Consolidation Accounting

Business Combination
and Consolidation Methods
Financial Accounting - Code 30005
Agenda
Objective and Scope

Consolidation: main references
Consolidation of Financial Statements
The Consolidation Process
Agenda
Objective and Scope

Objective and Scope

WHAT HAPPENS?
PASSIVE
INVESTMENTS
IAS 39
SIGNIFICANCE
INFLUENCE
EQUITY METHOD
CONTROL
CONSOLIDATION
Agenda
Objective and Scope

The issue of consolidation arises when one company controls another

company (normally by acquiring its shares), but the latter continues to
exist as a separate entity and to keep its own assets and liabilities.
From an accounting point of view, this is the case in which we have a

group of companies and we have to prepare consolidated financial
statements.
Before 2011, there were basically four main standards dealing with the
issue of consolidation:
IAS 27 Consolidated and separate financial statements
IFRS 3 Business combinations
IAS 31 Interests in joint-ventures
IAS 28 Investments in associates
and a main interpretation standard contained in SIC 12, Consolidation
Special purpose entities.
Due to a number of unclear aspects and in response to a rising demand for

additional information, in May 2011 the IASB issued a new standard that
basically superseded IAS 27which now only deals with separate financial
statements and SIC 12: IFRS 10 Consolidated Financial Statements.
This new accounting standard is the major output of the IASBs consolidation
project, which led to a single and more comprehensive definition of control.
Moreover,
IASB
adopted
two
other
new
standards
(IFRS
11
Joint
Arrangements and IFRS 12 Disclosure of Interests in Other Entities) and

revised two existing standards (as already mentioned IAS 27 Separate
Financial Statements and IAS 28 Investments in Associates and Joint
Ventures).
All of the new standards are effective for annual periods beginning on or after
1 January 2013, even though their earlier application is allowed.
Agenda
Objective and Scope

Consolidation of financial statements:

some definitions
Consolidated financial statements are 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.
Separate financial statements are those presented by a parent (i.e. an

investor with control of a subsidiary) or an investor with joint control of, or
significant influence over, an investee, in which the investments are
accounted for at cost or in accordance with IFRS 9 Financial Instruments.
In
simple
words,
the
consolidated
financial
statements
are
those
representing the group as a whole and the separate financial statements

are those of the parent company as a single legal entity.
Consolidation of financial statements:

some definitions
A group is a parent and all its subsidiaries.
Non-controlling [or minority] interest is the equity in a subsidiary not

attributable, directly or indirectly, to a parent.
A parent is an entity that has one or more subsidiaries
A subsidiary is an entity, including an unincorporated entity such as a

partnership, that is controlled by another entity (known as the parent).
Subsidiaries exist when control is the continuing power to determine its
strategic, operating, investing, and financing policies, without the cooperation of others.
10
Consolidation of financial statements
The most common case in which we prepare consolidated accounts is when

a company acquires enough equity to control another company.
In order to understand better who has to prepare consolidated accounts,

control must be defined. However, the notion of control is not easily
defined, since one company can actually control another in several different
means (e.g. by owning the majority of its shares, by contractual
agreements, by other legitimate claims, ).
This is why IFRS use a broad definition of control, naming it as the power
to govern the operating and financial policies of an entity so as to
obtain benefits from its activities.
11
The concept of control
WHEN DOES CONTROL EXIST?
An investor controls an investee when it is exposed, or has rights, to variable returns from
its involvement with the investee and has the ability to affect those returns through its
power over the investee.
Thus, an investor controls an investee if and only if the investor has all the following:
power over the investee;
exposure, or rights, to variable returns from its involvement with the investee; and
the ability to use its power over the investee to affect the amount of the investors
returns.
An investor shall consider all facts and circumstances when assessing whether it controls
an investee. The investor shall reassess whether it controls an investee if facts and
circumstances indicate that there are changes to one or more of the three elements of
control listed in paragraph 7.
12
The concept of control
WHEN DOES CONTROL EXIST?
In
other
words,
IFRS
assume
that
control
exists
(and
therefore
consolidation is required) when the investor:

(a) possesses power over the investee,
(b) has exposure to variable returns from its involvement with the investee,
and
(c) has the ability to use its power over the investee to affect its returns.
If all the three conditions simultaneously hold we face a situation of control.
13
The concept of control:

summary scheme
Consolidation required
[IFRS10, 4]
Relevant activities [IFRS10, 10]
Definition [IFRS10, 10; IFRS10, 10 Appendix A]

Suggested activities [IFRS10, B11]
Rights
Examples of rights [IFRS10, B15]

Substantive rights [IFRS10, B22-25]
Contractual and voting rights [IFRS10, B34-50]
Power
Exposition or rights to variable returns [IFRS10, 15]

Elements
Control
Returns
characterizing control
Definition of variable returns [IFRS10, B56]

Examples of returns
[IFRS10, B57]
Link between power and returns [IFRS10, 17-18]
principal vs agent [IFRS10, B58-72]
Purpouse and design of an investee [IFRS10, B5-B8]

Other issues to consider
De facto agents [IFRS10, B73-75]
in evaluating control
Control over a specific asset [IFRS10, B76-79]

Continuous assessment [IFRS10, B80-85]
Consolidation excemption [IFRS10, 4]
14
The elements characterizing control

A. POWER
An entity (called investor) has power over another entity (called investee) when it
owns the current ability to direct the relevant activities of the latter.
What are relevant activities?
IFRS 10 defines relevant activities as the investees activities that significantly affect
the investees returns. In plain words, relevant activities are the one concerning all
the core operations of a firm.
Examples of activities that, depending on the circumstances, can be relevant

activities include (but are not limited to):
(a) selling and purchasing of goods or services;
(b) managing financial assets during their life (including upon default);
(c) selecting, acquiring or disposing of assets;
(d) researching and developing new products or processes; and
(e) determining a funding structure or obtaining funding. [IFRS 10 App B par. B11]
15
The ability to direct the relevant activities of the investee arises from some legal
rights the investor entity has over the investee, for instance voting rights coming
from the ownership of shares or some contractual agreements between them.
Examples of rights that, either individually or in combination, can give an investor

power include (but are not limited to):
(a) rights in the form of voting rights (or potential voting rights) of an investee;
(b) rights to appoint, reassign or remove members of an investees key management
personnel who have the ability to direct the relevant activities;
(c) rights to appoint or remove another entity that directs the relevant activities;
(d) rights to direct the investee to enter into, or veto any changes to, transactions for
the benefit of the investor; and
(e) other rights (such as decision-making rights specified in a management contract)
that give the holder the ability to direct the relevant activities. [IFRS 10 App B par.
B15]
16
Rights that give power to the investor may be straightforward to recognize,

such as when they come directly from the voting rights contained in the stocks
owned.
In other cases, such as in the presence of contractual provisions contained in
(usually long and complex) legal agreements, the assessment will be more
difficult and require considering more than one factor.
The following situations may provide evidence that the investors rights are
sufficient to give it power over the investee:
(a) The investor can, without having the contractual right to do so, appoint or
approve the investees key management personnel who have the ability to
direct the relevant activities.
(b) The investor can, without having the contractual right to do so, direct the
investee to enter into, or can veto any changes to, significant transactions for
the benefit of the investor.
(c) The investor can dominate either the nominations process for electing
members of the investees governing body or the obtaining of proxies from
other holders of voting rights.
(d) The investees key management personnel are related parties of the
investor (for example, the chief executive officer of the investee and the chief
executive officer of the investor are the same person).
17
(e) The majority of the members of the investees governing body are related
parties of the investor. [IFRS 10 App B para. B18]
When considering whether certain rights give the investor power over the
investee, we should pay attention that those rights are substantive.
Substantive rights are those rights which the holder can practically exercise.
Examples are the voting rights of ordinary shares, if the investor can
legitimately vote; if for any reason the voting rights are not exercisable by the
investor (for instance because the investee went bankrupt and now all the
voting rights are legally exercised by an appointed external entity, e.g. a bank)
those are not substantive and shall not be considered in assessing control.
Examples of substantial rights over relevant activities

The investee has annual shareholder meetings at which decisions to direct the
relevant activities are made. The next scheduled shareholders meeting is in eight
months. However, a special meeting can be set up by shareholders that
individually or collectively hold at least 5% of the voting rights with at least 30
days notice. Policies over the relevant activities can be changed only at special or
scheduled shareholders meetings.
18

Case A
An investor holds a majority of the voting rights in the investee. The
investors voting rights are substantive because the investor is able to
make decisions about the direction of the relevant activities when they
need to be made. The fact that it takes 30 days before the investor can
exercise its voting rights does not stop the investor from having the
current ability to direct the relevant activities from the moment the
investor acquires the shareholding.
Case B
An investor is party to a forward contract to acquire the majority of
shares in the investee. The forward contracts settlement date is in 25
days. The existing shareholders are unable to change the existing
policies over the relevant activities because a special meeting cannot be
held for at least 30 days, at which point the forward contract will have
been settled. Thus, the investor has rights that are essentially equivalent
to the majority shareholder in example A above (i.e. the investor holding
the forward contract can make decisions about the direction of the
relevant activities when they need to be made). The investors forward
contract is a substantive right that gives the investor the current ability
to direct the relevant activities even before the forward contract is
settled.
19
However in assessing investors power, we have also to check whether

its rights are only protective. Protective rights relate to
fundamental changes to the activities of an investee or apply in
exceptional circumstances.
Examples may be the right of a bank to pledge an asset of the

investee if the latter fails to meet specified loan repayment conditions,
or another lender that has a right over the investee which prevent it to
undertake some specific operations. It is easy to see that protective
rights do not guarantee their owner with a specific power over the
investee but are some kind of defensive (protective indeed)
mechanism. This is the reason why we do not observe power when the
investor has only protective rights.
20
Another important dimension to consider in order to assess the

investors power is the mixture of voting and contractual rights the
investor owns.
In fact, a right usually originates either from the ownership of the
investee, expressed through the ownership of the majority of its
shares, or from one or more specific contracts, or from a combination
of the two situations. Depending on how they combine, the voting and
the contractual rights may give rise to four different situations:
Contractual
agreement
More than 50% votes
Less than 50% votes
No contractual
agreement
A
21
In situation A, the investor has power over the investee if the voting
rights steaming out of the owned shares let the investor decide over the
relevant activities or let it appoint the majority of the members of the
governing body that directs the relevant activities But is it always the
case that majority of votes equals power? Remember that, even if the
investor owns more than 50 per cent of the voting rights, it still misses
the power over the investee if he holds non-substantive voting rights.
If we are in situation B, the investor does not own a sufficient number of
shares to let it have the majority of voting rights; however, in virtue of
some contractual arrangement with other investors, it can obtain such
majority and hence exert power over the investee.
With respect to situation C, we need to distinguish further.
A first case may arise when, even if the investor holds less than 50
per cent of voting rights, it still has the ability to control all the
relevant activities because all other investors are too small and too
disperse to actually organize and effectively contrast the investor
(e.g. public companies). In this case we talk about de facto control
22
De facto control describes the situation where an entity owns less than
50 per cent of the voting shares in another entity, but is deemed to have
control when it has the practical ability to direct the relevant activities
unilaterally.
When an investor is required to consider whether it has de facto control
over an investee, it must consider all the relevant facts and
circumstances including the following:
(a) the size of the investors holding of voting rights relative to the size
and dispersion of holdings of the other vote holders;
(b) potential voting rights held by the investor, other vote holders or
other parties (paragraphs B47B50);
(c) rights arising from other contractual arrangements (paragraph B40);
and
(d) any additional facts and circumstances that indicate the investor has,
or does not have, the current ability to direct the relevant activities at
the time that decisions need to be made, including voting patterns at
previous shareholders meetings [IFRS 10 App B par. B42].
23

Another case concerning situation C arises when the investor not
only owns ordinary shares, but also other instruments embedded
with potential voting rights, such as call options or warrants. In
this case, if the stake owned by the investor is a minority one but
after exercising the options it gets greater than 50 per cent, this
let the investor have power over the investee. However, attention
must be paid on whether the potential rights are substantial: only
if the investor can effectively and practically exercise its conversion
rights it will obtain the majority of votes.
EXAMPLES
An investor acquires 48 per cent of the voting rights of an
investee. The remaining voting rights are held by thousands of
shareholders, none individually holding more than 1 per cent of
the voting rights. There are no contractual agreements among
them. In this case, on the basis of the absolute size of its holding
and the relative size of the other shareholdings, the investor
concludes that it has a sufficiently dominant voting interest to
meet the power criterion without the need to consider any other
evidence of power.
24
Investor A holds 45 per cent of the voting rights of an investee. Two other
investors each hold 26 per cent of the voting rights of the investee. The
remaining voting rights are held by three other shareholders, each holding
1 per cent. There are no other arrangements that affect decision-making.
In this case, the size of investor As voting interest and its size relative to
the other shareholdings are sufficient to conclude that investor A does not
have power. Only two other investors would need to co-operate to be able
to prevent investor A from directing the relevant activities of the investee.
Investor A and two other investors each hold a third of the voting rights of
an investee. The investees business activity is closely related to investor A.
In addition to its equity instruments, investor A also holds debt instruments
that are convertible into ordinary shares of the investee at any time for a
fixed price that is out of the money (but not deeply out of the money). If
the debt were converted, investor A would hold 60 per cent of the voting
rights of the investee. Investor A would benefit from realizing synergies if
the debt instruments were converted into ordinary shares. Investor A has
power over the investee because it holds voting rights of the investee
together with substantive potential voting rights that give it the current
ability to direct the relevant activities.
25

B. RETURNS
In order to have control, the investor must be exposed to the investment,
whose returns can be either negative or positive, and variable.
In defining variable returns the standards are quite flexible, including all
the returns which can potentially vary according to the investees
performances. In this sense, even if an investor holds a bond with fixed
interest rate payments, such payments are deemed as variable returns
within IFRS 10, since they are subject to default risk and they expose the
investor to the credit risk of the issuer of the bond.
26

Examples of returns include:
(a)dividends, other distributions of economic benefits from an investee (e.g.
interest from debt securities issued by the investee) and changes in the value
of the investors investment in that investee.
(b)remuneration for servicing an investees assets or liabilities, fees and
exposure to loss from providing credit or liquidity support, residual interests
in the investees assets and liabilities on liquidation of that investee, tax
benefits, and access to future liquidity that an investor has from its
involvement with an investee.
(c) returns that are not available to other interest holders. For example, an
investor might use its assets in combination with the assets of the investee,
such as combining operating functions to achieve economies of scale, cost
savings, sourcing scarce products, gaining access to proprietary knowledge or
limiting some operations or assets, to enhance the value of the investors
other assets. [IFRS 10 App B par. B23]
27

C. LINK BETWEEN POWER AND RETURNS
The last element characterizing control is that the investor has the ability to use
its power over the investee to affect the amount of the investors returns. In
particular, the standards want to make sure that the power is held only by the
last effective controller of the investment.
There may be cases, for instance, where the investor may seem to have control
over the investee, but the investor itself has to respond to some other entity. If
an entity is primarily engaged to act on behalf and for the benefit of another
entity, is said to be an agent. In these cases of delegated power, we want to
make sure that the control (and hence the burden of consolidation) is assigned to
the entity with the power to delegate, i.e. the principal, not to the agent which is
exercising its decision-making authority on behalf of someone else.
A typical example is the one within investment funds, i.e. a fund that provides
investment opportunities to a number of investors. There, a fund manager must
make decisions in the best interests of all investors and has wide decisionmaking discretion. To make sure he or she acts in the interests of shareholders,
some compensation mechanism are set up (for instance he or she is paid 1 per
cent of the assets being managed and 20 per cent of the funds profits).
28

Is the fund manager a principal or an agent? In other words, who controls the
fund? The answer is: it depends!
Case A
The fund manager has a 2% investment in the fund that aligns its interests with
those of the other investors. The fund manager does not have any obligation to
fund losses beyond its 2% investment.
The fund manager is an agent. In fact, even if his 2% investment increases its
exposure to variability of returns from the activities of the fund, such exposure
is not significant.
Case B
The fund manager has a substantial pro rata investment in the fund, but does not
have any obligation to fund losses beyond that investment. The investors can
remove the fund manager by a simple majority vote, but only for breach of
contract.
The fund manager is a principal. Evidently, the combination of the fund managers
investment together with its remuneration could create exposure to variability
of returns from the activities of the fund that is of such significance that it
indicates that the fund manager is a principal. Moreover, the other investors
rights to remove the fund manager are considered to be protective rights
because they are exercisable only for breach of contract.
29

OTHER ISSUES TO CONSIDER IN EVALUATING CONTROL
When the three elements of control power, variable returns, and the link
between power and returns are present, we can conclude that an entity
(investor) controls another entity (investee). In this case, we are facing a
group and the controlling entity (the parent) has to consolidate the
controlled one (subsidiary).
However, even if the investor has the control over one or more investee, the
parent is exempted from presenting consolidated financial statements when:
it is itself a fully-owned or partially owned subsidiary (in the latter case
all its other owners need not to object to the parent not presenting
consolidated financial statements ), AND
its debt or equity instruments are not traded in a public market nor the
parent is about to request such issuing, AND
its ultimate or any intermediate parent produces consolidated financial
statements that are available for public use and comply with IFRSs.
Besides the above conditions, which prevent the parent to prepare
consolidated financial statements only if all simultaneously satisfied, postemployment benefit plans or other long-term employee benefit plans are never
included within the consolidation scope.
30
The concept of control:

summary scheme
31
Agenda
Objective and Scope

32
The Consolidation process
Most large corporations own controlling interests in other companies.

These interests appear in the balance sheet of the parent company among
assets, in most cases at cost. Using this valuation method does not give
any indication of the value of the subsidiary.
Consolidation
accounting
is
method
of
combining
the
financial
statements of subsidiaries with that of the parent company.
Consolidated statements combine the balance sheet, income statement

and other financial statements of the holding with those of the subsidiaries
into an overall set of statements as if the parent and its subsidiaries
were a single entity.
In different words, the assets, liabilities, revenues and expenses of each

subsidiary are added to the parents accounts as if the parents had
acquired directly the assets and liabilities of the subsidiary instead of
investing in its shares.
33
So, the purpose of a set of consolidated statements is to show the

financial situation of the group of companies as if they were one only
company, that is as if their activity were performed directly by the parent
company.
Therefore, the consolidation process doesnt consist only in adding up the

individual companies financial statements, but also in making them
consistent with each other and in eliminating all those items that
wouldnt be there if the activities were actually performed by the parent
company only (thus avoiding double counting).
34

The consolidation process can be described in a number of steps:
1.
2.
Collect the individual companies financial statements

Make them uniform as concerns:
3.
4.
5.
6.
7.
8.
the accounting periods dates

the accounting policies
the reporting currency
the format
Combine like items - aggregate situation

Offset (eliminate) the carrying amount of the parents investment in each
subsidiary, the parents portion of equity of each subsidiary (IFRS 3 explains how
to account for any related goodwill) and recognize any increase in subsidiaries
assets and liabilities
Recognize non-controlling interests
Eliminate any intra-group transactions
Allocation of the groups and minorities results
Close the consolidation process and prepare the statements
35
THE BASIC ENTRY OF CONSOLIDATION PROCESS: THE ELIMINATION OF THE

INVESTMENT IN THE SUBSIDIARIES
In order to understand better what consolidation means, lets start from a very
simple example.
Lets suppose we have a company, A, that wants to perform a new activity.
In order to perform the new activity A can decide to:

buy the necessary assets and perform the activity directly
buy all the shares of a separate company, B, that owns the necessary assets ,
and perform the activity in an indirect way, that is by controlling B.
Now lets suppose that the balance sheet of A at the moment it decides to start the
new activity is the following:
BALANCE SHEET
Cash 200
Liabilities 300
Other Assets 300
Owners equity 200
36

The cost of the assets necessary to perform the new activity is 100.
If A decides to perform the new activity directly, after the purchase of the assets
(e.g. plants) its balance sheet is the following:
BALANCE SHEET
Cash 100
Liabilities 300
Plants 100
Owners equity 200
Other Assets 300
37

If A decides to perform the new activity by purchasing the shares of a new company,
B, which owns only the necessary plants, the two companies balance sheets at the
starting moment would be the following:
BALANCE SHEET A
Cash 100
Liabilities 300
Investments 100
Owners equity 200
Other Assets 300

BALANCE SHEET B
Plants 100
Owners equity 100
38

If we want to prepare the consolidated balance sheet of the two companies, we need
to go back to the financial situation that we would have if the activity were performed
directly by A.
In practice, in consolidation accounting, we start from the addition of the two balance
sheets and then we eliminate all those items that would not be there if the two
companies were only one, that is if A had decided to perform the new activity
directly.
BALANCE SHEET A+B
Cash 100
Liabilities 300
Investments 100
Owners equity 300
200
Plants 100
Other Assets 300
39

When consolidated accounts are prepared on a date subsequent to acquisition, the

investments in subsidiary and the subsidiarys owners equity are not the
only items to be eliminated in the consolidation process.
All intercompany items (also called mirror items) like receivables and payables with
other subsidiaries, costs and revenues, profits and losses deriving from transactions
carried out between two companies included in the same consolidated financial
statement must be eliminated, since they would not appear in the financial
statements if the subsidiaries activities were performed by the parent company
directly.
40
THE CONSOLIDATION WORKSHEET
Companies are not required to prepare a journal book for their consolidation
accounting. Most of them use worksheets similar to the one reported below.
(1) Elimination of investments and related O.E.
41
THE CONSOLIDATION WORKSHEET

The first columns of the worksheet are reporting the individual financial
statements of all the companies included in the consolidation area
After that, we always have an Aggregate column, that results simply

from summing up the values reported, for each item, in the individual
financial statements
For each consolidation entry we use a different column. On the top of it

we report a number so that we can describe the entry at the bottom of the
worksheet
Note that, because of the double-entry system, the total assets always
equals total liabilities + owners equity. This must be true in each column
of the worksheet
Finally, the consolidated financial statements result, for each item, from
summing up the values in the aggregate column and those reported in
each following column.
42

Consolidation Accounting

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What are the main references related to consolidation?

What are the main references related to consolidation?

What is the basic entry of the consolidation process?

What is the basic entry of the consolidation process?

Business Combination

and Consolidation Methods

Financial Accounting - Code 30005

Objective and Scope

Financial Accounting - Code 30005

Objective and Scope

Financial Accounting - Code 30005

Objective and Scope

Financial Accounting - Code 30005

Objective and Scope

Financial Accounting - Code 30005

Consolidation: main references

The issue of consolidation arises when one company controls another

From an accounting point of view, this is the case in which we have a

Financial Accounting - Code 30005

Consolidation: main references

Due to a number of unclear aspects and in response to a rising demand for

Arrangements and IFRS 12 Disclosure of Interests in Other Entities) and

Financial Accounting - Code 30005

Objective and Scope

Financial Accounting - Code 30005

Consolidation of financial statements:

Consolidated financial statements are the financial statements of a

Separate financial statements are those presented by a parent (i.e. an

representing the group as a whole and the separate financial statements

Financial Accounting - Code 30005

Consolidation of financial statements:

A group is a parent and all its subsidiaries.

Non-controlling [or minority] interest is the equity in a subsidiary not

A parent is an entity that has one or more subsidiaries

A subsidiary is an entity, including an unincorporated entity such as a

Financial Accounting - Code 30005

Consolidation of financial statements

The most common case in which we prepare consolidated accounts is when

In order to understand better who has to prepare consolidated accounts,

Financial Accounting - Code 30005

The concept of control

WHEN DOES CONTROL EXIST?

Financial Accounting - Code 30005

The concept of control

WHEN DOES CONTROL EXIST?

consolidation is required) when the investor:

If all the three conditions simultaneously hold we face a situation of control.

Financial Accounting - Code 30005

The concept of control:

Relevant activities [IFRS10, 10]

Definition [IFRS10, 10; IFRS10, 10 Appendix A]

Examples of rights [IFRS10, B15]

Exposition or rights to variable returns [IFRS10, 15]

Definition of variable returns [IFRS10, B56]

Link between power and returns [IFRS10, 17-18]

principal vs agent [IFRS10, B58-72]

Purpouse and design of an investee [IFRS10, B5-B8]

De facto agents [IFRS10, B73-75]