In the last article we started to learn the consolidation of the statement of financial position (SOFP). In this article we are going revise a bit from where we left of last time and then learn some new things. Make sure that you have read the previous articles on this topic, if not then take some time read them first.
Consolidation of Statement of Financial Position
We have already discussed that to make consolidation easy, you need to follow a step by step approach.
• Firstly, follow the preliminary steps that we have already discussed.
o Step 1: Identify the types of entities in the group
o Step 2: Identify the date of acquisition and the date of consolidation
o Step 3: Identify the consideration paid
o Step 4: Identify Non-Controlling Interest at acquisition
o Step 5: Identify goodwill at acquisition
• Secondly, consolidate the statements (we will discuss this in this and future articles)
• Thirdly, calculate the value of retained earnings and NCI at the date of consolidation.
So, these are the step but simply knowing the steps won`t help unless we practice and if you remember, in the last article we went over some very simple examples for consolidated SOFP. You may recall that consolidation SOFP is quite simple as it requires adding up the assets and liabilities of the parent and subsidiaries and then eliminating all inter-company balances and other complications.
Now we are going to discuss the consolidated related complications individually in detail so that both IFRS students and professionals reading this can learn how to deal with the complications individually.
Key Point to Remember
It is important to remember the general structure of consolidation. Before we consolidate the financial statements, the parent entity will have its own profit for the year and the subsidiary will have its own profit for the year. Now we cannot add the profits of the parent and subsidiary like assets.
The reason for this is that firstly the profit figure may have arisen both before and after the acquisition, so the profit that arose before the acquisition cannot be claimed by the parent because the parent did not play any part in its generation. Profit of the subsidiary can therefore be divided into
• Pre-acquisition profit
• Post-acquisition profit
Pre-acquisition profit cannot be consolidated with the post-acquisition retained earnings.
Post-acquisition profit of the subsidiary should be consolidated with the parent’s profit and retained earnings. This means that the retained earnings figure will need to be adjusted and this can be done by firstly taking out pre acquisition portion away from the retained earnings and then adjusting the earnings for complications such as depreciation, revaluations and intra company balances.
Hopefully, the rationale is now clear in your mind so we can proceed ahead now.
It often happens that the parent and subsidiary companies trade with each other and this trade gives rise to inventory bought and sold to each other in the books of both companies. Now from the individual company point of view, this transaction is legitimate and poses no problem but under IFRS 10, when we consolidate the statements of parents and subsidiaries, these intercompany transactions need to be eliminated otherwise they would be counted twice.
For example, Company A is a parent and it sells $1 million worth of inventory to Company B which is its subsidiary and it also purchases $0.5 million worth of inventory from Company B. Now this is a normal intercompany transaction. After purchasing the inventory both companies will use these inventories to create their finished goods and services and then sell them and the sales will generate revenue.
This is the usual process and from the individual company perspective this is completely fine but from the groups perspective this is not right. Why? Because When Company A sold its $1 million goods to Company B, it sold these for a profit and similarly when Company B sold its $0.5 million worth of goods to Company A, it sold them for a profit.
IFRS 10 states that unrealized profit from intercompany sales should be completely removed from the consolidated statements. Now this means that we only need to remove unrealized profit whereas realized profit can remain in the books.
What is realized profit?
If we look at the previous example, we can see that Company A sold goods worth $1 million to Company B. Now let us assume that Company A charged 20% on this transaction, so the actual cost of goods sold was $800,000 and therefore the profit on this transaction was $200,000.
Now let`s assume that Company B sold 50% of this inventory and at the year-end it still has 50% of the purchased inventory. This means that 50% of the profit on this transaction has been realized, since it has been sold. The profit for 50% of this sale can be included in the consolidated statements, however the remaining 50% profit is still unrealized because this inventory is still in the books of Company B and therefore Company A cannot record 50% of the profit.
If we look at this numbers, this means that out of $200,000 profit, $100,000 has been realized and the same amount is unrealized. The unrealized profit simply needs to be removed from the consolidated statements.
Removing Unrealized Profit from the Parent
Now since this unrealized profit is in the books of the parent, the following changes will need to be made:
Inventory Reduce the inventory figure in SOFP by the amount of unrealized profit
Retained earnings of the parent Reduce only by the amount of the unrealized profit
Removing Unrealized Profit from the Subsidiary
The treatment for removing unrealized profit from the subsidiary is similar but with an added complication. Let us first go over the easier part so that it makes sense.
If we take the above example then Company B sold $0.5 million worth of goods to Company A and at the end of year 80% of these goods had been sold, which means that only 20% goods were left and therefore unrealized profit from this transaction is 20% which needs to be cancelled.
If Company B make a profit of $100,000 on the sale, then this means that only $20,000 is the unrealized profit which we need to adjust now. So far, it is all simple right. Now the added complexity is that if the subsidiary is not 100% owned by the parent then the profit of the subsidiary does not go solely to the parent, instead it is divided according to the sharing ratio and this means that the effect of cancelling the unrealized profit will reduce the profit of the subsidiary and this reduction will therefore have to be shared by both the parent and the NCI.
Therefore, if there is unrealized profit on sale made by the subsidiary to the parent then the following changes will have to be made:
Inventory Reduce the inventory in SOFT by the amount of unrealized profit
Retained Profit of the Group Reduce the retained profit of the group by the amount of the share of parent in the unrealized profit.
Non controlling interest Reduce the NCI by the amount of the NCI share in the unrealized profit.
Now let us look at an example to make sense of this.
Company P is the Parent and it has got 80% stake in Company S which is the subsidiary.
During the year, company P sold goods worth $100,000 to S at a margin of 20% and Company S sold goods worth $50,000 to P at a margin of 10%. At yearend both P and S have 10% unsold goods in their inventory. Calculate the unrealized profit and show the adjustments in the SOFP.
So, in order to solve this, we should first simplify the matters
Goods sold by P to S $100,000
Margin on sales 20% of 100,000 = $20,000
Unrealized profit in the books of P $20,000 x 10% = $2000
Good sold by S to P $50,000
Margin on sales 10% of $50,000 = $5000
Unrealized profit in the books of S $5000 x 10% = $500
Portion of P 80% x $500 = $400
Portion of NCI 20% of $500 = $100
It seems so easy right, in theory it feels difficult but if you take a step by step approach then it becomes so simple. Now that we have calculated the unrealized profit, we will need to cancel it out.
• $2000 + $500 make up the total unrealized profit in the closing inventory. So firstly $2500 will have to be deducted from inventory because according to IAS 2, inventories must be shown at the lower of cost or net realizable value. To do this, we must deduct the unrealized profit of $2500 from the consolidated value of inventory in the SOFP.
• The second effect will be elimination of $2000 unrealized profit from the books of P. This will cause a reduction in the retained earnings figure. It is important to understand that this reduction is coming from the SOCI, which we will cover in future articles.
• The third effect will also go into the retained profit for the group. The post-acquisition profit of the subsidiary will be reduced by $400, to cancel the effect of unrealized profit from the group retained earnings in the SOFP. Once again, this effect is coming from the SOCI, where the profit of the subsidiary was reduced by $500 and out of this, $400 was apportioned to the group.
• The fourth effect goes into the NCI share of post-acquisition profit from the subsidiary. $100 will have to be deducted from NCI`s share in the equity and reserves section of the SOFP. If you look at second, third and fourth effects they amount up to $2500 and these three effects are happening in the equity and reserves portion of the SOFP. So, the assets portion saw a reduction of $2500 form inventory and the equity and reserves section saw reduction of $2500.
Assets Elimination of $2500 from inventory, reducing the assets
Retained Earnings Elimination of $2000 from parents’ profit, reducing the reserves
Retained Earnings Elimination of $400 from subsidiary`s profit, which was included in the group retained earnings, thus reducing the reserves
NCI Elimination of $100 from NCI, reducing the reserves
The net effect of these changes is going to be nil because as we have discussed before, this is the cancellation of intercompany balances, so when we cancel out the transaction from both the parent and subsidiary books, the effect will be nil but the amount with which the SOFP will balance, will be different.