Preparation of group financial statements
| by Steve Scott
04 Feb 2001
The most important single topic in Paper 10 ‘Accounting and Audit Practice’ and its equivalent paper under the ACCA’s new syllabus Paper 2.5 ‘Financial Reporting’ is that of group accounting. This article will cover the main issues involved in preparing consolidated financial statements and will refer to common errors made by candidates in answering such questions. It will also briefly refer to the most common areas where written questions are asked.
Objectives of group financial statementsThe main objective of group financial statements is to present information about the economic activities of the group. The Companies Act and FRS 2 ‘Accounting for Subsidiary Undertakings’ require the information to be presented as if the group was a single economic entity and to show the economic resources it controls, the group’s obligations and the group’s results. In simple terms this is largely achieved by adding together the financial statements of the individual members of the group and making a number of adjustments. A single economic entity cannot make a profit out of itself and it is for this reason that intra group trading and other intra group transactions are eliminated as part of the process of consolidation.
DefinitionsAn undertaking is the parent of a subsidiary if any of the following apply.
(a) It holds a majority of the voting rights in the undertaking. This aspect has been tested in examinations by asking candidates to consider the accounting treatment of a shareholding in a company that has both voting and non-voting shares in issue. See Example 1.
(b) It is a member of the undertaking and has the right to appoint or remove directors holding a majority of the voting rights at meetings of the board on all, or substantially all, matters.
(c) It has the right to exercise a dominant influence over the undertaking:
(d) It is a member of the undertaking and controls alone, pursuant to an agreement with other shareholders or members, a majority of the voting rights in the undertaking.
(e) It has a participating interest in the undertaking and:
(f) A parent undertaking is also treated as the parent undertaking of the subsidiary undertakings of its subsidiary undertakings.
All subsidiaries are required to be consolidated unless they qualify for exclusion under the requirements of the Companies Act or FRS 2. This is often the subject of a written question.
Exclusions from consolidationA subsidiary undertaking is to be excluded from consolidation if:
1 Severe long-term restrictions substantially hinder the exercise of the parent undertaking’s rights over the subsidiary undertaking’s assets or management.
This most often occurs in respect of foreign subsidiaries where there may be government intervention or political unrest. Another example would be where a receiver has been appointed to manage the affairs of a company.
Companies excluded for this reason are to be treated as fixed asset investments.
2 The group’s interest in the subsidiary undertaking is held exclusively with a view to subsequent resale and the subsidiary undertaking has not previously been consolidated.
This usually occurs when a subsidiary has been acquired as part of a larger acquisition and the acquiring company intends to dispose of the subsidiary in the near future. Such subsidiaries are treated as current assets. This exemption cannot be used to cease to consolidate a subsidiary merely because the parent intends to sell it.
The Act permits rather than requires exclusion in cases (i) and (ii) above, whereas FRS 2 requires exclusion.
3 The subsidiary’s activities are so different from those of other group members that its inclusion would be incompatible with the obligation to give a true and fair view. This is a Companies Act requirement. FRS 2 takes the view that this would be very rare in practice and the Accounting Standards Board (ASB) cannot think of any examples where it would be appropriate. Disclosure of different activities is best dealt with by the provision of segmental information. In any event a subsidiary excluded on these grounds would have to be equity accounted (the treatment required for associates and joint ventures), so its results are included in the consolidated financial statements, albeit in a different format.
The Companies Act also refers to ‘undue expense or delay’ as being a reason not to consolidate a subsidiary, FRS 2 only permits this if the subsidiary is immaterial.
Other mattersFRS 2 requires all group financial statements to be prepared on the bases that all companies within the reporting group have used uniform accounting policies. This can be achieved by all subsidiaries adopting the same accounting policies when preparing their entity financial statements (most common method in practice), or consolidating adjustments have to be made to the subsidiaries’ financial statements before they are consolidated. The latter effectively restates the financial statements as if they have applied uniform accounting policies. This area provides ample scope to Examiners to test consolidated adjustments.
FRS 2 also requires (ideally) all companies within the reporting group to prepare their financial statements for the same period (except in the year of acquisition) and to the same year end (co-terminus year-ends). This means that an acquired subsidiary may have to change its year-end. (Question 1 in the December 1999 Paper 10 is a good illustration of this.)
Where a subsidiary does not prepare co-terminus financial statements, perhaps for legal reasons, financial statements drawn up to a date not more than three months preceding the group year end may be used. Failing this interim statements would have to be produced.
Woodford plc has the following share capital structure:
10,000 A voting ordinary shares
Both classes of share have the same dividend rights.
Consider the following possible shareholdings:
In the first example Taylor plc would own 30% of the shares in Woodford plc (6,000/20,000) and accordingly receive 30% of any dividend that Woodford plc may pay. This may seem like it should be treated as an associated company investment (assuming other conditions relating to associated company status were satisfied), however as Taylor plc owns 60% of the voting shares (6,000/10,000) it does in fact control Woodford plc and should treat it as a subsidiary.
In the second example Taylor plc would own 70% of the ordinary shares in Woodford plc ((10,000 + 4,000)/20,000) and accordingly receive 70% of any dividend that Woodford plc may pay. In this example the roles are reversed and although it may appear that a 70% ownership of the ordinary shares should convey a subsidiary company status, close attention to the holding of the voting shares reveals that Taylor plc only holds 40% of them. Thus, Woodford plc would not be a subsidiary of Taylor plc and may not even be an associate. Although there is a presumption of associated company status when the investor’s share of the voting shares is 20% or above, there is no guarantee that this would give the investor the required influence. This would depend on other factors such as who holds the other shares in Woodford plc. For example, if another company X plc owns the remaining 60% of Woodford plc’s voting shares, Woodford plc would be a subsidiary of X plc as it would be under X plc’s control. Many commentators believe that in these circumstances a 40% shareholding would not be able to exert any influence and thus would not constitute an interest in associated company.
Comprehensive illustrative questionThe following question and answer (Example 2) will be used to illustrate the preparation of a consolidated profit and loss account and balance sheet. The commentary will discuss the approach to the answer and highlight common errors made by candidates in the past. It is based on a past Paper 10 examination question. A modified version has also been included in the pilot paper for the new Financial Reporting Paper 2.5.
On 1 October 1999 Hedley plc acquired 80% of the ordinary share capital of Smedley plc by way of a share exchange. Hedley plc issued five of its own shares for every two shares it acquired in Smedley plc. The market value of Hedley plc’s shares on 1 October 1999 was £3 each. The share issue has not yet been recorded in Hedley plc’s books. The summarised financial statements of both companies are:
The following information is relevant:
Required: Prepare a consolidated profit and loss account and balance sheet for Hedley plc for the year to 31 March 2000.
Introduction to the answerThe principle underlying the preparation of a consolidated profit and loss account is to aggregate the results of the parent and the subsidiary from the point in time at which control is achieved. In this case, this is the date of acquisition of 1 October 1999. The question gives the results of the subsidiary for a full year to 31 March 2000. Thus 6/12 of the subsidiary’s results should be included in the consolidated profit and loss account. Even though Hedley plc only owns 80% of Smedley plc, FRS 2 requires that the whole of its (post acquisition) results should be included in the profit and loss account line items (i.e., on a line-by-line basis) with the minority interest of 20% being shown as a deduction after the profit after tax figure. Intra group sales and cost of sales (in this case £100,000), together with any related unrealised profits (in this case £10,000), are eliminated.
Common errors are:
Note: although this last error would mean that nearly all the figures in the answer would be incorrect, it is not really a serious mistake. I have seen some scripts where the candidate, on realising that they have made this type of error, have crossed out the question and started again. This is not to be recommended. It is far better to note you have realised the error and explain that the post acquisition results are out by one month. Such errors are simple calculation errors that may be due to examination pressure, they are not errors of principle, and as such are not severely penalised.
Note: as the acquisition occurred during the current year the retained profits brought forward will not contain any profits relating to the subsidiary. In other questions, where the acquisition may have occurred in a previous year, they will.
The calculation of the minority interest is based on the post acquisition after tax profit of Smedley plc as adjusted for the depreciation adjustment i.e., (((200 x 6/12) – 5) x 20%).
Balance sheetThe principle involved in preparing a consolidated balance sheet is similar to that in the profit and loss account i.e., the parent and subsidiary’s assets and liabilities are aggregated together to form the group balance sheet. 100% of the subsidiary’s figures are included, with the minority interest being shown as a deduction in arriving at the net assets. Another way of looking at this (at the time of the acquisition) is to view the parent company’s investment in the subsidiary as being eliminated and replaced by the subsidiary’s underlying assets and liabilities acquired (at fair value at the date of acquisition). The difference between these two is effectively consolidated goodwill.
As in the profit and loss account the effects of intra group trading are eliminated (unrealised profits in stock and inter company debtors and creditors – after allowing for cash in transit). Common errors are:
(i) Cost of sales
As the plant is a depreciating asset, its fair value adjustment will create an additional depreciation charge in the subsidiary’s cost of sales (and subsequent profits) of £5,000. This is based on six months of the remaining life of 5 years i.e., £50,000/5 x 6/12. The unrealised profit (URP) in stock is calculated as:
Intra-group sales of £100,000 of which one half is in stock at the year end = £50,000
This has been sold at a mark-up of 25% on cost therefore the URP in stock is £50,000 x 25/125 = £10,000(ii) Goodwill/Cost of control in Smedley plc
Hedley plc issued 5 shares for every 2 shares it acquired in Smedley plc.
Therefore Hedley plc issued ((150,000/2 x 5) x 80%) = 300,000 shares at a value of £3 each for a total consideration of £900,000. This would be recorded in Hedley plc’s books as ordinary share capital of £300,000 and share premium of £600,000.
Pre-acquisition dividendsThese refer to dividends that have been paid by a subsidiary out of profits that were made prior to the acquisition. The treatment of these is relatively controversial. Many companies treat them in the same way as a dividend paid out of post acquisition profits i.e., they include them in the group’s profits. However an alternative view is that they represent a partial return of the investment paid to acquire the subsidiary and as such they should be deducted from the cost of the investment (as in this answer). Where dividends are immaterial the former method is probably acceptable, but where pre-acquisition dividends are material this treatment can lead to creative accounting. Effectively a parent company would be buying the profits of another company (a subsidiary) that have been made in the period before the subsidiary was acquired. These would be reported as group post acquisition profits in the year the pre acquisition dividends are paid (in this case in the current year). The requirements of the question make it clear that in this case pre-acquisition dividends are not to be included in income.
Pre and post-acquisition profitsSmedley plc’s adjusted profits (for additional depreciation) are £635,000 (£640,000 – £5,000). The acquisition occurred half way through the year therefore the pre-acquisition profits are £570,000 (£500,000 b/f + £140,000 x 6/12) and the post acquisition profits are £65,000 (£635,000 – £570,000).
Note: questions in Paper 10 and the new Paper 2.5 on group accounts will not involve more than one subsidiary, piecemeal acquisitions of subsidiaries or disposals of subsidiaries. However, questions may include one subsidiary and one associate or one joint venture.
Final thoughts – Criticisms of consolidated financial statements Whilst there is no denying that consolidated financial statements are of great value to analysts and investors, they are not without their critics. Some commentators feel that consolidated financial statements ‘average’ group performance. This may mean for example that within the consolidated profit and loss account, the results of a poorly performing subsidiary (i.e., low profits or losses) may be offset by the results of a subsidiary that is performing well.
A similar argument applies to balance sheet aspects, poor liquidity or near insolvency of some subsidiaries may be ‘hidden’ by healthy ratios of other subsidiaries.
It has also been said the consolidated financial statements give the impression that all the assets of the group are available to discharge all the liabilities of the group. This is not the case. These criticisms or limitations arise from the fact that a group is not a legal entity, it is the parent and the individual subsidiaries that are legal entities. Thus, the liabilities of one subsidiary will only be paid from the assets of that subsidiary. For this reason it is important to appreciate that if you are considering offering credit or a loan to a subsidiary within a group, the decision must be based on the information given in its entity financial statements, not the consolidated financial statements.
That said, there are circumstances where a parent company may guarantee the liabilities of a subsidiary, perhaps to maintain the value of goodwill. Clearly if this is the case the consolidated financial statements would provide useful information.
To a certain extent the criticisms of the ‘aggregation’ problems of consolidated financial statements are addressed by the provision of segmental information. This enables the user of the financial statements to assess those segments that are performing well and those that may be performing badly, but segmental information is not a complete answer. There is a common misconception that the separate segments of a group are separate subsidiaries; this is not the case. One subsidiary may have its results included in more than one segment, and several subsidiaries’ results may be included in the same segment. Thus segmental information does not (usually) provide information on individual subsidiaries.
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