The preparation of consolidated financial statements is a key element of the Financial Reporting (FR) exam. It can be an area where candidates perform extremely well but can also be an area where candidates make simple mistakes which could prove costly.

This article will not focus on the more technical, difficult adjustments that can arise within consolidated financial statements but will, instead, look at the most common errors that candidates make. These are the items that the FR examining team see repeatedly. Many of these errors are easy to make in a time-pressured exam. The good news is that they are also quite simple to fix. By avoiding these errors, candidates will be able to significantly improve their mark and their chances of progressing to the next stage.

This article also looks at equity accounting (for associates) and is a reminder of how it differs from acquisition accounting (for subsidiaries).

Before we look at these errors, we need to remind ourselves of some key principles surrounding the preparation of consolidated financial statements. If candidates are able to keep these key principles in mind, then hopefully they can avoid some of the most common (and costly) errors that we will outline below.

Key principles in consolidation

Control – We show control by adding in 100% of the items of the parent and the subsidiary. There are no exceptions to this. Even in a mid-year acquisition in the consolidated statement of profit or loss (CSPL) (where we time-apportion the results of the subsidiary), we still bring in 100% of the subsidiary’s income and expenses but restrict it for the period owned.

Ownership – We must remember that there are two owners of the group. The parent’s shareholders own the majority of the group (owning 100% of the parent, and therefore a majority holding in the subsidiary) and the ‘non-controlling interests’ (NCI). Although considered as a single element, ‘NCI’ may represent one or more other shareholders. Candidates are very good at remembering to reflect the amounts attributable to the different owners in the consolidated statement of financial position (CSFP) but generally perform less well in this aspect when preparing the CSPL (see error 2)

So, here are our ‘top five’ errors. They are worth being aware of. We have ranked these in order of how common they are.

Error 1 – Forgetting to time apportion the CSPL in mid-year acquisitions

When candidates have previously been asked to prepare a CSPL in an exam, it has often been that the company has acquired the subsidiary during the year. If this is the case, a fundamental principle of the CSPL is that the income and expenses are only consolidated from the date of acquisition.

This is easy to overlook but be ready for it. Dates are given in the scenario for a reason and should always be considered. A key part of preparing a CSPL is to check the date of acquisition before you attempt the question. Be ready for it to have been acquired during the year.

If it is a mid-year acquisition, instead of adding all of the income and expenses of the parent and subsidiary company, you add all of the parent’s income and expenses to the time-apportioned income and expenses of the subsidiary. So, if the parent acquired the subsidiary on 1 October 20X1 and the year-end is 31 December 20X1, you should only include three months of the subsidiary’s results.

This is deemed as a fundamental error. If you fail to do this, you can lose all marks for the basic principle of consolidating the results of the parent and subsidiary. You will still be able to gain marks for the adjustments made, but you will lose the simple ‘adding up’ marks for consolidating the income and expenses of the parent and subsidiary.

Error 2 – Omitting the NCI in the CSPL

This has become increasingly common, leading to students dropping numerous marks for failing to apply a core principle in the CSPL. The two major functions of the CSPL are:

1. It shows the total profits made by the group during the year – this is why we add all of the income and expenses of the parent and the subsidiary (time-apportioned for the subsidiary if necessary (see error 1); and
2. It shows  profits is attributable to owners of the parent and NCI at the bottom of the CSPL.

Generally, students recognise the importance of point (1) above but increasingly neglect point (2). This is an essential part of a CSPL.

Error 3 – One-sided adjustments

This error could be applied across any question where candidates are preparing financial statements and where the principles of double entry are forgotten, especially when preparing the CSFP.

Often, we see candidates calculate the correct figure for an adjustment and place that adjustment into one of the two (or more) correct areas of the financial statements. This means that candidates who do not fully understand adjustments can be losing up to half of the marks available for that item.

As a quick guide, here is a reminder of some of the key adjustments where this error occurs and the candidates should identify the two correct sides to the entry. The side most commonly omitted by candidates is shown in bold:

• Fair value adjustments – Increase non-current assets, increase subsidiary’s net assets at acquisition
• Fair value depreciation – Decrease non-current assets, decrease subsidiary’s post-acquisition net assets
• Unrealised profits – Decrease profit/ retained earnings of the seller, decrease inventories (or non-current assets if transfer is a non-current asset)
• Deferred consideration – Add to goodwill as part of consideration, add to liabilities
• Paying for a subsidiary in shares – Add to goodwill as part of consideration, add to the share capital/share premium of the parent

Error 4 – Time apportioning the assets and liabilities in the CSFP

The fourth error is the opposite of what we have seen in error 1, and it is less common. It is essential that students note the difference between a statement of profit or loss and a statement of financial position.

A statement of profit or loss has income and expenses accruing over a period and so requires time-apportionment of the subsidiary results.

A statement of financial position shows the assets and liabilities controlled by the entity at the reporting date. If the parent has control of the subsidiary at the reporting date, then all of the assets and liabilities of the subsidiary must be added in. At the year-end, the group control 100% of these assets and so all of them must be included.

The golden rule is this: NEVER time-apportion the assets and liabilities in consolidation. The only element of time-apportioning needed is any depreciation on a fair value adjustment between the acquisition date and the year end (ie the subsequent effect of accumulated depreciation). You would still, however, add 100% of the remaining assets and liabilities of the subsidiary into the CSFP at the reporting date.

Error 5 – Proportionate consolidation

A student who applies proportionate consolidation does not include 100% of the assets and liabilities of a subsidiary in a CSFP or income and expenses in a CSPL. Instead, they only apply the percentage that the parent owns in the subsidiary. Therefore, if the parent owns 80% of the subsidiary, these candidates add in 80% of the subsidiary’s assets, liabilities, income or expenses.

This is never the correct way to prepare consolidated financial statements including a subsidiary and any candidate doing this is making a severe and fundamental error.

Equity accounting

It is also important to note that acquisition accounting refers to the accounting required where the parent company controls another entity (subsidiary). Candidates should not confuse this with equity accounting, which is related to associate companies where significant influence is presumed with a shareholding between 20-50%. The following is a summary of equity accounting but you should refer to other learning materials for further detail.

CSPL
Do not consolidate a proportion of income and expenses line by line (common error) but present a single ‘Share of profit of associate’ line in the CSPL. This is presented after operating profit and immediately prior to profit before financing and income taxes. This is the parent’s share of the associate’s profit (time apportioned if appropriate).

CSFP
As for the CSFP, do not consolidate a proportionate share of assets and liabilities line by line (common error) but, instead, include in the CSFP a single ‘Investment in associate’ line under non-current assets. This is calculated as follows:

Another common error with equity accounting relates to the adjustment for unrealised profit where trade has occurred between the parent and the associate. A distinction is made between upstream and downstream transactions with the following adjusting journal entries required for an intragroup transfer of goods between a parent and its associate:

Upstream:
DR Share of profit of associate
     CR Inventories

Downstream:
DR Cost of sales
     CR Investment in associate

However, a common error is to calculate and adjust the unrealised profit in the same way as you would for a subsidiary. Candidates must remember to only adjust for the group % of the unrealised profit.

Summary

In conclusion, the preparation of consolidated financial statements is a key area for the FR exam. There are many technical aspects to these questions and question practice is crucial. If you keep the above key principles in mind, you will avoid dropping marks on the less complex areas:

• Time-apportion the subsidiary’s income/ expenses if mid-year
• Remember to include the NCI in a CSPL
• Ensure you process a double entry for all consolidation adjustments
• Never time-apportion assets or liabilities
• Never apply proportionate consolidation (equity accounting) to subsidiaries

So, take those tips away and know that you are protected from some of the more costly individual errors. Ensure you practice the CSPL as these questions are commonly less well done. This topic is important for both FR and Strategic Business Reporting, so it is essential to lock in the fundamentals.

Written by a member of the FR examining team