FRS 2, Accounting for subsidiary undertakings
| by Paul Robins
01 Jan 1999
This is the third in a series of articles which deal with all of the Financial Reporting Standards (FRSs) that are currently in issue. The first two articles dealt with FRS1, Cash Flow Statements. This article deals with FRS2, Accounting for Subsidiary Undertakings. This article will be of relevance to students studying for papers 10 and 13. FRS 2 does not concern itself with the basic mechanics of consolidation and neither does this article. The FRS seeks to build on the basic regulatory framework for the preparation of consolidated financial statements for parent undertakings that is contained in the 1985 UK Companies Act. (It is worth noting that in many areas of financial reporting Financial Reporting Standards build on the basic requirements of company law.) FRS 2 supplements the 1985 UK Companies Act with guidance on its application and additional requirements where necessary. FRS 2 is drafted in terms derived from the 1985 UK Companies Act. However, FRS 2 applies to all parent undertakings that prepare financial statements intended to give a true and fair view, whether or not they are legally incorporated as companies.
Consolidated accounts — the basic legal requirements
Section 227 of the 1985 Companies Act provides that, where,
at the end of its financial year, a company is a
parent company, it should prepare consolidated accounts unless it qualifies as an exempt parent undertaking (see the Exemption from the requirement to prepare consolidated accounts section of this article). The consolidated accounts should comprise:
FRS 2 effectively extends this requirement to all parent undertakings, whether or not they are legally companies. Clearly, then, it is important to be clear as to exactly what is meant by the term ‘parent undertaking’.
Definition of parent undertaking
This definition, included in FRS2, is taken directly from the 1985 UK Companies Act. Section 258 of the 1985 UK Companies Act provides that an undertaking P is the parent undertaking of another undertaking S if
any of the following conditions are satisfied:
Section 260 of the 1985 Act states that P holds a
participating interest in S if P owns shares (or their equivalent, for an unincorporated undertaking) in S for the
long term for the purpose of securing a contribution to its activities by exercising
control or influence arising out of that interest. A holding of 20% or more of the shares in S would lead to the
presumption of a participating interest.
‘dominant influence’ and
‘managed on a unified basis’ are not defined in the 1985 Act. We have already stated that one of the purposes of FRS 2 is to provide definitive guidance in the practical application of the 1985 Companies Act as regards accounting for subsidiary undertakings. FRS 2 interprets the actual exercise of dominant influence as:
The actual exercise of dominant influence is the exercise of an influence that achieves the result that the operating and financial policies of the undertaking influenced are set in accordance with the wishes of the holder of the influence andfor the holder’s benefit, whether or not these wishes remain explicit. The actual exercise of dominant influence is identified by its effect
in practice rather than by the way in which it is exercised.
FRS 2 interprets the term “managed on a unified basis” as occurring if:
The whole of the operations of the undertakings are integrated and they are managed as a single unit. Unified management does not arise solely because one undertaking manages another.
It is possible to summarise this fairly lengthy set of definitions by stating that, effectively, a subsidiary undertaking is an undertaking which the parent undertaking can control. Control is defined in FRS 2 as:
The ability of an undertaking to direct the financial and operating policies of another undertaking with a view to gaining economic benefits from its activities.
Therefore, the objective of consolidated accounts per FRS 2 is to present the state of affairs and results of the parent undertaking and all undertakings which it can control as a single set of accounts. As we have already stated, this article is not concerned with the mechanics of preparation of consolidated financial statements.
Exemption from the requirement to prepare consolidated accounts
We have already identified the general legal requirement to prepare consolidated accounts. Exemption from this requirement is granted in three circumstances:
Exclusion of subsidiaries from consolidation
requires exclusion of subsidiaries in the following circumstances:
Accounting treatment of excluded subsidiaries
This can be summed up in
Table 1 below.
Note re: equity method of accounting
A method of accounting for an investment that brings into the consolidatedprofit and loss account the investor’s share of the investment undertaking’s results and that records the investment in the consolidated balance sheet at the investor’s share of the investment undertaking’s net assets including any goodwill arising to the extent that it has not previously been written off.
This method of accounting is sometimes referred to as
one-line consolidation. The name is derived from the fact that the investor’s share of the net assets of the investment undertaking is dealt with in
one line of the consolidated balance sheet and the investor’s share of the operating profit of the investment undertaking dealt with in one line of the consolidated profit and loss account. Since it does not involve the aggregation of assets and liabilities on a line-by-line basis it is reckoned to be more appropriate where the ‘dissimiliar activities’ exclusion applies. Those of you who have studied associated undertakings will no doubt recognise the equity method as being the standard treatment for such undertakings in the consolidated financial statements. We will return to the topic of accounting for associated undertakings later in this series — there is now an FRS that deals with it.
Disclosures in the consolidated financial statements
1 Additional disclosures in respect of excluded subsidiaries
Despite the title ‘Minority Interests’ there is in principle no upper limit to the proportion of shares in a subsidiary undertaking that may be held as a minority interest. The amounts reported in the consolidated balance sheet and profit and loss account indicate the extent to which the assets, liabilities, profits and losses are attributable to shareholders other than group members. These amounts should be reported separately in the consolidated profit and loss account and the consolidated balance sheet (merely a confirmation of accepted best practice). The minority interest in the net assets of a subsidiary should be reported using the same basis as that on which the net assets are consolidated. This means that if fair value adjustments are required on acquisition (see a later article on FRS 7 for more details of these) then the minority interest will be reported on the basis of fair values. However, the goodwill arising on consolidation should be recognised only in relation to the group’s interest. In other words no goodwill being attributed to the minority interest. This provision (again confirmation of accepted best practice in the UK) is sensible since to do otherwise would be to recognise an amount of goodwill for the minority shareholders. This is hypothetical because the minority shareholders were not a party to the transaction by which the subsidiary undertaking became a group member.
Any inter-group profits or losses which are included in the book value of assets of any group member (e.g., unrealised profit on stock) should be eliminated in full on consolidation. This is because the object of consolidated financial statements is to present information about the economic activities of the group as a single economic entity. Therefore, such profits or losses have not yet arisen for the group as a whole. These inter-group profits or losses should be eliminated in full even when the transactions involve subsidiaries with minority interests. This is because the existence of minority interests does not effect the basic aggregation of assets, liabilities, profits and losses. However, the elimination of profits and losses in these circumstances should be set against the interest held by the group and the minority interest
in respective proportion to their holdings in the undertaking whose individual financial statements recorded the eliminated profits and losses.
DR: Consolidated reserves — £150,000
DR: Minority interest — £50,000
CR: Stock — £200,000
The alternative treatment, debiting reserves and crediting stock with £150,000, has been outlawed by FRS 2. Note that the profit on sale is recorded
in the books of S, so it is appropriate to charge the relevant proportion to the minority interest. If the sale had been the other way round, from H to S, then no charge would have been made against the minority interest since the profit would have been recorded in the books of the parent.
Uniform accounting policies
Wherever possible uniform accounting policies should be followed in preparing the consolidated financial statements. This may mean making adjustments on consolidation where one or more group members follow a different accounting policy in a certain area. In exceptional cases different policies may be used with disclosure.
Uniform accounting dates
Wherever possible the financial years of all subsidiaries should coincide with that of the parent. Where the financial years are different, the accounts to be used in respect of the relevant subsidiary are:
Changes in the composition of a group
1 Effective date of change
The effective date of a change in the group structure should be the date on which control passes to or from the investing undertaking within the group. This date is a matter of fact and cannot be altered. However, it is not immediately obvious in, for example, the case of a take-over of a listed company. Such a take-over is usually achieved by the acquiring company making an offer to the shareholders of the target company. Such an offer is usually framed in terms that it is conditional pending its acceptance by a given percentage of the shareholders of the target company. This percentage is often just over 50% — for obvious reasons. In such circumstances, the date on which control passes would be taken as the date on which the offer became unconditional due to its acceptance by the required number of shareholders. For private share sales, the date control passes is normally the date on which an unconditional offer is accepted by the shareholders of the target company. The date on which control passes is, therefore, not necessarily the date the parent company pays or receives the consideration. Consideration may also be deferred in some cases — we will consider this aspect more closely in a later article on FRS 7.
2 Ceasing to be a subsidiary undertaking (disposals)
2.1 Total disposals
The profit on sale of S that would be included in the consolidated financial statements for the year ended 31 December 1998 is:
The consolidated profit and loss account would include the profits of S Ltd for the 8 months to 31 August 1998.
2.2 Partial disposals
The treatment of S in the consolidated financial statements from 1 September 1998 onwards would depend on whether S remained a subsidiary of (perhaps more likely) became an associated undertaking. It would be necessary to apply the criteria for a subsidiary that we discussed earlier in this article to see which classification is appropriate.
2.3 Deemed disposals
Since H plc owns 80% of the shares in S Ltd. before the rights issue then H plc owns 80 million shares and the minority shareholders 20 million shares at this time. What happens is that the issued share capital of S Ltd. increases by 20 million shares due to the effect of the rights issue and the company receives £30 million in cash. Also the minority shareholders now own 40 million of the total shares of S Ltd. That are in issue (20 million + 20 million). Therefore, the interest of H in S has fallen from 80% to 66.67% and the group has made a deemed disposal. The gain or loss can be computed in one of two ways (see
The second method is probably more straightforward and is certainly more appropriate to deal with a situation where a deemed disposal changes the status of the subsidiary to, say, an associated undertaking
3 Step by step (or piecemeal) acquisitions
A step by step acquisition is one where the shares in the subsidiary undertaking are purchased on a number of different dates. FRS2 does not implicitly address the effective date of ‘acquisition’ but, as we have already seen, is quite clear on the event that triggers off recognition as a subsidiary. It is a further requirement of FRS 2 that the net identifiable assets should be included in the consolidated financial statements at their fair value at the date the investment becomes a subsidiary undertaking. This requirement applies equally well to a situation where the shares in a subsidiary are purchased in a number of separate transactions.
Where a parent or other group member purchases shares in an existing subsidiary then this will usually have the effect of increasing the group’s interest in that subsidiary. In such circumstances FRS 2 requires that the identifiable net assets of the subsidiary should be revalued to their fair value at the date of the increase in stake. Any difference between the price paid for the additional shares and the reduction in minority interest based on the new fair values would be treated as goodwill.
Under the principles we have just discussed the net assets of S would be revalued to £55 million for consolidation purposes. Therefore, just prior to the purchase the minority interest in S would be £22 million (£55 million X 40%). The effect of the share purchase would be to reduce the minority interest to 20% and so it would become £11 million. Therefore the reduction in the minority interest is £11 million. The group has paid £12 million to achieve this reduction of £11 million and so goodwill of £1 million would be recognised.
The rationale behind this treatment is that essentially the group has an 80% subsidiary. Therefore, the carrying value of its net identifiable assets in the consolidated financial statements should be based on fair value at the date the subsidiary became an 80% subsidiary. This applies whether the subsidiary was purchased in one transaction or in a series of transactions.
FRS 2 is a lengthy and fairly complex standard. However, its provisions are fundamental to a study of consolidated accounts. Therefore, it is highly relevant for both paper 10 and paper 13.
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