Chapter

16

Principles of
consolidated financial
statements
Chapter learning objectives

Upon completion of this chapter you will be able to:

• describe the concept of a group as a single economic unit

• explain the objective of consolidated financial statements
• explain and apply the definition of a subsidiary according to
IFRS 10
• identify circumstances in which a group is required to
prepare consolidated financial statements and those when it
can claim exemption
• explain why directors may not wish to consolidate a
subsidiary
• list the circumstances where it is permitted not to consolidate
a subsidiary
• explain the need for using coterminous year ends and
uniform accounting policies when preparing consolidated
financial statements
• explain why it is necessary to eliminate intra-group
transactions.

KAPLAN PUBLISHING 367

Principles of consolidated financial statements

1 The concept of group accounts

What is a group?

If one company owns more than 50% of the ordinary shares of another
company:
• this will usually give the first company ‘control’ of the second company
• the first company (the parent company, P) has enough voting power to
appoint all the directors of the second company (the subsidiary company,
S)
• P is able to manage S as if it were merely a department of P, rather than a
separate entity
• in strict legal terms P and S remain distinct, but in economic substance
they can be regarded as a single unit (a ‘group’).

368 KAPLAN PUBLISHING

 Chapter 16

Group concept
Although from the legal point of view, every company is a separate entity,
from the economic point of view companies may not be separate.
In particular, when one company owns enough shares in another
company to have a majority of votes at that company’s annual general
meeting (AGM), the first company may appoint all the directors of, and
decide what dividends should be paid by, the second company.
This degree of control enables the first company to manage the trading
activities and future plans of the second company as if it were merely a
department of the first company.
International accounting standards recognise this situation, and require a
parent company to produce consolidated financial statements showing
the position and results of the whole group.

Group accounts

The key principle underlying group accounts is the need to reflect the economic
substance of the relationship.

• P is an individual legal entity.

• S is an individual legal entity.
P controls S and therefore they form a single economic entity – the Group.

KAPLAN PUBLISHING 369

Principles of consolidated financial statements

The single economic entity concept

The purpose of consolidated accounts is to:
• present financial information about a parent undertaking and its
subsidiary undertakings as a single economic unit
• show the economic resources controlled by the group
• show the obligations of the group, and
• show the results the group achieves with its resources.
Business combinations consolidate the results and net assets of group
members so as to display the group’s affairs as those of a single
economic entity. As already mentioned, this conflicts with the strict legal
position that each company is a distinct entity. Applying the single entity
concept is a good example of the accounting principle of showing
economic substance over legal form.

Consolidated financial statements under the single entity concept

This is by far the most common form of group accounts. Consolidated
financial statements are prepared by replacing the cost of investment with
the individual assets and liabilities underlying that investment. If the
subsidiary is only partly owned, all the assets and liabilities of the
subsidiary are still consolidated, but the non-controlling shareholders’
interest in those net assets is also presented.
The single economic unit concept focuses on the existence of the
group as an economic unit rather than looking at it only through the eyes
of the dominant shareholder group. It concentrates on the resources
controlled by the entity.
This will mean that intra-group transactions will need to be removed,
meaning that no income, expenses, assets or liabilities are included that
have arisen from transactions between entities within the group.

Group financial statements

Group financial statements could be prepared in various ways, but in
normal circumstances the best way of showing the results of a group is to
imagine that all the transactions of the group had been carried out by a
single equivalent entity and to prepare a statement of financial position, a
statement of profit or loss and a statement showing other comprehensive
income for that entity.
Such statements are called consolidated financial statements. Note that
consolidated statements of cash flow are outside the FR syllabus.

370 KAPLAN PUBLISHING

 Chapter 16

There are three IFRS Standards within the FR syllabus relevant to the
preparation of consolidated financial statements:
• IFRS 3 Business Combinations (revised January 2008)
• IFRS 10 Consolidated Financial Statements (issued May 2011)
• IAS 28 Investments in Associates and Joint Ventures (revised May
2011).
Each company in a group prepares its own accounting records and
annual financial statements in the usual way. From the individual entities’
financial statements, the parent prepares consolidated financial
statements.
In addition to the above accounting standards dealing with the
preparation of consolidated financial statements, the IASB has now
issued:
• IFRS 12 Disclosure of Interests in Other Entities (not examinable in
FR).

2 Definitions
IFRS 10 Consolidated Financial Statements uses the following definitions
in Appendix A:
• 'parent – an entity that controls one or more entities'
• 'subsidiary – an entity that is controlled by another entity' (known as
the parent)
• 'control of an investee – an investor controls an investee when the
investor 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.'

Requirements for consolidated financial statements

IFRS 10 outlines the circumstances in which a group is required to prepare

consolidated financial statements.
Consolidated financial statements should be prepared when the parent
company has control over the subsidiary (for examination purposes control is
usually established based on ownership of more than 50% of voting power).
Control is identified by IFRS 10 as the sole basis for consolidation and
comprises the following three elements:
• 'power over the investee
• exposure, or rights, to variable returns from its involvement with the
investee
• the ability to use its power over the investee to affect the amount of
the investor's returns' (IFRS 10, para 7)

KAPLAN PUBLISHING 371

Principles of consolidated financial statements

IFRS 10 adopts a principles-based approach to determining whether or not

control is exercised in a given situation, which may require the exercise of
judgement. One outcome is that it should lead to more consistent judgements
being made, with the consequence of greater comparability of financial
reporting information.
IFRS 10 states that investors should periodically consider whether control over
an investee has been gained or lost and goes on to consider that a range of
circumstances may need to be considered when determining whether or not an
investor has power over an investee, such as:
• exercise of the majority of voting rights in an investee
• contractual arrangements between the investor and other parties holding
less than 50% of the voting shares, with all other equity interests held by a
numerically large, dispersed and unconnected group
• potential voting rights (such as share options or convertible loans) may
result in an investor gaining or losing control at some specific date.

Exemption from preparation of group financial statements

A parent need not present consolidated financial statements if and only if:
• the parent itself is a wholly owned subsidiary or a partially-owned
subsidiary and its owners, including those not otherwise entitled to vote,
have been informed about, and do not object to, the parent not preparing
consolidated financial statements• the parent's debt or equity instruments
are not traded in a public market
• the parent did not file its financial statements with a securities commission
or other regulatory organisation for the purpose of issuing any class of
instruments in a public market
• the ultimate parent company produces consolidated financial statements
that comply with IFRS Standards and are available for public use.

3 IAS 27 Separate Financial Statements

When exemption from the preparation of financial statements is permitted, IAS
27 Separate Financial Statements requires that the following disclosures are
made:
• the fact that consolidated financial statements have not been presented
• a list of significant investments (subsidiaries, associates etc.) including
percentage shareholding, principal place of business and country of
incorporation
• the bases on which those investments listed above have been accounted
for in its separate financial statements.

372 KAPLAN PUBLISHING

 Chapter 16

Reasons for wanting to exclude a subsidiary

The directors of a parent company may not wish to consolidate some
subsidiaries due to:
• poor performance of the subsidiary
• poor financial position of the subsidiary
• differing activities of the subsidiary from the rest of the group.
These reasons are not permitted under IFRS Standards.

Excluded subsidiaries
IFRS 10 and IAS 27 (revised) do not specify any other circumstances
when subsidiaries must be excluded from consolidation. However, there
may be specific circumstances that merit particular consideration as
follows:
Reason for
Accounting treatment
exclusion
Subsidiary held Held as current asset investment at the lower of
for resale carrying amount and fair value less costs to sell.
Materiality Accounting standards do not apply to immaterial
items. Therefore an immaterial item need not be
consolidated.

Subsidiary held for resale

If on acquisition a subsidiary meets the criteria to be classified as ‘held for
sale’ in accordance with IFRS 5, then it must still be included in the
consolidation but accounted for in accordance with that standard. The
parent's interest will be presented separately as a single figure on the
face of the consolidated statement of financial position, rather than being
consolidated as a subsidiary.
This might occur when a parent has acquired a group with one or more
subsidiaries that do not fit into its long-term strategic plans and are
therefore likely to be sold. In these circumstances the parent has clearly
not acquired the investment with a view to long-term control of the
activities, hence the logic of the exclusion.

Materiality
If a subsidiary is excluded on the grounds of immateriality, the case must
be reviewed from year to year, and the parent would need to consider
each subsidiary to be excluded on this basis, both individually and
collectively. Ideally, a parent should consolidate all subsidiaries which it
controls in all accounting periods, rather than report changes in the
corporate structure from one period to the next.

KAPLAN PUBLISHING 373

Principles of consolidated financial statements

Non-coterminous year ends

Some companies in the group may have differing accounting dates. In
practice such companies will often prepare financial statements up to the
group accounting date for consolidation purposes.
For the purpose of consolidation, IFRS 10 states that where the reporting
date for a parent is different from that of a subsidiary, the subsidiary
should prepare additional financial information as of the same date as the
financial statements of the parent unless it is impracticable to do so.
If it is impracticable to do so, IFRS 10 allows use of subsidiary financial
statements made up to a date of not more than three months earlier or
later than the parent's reporting date, with due adjustment for significant
transactions or other events between the dates.

Uniform accounting policies

'If a member of a group uses accounting policies other than those
adopted in the consolidated financial statements for like
transactions and events in similar circumstances, appropriate
adjustments are made to that group member's financial statements
in preparing the consolidated financial statements to ensure
conformity with the group's accounting policies' (IFRS 10, para B87).

374 KAPLAN PUBLISHING

 Chapter 16

4 Chapter summary

KAPLAN PUBLISHING 375

Principles of consolidated financial statements

Test your understanding 1

1 Which of the following definitions is not included within the
definition of control per IFRS 10?
A Having power over the investee
B Having exposure, or rights, to variable returns from its
investment with the investee
C Having the majority of shares in the investee
D Having the ability to use its power over the investee to affect
the amount of the investor’s returns

2 Which of the following situations is unlikely to represent

control over an investee?
A Owning 55% and being able to elect 4 of the 7 directors
B Owning 51 %, but the constitution requires that decisions need
the unanimous consent of shareholders
C Having currently exercisable options which would take the
shareholding of the company to 55%
D Owning 40% of the shares, but having the majority of voting
rights within the company

3 Which of the following is NOT a condition which must be met

for the parent to be exempt from producing consolidated
financial statements?
A The activities of the subsidiary are significantly different to the
rest of the group and to consolidate them would prejudice the
overall group position
B The ultimate parent company produces consolidated financial
statements that comply with IFRS Standards and are publicly
available
C The parent’s debt or equity instruments are not traded in a
public market
D The parent itself is a wholly-owned subsidiary or a partially-
owned subsidiary whose owners do not object to the parent
not producing consolidated financial statements

376 KAPLAN PUBLISHING

 Chapter 16

4 Which of the following statements regarding consolidated

financial statements is correct?
A For consolidation, it may be acceptable to use financial
statements of the subsidiary if the year-end differs from the
parent by 2 months
B For consolidation, all companies within the group must have
the same year-end
C All companies within a group must have the same accounting
policy in their individual financial statements
D Only 100% subsidiaries need to be consolidated

KAPLAN PUBLISHING 377