Consolidated Financial Statement
- Introduction
- Business Combination
Business combination is the merging of two separate entities into one reporting entity. The main reasons behind business combination includes cutting down on expenses, reducing competition, broadening product range, and being able to compete internationally. Two entities can sometimes decide to be more competitive by joining forces. When two businesses join to form one large business, they are able to capture a larger share of the market, and hence gain more control of the market. In addition to being more competitive, businesses also combine in order to reduce the general cost of production. This is because when two businesses combine, they become a big entity and are therefore able to purchase raw materials in bulk. The business is also able to produce in large scale. This large scale production and bulk purchasing reduces production expenses because it is cheaper to produce in large and purchase in bulk. Another reason for business combination is to enable the companies to compete in the international market. This is because as a bigger entity, the business has larger units and a range of experienced employees to enable it compete in the international market with other bigger industries. Lastly, two businesses may decide to combine in order to have a wide range of products. This is because different products from the companies combining will be brought together, and as a result, the product range will be wider.
There are three main types of business combination. These are share acquisition, statutory merger, and statutory consolidation (Elliot, 2008). Share acquisition is the attainment of more than 50% of the acquired company’s common shares by the company buying the other company. The acquiring company becomes the parent company, and the acquired is the subsidiary. Under statutory merger, the acquired company is dissolved and the purchasing company survives and takes control of the purchased company’s assets. The third type is statutory consolidation, which is a business combination where both company’s seas to exit and a new company is formed.
- Consolidation Theories
Several alternative theories on how to prepare consolidated financial statements have been put across by different people. The choice of the theory that one decides to use when preparing consolidated financial statement usually plays a very big role on how the statements will look like. The three main theories include parent company theory, traditional theory, and contemporary theory.
- Parent Company Theory
Parent company theory states that even though the parent does not have direct ownership of the subsidiary assets and liabilities, it has complete control over the subsidiary’s assets and liabilities and not just a proportion of the subsidiary. That is the consolidated statements are prepared for the use of parent company shareholders only. Under this theory, the consolidated income is the parent company stakeholders company and equity from the subsidiaries is considered a liability. Also all the unrealised profits are completely eliminated.
- Traditional theory
Under the traditional theory, the firm is viewed as an extension of its shareholders. The increase in the firm’s profits increases the shareholders wealth, and any decrease in the profits will lead to a reduction in the shareholders’ wealth. Therefore, when using the traditional theory, one only consolidates the parent’s share of the subsidiary. Under this theory the consolidated income is the income of the parent company and non-controlling interest is a deduction and not an expense. Unrealised profits due to an upstream sale are fully eliminated whereas unrealised profits from downstream sales are fully recognized in the consolidated statements.
- Contemporary theory
The last theory of consolidation is the contemporary theory. When consolidation is based on this theory, the company is seen as its own persons and not in terms of rights of its shareholders. Therefore, neither the minority nor controlling interest is given priority over the other. Therefore, when preparing the group’s financial statements, the assets, liabilities, and goodwill are recorded at their full value during the business combination. The net income for the consolidated income statement is both the income from parent company and subsidiary. Like under traditional theory, unrealised profits from upstream sales are fully eliminated whereas unrealised profits from downstream sales are fully recognized.
- Consolidated Financial Statements
In preparing the consolidated statements of a company, there are two methods that can be used. These are equity and acquisition method. Under acquisition method, the market value of the non-controlling and parent companies need to be identified on the date that the non-controlling is acquired. Equity method on the other hand requires that the initial investment is recorded as a cost, and adjustments are made later for the post acquisition charges.
- Entity Theory
The main point behind this theory is that the consolidated statements represent the viewpoint of the entire business entity. According to this theory, non-controlling interest income contributes to the business’s total income. The income and interests of subsidiary for all the shareholders are determined and then allocated between the controlling and non-controlling shareholders.
- Consolidated Income Statement
When preparing consolidated income statement under equity method, the general principle is that the company investing should always account for its share of earnings received from associates even if there are no dividends being distributed by the associate (Elliot, 2008). It is mainly used when consolidating financial statements of associate and joint ventures.
When preparing the consolidated income statement, the major steps is to determine the goodwill, share of bad debts and unrealised profits, investment income, and minority interest. The general format for consolidated income statement is as shown below. To get the group’s sales and cost of sales, intercompany sales are deducted. This is because the sales and cost of sales to be included in the group’s income statement should be from outsiders and intercompany sales are not from outsiders. Also dividends proposed by subsidiary are ignored because the earnings from which the dividend is to be given out is already consolidated and therefore dividends to controlling shareholders is just an internal transfers. If there is a preference share in the subsidiary, part of which is owned by outsiders, then preference dividend given to outsiders is deducted from the group profit. Non-controlling is then calculated from this figure.
Example: Statement of income for the year ended 31st December 2009
H Ltd S Ltd
‘000 ‘000
Sales 377 142
Cost of Sales 264 87
Gross Profit 113 55
Expenses 23 15
Net Profit before Tax 90 40
Tax 36 16
Net Profit for Year 54 24
Proposed Dividend 35 10
Retained Profit b/d 120 50
Additional Information:
a. H Ltd owns 70% of ordinary share capital in S Ltd
b. S Ltd also had 100,000 8% preference shares in issue. H Ltd had acquired 80% of these shares. H sold goods worth $100,000 to S
Required:
Prepare a statement of Income for the year ended 31st December 2009
| Items | $ |
| Sales (377+142-100) | 419 |
| C.O.S (264 +87 – 100) | (251) |
| Gross profit | 168 |
| Less expenses (23 + 15) | (38) |
| Net profit before tax | 130 |
| Tax (36 + 16) | (52) |
| Net profit after tax | 78 |
| Less dividends to outsiders (0.2×0.08×100) | (1.6) |
| Retained profit b/d | 76.4 |
- Consolidated balance sheet
When preparing group’s balance sheet, we add all the assets for both parent company and subsidiary. However investment is subsidiary will not be shown in the statement because it is automatically adjusted with the amount of share capital of the subsidiary. The same principle applies to liabilities. Minority interest will appear on the liability side of the consolidated balance sheet so it must be calculated. All common transaction must also be eliminated because the transactions are not from outsiders
Example
P limited acquired 80% of ordinary shares of S limited on 31st December,2010.The balance sheet of the two companies were as follows
H ltd S ltd
Fixed assets 90,000 80,000
Investment in S ltd 110,000
Current assets 50,000 30,000
Current Liabilities (30,000) (10,000)
220,000 100,000
Financed by
Ordinary share capital 100,000 80,000
Retained profit 120,000 20,000
220,000 100,000
Prepare the consolidated balance sheet.
Solution
Consolidated Balance Sheet
Fixed assets (90,000 +80,000) 170,000
Goodwill 30,000
Current assets (50,000 + 30,000) 80,000
Current liabilities (30,000 + 10,000) (40,000)
240,000
Financed by:
OSC 100,000
Retained profits 120,000
Minority share 20,000
240,000
- Change in owner’s equity statement
This statement shows the changes in owners’ equity over an accounting period. It includes retained earnings brought down, profit for the year for the parent only, dividends from parent company only and then we get retained profit carried down
Example: H Company acquired S company, the group’s retained profit brought down is $ 600,000, profit attributable to the parent shareholders and to non-controlling interest are $ 400,000 and $ 32,000 respectively. The parent company paid dividend of $ 50,000. Show the changes in equity.
Solution
Statement of changes in equity
Retained profit b/d 600,000
Profit for the year 400,000
Less: dividends (30,000)
Retained profit c/d 970,000
- Cash flow
The cash flow for a group of company is the same as one for a single company except for a few changes. These changes include minority interest, acquisition, and disposal of an associate. The cash dividends received from an associate is considered as a investing activity whereas the cash dividend paid to minority shareholder is considered as a financing activity.
Example
The following data was extracted from the books of XY limited for year ended 31st December.
2010 2011
Proposed dividend to minority shareholders 160,000 100,000
Minority interest in net assets 690,000 780,000
Minority interest in the consolidate P & L 230,000 120,000
Determine the cash dividend paid to minority shareholders
Solution
Minority interest Account
Dr Cr.
Cash dividend 90,000 Bal b/d –net assets 690,000
Bal c/d- net assets 780,000 -dividend 160,000
– Dividend 100,000 P & L 120,000
970,000 970,000
- Difference between IFRS and GAAP
Both IFRS and GAAPs are accounting standards that are applied when preparing financial statement, be it for a single company or for a group of companies. However, these two do not always agree in every circumstance. This is because GAAP is based on rules whereas IFRS is based on principles (pwc, 2012). There are a number of ways in which GAAP and IFRS differ. One of the major differences can arise when a subsidiary’s accounting policies are not the same with the holding company set of accounting policies. In this situation, GAAP will allow for use of different policies when preparing the consolidated financial statement. This will only be allowed if the industries are considered special. IFRS on the other hand do not give exceptions when it comes to preparation of consolidated financial statements. Another difference usually arises where the holding company and the subsidiary have different fiscal end years. This means that the subsidiary consolidated statements are prepared on a lag creating a gap period. According to GAAP, the transaction and activities during the gap period are just disclosed and not recognized in the financial statements. IFRS on the other hand requires that the transaction be recognized in the consolidated financial statements. Another difference is on the potential voting rights. Under GAAP, there are no specific guidelines stating how potential voting rights will be assessed. GAAP is not interested in the significance of the potential voting in determining whether an investor has a controlling influence. IFRS on the other hand requires that the potential voting rights be accessed. This is because under IFRS, the potential voting right is used to determine whether a company is an associate or not. Under GAAP, there is specific guidance in determining whether a decision maker of the company is the company’s agent or principal whereas IFRS do not have any such guidelines. GAAP and IFRS also differ when it comes to related parties interest. Related parties to a business include such groups as advisors, employees, and supplies. Whereas IFRS do not in any way address the issue of related party’s interest, GAAP has guidelines for determining related parties’ interest. Lastly, the two accounting standards differ in terms of joint venture definition and types of joint venture. According to GAAP, a joint venture only refers to entities that are jointly controlled and this arrangement is carried out by an entirely separate entity. IFRS on the other hand defines joint venture as an arrangement between two parties where the two parties have joint control of the entity. This means that when decisions are being made unanimous, consent of the parties that have joint control is required.
- Best Practices in Consolidation
Most large companies with several branches usually prepare and convey accurate information to their stakeholders by preparing consolidated financial statements. To ensure that the group’s financial statements indicate a true and fair view of the company, there are three best practices that the company’s accountant must follow. One of the practices is the accounting standards. The accountant that is preparing the financial statements of the company should make sure that they have followed all the accounting standards as presented by the country’s accounting standards board and other international accounting regulation bodies (Elliot, 2008). The accountant will be able to achieve this by first reviewing all the accounting standards before starting the consolidation process. By reviewing the accounting standards, he/she will be able to know what to include in the statements, and how to present the information so that the statements convey accurate data to the company’s stakeholders. In addition to knowing the accounting standards, a company should ensure that its accountants are up to date with the latest accounting principles. This is because accounting is a skill and it keeps improving with time. With this improvement, accounting standards are often revised and therefore accountants should be able to know the latest accounting principles before they start the consolidation process.
The second best practice is the accounting packages. In doing consolidation, a company should ensure that their accounting staffs have the most appropriate accounting packages. This will enhance the speed with which consolidation is done. In addition, efficiency will also be improved as a result of appropriate package. These packages are very helping in doing the consolidation work faster and according to standards. This is because with the help of these packages, a person is able to organize data on a monthly, quarterly or yearly basis while applying the right accounting principles. All is needed is to give the right command to the machine.
Besides having the right packages, the company’s accountant should have high proficiency in the use of these packages. In addition to presenting the data according to the accounting principles, these packages are also very helpful in data analysis. Hence, they also help the management analyse financial data and come up with the best ways of improving the company’s revenues.
The third and the last major practise that accountants should adhere to when doing consolidation is handling inter-company transactions (Haslam & Chow, 2012). There are times when the holding and subsidiary companies transact with each other. This transaction can be from the parent to the subsidiary or from the subsidiary to the parent. These transactions should be considered when preparing consolidated financial statements to ensure that the right amounts are recorded in the group’s financial statements. First are the inter-company balances, which should be eliminated totally when doing consolidation. However, there are cases where the balances are not the same in the two companies’ books. This situation is usually brought about by the fact there are still goods in transit or cash in transit. Therefore, in such a case, adjustments should be made in the group’s books before eliminating the balances. The inter-company transaction can also lead to expenses and revenue. These should be eliminated fully after making the necessary adjustments in terms of unrealised profits.
- Conclusion
According to IFRS 10, a holding company is required by the authority to present to its stakeholders consolidated financial statements of the company. The data in these statements are expected to be accurate and true because they are used by the company’s current and potential stakeholders to make financial decisions. The preparation and the final outcome of consolidated financial statements are influenced by factors, such as consolidation theories, GAAP, and IFRS. Therefore, when preparing the financial statement of a group, the accountant in charge should ensure that consolidation best practice is adhered to. This will ensure accurate, true, and informative consolidated financial statements.
References
Haslam, J., & Chow, D. (2012). Financial Reporting. London: Heriot-Watt University. http://www.londoninternational.ac.uk/sites/default/files/programme_resources/lse/lse_pdf/subject_guides/ac3091_ch1-3.pdf
Elliott, B., & Elliott, J. (2008). Financial accounting and reporting (12th ed.). Harlow: Financial Times Prentice Hall. http://ebooks.narotama.ac.id/files/Financial%20Accounting%20and%20Reporting%20%2814th%20Edition%29/Cover%20&%20Table%20of%20Contents%20-%20Financial%20Accounting%20and%20Reporting.pdf
Pwc. (2012, October 1). IFRS and US GAAP: Similarities and differences. Retrieved February 15, 2015, from http://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/ifrs-and-us-gaap-similarities-and-differences-2012.pdf