Getting to grips with consolidated accounts

The purpose of consolidated accounts is to present the financial situation of a group of companies as if they formed one single entity. This chapter deals with the basic aspects of consolidation that anyone interested in corporate finance should fully master.

An analysis of the accounting documents of each individual company belonging to a group does not serve as a very accurate or useful guide to the economic health of the whole group. The accounts of a company reflect the other companies that it controls only through the cost of its shareholdings (revalued or written down, where appropriate) and the size of the dividends that it receives. Consolidation is intended to remedy these deficiencies.

The purpose of consolidated accounts is to present the financial situation of a group of companies as if they formed one single entity.

The goal of this chapter is to familiarise readers with the problems arising from consolidation. Consequently, we present an example-based guide to the main aspects of consolidation to facilitate analysis of consolidated accounts. In some cases, consolidated accounts take some time to come out or do not even exist.1 That said, for various reasons financial analysts may need to know, albeit only approximately, some of the key consolidated figures, such as earnings and shareholders’ equity.

Consolidation methods

Any firm that controls other companies exclusively or that exercises significant influence over them should prepare consolidated accounts and a management report for the group.

Full consolidation

The accounts of a subsidiary are fully consolidated if it is controlled by its parent. Control is presumed to exist when the parent company:

• holds, directly or indirectly, over 50% of the voting rights in its subsidiary;
• holds, directly or indirectly, less than 50% of the voting rights but has power over more than 50% of the voting rights by virtue of an agreement with other investors;
• has power to govern the financial and operating policies of the subsidiary under a statute or an agreement;
• has power to cast the majority of votes at meetings of the board of directors; or
• has power to appoint or remove the majority of the members of the board.

The criterion of exclusive control is the key factor under IAS. Under US GAAP, the determining factor is whether or not the parent company holds the majority of voting rights. This requirement is currently being revised by the FASB7 and the IASB. They want to introduce a broader definition of control, such as the power to make decisions regarding the company’s strategy and management with a view to increase its own profits or limiting its losses.

As its name suggests, full consolidation consists in transferring all the subsidiary’s assets, liabilities and equity to the parent company’s balance sheet and all the revenues and costs to the parent company’s income statement.

The assets, liabilities and equity thus replace the investments held by the parent company, which therefore disappear from its balance sheet. That said, when the subsidiary is not controlled exclusively by the parent company, the claims of the other ‘‘minority’’ shareholders on the subsidiary’s equity and net income also need to be shown on the consolidated balance sheet and income statement of the group.

Assuming there is no difference between the book value of the parent’s investment in the subsidiary and the book value of the subsidiary’s equity,8 full consolidation works as follows:

• On the balance sheet: e the subsidiary’s assets and liabilities are added item by item to the parent company’s balance sheet; e the historical cost amount of the shares in the consolidated subsidiary held by the parent is eliminated from the parent company’s balance sheet and the same amount is deducted from the parent company’s reserves; e the subsidiary’s equity (including net income) is added to the parent company’s equity and then allocated between the interests of the parent company (added to its reserves) and those of minority investors, which is added to a special minority interests line below the line item showing the parent company’s shareholders’ equity.
• On the income statement, all the subsidiary’s revenues and charges are added item by item to the parent company’s income statement. The parent company’s net income is then broken down into: e the portion attributable to the parent company, which is added to the parent company’s net income on both the income statement and the balance sheet; e the portion attributable to third-party investors, which is shown on a separate line of the income statement under the heading ‘‘minority interests’’.

From a solvency standpoint, minority interests certainly represent shareholders’ equity. But from a valuation standpoint, they add no value to the group since minority interests represent shareholders’ equity and net profit attributable to third parties and not to shareholders of the parent company.

Right up until the penultimate line of the income statement, financial analysis assumes that the parent company owns 100% of the subsidiary’s assets and liabilities and, implicitly, that all the liabilities finance all the assets. This is true from an economic, but not from a legal perspective.

To illustrate the full consolidation method, consider the following example assuming that the parent company owns 75% of the subsidiary company.

Proportionate consolidation

When the parent company exercises joint control with a limited number of partners over another company, this company is accounted for using the proportionate consolidation method. The key factors determining joint control are: (i) a limited number of partners sharing control (without any partner able to claim exclusive control), and (ii) a contractual arrangement outlining and defining how this joint control is to be exercised.

Proportionate consolidation is used to consolidate the accounts of companies controlled jointly with a limited number of partners. Such companies are known as joint ventures. Similar to full consolidation, proportionate consolidation leads to the replacement of the investment held in the joint venture with the assets, liabilities and equity of the joint venture. As its name suggests, the key difference with respect to full consolidation is that assets and liabilities are transferred to the parent company’s balance sheet only in proportion to the parent company’s interest in the joint venture. Likewise, the joint venture’s revenues and charges are added to those of the parent company on the consolidated income statement only in proportion to its participation in the joint venture.

From a technical standpoint, proportionate consolidation is carried out as follows:

• the joint venture’s assets and liabilities are added to the parent company’s assets and liabilities in proportion to the latter’s interest in the joint venture;
• the carrying amount of the shares in the joint venture held by the parent company is subtracted from long-term investments and from reserves in the balance sheet;
• the parent company’s share in the shareholders’ equity of the joint venture excluding the latter’s net income is added to the parent company’s reserves;
• all the joint venture’s revenues and charges are added in proportion to the level of the parent company’s shareholding to the corresponding line items of the parent company’s income statement;
• the portion of the joint venture’s net income attributable to the parent company is added to its net income on the balance sheet and income statement.

Equity method of accounting

Finally, when the parent company exercises significant influence over the operating and financial policy of its associate, the latter is accounted for under the equity method. Significant influence over the operating and financial policy of a company is assumed when the parent holds, directly or indirectly, at least 20% of the voting rights. Significant influence may be reflected by participation on the executive and supervisory bodies, participation in strategic decisions, the existence of major intercompany links, exchanges of management personnel and a relationship of dependence from a technical standpoint.

Equity accounting consists in replacing the carrying amount of the shares held in an associate (also known as an equity affiliate or associated undertaking) with the corresponding portion of the associate’s shareholders’ equity (including net income).

This method is purely financial. Both the group’s investments and aggregate profit are thus reassessed on an annual basis. Accordingly, the IASB regards equity accounting as being more of a valuation method than a method of consolidation.

From a technical standpoint, equity accounting takes place as follows:

• the historical cost amount of shares held in the associate is subtracted from the parent company’s investments and replaced by the share attributable to the parent company in the associate’s shareholders’ equity including net income for the year;
• the carrying value of the associate’s shares is subtracted from the parent company’s reserves, to which is added the share in the associate’s shareholders’ equity, excluding the associate’s income attributable to the parent company;
• the portion of the associate’s net income attributable to the parent company is added to its net income on the balance sheet and the income statement.

Investments in associates represent the share attributable to the parent company in associates shareholders’ equity attributable to the parent company. The equity method of accounting therefore leads to an increase each year in the carrying amount of the shareholding on the consolidated balance sheet, by an amount equal to the net income transferred to reserves by the associate.

However, from a solvency standpoint, this method does not provide any clues to the group’s risk exposure and liabilities vis-a`-vis its associate. The implication is that the group’s risk exposure is restricted to the value of its shareholding. The equity method of accounting is more a method used to revalue certain participating interests than a genuine form of consolidation.