Joint forces
| by Ronnie Patton 19 Aug 2004 Diploma in Financial Management Relevant to Subject area 1 |
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Group accounting is an important part of the Interpretation of Financial Statements syllabus. This article provides guidance on the following outcomes from Sessions 18 and 19 of the Study Guide for Interpretation of Financial Statements:
- distinguish between subsidiaries, associates and joint ventures
- describe the concept of a group and explain the terminology of accounting for groups
- explain and apply to simple examples consolidation accounting, equity accounting and the gross equity method
- explain and apply the treatment of goodwill arising on acquisition.
The calculation of goodwill on acquisition, consolidated reserves and minority interest are not considered in this article, but will be the subject of a future article. Furthermore, it should be noted that only the consolidated balance sheet is considered in this article. Candidates are advised to ensure that, once they understand the principles outlined here, they also consider the preparation of the consolidated profit and loss account.
What is a group?
A group is the structure which arises when one company (the investor) acquires an interest in another company (the investee). If the interest is for the long term, and the investor is able to exercise a degree of influence over the operation of the investee, it will be necessary to prepare consolidated financial statements.
It should be noted that in the financial statements of the investing company, an interest in another company will initially be carried at cost. If the interest is intended to be held for the short term only, it will be reported as part of current assets. If the interest is held for the long term, it will be reported as part of fixed assets.
If the only interest held by the investor is a short term investment, consolidated financial statements are not required. However, if the investor has another investment which gives rise to the need for consolidated financial statements, the treatment of the short term investment in the consolidated accounts means that it will continue to be reported as a current asset.
Control/Influence
When the interest is held for the long term, a distinction must be made between an investment in a subsidiary and an investment in an associate. The correct classification of the investment will depend on the extent to which the investing company can exercise control or influence over the investee.
It is worth remembering that, in an exam, the most common way of indicating the degree of influence of the investor is on the basis of the number of shares held. Unless the question states otherwise, it can be assumed that all shares have equal voting rights. If more than one class of share is in issue, it is important to calculate the proportion of the total votes which are held by the investor.
Accounting treatment
Subsidiary
A subsidiary is defined as an investee over which the investor can exercise dominant influence. Usually this means that the shares held give control of more than 50% of the votes, and the investor can control the board of directors of the investee. The investee is incorporated into the consolidated balance sheet using acquisition accounting (sometimes referred to as consolidation accounting). Basically the treatment is as follows:
- The cost of the investment in the balance sheet of the investor (which is a debit balance), together with the share capital and the pre-acquisition reserves of the investee (which are credit balances) will cancel each other out. This is done through the calculation of goodwill on acquisition, with the resulting debit balance giving the value of the asset of goodwill. Goodwill is amortised according to the accounting policy noted in the question, with the remaining, or unamortised, balance reported on the consolidated balance sheet.
- The consolidated value of each of the other assets and liabilities is found by adding the individual amounts from each company's balance sheet. Thus the consolidated value of the total net assets represents the value of the resources controlled by the group. The group reserves will comprise:
- the retained reserves of the investor
- plus the group share of the retained reserves of the investee since acquisition
- less the amount of goodwill on acquisition which has been amortised to date.
The fact that a proportion of the company is held by shareholders outside the group is reflected in the value for the minority interest. This is reported as part of the total for capital and reserves.
Consequently, the capital and reserves section of the balance sheet indicates the ownership of the net assets controlled by the group.
Associate
An associate is defined as an investee over which the investor can exercise significant influence. Usually this means that the shares held give control of more than 20% (but less than 50%) of the votes, and the investor is represented on the board of directors of the investee.
The investee is incorporated into the consolidated balance sheet using equity accounting (sometimes referred to as one line consolidation, as the interest in the associate is reported as a single line on the balance sheet).
The interest in the associate is reported as part of fixed assets. This is calculated as:
- the group share of the value of the net assets of the associate
- plus any goodwill on acquisition which has not yet been amortised.
This means that the consolidated net assets reported in the consolidated balance sheet only include the group share of the net assets of the associate. Therefore no minority interest arises. The reserves of the group comprise:
- the retained reserves of the investor
- plus the group share of the retained reserves of the investee since acquisition
- less the amount of goodwill on acquisition which has been amortised to date.
Joint venture
A joint venture is an investee which is under the joint control of two or more investees. When preparing the consolidated financial statements, the gross equity method is used. This treatment is very similar to the equity method of accounting.
The only difference is that, on the face of the balance sheet, the value of the investor's share in the total (or gross) assets of the investee is reported, with the value of the investor's share in the total (or gross) liabilities being deducted. The result, of course, is the value of the investor's share of the net assets. Quite simply, the difference between a joint venture and an associate is that more information is disclosed on the balance sheet in respect of a joint venture.
Summary
In deciding on the nature of an investment, you should carefully consider the information given in the question. If the investor is able to control (ie have a dominant influence over) the investee, the investee is a subsidiary.
If the investor has significant influence over the investee, but cannot control it, the investee is an associate. When preparing a consolidated balance sheet, remember:
- for a subsidiary, add the value of each individual asset and liability to obtain the consolidated value, and include minority interest in the capital and reserves section
- for an associate, calculate the total value of the net assets of the associate, and include the group share as a single figure, together with the unamortised goodwill, on the consolidated balance sheet - there will be no minority interest.
If you are clear on these issues, your marks will be maximised.
Types of investment
| Subsidiary | Arises when the investing company can exercise a dominant influence over the operation of, and can therefore control, the investee. |
| Associate | Arises when the investing company can exercise significant influence over the operation of the investee, but cannot control it. |
| Joint venture | Arises when two or more companies agree to jointly fund and operate a third company. The operation of the investee is subject to agreement between the two investors. |
Glossary of terms
Acquisition accounting
The treatment applied to a subsidiary when preparing consolidated financial statements. The value of each asset and liability in the consolidated balance sheet is found by adding the value of each item from the individual companies' balance sheets.
Associate
An investee over which the investor exercises significant influence.
Consolidated financial statements
The combined financial statements to show the outcome if the individual companies were a single entity. Sometimes referred to as group financial statements.
Dominant influence
The ability of an investor to control the operation of an investee.
Equity accounting
The method of consolidating an associate. The interest in the associate is reported as the group share of the net assets, plus the unamortised goodwill.
Goodwill
The difference between the cost of the investment, and the value of the share of the net assets which were acquired.
Group financial statements
See consolidated financial statements.
Holding company
The company which holds an investment in a subsidiary or an associate. Also referred to as parent company.
Investor
The company that has made the investment.
Investee
The company in which an investment has been made.
Minority interest
The value of the net assets of the group which are owned by investors outside the group.
Parent company
See holding company.
Post acquisition reserves
The reserves which have been generated since the date of the acquisition.
Pre-acquisition reserves
The reserves which had been generated at the date of the acquisition.
Significant influence
The ability of the investor to influence - but not control - the operation of the investee.
Subsidiary
An investee over which the investor exercises dominant influence.
Ronnie Patton is examiner for Module A of the Diploma in Financial Management