Consolidated Financial Statements Standards
Weightage: Chapter 10 of ICAI's Paper 1 syllabus, roughly 10 marks. The most technically demanding standards group in the paper, and the one that most rewards being studied last, once the rest of the paper is fluent.
One question, three answers
A company holds shares in another company. How much of that other company's assets, liabilities, income and expenses belongs in its own financial statements?
The answer depends entirely on the nature of the relationship, and the three standards in this group are three answers to that one question:
| Relationship | Standard | Method | Rationale |
|---|---|---|---|
| Control — a subsidiary | AS 21 | Line-by-line consolidation | The parent directs the assets, so it should account for all of them and show what portion others own |
| Significant influence — an associate | AS 23 | Equity method | The investor influences but does not direct, so it takes its share of results without claiming the assets |
| Joint control — a joint venture | AS 27 | Proportionate consolidation | Control is shared, so each venturer takes its own share of everything |
Get the relationship right and the method follows. Almost every error in this area is a misclassification rather than a miscomputation.
AS 21 — Consolidated Financial Statements
Why consolidate at all
A parent company's standalone balance sheet shows one line — investment in subsidiary, at cost. That line conceals everything: the subsidiary might hold a factory and a large loan, or nothing at all. A shareholder in the parent has an economic interest in the subsidiary's assets and is exposed to its liabilities, and a single cost figure tells them nothing about either.
Consolidation presents the group as if it were a single entity. The parent's investment is replaced by the underlying assets and liabilities it represents, and transactions within the group are eliminated because a group cannot trade with itself.
Control
Control means either the ownership, directly or indirectly through subsidiaries, of more than one half of the voting power of an enterprise, or control of the composition of the board of directors or corresponding governing body so as to obtain economic benefits from its activities.
The second limb matters: control is not only about shares. An enterprise able to appoint or remove a majority of directors controls the entity regardless of its shareholding percentage.
Exclusion from consolidation is permitted in only two cases: where control is intended to be temporary because the subsidiary is acquired and held exclusively with a view to its subsequent disposal in the near future; and where the subsidiary operates under severe long-term restrictions which significantly impair its ability to transfer funds to the parent. An excluded subsidiary is accounted for under AS 13.
Note what is not a ground for exclusion: dissimilar activities. A manufacturing parent with a finance subsidiary must consolidate it, and the answer to the resulting loss of information is segment disclosure under AS 17, not exclusion.
The consolidation procedure
Step 1 — Combine like items. Add together the assets, liabilities, income and expenses of parent and subsidiary line by line.
Step 2 — Eliminate the investment against equity. The cost of the parent's investment is set against the parent's portion of the subsidiary's equity at the date of acquisition. The difference is goodwill or capital reserve:
A negative figure is a capital reserve. Goodwill arising on consolidation is presented as an asset; the treatment of its amortisation follows AS 26 principles.
Step 3 — Compute minority interest. Minority interest is that part of the net results of operations and of the net assets of a subsidiary attributable to interests which are not owned, directly or indirectly through subsidiaries, by the parent.
Minority interest in the consolidated balance sheet consists of the minority's share of the equity of the subsidiary at the date of acquisition, plus the minority's share of movements in equity since that date. It is presented separately from liabilities and from the parent shareholders' equity.
Step 4 — Eliminate intra-group balances and transactions. Intra-group balances, intra-group transactions, and resulting unrealised profits are eliminated in full. Unrealised losses are also eliminated unless cost cannot be recovered.
The pre-acquisition and post-acquisition split
This is the concept that decides most consolidation questions, and it is worth stating from first principles.
When a parent buys a subsidiary, it pays for the net assets as they stand at that date — including reserves the subsidiary has already accumulated. Those pre-acquisition reserves are therefore part of what was bought; they are capital to the group, and they enter the goodwill computation. They do not appear in consolidated reserves, because the group did not earn them.
Post-acquisition reserves — profits earned after the parent took control — are earned by the group. The parent's share is added to consolidated reserves; the minority's share is added to minority interest.
The single most common consolidation error is including pre-acquisition profits in consolidated reserves, which double-counts them: once in goodwill and once in reserves.
Unrealised profit on intra-group transactions
If a parent sells goods to its subsidiary at a profit and the subsidiary still holds them at the year end, the group as a whole has sold nothing. The profit is unrealised from the group's point of view and must be eliminated from both inventory and profit.
Where the seller is the subsidiary and there is a minority, the elimination is shared with the minority in the proportion of their holding, because the minority shares in the subsidiary's profit that is being reversed.
Other requirements
The financial statements used in consolidation should ordinarily be drawn up to the same reporting date. Where they are not, the difference should not be more than six months, and adjustments should be made for the effects of significant transactions in between.
Uniform accounting policies should be used. Where a member of the group uses different policies, appropriate adjustments are made; if impracticable, the fact is disclosed together with the proportions of the items to which the different policies were applied.
AS 23 — Accounting for Investments in Associates in Consolidated Financial Statements
Significant influence
An associate is an enterprise in which the investor has significant influence and which is neither a subsidiary nor a joint venture.
Significant influence is the power to participate in the financial and operating policy decisions of the investee but not control over those policies.
It is presumed where the investor holds, directly or indirectly through subsidiaries, twenty per cent or more of the voting power, unless it can be clearly demonstrated that this is not the case. It is presumed not to exist below twenty per cent, unless significant influence can be clearly demonstrated.
The presumption is rebuttable in both directions, which is examined. An investor holding twenty-five per cent of a company whose remaining shares are held by a single hostile majority owner, and which has no board representation and no participation in policy, may be able to demonstrate that it has no significant influence. Conversely, an investor holding fifteen per cent with a board seat and contractual participation in policy decisions may have it.
Evidence of significant influence includes representation on the board of directors, participation in policy-making processes, material transactions between the parties, interchange of managerial personnel, and provision of essential technical information.
The equity method
Under the equity method, the investment is initially recorded at cost, and the carrying amount is then increased or decreased to recognise the investor's share of the profits or losses of the investee after the date of acquisition. Distributions received from the investee reduce the carrying amount.
The goodwill or capital reserve arising on acquisition is identified and disclosed separately, though it is included in the carrying amount of the investment.
Losses are recognised only to the extent of the carrying amount. Once the investor's share of losses equals or exceeds the carrying amount of the investment, the investor discontinues recognising its share of further losses and the investment is reported at nil. Additional losses are provided for only to the extent that the investor has incurred obligations or made payments on behalf of the associate. If the associate subsequently reports profits, the investor resumes recognising its share only after its share of profits equals the share of net losses not recognised.
Where the equity method is applied
AS 23 applies the equity method only in consolidated financial statements. In the investor's separate financial statements, an investment in an associate is accounted for under AS 13, at cost or lower of cost and fair value according to its classification.
An investor that has no subsidiaries and therefore prepares no consolidated statements does not apply the equity method at all.
The equity method is not applied where the investment is acquired and held exclusively with a view to its subsequent disposal in the near future, or where the associate operates under severe long-term restrictions significantly impairing its ability to transfer funds to the investor. Such investments are accounted for under AS 13.
AS 27 — Financial Reporting of Interests in Joint Ventures
Joint control
A joint venture is a contractual arrangement whereby two or more parties undertake an economic activity which is subject to joint control.
Joint control is the contractually agreed sharing of control over an economic activity. The defining feature is that no single venturer is in a position to unilaterally control the activity — strategic financial and operating decisions require the consent of the venturers sharing control.
The contractual arrangement is what distinguishes a joint venture from an associate. An investor may hold fifty per cent of a company and not have joint control, if there is no agreement establishing it. Conversely, a contractual arrangement may establish joint control at a much lower holding.
The three forms
Jointly controlled operations involve the use of the assets and other resources of the venturers rather than the establishment of a separate entity. Each venturer uses its own property, plant and equipment and carries its own inventories, incurs its own expenses and liabilities, and raises its own finance. The venturer recognises in its own financial statements the assets it controls, the liabilities it incurs, the expenses it incurs, and its share of the income from the sale of goods or services by the joint venture. No separate adjustment is needed on consolidation.
Jointly controlled assets involve joint control, and often joint ownership, of one or more assets contributed to or acquired for the purpose of the joint venture. The venturer recognises its share of the jointly controlled assets classified according to their nature, any liabilities it has incurred, its share of jointly incurred liabilities, income from the sale or use of its share of the output, its share of expenses incurred by the venture, and expenses incurred directly in respect of its interest.
Jointly controlled entities involve the establishment of a separate entity — a company or partnership — in which each venturer has an interest. This is the form that requires a consolidation method, and it is the form examined.
Proportionate consolidation
In its consolidated financial statements, a venturer reports its interest in a jointly controlled entity using proportionate consolidation: it combines its share of each of the assets, liabilities, income and expenses of the jointly controlled entity with the similar items, line by line, in its own consolidated financial statements.
The logic is direct. Under AS 21 a parent consolidates one hundred per cent and shows minority interest, because it controls the whole. Under AS 27 a venturer controls only its share, so it brings in only its share and there is no minority interest to show. Under AS 23 an investor controls nothing and merely takes its share of results into one line.
Goodwill or capital reserve arising on the acquisition of an interest in a jointly controlled entity is identified and treated in accordance with AS 21 principles.
Where the venturer prepares separate financial statements, the interest in the jointly controlled entity is accounted for under AS 13.
Transactions between a venturer and a joint venture
When a venturer contributes or sells assets to a joint venture, it recognises only that portion of the gain or loss attributable to the interests of the other venturers, because the portion attributable to its own interest is unrealised. The full amount of any loss is recognised where the contribution or sale provides evidence of a reduction in net realisable value or an impairment loss.
When a venturer purchases assets from a joint venture, it does not recognise its share of the profits of the joint venture from the transaction until it resells the assets to an independent party.
