Consolidation

Consolidation means presenting the results of a group of companies as if they were a single company.

The primary purpose of consolidated financial statements is to provide a true and fair view of the position and earnings of the parent company
group as a whole, from the standpoint of the shareholders in the parent company. The shareholders of a parent company would not be given
sufficient information from the financial statements of the parent company on its own, because not enough would be known about the nature of
the assets, income and profits of all the subsidiary companies in which the parent company has invested.

Subsidiaries
A subsidiary is an entity controlled by another entity.
Definitions
 Control. An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the
investee and has the ability to affect those returns through its power over the investee.
 Power. Existing rights that give the current ability to direct the relevant activities.
 Subsidiary. An entity that is controlled by another entity (known as the parent).
 Parent. An entity that controls one or more entities.
 Group. A parent and all its subsidiaries.
 Consolidated financial statements. The financial statements of a group in which the assets, liabilities, equity, income, expenses and cash
flows of the parent and its subsidiaries are presented as those of a single economic entity.
 Non-controlling interest. The equity in a subsidiary not attributable, directly or indirectly, to a parent.
 A trade (or 'simple') investment. An investment in the shares of another entity, that is held for the accretion of wealth, and is not an associate
or a subsidiary.
Investments in subsidiaries
Control can usually be assumed to exist when the parent owns more than half (ie over 50%) of the voting power of an entity unless it can be
clearly shown that such ownership does not constitute control (these situations will be very rare).
The following situations show where control exists, even when the parent owns only 50% or less of the voting power of an entity.
(a) The parent has power over more than 50% of the voting rights by virtue of agreement with other investors.
(b) The parent has power to govern the financial and operating policies of the entity by statute or under an agreement.
(c) The parent has the power to appoint or remove a majority of members of the board of directors (or equivalent governing body).
(d) The parent has power to cast a majority of votes at meetings of the board of directors.

Accounting treatment of subsidiaries in consolidated financial statements

IFRS 10 requires a parent to present consolidated financial statements in which the accounts of the parent and subsidiary (or subsidiaries) are
combined and presented as a single entity.
Consolidated financial statements ignore the legal boundaries of the separate legal entities. But why are they considered necessary? They are
important because the users of the parent's financial statements need to know about the financial position, results of operations and changes in
financial position of the group as a whole.
IFRS 10 requires that, when a parent issues consolidated financial statements, it should consolidate all subsidiaries, both foreign and domestic.

QUESTION Subsidiaries
Socket Co has 100,000 shares of $1 each. On 1 January 20X3, Power Co acquired 45,000 of these shares. In addition, Power Co is able to appoint 4
out of the 5 directors of Socket Co, thus exercising control over their activities. How should Socket Co be treated in the consolidated financial
statements of Power Co?

ANSWER
Power Co holds less than 50% of the ordinary shares of Socket. Nevertheless, Socket Co is a subsidiary of Power Co because its status is determined
by a number of factors other than percentage of shares held. The key point is control rather than share ownership.
Socket Co will be treated as a subsidiary if any of the following apply.
A. It holds more than half the voting power.
B. It has power over more than half the voting rights by virtue of an agreement with other investors.
C. It has power to govern the financial and operating policies of the entity under a statute or agreement.
D. It has power to appoint or remove the majority of the members of the board of directors.
E. It has power to cast the majority of votes at meetings of the board of directors.
Socket Co should be treated as a subsidiary on the grounds that Power is able to appoint four out of the five directors (criterion D). Assuming that
the other criteria do not apply, if Power Co did not have such a power, consolidation would not be appropriate because Socket Co would not be a
subsidiary.
Associates and trade investments
An associate is an entity over which another entity exerts significant influence. Associates are accounted for in the consolidated statements of a
group using the equity method.

Investments in associates
This type of investment is something less than a subsidiary, but more than a simple trade investment. The key criterion here is significant influence.
This is the 'power to participate', but not to 'control'
 Associate. An entity over which the investor has significant influence.
 Significant influence. The power to participate in the financial and operating policy decisions of the investee but which is not control or joint
control of those policies. (IAS 28)

IAS 28 states that if an investor holds 20% or more of the voting power of the entity, it can be presumed that the investor has significant influence
over the entity, unless it can be clearly shown that this is not the case.
Significant influence can be presumed not to exist if the investor holds less than 20% of the voting power of the entity, unless it can be
demonstrated otherwise.
The existence of significant influence is usually evidenced in one or more of the following ways.
(a) Representation on the board of directors (or equivalent) of the investee
(b) Participation in the policy making process
(c) Material transactions between investor and investee
(d) Interchange of management personnel
(e) Provision of essential technical information

Equity method
IAS 28 requires the use of the equity method of accounting (or 'equity accounting') for investments in associates.

Consolidated statement of profit or loss

The basic principle of equity accounting is that the investing company (P Co) should take account of its share of the earnings of the associate, A Co,
whether or not A Co distributes the earnings as dividends. P Co achieves this by adding to consolidated profit the group's share of A Co's profit
after tax.
Under equity accounting, the associate's sales revenue, cost of sales and so on are not amalgamated with those of the group. Instead, only the
group share of the associate's profit after tax is added to the group profit.

Consolidated statement of financial position

A figure for investment in associates is shown in the consolidated statement of financial position which must be stated at cost at the time of the
acquisition of the associate.

No consolidated accounts
Equity accounting is only applied in the consolidated accounts. A company only has to prepare consolidated accounts if it has one or more
subsidiaries. If a company has no subsidiaries, then it is not required to prepare consolidated accounts and so any investments in associates will be
treated as a simple investment in the parent company's individual accounts.

Trade investments
A trade investment is a simple investment in the shares of another entity that is not an associate or a subsidiary.
A trade investment is a simple investment in the shares of another entity, that is held for the accretion of wealth, and is not an associate or a
subsidiary.
Trade investments are simply shown as investments under non-current assets in the consolidated statement of financial position of the group.
QUESTION Associates
Which two of the following investments would be treated as an associate in the consolidated financial statements of Smith Co?
A. Smith Co owns 15% of the ordinary shares of Red Co and has significant influence over Red Co.
B. Smith Co owns 45% of the ordinary shares of Pink Co and can appoint 4 out of 5 directors to the board of directors of Pink Co.
C. Smith co owns 40% of the preference shares (non-voting) and 15% of the ordinary shares of Yellow Co.
D. Smith Co owns 60% of the preference shares (non-voting) and 40% of the ordinary shares of Aquamarine Co.

ANSWER
The correct answers are A and D.
A. Red Co is an associate of Smith Co, as Smith Co has significant influence over Red Co.
B. Pink Co is a subsidiary of Smith Co, as Smith Co's ability to appoint 4 out of 5 directors gives it control over Pink Co.
C. Yellow Co is a trade investment of Smith Co, as Smith Co holds less than 20% of the voting rights of Yellow Co, so is assumed not to have
significant influence. Note that the preference shares do not have voting rights so do not have any influence over the running of the
company. Remember that shareholdings are not the only way of demonstrating control or significant influence. If it could be shown in
another way that Smith Co does have significant influence over Yellow Co, Yellow Co would be classified as an associate.
D. Aquamarine Co is an associate of Smith Co, as Smith Co holds more than 20% of the voting rights of Aquamarine Co and is therefore
presumed to have significant influence over Aquamarine Co.

Content of consolidated financial statements

Consolidated financial statements present the results of the group; they do not replace the separate financial statements of the individual group companies.
It is important to note at this point that consolidated financial statements are an additional set of financial statements that are produced. They do not
replace the individual financial statements of the parent or its subsidiaries. The group itself has no legal form, the group accounts are produced to satisfy
accounting standards and, in some countries, legal requirements.
Consolidated financial statements are issued to the shareholders of the parent and provide information for those shareholders on all the companies
controlled by the parent.

Most parent companies present their own individual accounts and their group accounts in a single package. The package typically comprises the
following.
 Parent company financial statements, which will include 'investments in subsidiary undertakings' as an asset in the statement of financial
position, and income from subsidiaries (dividends) in the statement of profit or loss and other comprehensive income
 Consolidated statement of financial position
 Consolidated statement of profit or loss and other comprehensive income (the other comprehensive income element of consolidated
financial statements is beyond the scope of the F3/FFA syllabus)
 Consolidated statement of cash flows (this is beyond the scope of the F3/FFA syllabus)

QUESTION Consolidated financial statements

Companies with subsidiaries are required to publish consolidated financial statements.
Required - State why you feel the preparation of consolidated financial statements is necessary and outline their limitations, if any.

ANSWER
The object of financial statements is to help shareholders exercise control over their company by providing information about how its affairs have been
conducted. The shareholders of a parent company would not be given sufficient information from the financial statements of the parent company on its
own, because not enough would be known about the nature of the assets, income and profits of all the subsidiary companies in which the parent company
has invested. The primary purpose of consolidated financial statements is to provide a true and fair view of the position and earnings of the parent
company group as a whole, from the standpoint of the shareholders in the parent company.

A number of arguments have been put forward, however, which argue that consolidated financial statements have certain limitations.
1. Consolidated financial statements may be misleading.
A. The solvency (liquidity) of one company may hide the insolvency of another
B. The profit of one company may conceal the losses of another
C. They imply that group companies will meet each others' debts (this is certainly not true: a parent company may watch creditors of an
insolvent subsidiary go unpaid without having to step in)

2. There may be some difficulties in defining the group or 'entity' of companies, although IFRS 10 has removed many of the grey areas here.
3. Where a group consists of widely diverse companies in different lines of business, a set of consolidated financial statements may obscure much
important detail unless supplementary information about each part of the group's business is provided.
  Consolidation means presenting the results, assets and liabilities of a group of companies as if they were one company.
 Consolidate as if you owned everything, and then show the extent to which you do not.
 A subsidiary is an entity controlled by another entity.
 An associate is an entity over which another entity exerts significant influence. Associates are accounted for in the consolidated
statements of a group using the equity method.
 A trade investment is a simple investment in the shares of another entity that is not an associate or a subsidiary.
 Consolidated financial statements present the results of the group; they do not replace the separate financial statements of the
individual group companies.
 50% investment will usually mean that an investment is a subsidiary, however, if it can be shown that the investor does not have
control over the investee company, it will not be classified as a subsidiary.

1 When the parent owns over 50% of the voting power of an entity, control can be assumed. True or false?
2 What accounting treatment does IFRS 10 require of a parent company?
3 What is a non-controlling interest?
4 Define an associate in no more than 25 words.
5 How should trade investments be accounted for in the consolidated financial statements of the investor?
A. They should be consolidated on a line by line basis.
B. They should be equity accounted for.
C. A percentage of the investment's profits and assets and liabilities should be consolidated on a line by line basis.
D. The amount paid for the investment at cost should be shown in the statement of financial position.

2 To prepare consolidated financial statements

3 That part of the equity or preference capital not owned by the parent
4 An entity in which an investor has a significant influence, but which is not a subsidiary or a joint venture of the investor
5 D / A trade investment is simply shown as an investment in the statement of financial position. The investor will only produce consolidated
accounts if they also have subsidiaries.

QUESTION Associates

Which two of the following investments would be treated as an associate in the consolidated financial statements of Smith Co?
A. Smith Co owns 15% of the ordinary shares of Red Co and has significant influence over Red Co.
B. Smith Co owns 45% of the ordinary shares of Pink Co and can appoint 4 out of 5 directors to the board of directors of Pink Co.
C. Smith co owns 40% of the preference shares (non-voting) and 15% of the ordinary shares of Yellow Co.
[

D. Smith Co owns 60% of the preference shares (non-voting) and 40% of the ordinary shares of Aquamarine Co.

ANSWER
The correct answers are A and D.
A. Red Co is an associate of Smith Co, as Smith Co has significant influence over Red Co.
B. Pink Co is a subsidiary of Smith Co, as Smith Co's ability to appoint 4 out of 5 directors gives it control over Pink Co.
C. Yellow Co is a trade investment of Smith Co, as Smith Co holds less than 20% of the voting rights of Yellow Co, so is assumed not to have
significant influence. Note that the preference shares do not have voting rights so do not have any influence over the running of the company.
Remember that shareholdings are not the only way of demonstrating control or significant influence. If it could be shownin another way that
Smith Co does have significant influence over Yellow Co, Yellow Co would be classified as an associate.
D. Aquamarine Co is an associate of Smith Co, as Smith Co holds more than 20% of the voting rights of Aquamarine Co and is therefore
presumed
 Consolidated Financial Statements
The primary purpose of consolidated financial statements is to provide a true and fair view of the position and earnings of the parent
company group as a whole, from the standpoint of the shareholders in the parent company.

IFRS 10
IFRS 10 requires a parent to present consolidated financial statements in which the accounts of the parent and subsidiary (or
subsidiaries) are combined and presented as a single entity. IFRS 10 requires that, when a parent issues consolidated financial
statements, it should consolidate all subsidiaries, both foreign and domestic.

Investments in subsidiaries
Control can usually be assumed to exist when the parent owns more than half (ie over 50%) of the voting power of an entity unless it
can be clearly shown that such ownership does not constitute control (these situations will be very rare).
The following situations show where control exists, even when the parent owns only 50% or less of the voting power of an entity.
(a) The parent has power over more than 50% of the voting rights by virtue of agreement with other investors.
(b) The parent has power to govern the financial and operating policies of the entity by statute or under an agreement.
(c) The parent has the power to appoint or remove a majority of members of the board of directors (or equivalent governing body).
(d) The parent has power to cast a majority of votes at meetings of the board of directors.
50% investment will usually mean that an investment is a subsidiary, however, if it can be shown that the investor does not have control
over the investee company, it will not be classified as a subsidiary.

Consolidated statement of profit or loss

The basic principle of equity accounting is that the investing company (P Co) should take account of its share of the earnings of the
associate, A Co, whether or not A Co distributes the earnings as dividends. P Co achieves this by adding to consolidated profit the
group's share of A Co's profit after tax. Under equity accounting, the associate's sales revenue, cost of sales and so on are not
amalgamated with those of the group. Instead, only the group share of the associate's profit after tax is added to the group profit.

Consolidated statement of financial position

A figure for investment in associates is shown in the consolidated statement of financial position which must be stated at cost at the
time of the acquisition of the associate.

No consolidated accounts
Equity accounting is only applied in the consolidated accounts. A company only has to prepare consolidated accounts if it has one or
more subsidiaries. If a company has no subsidiaries, then it is not required to prepare consolidated accounts and so any investments in
associates will be treated as a simple investment in the parent company's individual accounts.

Associates and trade investments

An associate is an entity over which another entity exerts significant influence. Associates are accounted for in the consolidated
statements of a group using the equity method.

Investments in associates
This type of investment is something less than a subsidiary, but more than a simple trade investment. The key criterion here is
significant influence. This is the 'power to participate', but not to 'control'
 Associate. An entity over which the investor has significant influence.
 Significant influence. The power to participate in the financial and operating policy decisions of the investee but which is not
control or joint control of those policies. (IAS 28)

IAS 28 states that if an investor holds 20% or more of the voting power of the entity, it can be presumed that the investor has significant
influence over the entity, unless it can be clearly shown that this is not the case. Significant influence can be presumed not to exist if the
investor holds less than 20% of the voting power of the entity, unless it can be demonstrated otherwise.
The existence of significant influence is usually evidenced in one or more of the following ways.
(a) Representation on the board of directors (or equivalent) of the investee
(b) Participation in the policy making process
(c) Material transactions between investor and investee
(d) Interchange of management personnel
(e) Provision of essential technical information
1) Which of the following investments owned by Indigo Co should be equity accounted in the consolidated financial statements?
1. 30% of the non-voting preference share capital in Yellow Co
2. 18% of the ordinary share capital in Blue Co with directors of Indigo Co having two of the five places on the board of Blue Co
3. 45% of the ordinary share capital of Red Co, with directors of Indigo Co having four of the six places on the board of Red Co

A 1 and 2
B 2 only
C 1 and 3 only
D 2 and 3 only

Answer
Statement (1): Although a 30% holding appears to fall within the 20–50% range, it is a 30% holding in non-voting preference share capital. These
do not give Indigo Co significant influence over Yellow Co and, therefore, Yellow Co is not an associate and would not be equity accounted.

Statement (2): Despite only 18% of the ordinary share capital being held by Indigo Co, as we have already discussed, we do not just consider the
percentage of equity shares held, but also look at whether there can be an exercise of significant influence. Having two out of the five directors
effectively gives Indigo Co influence, but not control, over decision making in the company and, therefore, Blue Co is an associate and would
be equity accounted.

Statement (3): Don’t just look at the 45% holding and presume it is an associate without considering the other facts. By looking at the ability to
appoint directors shows that Indigo Co has four of the six directors, effectively giving them control over the decision making in the company.
Having control should make you spot that actually Red Co is a subsidiary and, therefore, would be consolidated line by line in the group
accounts and would not be equity accounted.

Therefore, the correct answer is B – Statement 2 only.

2) Which of the following statements is/are correct?

1. If a company owns more than 50% of the ordinary shares of another company, the investment will always be classified as a subsidiary.
2. Consolidated accounts are required for a group of companies in order to represent the legal form, rather than the substance, of the
relationship between the parent and its subsidiaries.
3. An trade investment is an entity in which an investor has significant influence, which is neither a subsidiary or a joint venture of the
investor.
A. A 1 and 2 only
B. B 1 only
C. C All three statements are correct
D. D None of the statements are correct

D / None of the statements are correct.

A / 50% investment will usually mean that an investment is a subsidiary, however, if it can be shown that the investor does not have control
over the investee company, it will not be classified as a subsidiary.
Consolidated accounts are prepared to represent the substance and not the legal form of the relationship between parent and subsidiary.
An associate is an entity in which an investor has significant influence.

3) Alpha is an associate of Delta. How should profits generated by Alpha be shown in the consolidated accounts of Delta?
A. All the profits after tax generated by Alpha are included by consolidating the revenue and expenses of Alpha on a line by line basis from
revenue down to profit for the year.
B. Delta's share of Alpha's profit after tax is included by the payment of a dividend from Alpha to Delta, which is shown in the consolidated
statement of profit or loss of Delta.
C. Delta's share of Alpha's profit after tax is included in the consolidated statement of profit or loss of Delta as a single amount.
D. All the profits after tax generated by Alpha are included in the consolidated statement of profit or loss of Delta as a single amount.

C Delta's share of profit after tax should be included as a single amount in the consolidated statement of profit or loss.