Consolidated financial statements

IFRS 10 Definition of 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.

Parent – An entity that controls one or more entities.

The other types of financial statements are unconsolidated financial statements (or company accounts) and combined financial statements.

Single economic entity concept

The concept of a single economic entity is illustrated in the example below:

Example – Single economic entity concept A subsidiary buys an asset from a third party for CU 100. It subsequently sells the asset on to its parent for CU 130. The subsidiary records a profit of CU 30 and the parent records an asset of CU 130 in its separate financial statements. If the parent and subsidiary are viewed as being a single entity, all that has happened is that this single entity has bought an asset for CU 100 from a third party. This is what would be shown in the parent’s consolidated financial statements. So upon consolidation the CU 30 would be eliminated.

The (financial) consolidation process

The detailed ‘mechanics’ of the consolidation process vary from one group to another, depending on the group’s structure, history and financial reporting systems. IFRS 10 and much of the literature on consolidation are based on a traditional approach to consolidation under which the financial statements (or, more commonly in practice, group ‘reporting packs’) of group entities are aggregated and then adjusted on each reporting date. Larger groups using enterprise reporting systems may prepare consolidated financial information in a more real time and automated manner. However, the traditional approach still serves to illustrate the underlying concepts.

Consolidation Step-by-Step		Issues
Step 1 – combine financial statements of each group entity		uniform accounting policies (almost) the same reporting dates overseas subsidiaries immaterial subsidiaries changes in group composition
Step 2 – eliminate intra-group transactions and balances		intra-group losses/profits tax effects intra-group arrangements that affect classification
Step 3 – eliminate the parent’s investment in each subsidiary and recognise goodwill and other business combination-related adjustments		business combination adjustments goodwill impairment
Step 4 – allocate comprehensive income and equity to non-controlling interests (NCI)		determining the effective ownership percentage NCI valuation method

Step 1 Combine financial statements of each group entity

In an ideal situation the financial information for each group entity used in the consolidation would be fully IFRS compliant, drawn up to the same reporting date and prepared using the parent’s or group’s accounting policies. In reality this is often not the case. The following paragraphs consider the most common practical issues.

Uniform accounting policies
If a group entity uses accounting policies other than those in the consolidated financial statements, appropriate adjustments should be made on consolidation [IFRS 10 B87]. The extent and complexity of this exercise depend on the nature of the group’s activities and the basis of preparation of individual group entities’ financial statements.

In carrying out this exercise a distinction should be made between accounting policies and:

• accounting estimates
• designations permitted or required in IFRSs on a transactional or item-by-item basis (for example, hedge accounting and use of the fair value option in financial instruments accounting).

Example – Accounting policy alignment Parent company P heads a property investment group that includes subsidiaries S1 and S2. P’s group accounting policy for investment property is to apply the fair value model in accordance with IAS 40 ‘Investment Property’. In their individual financial statements S1 also applies the fair value model but S2 uses the cost model. Both S1 and S2 use interest rate swaps to manage interest rate risk on floating rate borrowings. However, S1 applies hedge accounting and S2 does not. Analysis: On consolidation adjustments should be made to reflect S2’s investment property at fair value (unless, in exceptional circumstances, it is impractical to reliably measure the fair value of the properties). There is no need to make adjustments to remove the effects of hedge accounting for S1, or to apply hedge accounting for S2. IFRS 9 permits but does not require hedge accounting, on a case by case basis, if the applicable conditions are met.

Non-coterminous reporting dates
The basic requirement in IFRS 10 is that each group entity’s financial statements are drawn up to the same reporting date for consolidation purposes. Where reporting dates differ, additional financial information is prepared for consolidation purposes, unless impractical [IFRS 10 B92].

IFRS 10 does allow some flexibility if it is impractical to obtain the additional information. In that situation the subsidiary’s financial statements are used for consolidation purposes, with adjustments for significant transactions or events occurring outside the period covered by the consolidated financial statements. In this situation:

• the difference between the subsidiary’s and parent’s reporting date may not exceed three months
• the length of the subsidiary’s reporting period and difference in dates must be the same from one period to the next.

Example – Non-coterminous year-end Parent company P is preparing consolidated financial statements to 31 March 20X1. For this purpose, it uses statutory, IFRS-based financial statements for Subsidiary S. S has a year end of 31 December 20X0. In February 20X1 Subsidiary S sold a property held at cost, realising a large profit that is material to the consolidated financial statements. Analysis: P should obtain additional information for S, such as a reporting pack or appropriately prepared management accounts, covering: the 3 month period from 1 January 20X1 to 31 March 20X1 the comparative 3 month period from 1 January 20X0 to 31 March 20X0. S’s financial statements should be adjusted for consolidation purposes by adding its results for the current 3 month period and deducting those for the comparative period. If this is impractical then S’s financial statements may be used without including this comprehensive additional information. However, in that situation adjustments should still be made for the property sale in February 20X1 (and for any other significant transactions or events of Subsidiary S occurring in Parent P’s annual period but outside S’s annual period).

Overseas subsidiaries
The financial statements of foreign subsidiaries must be translated into the group’s presentation currency (which is often, but not always, the parent’s functional currency). The relevant requirements are in IAS 21 ‘The Effects of Changes in Foreign Exchange Rates’.

A detailed discussion of IAS 21’s requirements is provided here but, in summary, the process involves:

• translating assets and liabilities at closing rate
• translating income and expenses at transaction date rates
• recording resulting exchange differences in other comprehensive income [IAS 21 39].

In practice, income and expenses are usually translated at a rate that approximates the rate at the dates of the transactions, typically an average rate for the period. However, this is not appropriate if exchange rates have fluctuated significantly during the period [IAS 21 40].

Goodwill and other business combination-related adjustments (for example, fair value adjustments) relating to an overseas subsidiary are treated as assets or liabilities of that subsidiary. Accordingly, they are translated at the closing rate in the same way as assets and liabilities recognised in the subsidiary’s individual financial statements.

Immaterial subsidiaries
The question of whether a parent is required to consolidate immaterial subsidiaries arises frequently. IFRS 10 is silent on this question. However, the concept of materiality applies to consolidation in the same way as to any other requirement in IFRS. Accordingly a parent is not required to consolidate subsidiaries that are individually and collectively immaterial to the consolidated financial statements. However, care should be taken to ensure that materiality is:

• reassessed at each reporting date
• considered broadly such that it takes into account:
  • gross assets, liabilities, income and expense as well as the net position
  • items for potential disclosure even if not recognised in the primary statements and disclosure items (for example, contingent liabilities and related party transactions).

Changes in group composition
Subsidiaries should be included in the consolidation from the date control is obtained to the date control is lost [IFRS 10 B88]. When these events occur part way through a group’s reporting period it will be necessary to obtain additional information covering that part of the period for which the parent has control.

Subsidiary expected to be liquidated
If a subsidiary (that is still controlled by the parent) is expected to be liquidated and its financial statements are prepared on a non-going concern basis, but the parent is expected to continue as a going concern, then the consolidated financial statements should be prepared on a going concern basis. The subsidiary should continue to be consolidated until it is liquidated or otherwise disposed of.

Step 2 Eliminate intragroup transactions and balances

As noted above, the single entity concept requires that a parent eliminates in full intragroup assets and liabilities, equity, income, expenses and cash flows relating to transactions between group entities. Profits or losses resulting from intragroup transactions that are included in the carrying amount of assets, such as inventory and property, plant and equipment, are also eliminated.

Intragroup losses may indicate an impairment that requires recognition in the consolidated financial statements [IFRS 10 B86].

Example – Elimination of intragroup loss Parent company P acquired an item of property 8 years ago at a cost of CU200. P estimates the economic useful life to be 20 years and residual value to be zero. P has recorded accumulated depreciation of CU80 to 1 January 20X1 and carrying value at that date is CU120. On 1 January 20X1 P sells the property to Subsidiary S for CU100, incurring a loss of CU20. S records the property at cost of CU100. S records depreciation of CU8.3 in the year to 31 December 20X1 (resulting in a carrying value of CU91.7). Analysis: On consolidation at 31 December 20X1 the following adjustments are required to adjust the carrying value and depreciation expense to the amounts they would have been if the intragroup sale had not occurred (ignoring tax effects): CU CU Property (110.0-91.7) 18.3 Depreciation expense (10.0-8.3) 1.7 Loss on sale of property 20.0 Because the intragroup sale incurred a loss, Parent P should consider whether the adjusted carrying value of CU110 exceeds the asset’s recoverable amount.

The treatment of tax on consolidation requires care. IFRS 10 notes that IAS 12 ‘Income Taxes’ applies to temporary differences that arise from the elimination of profits and losses resulting from intragroup transactions. The applicable tax base and tax rate for this purpose are determined based on the entity that holds the asset (the acquirer). However, an intragroup elimination changes the asset’s carrying value in the consolidated financial statements. This creates or changes the amount of the temporary difference. This change needs to be ‘tax effected’, as shown in the example below:

Example – Tax effecting an intragroup elimination The basic facts are the same as the example above. In addition: when S purchases the property for CU100 on 1 January 20X1 the tax base for S is equal to cost (ie also CU100) in the 12 months to 31 December S receives tax allowances of CU20, reducing the tax base to CU80 S’s tax rate is 25%. Analysis: In its individual financial statements S has a taxable temporary difference of CU11.7 (CU 91.7 – CU80). S should therefore have already recognised a deferred tax Iiability of CU 2.9 (CU11.7* 25%) in its individual financial statements. On consolidation the carrying value is increased by CU18.3 to CU110, resulting in a taxable temporary difference of CU30. Of this amount CU20 relates to the original intragroup sale. The following further adjustment is required to ‘tax effect’ this elimination: CU CU Tax expense 4.61 Deferred tax liability 4.62

Another tax issue that often causes confusion in practice is the need to recognise deferred tax on some temporary differences associated with investments in subsidiaries (event though the investment is eliminated). It should be noted that exchange gains or losses on intercompany loans and balances denominated in a foreign currency (from the perspective of one or more of the group entities involved) do not eliminate on consolidation. This is demonstrated in the example below:

Example – Intercompany loan between entities with different functional currencies Parent company P has a functional currency of GBP and Subsidiary S has a functional currency of USD. During one financial period P makes a loan to S of USD60,000 at a time when spot rate is 1GBP = 1.5 USD. At year end the spot rate is 1GBP = 1.6 USD. In its individual financial statements Parent P therefore retranslates the inter-company loan receivable from its initial carrying value of GBP40,000 (60,000/1.5) to GBP37,500 (60,000/1.6). P therefore records a loss of GBP2,500. Subsidiary S does not recognise any exchange difference as the loan is denominated in its own functional currency. Analysis: On consolidation Subsidiary S’s assets and liabilities are translated into GBP at the year-end spot rate of 1.6. The resulting intercompany liability of GBP37,500 is eliminated against P’s corresponding intercompany receivable. P’s exchange loss of GBP2,500 is not eliminated and is therefore included in consolidated profit or loss. If the loan is part of Parent P’s net investment in Subsidiary S (ie settlement is neither planned nor likely in the foreseeable future – IAS 21.15), however, it is recognised in other comprehensive income on consolidation in accordance with IAS 21.32.

In addition to elimination requirements, some intragroup arrangements can cause particular transactions and arrangements to be classified and measured differently on consolidation. The table below summarises some of the more common examples:

Impacts of intergroup arrangements

Investment property If a group entity holds property that is leased to another group entity, this property might meet the definition of investment property in the individual financial statements of the holder but would be considered ‘owner occupied’ at group level (see IAS 40).

Debt-equity classification and parent company guarantees When a subsidiary issues shares or other financial instruments and a parent or other group entity agrees additional terms directly with the holders (for example, a guarantee), this may require reclassification of the instruments from equity to liability on consolidation (see IAS 32 ‘Financial Instruments: Presentation’ – IAS 32 AG29).

Group share-based payment schemes A subsidiary that enters into a share-based payment scheme that requires it to settle the obligation by providing shares in the parent company would classify the scheme as cash-settled in its individual financial statements. On consolidation the scheme would be treated as equity-settled (see IFRS 2 ‘Share-based Payment’ – IFRS 2 43A-43D).

Step 3 Eliminate the parent’s investment and recognise goodwill and other business combination-related adjustments

The single entity concept requires that the parent’s investment in each subsidiary is eliminated on consolidation. In practice the following inter-related steps are usually combined:

• the investment is offset against the subsidiary’s share capital and pre-acquisition reserves
• goodwill is recognised in accordance with IFRS 3 (for subsidiaries acquired in a business combination)
• fair value adjustments to assets, liabilities and contingent liabilities made in the business combination accounting are reflected
• non-controlling interests are recognised.

The basic process is illustrated in the example below:

Example – Elimination of parent’s investment Some years ago Parent P acquired 80% of the issued share capital of Subsidiary S for CU 5,000. At that time S’s balance sheet showed net assets of CU4,000. Fair value adjustments totalling CU800 were recognised in the business combination. P decides to recognise non-controlling interests using the proportionate share of net assets method rather than fair value (see IFRS 3.19).S’s summary balance sheet is therefore: Analysis: Having added together P’s and S’s individual balance sheets, the entries to eliminate P’s investment, reflect the fair value adjustments and to recognise goodwill and non-controlling interests, are as follows:

In subsequent periods the consolidation eliminations and adjustments are updated to reflect :

• the income statement effects of fair value adjustments
• any goodwill impairment (goodwill identified in the business combination must be tested annually for impairment, by applying the requirements of IAS 36 ‘Impairment of Assets’)
• changes in ownership without loss of control.

Example – Updating consolidation entries to reflect fair value adjustments Continuing the example above assume that: the acquisition took place at the start of P’s annual period the CU800 fair value adjustment related entirely to property, plant and equipment with carrying value at the acquisition date of CU2,500 and fair value of CU3,300 the remaining useful life after this date is 10 years in S’s books the annual depreciation expense is CU250. Analysis: On consolidation the depreciation expense should be increased by CU80 to CU330. Of this excess depreciation, 20% is allocated to the non-controlling interest (CU16). Accordingly, after making the basic entry in the example above, the following catch-up entries are recorded:

Step 4 Allocate comprehensive income and equity to non-controlling interests

When a parent entity first obtains control over another entity, it recognises any non-controlling interest in the new subsidiary’s net assets as illustrated in the example above. In subsequent periods the parent allocates to the non-controlling interest its proportion of:

• profit or loss
• each component of other comprehensive income [IFRS 10 B94].

Definition of non-controlling interests
[IFRS 10.Appendix]
Non-controlling interest is the equity in a subsidiary not attributable, directly or indirectly, to a parent.

The proportion allocated to non-controlling interest is based on ‘existing ownership interests’ [IFRS 10 B89]. In our view ownership interests in this context are the parent’s economic interests in the subsidiary rather than the voting rights. In most cases involving a traditional corporate structure these proportions will be the same and will reflect the ownership of ordinary shares. However, differences can arise as illustrated below:

Example – Different voting rights and economic interests Parent company P owns all of the 100 ‘A’ shares in an investee and another investor owns all the 100 ‘B’ shares. There two types of share have equal rights to dividends and to available assets on a winding-up. However, each A share carries two votes and each B share only one vote.Analysis: Parent P owns two-thirds of the voting power (and therefore has control) but is entitled only to half the dividends and rights to net assets. Accordingly its economic interest is 50%. Equity and comprehensive income will be apportioned to the non-controlling interest based on 50%.

If a subsidiary has outstanding cumulative preference shares that are classified as equity and held by non-controlling interests, the parent deducts the preference dividends in arriving at the controlling interest’s share of profit. The parent allocates the dividends to non-controlling interest, irrespective of whether they have been declared [IFRS 10 B95].
Other practical issues in determining the allocation percentage include:
• indirect holdings
• potential voting rights and other derivatives.

Indirect holdings
If some of a parent’s interests in a subsidiary are owned indirectly (through another subsidiary) the non-controlling interest is determined based on the parent’s effective economic ownership. This is illustrated as follows:

Example – Indirect holdings Parent P controls two subsidiaries, S1 and S2, in the following group structure. Both subsidiaries were established as start-ups. Accordingly there is no goodwill and S1 and S2’s retained earnings were all generated while P had control: The summarised statements of financial position are as follows: Analysis: The effective controlling and non-controlling interest percentages are: S1 S14 S2 % CU % CU Controlling interests 90 1,179 66 495 Non-controlling 10 131 34 255 100 1,310 100 750 The consolidated statement of financial position is as follows:

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Consolidated financial statements