session-2- consolidated financial statement

Session-2: Consolidated Financial Statements

Overview of Financial Statements: Holding company and consolidated financial

statements Standalone Vs. Consolidated Statements Theories of CFS for reporting minority interest. Analysis of group performance

Key Words: Parent-only, stand-alone, consolidated, minority interest, holding/parent company, subsidiary.

13/06/2014IIM Lucknow

1

Analyst point

Users of the financial statements of a parent company are usually concerned with, and need to be informed about, the financial position and results of operations of not only the enterprise itself, but also of the group as a whole.

This need is served by providing the users -

(a) separate financial statements of the parent; and

(b) consolidated financial statements, which present financial information about the group as that of a single enterprise without regard to the legal boundaries of the separate legal entities.

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Some facts

Sl.No

Company Operating though number of subsidiaries

1 Reliance Industries Ltd.

The number of RIL’s subsidiary Companies as on 31st March, 2014 was 103. (AR-2013-14 page-89).

2 ITC Ltd. 31 (AR-2012-2013)

3. Jaiprakash Associates

22 (AR-2012-2013)

4 Infosys technologies Ltd.

11 direct and 25 step down (AR-2014)


3

NIKE, Inc.

NIKE, Inc. has 130 wholly-owned subsidiaries, 20 of which operate in the United States, and 110 of which operate in foreign countries. All of the subsidiaries, except for NIKE IHM, Inc., Triax Insurance, Inc., and NIKE (Suzhou) Sports Company, Ltd. carry on the same line of business, namely the design, marketing distribution and sale of athletic and leisure footwear, apparel, accessories, and equipment. NIKE IHM, Inc., a Missouri corporation, and NIKE (Suzhou) Sports Company, Ltd., a Chinese corporation, manufacture plastics and Air-Sole shoe cushioning components. Triax Insurance, Inc., a Hawaii corporation, is a captive insurance company that insures the Company for certain risks.


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Consolidated Financial Statement Financial statements for a group of enterprises under the

control of a parent. Along with several new accounting regulations related to

disclosure practices, Indian companies were asked to provide Consolidated Financial Statements (CFS) since 2002.

Unlike other disclosure regulations, consolidation was a major deviation from the earlier stand that consolidation would not provide additional information to the users of financial statements (Specially in Indian Practice).

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What the research says

The move towards harmonizing of the accounting standards led to the issue of consolidated accounting in 1997 which became effective from the year 2000. This standard treats CFS as the primary financial statements.

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Implication

Presented by parent: Consolidated financial statements are presented by a parent (also known as holding enterprise) to provide financial information about the economic activities of its group.

Resources controlled by group: These statements are intended to present financial information about a parent and its subsidiary(ies) as a single economic entity to show the economic resources controlled by the group, the obligations of the group and results the group achieves with its resources.

Application of Accounting Standard: In the preparation of consolidated financial statements, other Accounting Standards also apply in the same manner as they apply to the separate financial statements.

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A: Concept of holding company8

A holding company is a company which controls another company (known as subsidiary) by owning its majority of shares carrying voting rights or controlling the composition of its board of directors.

AS-21 on consolidated financial statements gives the following definition:

a. Subsidiary- is an enterprise being controlled by parent company

b. Parent- is an enterprise that has one or more subsidiaries

c. A group- parent and all its subsidiary

d. Control- It is the power to govern the financial and operating policies of an entity, so as to obtain benefits from its activities.


Criterion for determining control

Majority voting power: when parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity.

Other criteria of deciding existence of control:

1.Power over more than half of the voting rights by virtue of an agreement with other investors

2.Power to govern the financial and operating policies of the entity under a statute or an agreement

3.Power to appoint or remove the majority of the members of the board.

4.Power to cast the majority of votes at meetings of the BOD

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Example-110

Financial institutions support A Ltd in the management of B Ltd.Does A Ltd. Controls B Ltd.?

Observe the shareholding pattern of B Ltd.


Implication

A. No control can establish through holding majority voting power.

B. Point No. 1, 3, and 4 is not applicable.C. Only issue is that it governs the financial

and operating policies of B Ltd.D. In case there is an agreement between the

FIs and A Ltd. regarding governance of B Ltd., then only the control establishes.

E. Control is by agreement with other shareholders.

F. Effective from the date of agreement.

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What about potential voting rights (PVR)

Financial instruments which are convertible into equity shares with voting rights are termed as instruments having potential voting rights.

Example: Convertible debentures, convertible preference shares, share warrants.

The issue is whether potential voting rights are to be counted for the purpose of evaluating control.?

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Implication

As per Indian Accounting standards PVRs are not considered while evaluating control.

In international practice those PVRs are taken into account while evaluating control.

Example-2 : X ltd. holds 40% stake in Y ltd., out of 20 million equity shares of the investee company. In addition it holds 20 million out of 30 million share warrants issued by the company.

Does X ltd. control Y ltd.? Assume 1 equity share= 1 voting right.

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Implication

X Ltd holds majority voting right of Y ltd on the basis of current and potential voting rights. Hence Y Ltd is a subsidiary of X Ltd.

It is not relevant to analyze whether X ltd intends to exercise the warrants or it has the financial ability to exercise the warrants. Only issue is to be evaluated that, whether it has authority to exercise the warrants.

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Share warrants

A certificate, usually issued along with a bond or preferred stock, entitling the holder to buy a specific amount of securities at a specific price, usually above the current market price at the time of issuance, for an extended period, anywhere from a few years to forever. In the case that the price of the security rises to above that of the warrant's exercise price, then the investor can buy the security at the warrant's exercise price and resell it for a profit. Otherwise, the warrant will simply expire or remain unused. Warrants are listed on options exchanges and trade independently of the security with which it was issued, also called subscription warrant.


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Indirect control and consolidation

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Note: Is it possible to establish control by means of voting rights enjoyed by the group as a whole.

S Ltd. has the following shareholding pattern:

Analysis

Both B Ltd. and C Ltd., are subsidiaries of A ltd. While evaluating control the voting rights of the group as a whole are taken into account. So A Ltd controls S Ltd.

Even voting rights held by sub-subsidiary of A ltd. (i.e. B Ltd and C Ltd) are also taken into account. The chain continues to the lowest possible level.

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Advantages of holding company

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1. Used extensively to further the combination movement

2. Fruits of monopoly

3. The person controlling holding company need to invest a comparatively small amount in order to control the subsidiary companies.

4. Maintaining separate identities of various companies, it would be possible to carry forward losses for income tax purposes.

5. Each subsidiary company has to prepare its own accounts separately.

6. If it is desirable that the control of the holding company be given up , it can be easily arranged- shares in the subsidiary company should be disposed in the market.


Parents excluded from consolidationA. A parent which is a subsidiary of

another company having informed its minority shareholders and not having any objections from shareholders.

B. Parents debt and equity are not listed.C. The parent is not a potential listing

candidate.

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Exclusion of subsidiary20

A parent which presents CFS should consolidate all subsidiaries, domestic as well as foreign, other than the following:

a. When control is intended to be temporary.

b. It operates under severe long-term restrictions which significantly impair its ability to transfer funds to the parent.

Note: a subsidiary is not excluded from consolidation, just because its business activities are dissimilar from those of the other entities within the group.


Some issues21

1. Inter company transactions

2. Danger in the oppression of minority shareholders

3. Subsidiary companies are forced to appoint persons as directors with unduly high remuneration.

4. Manipulation of accounts-especially if the accounts of various companies are made up to different dates.

Note; private companies, subsidiary to a public limited company , do not enjoy the privileges given to private companies.


Accounting Standards (for CFS)

Accounting Standard (AS) 21, ‘Consolidated Financial Statements’, issued by the Council of the Institute of Chartered Accountants of India, comes into effect in respect of accounting periods commencing on or after 1-4-2001.

An enterprise that presents consolidated financial statements should prepare and present these statements in accordance with this Standard.

SEBI has made CFS mandatory (Clause-32 of the listing agreement)

Note: AS-21 does not deal with the following: Accounting standard for amalgamation (As-14), Accounting for investments in associates (AS-23), and accounting for investments in joint ventures.

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International context

The consolidation process in the International Financial Reporting Standards (IFRS) is similar to the Indian accounting standards.

However, the assets and liabilities are to be measured at the fair value for the purpose of arriving at the goodwill. The excess amount paid over the fair value of the assets taken over will be treated as goodwill.

Minority interest also gets presented in the balance sheet. The US GAAP requires the parent view of consolidation and does not allocate goodwill that belong to the minority interest.

Note: Principles of preparation of consolidated financial statements are explained in IAS 27.

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Transitional Provisions

1. On the first occasion that consolidated financial statements are presented, comparative figures for the previous period need not be presented.

2. In all subsequent years full comparative figures for the previous period should be presented in the consolidated financial statements.

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Minority Interest

That part of the net results of operations and of the net assets of a subsidiary attributable to interests which are not owned, directly or indirectly through subsidiary(ies), by the parent.

Para -25. Minority interests should be presented in the consolidated balance sheet separately from liabilities and the equity of the parent’s shareholders. Minority interests in the income of the group should also be separately presented.

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Content of CFS

Consolidated financial statements normally include:

Consolidated balance sheet Consolidated statement of profit and loss and notes, other statements and explanatory

material that form an integral part thereof. Consolidated cash flow statement is presented in

case a parent presents its own cash flow statement.

Note: Consolidated financial statements are presented, to the extent possible, in the same format as that adopted by the parent for its separate financial statements

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Disclosures in CFS

Following disclosures should be made:(a) List of all subsidiaries including the name, country of incorporation or

residence, proportion of ownership interest and, if different, proportion of voting power held;

(b) in consolidated financial statements:(i) Nature of the relationship between the parent and a subsidiary, if the parent does not own, directly or indirectly through subsidiaries, more than one-half of the voting power of the subsidiary;(ii) the effect of the acquisition and disposal of subsidiaries on the financial position at the reporting date, the results for the reporting period and on the corresponding amounts for the preceding period; and (iii) the names of the subsidiary(ies) of which reporting date(s) is/are different from that of the parent and the difference in reporting dates.

Example: RIL AR 2013-2014 pp. 269-272

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B: Consolidation procedure28

Club financial statements of holding company and subsidiaries on a line by line basis by adding together like terms of assets, liabilities, income and expenses.

Note: Shares in the subsidiary company held by the holding company represent the assets (and liabilities) of the subsidiary company.


Preparation of Consolidated Balance Sheet29

A: Controlling interest acquired at the end of financial Year: Balance sheet of H Ltd. And S Ltd. As at 31st March 2012 (suppose H Ltd acquires all the shares of S Ltd on 31st March 2012.)

Liabilities H Ltd S Ltd Assets H Ltd S Ltd

share capital shares of Rs. 10 each fully paid 500000 200000 Sundry assets 480000 260000

Reserves 100000 100% shares in S Ltd. 200000

Creditors 80,000 60,000

Total 680000 260000 Total 680000 260000

1. Cost of Control/Capital Reserve

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1. If the holding company pays more for acquiring the stake in subsidiary company – payment for goodwill or cost of control. Recognized as an asset in the consolidated balance sheet.

2. If the holding company pays less for acquiring the stake in subsidiary company – Capital profit and is shown as capital reserve in the consolidated balance sheet (that is negative goodwill).

Refer Excel sheet


2. Minority Interest31

The holding company may not hold 100% shares of the subsidiary company. Subsidiary company may not be wholly owned by the holding company.

Example: Suppose, H Ltd. holds 70% of the shares in S Ltd. and the balance 30% kept by outsiders.

Two possible approach:1. To include up to the proportion of holding- to include 70% of

the respective items i.e. assets and liabilities relating to S ltd. 2. To include 100% of all such items and show the difference

(30%)as outside ownership on the liability side as a compensating adjustment.

Note: In actual practice the second method is adopted.

The interest of the minority share holders in the net assets of the subsidiary company is registered and shown as MINORITY INTEREST on the liability side of the consolidated balance sheet.

Refer Excel sheet

3. Treatment of Reserves and surplus and preliminary expenses (Holding 100%)32

The holding company, while acquiring shares of the subsidiary company pays not only for the paid up value of the shares acquired but also pays for the profits that the subsidiary company has accumulated till the date of acquisition.

By the same logic, the worth of shares of the subsidiary company decreases if on the date of acquisition of its shares by the holding company, the subsidiary company has some accumulated losses or expenses which have not been written off till that date.

Refer Excel sheet 13/06/2014IIM Lucknow

4. Treatment of Reserves and surplus and preliminary expenses (<100%) 33

Case of minority interest- Minority shareholders are also entitled to their proportionate share of profits and reserves of the subsidiary company.

Thus the minority interest is increased by the profits and decreased by the losses of the subsidiary company.

Refer Excel sheet-Minority-113/06/2014IIM Lucknow

5. Revaluation of fixed assets by subsidiary as on date of consolidation34

Revaluation of fixed assets by subsidiary as on date of consolidation also has an effect on the cost of control (or capital reserve) and minority interest.

Profit on revaluation is also shared by minority shareholders.

Refer Excel Sheet13/06/2014IIM Lucknow

6. Capital profits and revenue profits

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1. Profits and losses of the subsidiary company pertaining to pre-acquisition period are capital profits and losses for purpose of preparation of Consolidated Balance Sheet.

2. It connotes profit earned by subsidiary company till the date of acquisition.

3. As a result profits which may be of revenue nature for the subsidiary company, may be capital profits so far as the holding company is concerned.


Point to be noted

Profit arising out of appreciation of fixed assets on their revaluation even in the post acquisition period is also a capital profit and is treated like profits pertaining to pre-acquisition period.

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Revenue profits

1. Profits earned and losses incurred by the subsidiary in the post acquisition period are treated as revenue profit or loss respectively.

2. Holding company’s share of such profits and losses are shown in the consolidated balance sheet.

3. Minority shareholders share of post acquisition profits increases the minority interest (MI) and their share of post acquisition losses decreases MI.

Refer Excel sheet- Capital and Rev

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B: Controlling interest acquired during the course of the year.

How to treat the Reserves and Profit & Loss A/C balances ?.

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Implication

Acquisition date and the date on which subsidiary company prepares its final accounts may not coincide.

Holding company may acquire shares in the course of a financial year.

Refer-Excel-during year

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Implication

Profits already earned and accumulated by the subsidiary company up to the date of acquisition of the shares by the holding company are capital profits.

It the shares are acquired during the course of the year the profit should be treated as accruing from day to day (in the absence of any other indication) and therefore should be apportioned on the time basis

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B. Treatment Relating to Preference shares of the subsidiary A subsidiary company may have issued

equity shares as well as preference shares. In such a case , irrespective of the

percentage of preference shares held by outsiders, the MI will include the paid up value of the preference shares held by the outsiders plus the dividend accrued thereon to the date of consolidation.

Refer Excel- Pref. Shares

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C. Unrealized profits

Usually there will be transactions between holding company and the subsidiary company involving profits and losses.

Example-1

42


D. Mutual owings

In preparing consolidated balance sheet, sums owed by holding company to its subsidiary and vice versa have to be eliminated.

(Example-1)

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Implication

Dividends received out of capital profits must be credited to Investment Account : since the cash received is against the price of shares paid at the time of acquisition.

Only dividends received out of revenue profits can be treated as income and credited to the profit and loss account

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Example:

On 1st November, 1999 H ltd acquired 3,000 equity shares of Rs.100 each (at a cost of Rs.150 per share) in S ltd., whose total share capital consisted of 5,000 equity shares of Rs.100 each fully paid up. The balance in the profit and loss account of S ltd.on 31st March 2000 was Rs.4,40,000 made up as follows:

Balance brought forward on 1st April 1999 = 140000 Profit (after meeting all expenses and taxation) = 300000

Total = 440000

S Ltd declared a dividend of 40% and issued bonus shares in the ratio of 1:1.

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9. Proposed dividend46

On the liability side of the balance sheet of the subsidiary company , proposed dividend may appear.

It is assumed that proposed dividend is out of post acquisition profits. Hence holding company’s share of proposed dividend will be added to the holding company’s profit and loss account, where as minority shareholders share will be added to minority interest.


2. Consolidation of Profit and Loss Account.

47

Usual items of gains, losses and expenses which will appear in the profit and loss accounts of both holding and subsidiary company and will be aggregated, but some adjustments are required.

1. Profit of the subsidiary company arising before the date of acquisition- should be debited to consolidated P&L and credited to capital reserve or goodwill.

2. All items internal to the holding and subsidiary companies should be eliminated.


Consolidation of P& L Account.3. Transfer of goods between the holding company and the

subsidiary company should be eliminated from the purchases and sales appearing in the consolidated P&L.

4. Debenture interest or dividends received by the holding company from the subsidiary will have to be eliminated from both sides of consolidated P&L.

5. No adjustment is required in respect of tax on dividends or interest on debentures paid by the subsidiary company to the holding company.

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Consolidation of P& L Account.6. In case cumulative preference shares are held by outsiders

and in case the dividend is in arrear, such arrear may be shown by way of a note in the consolidated balance sheet.

Alternatively the amount due by way of dividends should be debited to the consolidated P&L and credited to the minority shareholders account and shown as liability in the consolidated balance sheet.

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Empirical research.

1. THE VALUE RELEVANCE OF CONSOLIDATED VERSUS PARENT COMPANY FINANCIAL REPORTING ON THE LONDON STOCK EXCHANGE

By Victor O. Müller, Babeș-Bolyai University, Cluj-Napoca, Romania

Journal: INTERNATIONAL JOURNAL OF BUSINESS RESEARCH, Volume 11, Number 5, 2011

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Theoretical Framework

Relevance and faithful representation are the two fundamental qualitative characteristics of financial information.

Therefore, in order to make assessments on the quality of information of financial statements, it is absolutely necessary to quantify this relevance (capacity to influence) of financial information.

A fertile environment to perform such a measurement is the capital market, where investors’ decisions are reflected directly in the share price of the reporting entity.

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Objective

Parent companies are obligated to a dual reporting materialized in two sets of financial statements – one at individual level, the other at group level. Therefore, the question arises naturally – which of the two sets best serves the information needs of investors, respectively which of the two sets is more value relevant.

Analyze the absolute and relative market value relevance of consolidated accounting information of listed companies on the London Stock Exchange between 2003 and 2008.

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Methodology and Analysis

Econometric valuation models which measure the degree of association between share price and accounting information supplied by financial statements (equity and net income).

The basis for this models is the Ohlson (1995) valuation model, which expresses share price as a function of current accounting value of equity plus discounted value of future (abnormal) results.

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Implication

Results prove the importance (usefulness) of consolidated financial statements especially for investors on the capital market, and on the other hand, they question the necessity of publishing parent company financial statements.

Students can take this as project assignment-

“ Value Relevance of CFS: an investigation in Indian Capital Market”

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2. Empirical evidence

2. An Analysis of Consolidated and Parent-Only Financial Statements of Indian Companies

By: Padmini Srinivasan* and M S Narasimhan**Journal: The Icfai University Journal of Accounting Research, Vol. VII, No. 3, 2008

55


Sample Data

For the purpose of this study companies in the BSE 500 were taken. Data for the years 2003- 2007 were taken from CMIE Database, Prowess and from Capitaline Database. Out of these, companies with no subsidiary companies (124 companies) and companies that did not exist (185 companies) for the time period were eliminated. This resulted in 191 sample companies. For analysis, sales, profit and assets are taken between parent-only and CFS.

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Implication

The study concludes that the change of disclosure regulation favoring consolidation is more proactive in nature and consistent with the international practices than changes in the operations of Indian companies.

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Analysis of Minority Interest

Keeping with the emphasis on effective control, MI refers as noncontrolling interest.

Balance in the MI account shown on the B/S and the MI in net income are necessarily related.

If the subsidiary pays no cash dividends, then the change in the balance sheet account equals the MI in net income.

If a cash dividend is paid , then B/S change equals the MI in net income less the dividends paid to minority owners (B/S change by amount of undistributed earnings for the period).

Capital contributions or withdrawals also affect the MI shown on the parent company B/S.

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Example

Opening balance sheet liability: MI 679

Income statement: MI 83

Financing cash flow: Dividends paid to minority shareholders

-55

Closing B/S Liability : MI 707

59

(All figures are in Rs.millions)


Analysis

MI reflects the minority shareholders investment in the consolidated subsidiary.

Assets of a less than wholly owned subsidiary are not freely available to the parent as those of a 100%-owned subsidiary because of the minority investor.

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Analysis

Minority shareholders have only a residual claim on the assets of the subsidiary.

Generally, the creditors and shareholders of the parent cannot benefit from the assets of the subsidiary without respecting the claims of its creditors and minority holders.

Thus MI occupies a special position and should not be mechanically aggregated with either liabilities or equity.

Note: MI has the characteristics of a preferred shareholder.

61


session-2- consolidated financial statement

Documents

separate financial statements

users of financial statements

primary financial statements

financial position

present financial information

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holdingparent company