consolidation accounting

Business Combination and Consolidation Methods

Financial Accounting - Code 30005

Agenda

• Objective and Scope

• Consolidation: main references

• Consolidation of Financial Statements

• The Consolidation Process

2 Financial Accounting - Code 30005

Agenda






Objective and Scope

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PASSIVE INVESTMENTS

SIGNIFICANCE INFLUENCE

CONTROL

WHAT HAPPENS?

EQUITY METHOD

CONSOLIDATION

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Agenda






Consolidation: main references

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• The issue of consolidation arises when one company controls another company (normally by acquiring its shares), but the latter continues to exist as a separate entity and to keep its own assets and liabilities.

• From an accounting point of view, this is the case in which we have a “group of companies” and we have to prepare consolidated financial statements.

• Before 2011, there were basically four main standards dealing with the issue of consolidation: – IAS 27 – Consolidated and separate financial statements – IFRS 3 – Business combinations – IAS 31 – Interests in joint-ventures – IAS 28 – Investments in associates and a main interpretation standard contained in SIC 12, Consolidation –

Special purpose entities.


Consolidation: main references

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• Due to a number of unclear aspects and in response to a rising demand for additional information, in May 2011 the IASB issued a new standard that basically superseded IAS 27–which now only deals with separate financial statements – and SIC 12: IFRS 10 – Consolidated Financial Statements.

• This new accounting standard is the major output of the IASB’s consolidation project, which led to a single and more comprehensive definition of control.

• Moreover, IASB adopted two other new standards (IFRS 11 – Joint Arrangements and IFRS 12 – Disclosure of Interests in Other Entities) and revised two existing standards (as already mentioned IAS 27 – Separate Financial Statements and IAS 28 – Investments in Associates and Joint Ventures).

• All of the new standards are effective for annual periods beginning on or after 1 January 2013, even though their earlier application is allowed.


Agenda






Consolidation of financial statements: some definitions

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• Consolidated financial statements are 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.

• Separate financial statements are those presented by a parent (i.e. an investor with control of a subsidiary) or an investor with joint control of, or significant influence over, an investee, in which the investments are accounted for at cost or in accordance with IFRS 9 Financial Instruments.

• In simple words, the consolidated financial statements are those representing the group as a whole and the separate financial statements are those of the parent company as a single legal entity.


Consolidation of financial statements: some definitions

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• A group is a parent and all its subsidiaries.

• Non-controlling [or minority] interest is the equity in a subsidiary not

attributable, directly or indirectly, to a parent.

• A parent is an entity that has one or more subsidiaries

• A subsidiary is an entity, including an unincorporated entity such as a

partnership, that is controlled by another entity (known as the parent).

Subsidiaries exist when control is the continuing power to determine its

strategic, operating, investing, and financing policies, without the co-

operation of others.


Consolidation of financial statements

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• The most common case in which we prepare consolidated accounts is when

a company acquires enough equity to control another company.

• In order to understand better who has to prepare consolidated accounts,

control must be defined. However, the notion of control is not easily

defined, since one company can actually control another in several different

means (e.g. by owning the majority of its shares, by contractual

agreements, by other legitimate claims, …).

• This is why IFRS use a broad definition of control, naming it as “the power

to govern the operating and financial policies of an entity so as to

obtain benefits from its activities”.


The concept of control

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• WHEN DOES CONTROL EXIST?

An investor controls an investee when it 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.

Thus, an investor controls an investee if and only if the investor has all the following:

•power over the investee;

•exposure, or rights, to variable returns from its involvement with the investee; and

•the ability to use its power over the investee to affect the amount of the investor’s

returns.

An investor shall consider all facts and circumstances when assessing whether it controls

an investee. The investor shall reassess whether it controls an investee if facts and

circumstances indicate that there are changes to one or more of the three elements of

control listed in paragraph 7.


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• WHEN DOES CONTROL EXIST?

• In other words, IFRS assume that control exists (and therefore

consolidation is required) when the investor:

(a) possesses power over the investee,

(b) has exposure to variable returns from its involvement with the investee,

and

(c) has the ability to use its power over the investee to affect its returns.

• If all the three conditions simultaneously hold we face a situation of control.

The concept of control


The concept of control: summary scheme

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► Consolidation required [IFRS10, 4] • Definition [IFRS10, 10; IFRS10, 10 Appendix A]• Suggested activities [IFRS10, B11]

► Power• Examples of rights [IFRS10, B15]

■ Rights • Substantive rights [IFRS10, B22-25]• Contractual and voting rights [IFRS10, B34-50]

■ Exposition or rights to variable returns [IFRS10, 15]► Elements ► Returns ■ Definition of variable returns [IFRS10, B56]characterizing control ■ Examples of returns [IFRS10, B57]

► Link between power and returns [IFRS10, 17-18] • principal vs agent [IFRS10, B58-72]

► Purpouse and design of an investee [IFRS10, B5-B8]► Other issues to consider ► De facto agents [IFRS10, B73-75]in evaluating control ► Control over a specific asset [IFRS10, B76-79]

► Continuous assessment [IFRS10, B80-85]

► Consolidation excemption [IFRS10, 4]

■ Relevant activities [IFRS10, 10]

Control


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A. POWER • An entity (called “investor”) has power over another entity (called “investee”) when it

owns the current ability to direct the relevant activities of the latter.

• What are “relevant activities”?

• IFRS 10 defines relevant activities as the investee’s activities that significantly affect

the investee’s returns. In plain words, relevant activities are the one concerning all

the core operations of a firm.

• Examples of activities that, depending on the circumstances, can be relevant

activities include (but are not limited to):

(a) selling and purchasing of goods or services;

(b) managing financial assets during their life (including upon default);

(c) selecting, acquiring or disposing of assets;

(d) researching and developing new products or processes; and

(e) determining a funding structure or obtaining funding. [IFRS 10 App B par. B11]

The elements characterizing control


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• The ability to direct the relevant activities of the investee arises from some legal

rights the investor entity has over the investee, for instance voting rights coming

from the ownership of shares or some contractual agreements between them.

• Examples of rights that, either individually or in combination, can give an investor

power include (but are not limited to):

(a) rights in the form of voting rights (or potential voting rights) of an investee;

(b) rights to appoint, reassign or remove members of an investee’s key management

personnel who have the ability to direct the relevant activities;

(c) rights to appoint or remove another entity that directs the relevant activities;

(d) rights to direct the investee to enter into, or veto any changes to, transactions for

the benefit of the investor; and

(e) other rights (such as decision-making rights specified in a management contract)

that give the holder the ability to direct the relevant activities. [IFRS 10 App B par.

B15]



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• Rights that give power to the investor may be straightforward to recognize, such as when they come directly from the voting rights contained in the stocks owned.

• In other cases, such as in the presence of contractual provisions contained in (usually long and complex) legal agreements, the assessment will be more difficult and require considering more than one factor.

• The following situations may provide evidence that the investor’s rights are sufficient to give it power over the investee:

(a) The investor can, without having the contractual right to do so, appoint or approve the investee’s key management personnel who have the ability to direct the relevant activities.

(b) The investor can, without having the contractual right to do so, direct the investee to enter into, or can veto any changes to, significant transactions for the benefit of the investor.

(c) The investor can dominate either the nominations process for electing members of the investee’s governing body or the obtaining of proxies from other holders of voting rights.

(d) The investee’s key management personnel are related parties of the investor (for example, the chief executive officer of the investee and the chief executive officer of the investor are the same person).

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(e) The majority of the members of the investee’s governing body are related

parties of the investor. [IFRS 10 App B para. B18] • When considering whether certain rights give the investor power over the

investee, we should pay attention that those rights are ‘substantive’. Substantive rights are those rights which the holder can practically exercise.

• Examples are the voting rights of ordinary shares, if the investor can legitimately vote; if for any reason the voting rights are not exercisable by the investor (for instance because the investee went bankrupt and now all the voting rights are legally exercised by an appointed external entity, e.g. a bank) those are not substantive and shall not be considered in assessing control.

Examples of substantial rights over relevant activities The investee has annual shareholder meetings at which decisions to direct the relevant activities are made. The next scheduled shareholders’ meeting is in eight months. However, a special meeting can be set up by shareholders that individually or collectively hold at least 5% of the voting rights with at least 30 days notice. Policies over the relevant activities can be changed only at special or scheduled shareholders’ meetings.



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Case A • An investor holds a majority of the voting rights in the investee. The

investor’s voting rights are substantive because the investor is able to make decisions about the direction of the relevant activities when they need to be made. The fact that it takes 30 days before the investor can exercise its voting rights does not stop the investor from having the current ability to direct the relevant activities from the moment the investor acquires the shareholding.

Case B • An investor is party to a forward contract to acquire the majority of

shares in the investee. The forward contract’s settlement date is in 25 days. The existing shareholders are unable to change the existing policies over the relevant activities because a special meeting cannot be held for at least 30 days, at which point the forward contract will have been settled. Thus, the investor has rights that are essentially equivalent to the majority shareholder in example A above (i.e. the investor holding the forward contract can make decisions about the direction of the relevant activities when they need to be made). The investor’s forward contract is a substantive right that gives the investor the current ability to direct the relevant activities even before the forward contract is settled.



• However in assessing investor’s power, we have also to check whether its rights are only ‘protective’. Protective rights relate to fundamental changes to the activities of an investee or apply in exceptional circumstances.

• Examples may be the right of a bank to pledge an asset of the

investee if the latter fails to meet specified loan repayment conditions, or another lender that has a right over the investee which prevent it to undertake some specific operations. It is easy to see that protective rights do not guarantee their owner with a specific power over the investee but are some kind of defensive (‘protective’ indeed) mechanism. This is the reason why we do not observe power when the investor has only protective rights.

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• Another important dimension to consider in order to assess the investor’s power is the mixture of voting and contractual rights the investor owns.

• In fact, a right usually originates either from the ownership of the investee, expressed through the ownership of the majority of its shares, or from one or more specific contracts, or from a combination of the two situations. Depending on how they combine, the voting and the contractual rights may give rise to four different situations:

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Contractual agreement

No contractual agreement

More than 50% votes A

Less than 50% votes B C


• In situation A, the investor has power over the investee if the voting rights steaming out of the owned shares let the investor decide over the relevant activities or let it appoint the majority of the members of the governing body that directs the relevant activities But is it always the case that majority of votes equals power? Remember that, even if the investor owns more than 50 per cent of the voting rights, it still misses the power over the investee if he holds non-substantive voting rights.

• If we are in situation B, the investor does not own a sufficient number of shares to let it have the majority of voting rights; however, in virtue of some contractual arrangement with other investors, it can obtain such majority and hence exert power over the investee.

• With respect to situation C, we need to distinguish further. – A first case may arise when, even if the investor holds less than 50

per cent of voting rights, it still has the ability to control all the relevant activities because all other investors are too small and too disperse to actually organize and effectively contrast the investor (e.g. public companies). In this case we talk about “de facto control”

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• De facto control describes the situation where an entity owns less than 50 per cent of the voting shares in another entity, but is deemed to have control when it has the practical ability to direct the relevant activities unilaterally.

• When an investor is required to consider whether it has de facto control over an investee, it must consider all the relevant facts and circumstances including the following:

(a) the size of the investor’s holding of voting rights relative to the size and dispersion of holdings of the other vote holders;

(b) potential voting rights held by the investor, other vote holders or other parties (paragraphs B47–B50);

(c) rights arising from other contractual arrangements (paragraph B40); and

(d) any additional facts and circumstances that indicate the investor has, or does not have, the current ability to direct the relevant activities at the time that decisions need to be made, including voting patterns at previous shareholders’ meetings [IFRS 10 App B par. B42].

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– Another case concerning situation C arises when the investor not only owns ordinary shares, but also other instruments embedded with potential voting rights, such as call options or warrants. In this case, if the stake owned by the investor is a minority one but after exercising the options it gets greater than 50 per cent, this let the investor have power over the investee. However, attention must be paid on whether the potential rights are substantial: only if the investor can effectively and practically exercise its conversion rights it will obtain the majority of votes.

EXAMPLES • An investor acquires 48 per cent of the voting rights of an

investee. The remaining voting rights are held by thousands of shareholders, none individually holding more than 1 per cent of the voting rights. There are no contractual agreements among them. In this case, on the basis of the absolute size of its holding and the relative size of the other shareholdings, the investor concludes that it has a sufficiently dominant voting interest to meet the power criterion without the need to consider any other evidence of power.

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• Investor A holds 45 per cent of the voting rights of an investee. Two other investors each hold 26 per cent of the voting rights of the investee. The remaining voting rights are held by three other shareholders, each holding 1 per cent. There are no other arrangements that affect decision-making. In this case, the size of investor A’s voting interest and its size relative to the other shareholdings are sufficient to conclude that investor A does not have power. Only two other investors would need to co-operate to be able to prevent investor A from directing the relevant activities of the investee.

• Investor A and two other investors each hold a third of the voting rights of an investee. The investee’s business activity is closely related to investor A. In addition to its equity instruments, investor A also holds debt instruments that are convertible into ordinary shares of the investee at any time for a fixed price that is out of the money (but not deeply out of the money). If the debt were converted, investor A would hold 60 per cent of the voting rights of the investee. Investor A would benefit from realizing synergies if the debt instruments were converted into ordinary shares. Investor A has power over the investee because it holds voting rights of the investee together with substantive potential voting rights that give it the current ability to direct the relevant activities.

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B. RETURNS •In order to have control, the investor must be exposed to the investment, whose returns can be either negative or positive, and variable.

•In defining variable returns the standards are quite flexible, including all the returns which can potentially vary according to the investee’s performances. In this sense, even if an investor holds a bond with fixed interest rate payments, such payments are deemed as variable returns within IFRS 10, since they are subject to default risk and they expose the investor to the credit risk of the issuer of the bond.



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Examples of returns include: (a)dividends, other distributions of economic benefits from an investee (e.g. interest from debt securities issued by the investee) and changes in the value of the investor’s investment in that investee.

(b)remuneration for servicing an investee’s assets or liabilities, fees and exposure to loss from providing credit or liquidity support, residual interests in the investee’s assets and liabilities on liquidation of that investee, tax benefits, and access to future liquidity that an investor has from its involvement with an investee.

(c) returns that are not available to other interest holders. For example, an investor might use its assets in combination with the assets of the investee, such as combining operating functions to achieve economies of scale, cost savings, sourcing scarce products, gaining access to proprietary knowledge or limiting some operations or assets, to enhance the value of the investor’s other assets. [IFRS 10 App B par. B23]



C. LINK BETWEEN POWER AND RETURNS • The last element characterizing control is that the investor has the ability to use

its power over the investee to affect the amount of the investor’s returns. In particular, the standards want to make sure that the power is held only by the last effective controller of the investment.

• There may be cases, for instance, where the investor may seem to have control over the investee, but the investor itself has to respond to some other entity. If an entity is primarily engaged to act on behalf and for the benefit of another entity, is said to be an agent. In these cases of delegated power, we want to make sure that the control (and hence the burden of consolidation) is assigned to the entity with the power to delegate, i.e. the principal, not to the agent which is exercising its decision-making authority on behalf of someone else.

• A typical example is the one within investment funds, i.e. a fund that provides investment opportunities to a number of investors. There, a fund manager must make decisions in the best interests of all investors and has wide decision-making discretion. To make sure he or she acts in the interests of shareholders, some compensation mechanism are set up (for instance he or she is paid 1 per cent of the assets being managed and 20 per cent of the fund’s profits).

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• Is the fund manager a principal or an agent? In other words, who controls the fund? The answer is: it depends!

Case A The fund manager has a 2% investment in the fund that aligns its interests with

those of the other investors. The fund manager does not have any obligation to fund losses beyond its 2% investment.

The fund manager is an agent. In fact, even if his 2% investment increases its exposure to variability of returns from the activities of the fund, such exposure is not significant.

Case B The fund manager has a substantial pro rata investment in the fund, but does not

have any obligation to fund losses beyond that investment. The investors can remove the fund manager by a simple majority vote, but only for breach of contract.

The fund manager is a principal. Evidently, the combination of the fund manager’s investment together with its remuneration could create exposure to variability of returns from the activities of the fund that is of such significance that it indicates that the fund manager is a principal. Moreover, the other investors’ rights to remove the fund manager are considered to be protective rights because they are exercisable only for breach of contract.

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OTHER ISSUES TO CONSIDER IN EVALUATING CONTROL • When the three elements of control –power, variable returns, and the link

between power and returns – are present, we can conclude that an entity (investor) controls another entity (investee). In this case, we are facing a group and the controlling entity (the parent) has to consolidate the controlled one (subsidiary).

• However, even if the investor has the control over one or more investee, the

parent is exempted from presenting consolidated financial statements when: – it is itself a fully-owned or partially owned subsidiary (in the latter case

all its other owners need not to object to the parent not presenting consolidated financial statements ), AND

– its debt or equity instruments are not traded in a public market nor the parent is about to request such issuing, AND

– its ultimate or any intermediate parent produces consolidated financial statements that are available for public use and comply with IFRSs.

• Besides the above conditions, which prevent the parent to prepare consolidated financial statements only if all simultaneously satisfied, post-employment benefit plans or other long-term employee benefit plans are never included within the consolidation scope.

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The concept of control: summary scheme


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Agenda






The Consolidation process

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• Most large corporations own controlling interests in other companies. These interests appear in the balance sheet of the parent company among assets, in most cases at cost. Using this valuation method does not give any indication of the value of the subsidiary.

• Consolidation accounting is a method of combining the financial statements of subsidiaries with that of the parent company.

• Consolidated statements combine the balance sheet, income statement and other financial statements of the holding with those of the subsidiaries into an overall set of statements as if the parent and its subsidiaries were a single entity.

• In different words, the assets, liabilities, revenues and expenses of each subsidiary are added to the parent’s accounts as if the parents had acquired directly the assets and liabilities of the subsidiary instead of investing in its shares.



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• So, the purpose of a set of consolidated statements is to show the financial situation of the group of companies as if they were one only company, that is as if their activity were performed directly by the parent company.

• Therefore, the consolidation process doesn’t consist only in adding up the individual companies’ financial statements, but also in making them consistent with each other and in eliminating all those items that wouldn’t be there if the activities were actually performed by the parent company only (thus avoiding double counting).



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The consolidation process can be described in a number of steps:

1. Collect the individual companies’ financial statements

2. Make them uniform as concerns:

• the accounting period’s dates

• the accounting policies

• the reporting currency

• the format

3. Combine like items - ‘aggregate situation’

4. Offset (eliminate) the carrying amount of the parent’s investment in each

subsidiary, the parent’s portion of equity of each subsidiary (IFRS 3 explains how

to account for any related goodwill) and recognize any increase in subsidiaries’

assets and liabilities

5. Recognize non-controlling interests

6. Eliminate any intra-group transactions

7. Allocation of the group’s and minorities’ results

8. Close the consolidation process and prepare the statements



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• THE BASIC ENTRY OF CONSOLIDATION PROCESS: THE ELIMINATION OF THE INVESTMENT IN THE SUBSIDIARIES

• In order to understand better what consolidation means, let’s start from a very simple example.

• Let’s suppose we have a company, A, that wants to perform a new activity.

• In order to perform the new activity A can decide to:

– buy the necessary assets and perform the activity directly

– buy all the shares of a separate company, B, that owns the necessary assets , and perform the activity in an indirect way, that is by controlling B.

• Now let’s suppose that the balance sheet of A at the moment it decides to start the new activity is the following:

BALANCE SHEET

Cash 200 Liabilities 300

Other Assets 300 Owner’s equity 200



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BALANCE SHEET


Plants 100 Owner’s equity 200

Other Assets 300

• The cost of the assets necessary to perform the new activity is 100.

• If A decides to perform the new activity directly, after the purchase of the assets

(e.g. plants) its balance sheet is the following:



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BALANCE SHEET –A


Investments 100 Owner’s equity 200

Other Assets 300

• If A decides to perform the new activity by purchasing the shares of a new company,

B, which owns only the necessary plants, the two companies balance sheets at the

starting moment would be the following:

BALANCE SHEET –B

Plants 100 Owner’s equity 100



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• If we want to prepare the consolidated balance sheet of the two companies, we need

to go back to the financial situation that we would have if the activity were performed directly by A.

• In practice, in consolidation accounting, we start from the addition of the two balance sheets and then we eliminate all those items that would not be there if the two companies were only one, that is if A had decided to perform the new activity directly.

BALANCE SHEET A+B


Investments 100 Owner’s equity 300 200

Plants 100

Other Assets 300



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• When consolidated accounts are prepared on a date subsequent to acquisition, the

investments in subsidiary and the subsidiary’s owners’ equity are not the

only items to be eliminated in the consolidation process.

• All intercompany items (also called mirror items) like receivables and payables with

other subsidiaries, costs and revenues, profits and losses deriving from transactions

carried out between two companies included in the same consolidated financial

statement must be eliminated, since they would not appear in the financial

statements if the subsidiaries’ activities were performed by the parent company

directly.



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• THE CONSOLIDATION WORKSHEET

• Companies are not required to prepare a “journal book” for their consolidation accounting. Most of them use worksheets similar to the one reported below.

(1) Elimination of investments and related O.E.



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• THE CONSOLIDATION WORKSHEET

• The first columns of the worksheet are reporting the individual financial statements of all the companies included in the consolidation area

• After that, we always have an “Aggregate” column, that results simply from summing up the values reported, for each item, in the individual financial statements

• For each “consolidation entry” we use a different column. On the top of it we report a number so that we can describe the entry at the bottom of the worksheet

• Note that, because of the double-entry system, the total assets always equals total liabilities + owners’ equity. This must be true in each column of the worksheet

• Finally, the consolidated financial statements result, for each item, from summing up the values in the aggregate column and those reported in each following column.


consolidation accounting

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