The FA/FFA syllabus examines the principles contained in:
Please note that 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 that they can expect to see in this exam.
(1). How is a parent-subsidiary relationship identified?
IAS 27 defines consolidated financial statements as ‘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.’
The diagram below shows an example of a typical group structure:
This diagram shows how a parent company has control over a subsidiary. At FA/FFA 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 that an investor (i.e. the parent) controls an investee if and only if the investor has all of the following:
i. power over the investee (ie 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 investor’s returns.
Power may be evidenced by all or some of the following:
A typical OT question may describe a number of different investments and you would need to decide if they are subsidiaries – i.e. if control exists. Illustration 1 is an example of a typical question.
Green Co owns the following investments in other companies:
|Equity shares||Non-equity shares held|
Green Co has also 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 Co only
B Amber Co only
C Violet Co and Black Co only
D Violet Co, Amber Co and Black Co
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.
Therefore, the correct answer is C.
(2). Elimination of intra-group trading balances
Entities within the same group will often trade with each other and this can lead to some intra-group balances which need to be eliminated. This is required because of the single economic entity approach to consolidated financial statements. The following illustration demonstrates such a scenario:
Pink Co acquired 80% of Scarlett Co’s 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 Co of $4,600. Scarlett Co has a corresponding payables balance.
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 outside 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
Answer A completely omits the elimination of the intra-group balances and answer B does not cancel the corresponding payable within liabilities.
Answer C 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 subsidiary’s 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 outside the group, any profit is unrealised and should be eliminated from the consolidated financial statements.
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 the consolidated revenue be 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 (2) – 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:
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 cost of sales which reflect group performance with external, non-group, entities only.
The journal entry required to remove the intra-group sale would be:
Dr Revenue $5,000
Cr Cost of sales $5,000
Therefore, the consolidated revenue is simply calculated as:
$79,300 + $29,900 – $5,000 = $104,200
The correct answer is D.
Had the question asked for the consolidated cost of sales figure, the next step would have been to identify the provision for unrealised profit (PUP). Note that 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. Candidates should be aware that in many FA/FFA exam questions, you will be expected to calculate the profit made by using margins or mark-ups, which are not discussed here.
The consolidation adjustment required for this deals with the fact 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 the PUP, the group would be recording a profit of $500 from selling inventory to itself. This inflates the value of the inventory held by the group in the statement of financial position and the profit in the statement of profit or loss. Remember, closing inventory is a component of cost of sales so the adjustment for PUP affects both the statement of profit or loss and the statement of financial position.
The adjustment required to eliminate this unrealised profit would be:
Dr Cost of sales $500
Cr Inventory (SOFP) $500
Therefore, the consolidated cost of sales would be calculated as:
$54,990 + $17,940 – $5,000 + $500 = $68,430
The PUP is added back to cost of sales, which eliminates the unrealised profit. (Effectively what you are doing is adjusting the closing inventory that is part of the cost of sales figure).
However, in this particular question, by reading the question carefully you will see that eliminating the unrealised profit was a red herring as we were simply being asked for the consolidated revenue.
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/FFA exam question will require you to calculate goodwill.
Under this syllabus, the non-controlling interest (NCI) will be recorded at its fair value. Therefore, goodwill 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 goodwill calculation – cost, NCI and net assets. You should look at the specimen exam and extra MTQs available on the ACCA website.
Even though we might own less than 100% of the share capital, the goodwill calculation brings the full 100% of the goodwill onto 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 NCI in our goodwill calculation. See Illustration 4 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 example, for the cost of investment that would be recorded in the parent’s individual financial statements.
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 acquired.
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 Co 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 acquisition||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 FA/FFA 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 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 5).
Conversely, significant influence can still be demonstrated where less than 20% of the voting rights are obtained, usually evidenced by:
Once we have identified that significant influence 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 plus the parent’s share of post-acquisition retained profits (i.e. 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?
A 1 and 2
B 2 only
C 1 and 3
D 2 and 3
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): Do not 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 FA/FFA level, a good solid platform of understanding the principles of consolidation is required.
This is because, although we have used OT questions 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 exam (the full exam and the additional MTQs) for practice of the fuller consolidation exam questions. Your learning provider’s question banks and revision material will also provide further practice.
Practising full-length consolidation questions will help you to develop 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 FR and SBR studies.
When answering OT questions and MTQs, remember to:
Written by a member of the FA/FFA examining team