company



adding the liabilities of the parent and the subsidiary, line by line.

The equity and reserves in the consolidated statement of financial position consist of: 

the equity and reserves of the parent, and



only the reserves of the subsidiary that have been earned since its acquisition. As at the date of acquisition, these are zero.

Example A parent entity P acquired 100% of the equity shares of a subsidiary entity S when the subsidiary was first established. The net assets of S when it was first set up (total assets minus total liabilities) were valued at $120,000 and P paid $120,000 to acquire these net assets.

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Paper F7: Financial reporting (International)

The summary statements of financial position of both entities when S was established and P acquired 100% ownership were as follows. ParentȱP

SubsidiaryȱSȱ

$ Noncurrentassets:



Property,plantandequipment

$ 



640,000

125,000

InvestmentinS  

120,000 ––––––– 760,000

 ––––––– 125,000

Currentassets    Equity

140,000 ––––––– 900,000 –––––––

20,000 ––––––– 145,000 ––––––– 

Equitysharesof$1each

200,000

80,000

Sharepremium Retainedearnings  

250,000 350,000 ––––––– 800,000

40,000  ––––––– 120,000

Currentliabilities   

100,000 ––––––– 900,000 –––––––

25,000 ––––––– 145,000 –––––––

A consolidated statement of financial position as at the date of incorporation can be prepared as follows: PȱGroup:ȱconsolidatedȱstatementȱofȱfinancalȱpositionȱasȱatȱtheȱdateȱofȱacquiringȱSȱ Noncurrentassets: Property,plantandequipment Currentassets    Equity Ordinarysharesof$1each Sharepremium Retainedearnings   Bankloans   

 (640,000+125,000) (140,000+20,000)   (parentcompanyonly) (parentcompanyonly)   (100,000+25,000) 

$ 765,000 160,000 ––––––– 925,000 –––––––  200,000 250,000 350,000 ––––––– 800,000 125,000 ––––––– 925,000 –––––––

Note: In practice, there is no reason to prepare a consolidated statement of financial position when a subsidiary is acquired. However, it is used here to illustrate the basic principles of consolidation, before going on to consider what happens after the subsidiary has been acquired.

360

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Chapter 18: Consolidated accounts

2.2

Acquiring a subsidiary after incorporation: pre- and post-acquisition profits Subsidiaries are often acquired after they have been incorporated or established, and after they have been in business for some time. The acquired subsidiary will have some accumulated profits (retained earnings) at the date of the acquisition. These are called ‘pre-acquisition profits’. Pre-acquisition profits of a subsidiary are not included as retained earnings in the consolidated financial statements – they are dealt with as part of the purchased goodwill calculation (see below). However, post-acquisition profits of a subsidiary are included in group profits in the consolidated statement of comprehensive income, as a part of the profits of the entire group. They are also included in the retained earnings of the group, and so are included in the consolidated statement of financial position. Example A parent P acquired 100% of the share capital of subsidiary S on 1 January Year 3. The net assets of S (total assets minus total liabilities) were valued at $200,000 at the date of acquisition and P paid $200,000 to acquire the shares in S. (Note: This means that there is no purchased goodwill. Goodwill is explained later). The summary statements of financial position of both entities at 1 January Year 3 and at 31 December Year 3 are as follows. 

Atȱtheȱacquisitionȱdate 1ȱJanuaryȱYearȱ3ȱ $

Noncurrentassets: Property,plantand equipment InvestmentinS   Currentassets    Equity Equityshares Sharepremium...