A Primer into
Consolidation of Group
Financial Statements
The consolidation of financial statements of groups is an important topic when it comes to financial accounting and reporting. While making the financial statements of single entities is straightforward, making the consolidated group statements is an area where most financial accountants face a number of difficulties because of the complexities involved in consolidation.
In this article we are going to cover the basics of consolidation. If you are a student or a professional accountant looking for a revision of some core concepts, then at the onset it is important to understand that consolidation is not a difficult topic, it only appears as difficult because of the complexities that are involved, so a very simple method of taking this topic head on is to firstly understand the basic concepts that underpin the consolidation of group financial statements and then adopt a step by step approach and take each problem or question in a systematic manner. If you do these two things, then this topic will seem quite easy and exciting to approach in your studies or practical life.
Applicable IFRS
As far as consolidated group statements are considered, the International and Financial Reporting Standards (IFRS) that are applicable are as follows
• IFRS 3: Business Combinations
• IFRS 10: Consolidated Financial Statements
• IFRS 11: Joint Arrangements
• IFRS 12: Disclosure of interest in other entities
• IFRS 13: Fair Value Measurements
• IAS 28: Investment in associates and other entities
These are the standards that are mainly applicable on any scenario that is related to consolidation of group financial statements. Now before we begin with the actual topic, at this point it is very important to mention that it is vital to understand the terminologies that are used in the above-mentioned standards. You must be able to distinguish between a parent, subsidiary, and an associate. Therefore, we are going to cover the key definitions first, so that moving on there is no confusion.
If you have already covered these definitions before, then this should be a nice revision for you to brush up on your knowledge and if you haven`t covered these definitions before then I suggest that you make an effort to understand the definitions because you will be required to apply the understanding in the actual consolidation.
Key Definitions and Explanations
1- Control (IFRS 3 and IFRS 10)
Control in terms of the above-mentioned standards means the power to "govern" the financial and operating policies of an entity in order to obtain benefits from the said entity.
One of the control signs that the controlling entity must have the power to appoint directors on the board and we can link this power to the % of shares owned.
For example, a shareholder who owns 20% share of a company can be said to hold a significant number of shares but this shareholder does not control the entity because the shareholder has no power to govern the financial and operating activities. Same applies to a shareholder who owns 40% shares, however a shareholder who owns more than half of the shares can be considered as s significant holder of shares because this shareholder can exercise his power to exert control over the board. And the most important thing to note that it is not necessarily for an entity to hold more than 50% ownership in order to exercise control. We found a lot of cases where entities have less than 50% and at the same time exercise control on investees, this might happen when other shareholders are too many and each of them own minor % of ownership and our entity which owns 30% for example is the largest shareholder and can exercise control. There are also other indicators of control which not necessarily also to be related to % of ownership.
2- Parent (IFRS 10)
Parent refers to any entity that controls one or more subsidiaries. This means that a parent company is one that has the power to govern the financial and operating policies of an entity.
3- Subsidiary (IFRS 10)
Subsidiary refers to an entity that is controlled by a parent entity. A subsidiary can be wholly or partially owned by the parents. If the subsidiary is partially owned then its profit will be divided between the parent and the non-controlling shareholders in a relevant manner.
4- Group (IFRS 10)
Group simply refers to a parent and all the subsidiaries combined. Group financial statements therefore refer to parents and subsidiaries. But in most of the scenarios, it will not be as simple as this.
5- Associate (IAS 28)
An associate refers to any entity in which an investing entity has got "significant influence".
For reference, an associate cannot be considered as a
• Subsidiary, or
• Interest in a Joint venture
What does significant influence mean? According to IAS 28, significant influence refers to the power to participate in the financial and operating decisions of an entity, but this power does NOT amount to control over the policies in any manner. Usually if an investor owns at least 20% of shares in an entity, this can be said to be "significant influence" over that entity and ownership of shares less than 20% does not amount to significant control.
Control has been the operative word in all the above-mentioned definitions.
If you can understand this point, then you do not need to memorize the definitions. A subsidiary is one that is controlled by a parent whereas an associate is one in which the investing entity does NOT have control, instead the investing entity only has "significant influence" over an associate.
Before closing this section, let us just go over the main concept that we learned through the definitions.
• A subsidiary is controlled by its investing entity or the parent entity
• An associate is not controlled by its investing entity, but the later only has "significant influence" in the associate.
Why is this important?
Knowing the difference between a subsidiary and an associate is very important because the accounting treatment for both is different. A subsidiary is fully consolidated into the group financial statements whereas investment in an associate is not consolidated, instead it is treated according to equity accounting.
If you can identify subsidiaries and associates properly then you will not make the rookie mistake of wrongly identifying subsidiaries and associates. Believe it or not, IFRS students/ accounting professionals mix up the two and this shows that they have weak fundamental concepts. Therefore we are focusing so much on getting this right.
Let us now look at a few examples
Scenario 1
Suppose a parent company purchases 60% stake in company A and 40% stake in company B. Identify the subsidiary and the associate?
It is clear here that the parent company controls company A because of a majority shareholding therefore company A is a subsidiary whereas the shareholding in company B is minority shareholding (with the assumptions that there are no any other indicators of power), which clearly means that it is not a subsidiary. The shareholding in company B is 40% which is more than 20% and therefore this makes company B an associate of the parent company.
Scenario 2
Suppose a parent company has invested in 3 companies.
• The parent has acquired 80% stake in Company C
• The parent has acquired 20% stake in company D
• The parent has acquired 9% stake in company E
Identify each type of company with relation to the group.
it is quite simple if you go by the definition. Company C is clearly a subsidiary as the parent has 80% control over it, company D is an associate as the parent has got significant influence over it, however if at any time the shareholding in company D decreases below 20% then the company D will cease to be an associate. Company E is simply an investment, it is not a subsidiary and not an associate. It will be disclosed as an investment in the consolidated accounts.
So, now hopefully your concepts for the identification of subsidiary, associates and investments must be clear. We are now ready to move on to the next stage of consolidation.
Preliminary Steps
What are preliminary steps?
Preliminary steps are the steps that you must take before you begin the consolidation of a group. Remember earlier we mentioned that you need to tackle consolidation related questions and scenarios in a very systematic manner this is the only way to get through consolidation without confusing yourself and whoever will be reviewing your work, whether he/she is your supervisor or the examiner.
Step 1: Identify the types of entities in the group
This should be the very first thing that you do. Identify all the entities that are present in the group. Make sure that you identify the subsidiaries, associates, investments, joint ventures etc. everything properly. Remember the key definitions and mark out each entity accordingly.
Step 2: Identify the date of acquisition and the date of consolidation
This is the second most important step and one that is very important for your calculations. You will need to correctly identify the date of acquisition and the date of consolidation of the financial statements. Identification of the acquisition date for the different entities will help you identify the time periods for which you will have to apportion the costs, assets, and liabilities etc.
Remember that the date of acquisition is the later of the date of legal acquisition or the date on which control passes over to the acquirer.
The acquisition date can be easily identified by looking at the acquisition documents if you are in the practical field and if you are IFRS student then this date should be mentioned in the question that is presented to you.
Step 3: Identify the consideration paid
The consideration paid for acquiring controlling interest or significant influence needs to be identified correctly. For an associate it will simply be the cost of acquiring the stake however for subsidiaries the consideration paid may include some complexities.
It rarely happens that a parent pays out the consideration in full cash. Mostly the consideration is paid by a combination of
• Share acquisition,
• Issuing some debt for instance bonds,
• Partial cash payment and
• Contingent consideration (measured at fair value - IFRS 3)
The full amount of consideration should be the total of these amounts. Any acquisition relates expenses such as fee for due diligence contracts to identify potential target should be expensed.
Step 4: Identify goodwill at acquisition
Goodwill must be identified at acquisition, IFRS 3 gives out the following simple formula for calculating goodwill upon acquisition.
Goodwill can be calculated in two ways
• Fair value or full method
• Proportionate value
The fair value method is used when the group decides to value non-controlling interest at fair value or full value whereas the proportionate value is used when non-controlling interest is valued at its proportionate value. This is a very important detail to remember because most IFRS students and accounting professionals make the error of mixing these two methods up.
Step 5: Identify Non-Controlling Interest at Acquisition
The final preliminary step is to identify non-controlling interest at acquisition. IFRS 3 gives a choice to measure NCI on either the fair value or the proportionate value. It is up to the group; the usage of fair value gives a higher value whereas proportionate value gives a lower value.
If the fair value method is used then the closest market value of the shares is used to identify the share of NCI whereas if the proportionate value of the fair value of net assets is used then the percentage of NCI shareholding is applied to the fair value of net assets at acquisition.
So, hopefully this introduction into consolidation of financial statements would have helped you out. In the next articles, we will cover some advanced topics related to consolidation of group financial statements, so stay tuned!