The FA syllabus examines the principles contained in:
- IAS 27, Separate Financial Statements
- IAS 28, Investments in Associates and Joint Ventures
- IFRS 3, Business Combinations
- IFRS 10, Consolidated Financial Statements
Please note the syllabus does not cover Joint Ventures but IAS 28 is applicable to Associates which are covered.
This article focuses on some of the main principles of consolidated financial statements that a candidate must be able to understand and gives examples of how they may be tested in objective test questions (OTs) and multi-task questions (MTQs).
It does not attempt to cover every technical aspect of consolidation, but to give candidates the tools they need to prepare for the style and level of testing, they can expect to see in this paper.
(1) How is a parent-subsidiary relationship identified?
IAS 27 defines consolidated financial statements as ‘the financial statements of a group presented as those of a single economic entity.’
A group is made up of a parent and its subsidiary.
Illustration 1 shows an example of a typical group structure.
The illustration shows how a parent company has control over a subsidiary. At Paper FA level, it is assumed that control exists if the parent company has more than 50% of the ordinary (equity) shares – ie giving them more than 50% of the voting power.
However, there are examples where a holding of less than 50% of the ordinary shares can still lead to control existing. IFRS 10 states control arises when the investor (the parent) has:
i. power over the investee (the subsidiary)
ii. exposure, or rights, to variable returns from its involvement with the investee, and
iii. the ability to use its power over the investee to affect the amount of the investors returns.
Power may be evidenced by all or some of the following:
- the power over more than 50% of the voting rights by virtue of agreement with other investors
- the power to govern the financial and operating policies of the entity under statute or an agreement
- the power to appoint or remove the majority of the members of the board of directors, or
- the power to cast the majority of the votes at meetings of the board of directors.
A typical OT may describe a number of different investments and you would need to decide if they are subsidiaries – ie if control exists. Illustration 2 is an example of a typical question.
Green Co owns the following investments in other companies:
|Equity shares||Non-equity shares held|
Green Co also has appointed five of the seven directors of Black Co.
Which of the following investments are accounted for as subsidiaries in the consolidated accounts of Green Co Group?
A Violet only
B Amber only
C Violet and Black
D All of them
Let’s consider each of the investments in turn to determine if control exists and, therefore, if they should be accounted for as a subsidiary.
- Violet Co – by looking at the equity shares, Green Co has more than 50% of the voting shares – ie an 80% equity holding. This gives them control and, therefore, Violet Co is a subsidiary.
- Amber Co – you must remember to look at the equity shares, as despite having the majority of the non-equity shares, these do not give voting power. As Green Co only has 25% of the equity shares, they do not have control and, therefore, Amber Co is not a subsidiary.
- Black Co – by looking at the percentage of equity shares, you may incorrectly conclude that Black Co is not a subsidiary, as Green Co has less than half of the voting rights. However, by looking at the fact that Green Co has appointed five of the seven directors, effectively they have the power, and ability to use that power, to affect the decision making in the company which will impact on the returns to be made. This should make you conclude that Black Co is a subsidiary.
Therefore the correct answer is C.
Pink Co acquired 80% of Scarlett’s Co ordinary share capital on 1 January 20X2.
As at 31 December 20X2, extracts from their individual statements of financial position showed:
As a result of trading during the year, Pink Co’s receivables balance included an amount due from Scarlett of $4,600.
What should be shown as the consolidated figure for receivables and payables?
From the question, we can see that Pink Co has control over Scarlett Co. This should mean that you immediately consider adding together 100% of Pink Co’s balances and Scarlett Co’s balances to reflect control.
However, the intra-group balances at the year end need to be eliminated, as the consolidated accounts need to show the group as a single economic entity. The group statement of financial position should only include amounts owed and owing to entities outwith the group. As Pink Co shows a receivable of $4,600, then in Scarlett Co’s individual accounts there must be a corresponding payable of $4,600. When these balances are eliminated, the consolidated figures become:
Receivables ($50,000 + $30,000 – $4,600) = $75,400
Payables ($70,000 + $42,000 – $4,600) = $107,400
Therefore, the correct answer is D, not A which completely omits the elimination of the intra-group balances, nor answer B which omits to cancel the corresponding payable within liabilities.
You would not select answer C, which incorrectly adds 100% of Pink Co (the parent) and only 80% of Scarlett Co (the subsidiary). Although Pink Co only owns 80% of Scarlett Co, it controls 100%. Consolidated financial statements reflect control, not ownership. It would be a fundamental mistake in any consolidation question to ever pro-rate a subsidiaries statement of financial position where there is less than 100% ownership.
(3) Adjustments for unrealised profits
Another common adjustment that you could be asked to deal with is the removal of unrealised profit. This arises when profits are made on intra-group trading and the related inventories have not subsequently been sold to customers outside the group. Until inventory is sold to entities outwith the group, any profit is unrealised and should be eliminated from the consolidated accounts.
The following illustration demonstrates this in the context of the consolidated statement of profit or loss.
Purple Co acquired 70% of the voting share capital of Silver Co on 1 October 20X1.
The following extracts are from the individual statements of profit or loss of the two companies for the year ended 30 September 20X2:
|Cost of sales||(54,990)||(17,940)|
Purple Co had made sales to Silver Co during the year of $5,000. Purple Co had originally purchased the goods at a cost of $4,000. Half of these items remained in the inventory of Silver Co at the year end.
What should be the consolidated revenue for the year ended 30 September 20X2?
Even though this question requires an extract from the consolidated statement of profit or loss, the principle is still the same as Illustration (3) – consolidate the group as if it is a single economic entity by adding in 100% line by line, and showing group performance with all non-group entities.
Therefore, answer B would not be selected as it incorrectly adds 100% of Purple Co and only 70% of Silver Co.
The other adjustment that requires careful consideration is the intra-group trading. In the consolidated statement of profit or loss we must always consider two steps:
- Has there been any intra-group trading during the year, irrespective of whether the goods are still included in inventory at the year end?
- Do any of the items remain in inventory at the end of the year?
In this question, $5,000 of sales have been made from Purple Co selling to Silver Co. This must be eliminated, irrespective of whether the items remain unsold at the year end. This is because the consolidated statement of profit or loss needs to show revenue and costs of sales which reflects group performance with external, non-group, entities.
The second step here is to identify the provision for unrealised profit (PUP). Note although we refer to this as a provision, it is not a liability but an adjustment to the asset, inventory. Purple Co has made a profit of $1,000 (calculated as revenue of $5,000 – cost of $4,000). As only half of the items remain in inventory, the inventory value is overstated by half of that profit – that is, $500. Note: in many Paper FA questions, you will be expected to calculate the profit made by using margins or mark-ups, which are not discussed here.)
The consolidation adjustment is saying that the group has made a profit of $500 on items, which have not been sold on to a third party/non-group entity. Effectively if you did not make an adjustment for PUP the group would be recording a profit of $500 selling inventory to itself. This inflates the value of the inventory held by the group in the statement of position and the profit in the statement of profit or loss.
The adjustment would be:
Dr. Cost of sales $500
Cr. Inventory (SoFP) $500
However, by reading the question stem carefully, you will see that eliminating the unrealised profit is a red herring, as we are being asked for consolidated revenue.
Therefore, the consolidated revenue is calculated as:
$79,300 + $29,900 – $5000 = $104,200
The correct answer is D.
Had the question stem asked for the consolidated cost of sales figure, the answer would be correctly calculated as:
$54,990 + $17,940 + $500 – $5,000 = $68,430
The PUP is added back to cost of sales, which reduces/eliminates the profit. (Effectively what you are doing is adjusting the closing inventory that is part of the cost of sales figure).
Note: Answer A is incorrect, as although it correctly cancels the intra-group sale of $5,000, it incorrectly adds the $500 adjustment for unrealised profit to the revenue figure ($79,300 + $29,900 – $5,000 + $500 = $104,700)
Answer C is also incorrect because it omits the cancelling of $5,000 sales and deals incorrectly with the provision for unrealised profit of $500. ($79,300 + $29,900 – $500 = $108,700).
(4) How is goodwill calculated?
Another typical FA exam question will require you to calculate goodwill.
Under this syllabus, only the full goodwill method is examinable and is calculated as:
|(1)||Fair value of consideration transferred||X|
|(2) plus:||Fair value of non-controlling interest||X|
|(3) less:||Fair value of net assets at acquisition||X|
|Goodwill at acquisition||X|
This could be asked as an OT question but is more likely to be a MTQ where you will be calculating and submitting a figure for each of the component parts of the good will calculation – cost, NCI and net assets. You should look at the specimen paper and extra MTQs available on the ACCA website.
Even though we only own 80% of the share capital, the full goodwill method brings 100% of the goodwill on to the consolidated statement of financial position. This is consistent with the treatment of other assets and the concept of control. This is why we need to include the fair value of the non-controlling interest in our goodwill calculation. See Illustration 5 below for a typical MCQ on goodwill.
Red Co acquired 80% of Blue Co’s 40,000 $1 ordinary share capital on 1 January 20X2 for a consideration of $3.50 cash per share.
The fair value of the non-controlling interest was $30,000 and the fair value of the net assets acquired was $125,000.
What should be recorded as goodwill on acquisition of Blue Co in the consolidated financial statements?
Goodwill can be tested in a variety of different ways (see above). Always start by reading the question requirement carefully to determine what is being asked for. Here, in this specific OT question, it is the goodwill on acquisition that is being asked for, whereas other questions may ask for the cost of investment that would be recorded in the parent’s books.
If we consider each component in turn, the first thing to identify is how much the parent company has paid to acquire control over the subsidiary. In this question, Red Co acquires control by paying $3.50 cash per share.
Note: Red Co has only acquired 80% of Blue Co’s shares, so consideration transferred is 80% x 40,000 = 32,000 x $3.50 = $112,000.
Had the question asked for the cost of the investment that would be recorded in the parent’s books this would be it – hence the inclusion of the distracter, and incorrect answer D.
Secondly, once we have identified the amount of consideration transferred to acquire control over the subsidiary, the fair value of the non-controlling interest needs to be identified. In this question the fair value of the non-controlling interest is given, so in our calculation we just need to add it to the consideration transferred. In a MTQ it is likely you would be given the value of a NCI share and have to apply it to the 8,000 shares that Red did not acquire.
In the final part of the calculation, following on from the point just made, it is necessary to look at all (100%) of the fair value of net assets at acquisition. Again this figure is given in this question and just requires slotting into our goodwill working. In other MTQs, you may be expected to do more work on finding the fair value of the net assets at acquisition.
Goodwill can then be calculated as:
|Plus: Non-controlling interest||30,000|
|Less: fair value of net assets at acquisition||(125,000)|
|Goodwill at aquisition||17,000|
The correct answer is A.
Note: Answer B ignores that Red Co only acquired 80% of the shares and calculates the cost of investment incorrectly as 40,000 x $3.50 = $140,000 – therefore, goodwill of $140,000 + $30,000 – $125,000 = $45,000.
Answer C is incorrect as, despite calculating the cost of investment correctly as $112,000 + non controlling interest of $30,000 = $142,000, it incorrectly deducts (80% x $125,000) as the share of net assets at acquisition giving goodwill of $42,000.
(5) What is an associate and how does equity accounting work?
We began this article with consideration of how to identify a subsidiary, and we conclude it with consideration of a relationship between a parent and an associate.
The Paper FA syllabus is limited to the definition and identification of an Associate and describing the principle of equity accounting only.
An associate is defined by IAS 28, Investments in Associates and Joint Ventures as ‘an entity over which the investor has significant influence’.
Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies.
IAS 28 also states that a holding of 20% or more of the ordinary (voting) shares can be presumed to give the investor significant influence unless it can be demonstrated otherwise. You should use the range 20-50% of voting shares in the exam as your main indicator of significant influence. However make sure you read any other information with regards power to participate or other shareholdings ( see illustration 6).
Conversely, significant influence can still be demonstrated where less than 20% of the voting rights are obtained, usually evidenced by:
- representation on the board of directors of the investee
- participation in the policy-making process
- material transactions between the investor and investee
- interchange of management personnel
- provision of essential technical information.
Once we have identified an associate exists, we do not consolidate line by line like we do for a subsidiary. This is simply because we do not have control. Equity accounting is not the same process as consolidation.
For an associate we have to use the equity method, which means we simply bring in our share of the associate’s results. In the consolidated statement of profit or loss, any dividend income received from the associate is replaced by bringing in one line that shows the parent’s share of the associate’s profit. This is presented as ‘Share of profits of Associate’ as a new heading immediately before the consolidated profit before tax.
In the consolidated statement of financial position, the investment in the associate is shown as a single figure in non-current assets. It is calculated as the cost of the investment + parents share of post-acquisition retained profits (ie the profits the associate has earned since the parent has had significant influence).
Which of the following investments owned by Indigo Co should be accounted for using the equity method in the consolidated financial statements?
- 30% of the non-voting preference share capital in Yellow Co
- 18% of the ordinary share capital in Blue Co with directors of Indigo Co having two of the five places on the board of Blue Co
- 45% of the ordinary share capital of Red Co, with directors of Indigo Co having four of the six places on the board of Red Co
A 1 and 2
B 2 only
C 1 and 3 only
D 2 and 3 only
Statement (1): Although a 30% holding appears to fall within the 20–50% range, it is a 30% holding in non-voting preference share capital. These do not give Indigo Co significant influence over Yellow Co and, therefore, Yellow Co is not an associate and would not be equity accounted.
Statement (2): Despite only 18% of the ordinary share capital being held by Indigo Co, as we have already discussed, we do not just consider the percentage of equity shares held, but also look at whether there can be an exercise of significant influence. Having two out of the five directors effectively gives Indigo Co influence, but not control, over decision making in the company and, therefore, Blue Co is an associate and would be equity accounted.
Statement (3): Don’t just look at the 45% holding and presume it is an associate without considering the other facts. By looking at the ability to appoint directors shows that Indigo Co has four of the six directors, effectively giving them power and therefore control over the decision making in the company. Having power and control should make you spot that actually Red Co is a subsidiary and, therefore, would be consolidated line by line in the group accounts and would not be equity accounted.
Therefore, the correct answer is B – Statement 2 only.
(6) Concluding exam tips
Remember that at Paper FA, a good solid platform of understanding the principles of consolidation is required.
This is because, although we have used OTs to demonstrate how the consolidation principles could be examined, they could also be assessed using the MTQs in part B of the exam. Typically this will involve calculating the figures for a consolidated statement of profit or loss or a consolidated statement of financial position. You should ensure you have looked at the specimen paper (the full exam amd the additional MTQs) for practice of the fuller consolidation exam questions. You learning providers question banks and revision material will also provide further practice.
Practising full length consolidation questions will help you grasp a better understanding of consolidation. It is important to understand how each calculation fits into the consolidated financial statements, and this will also benefit your future studies when you revisit consolidation in your later Paper Fr and Paper SBR studies.
When answering OTs and MTQs, remember to:
- read the questions requirement carefully and understand what is being asked for
- think about relevant consolidation workings or extracts that may help you
- calculate what you think the correct figure is before you look at OT answer options – be careful not to let the distracters catch you out, so think carefully about your calculation
- re-read the question to ensure you understand it and check you are answering the question set if your initial calculation does not match any of the answer options.
Written by a member of the FA examining team