Question

There are several theories to application accounting for combination and consolidation of business and there are many methods to measure the consolidation, explain these theories and measurement methods?

Answer 1

Difference between Combination and consolidation

Combined Financial Statements

A combined financial statement shows financial results of different subsidiary companies from that of the parent company. The complete financial statement of one subsidiary is shown separately from another as a stand-alone company. The benefit of combined financial statements is that it allows an investor to analyze the results and gauge the performance of the individual subsidiary companies separately.

Consolidated Financial Statements

Consolidated financial statements aggregate the financial position of a parent company and its subsidiaries. This allows an investor to check the overall health of the company in a holistic manner rather than viewing the individual company's financial statements separately. In other words, the consolidated financial statements agglomerates the results of the subsidiary businesses into the parent company's income statement, balance sheet and cash flow statement.

Consolidation Theories

1) Parent Company Theory

This theory assumes that consolidated financial statements are an extension of parent company statements and should be prepared from the viewpoint of the parent company stockholders. Advocates of this theory believe that consolidated financial statements do not provide any value to the non-controlling stockholders of the acquired subsidiary.The parent company theory has unique characteristics in the way certain elements of the consolidated financial statements are disclosed when a non-controlling interest is present. When net income for the consolidated entity is reported, the parent company theory only takes into account the parent company’s share of subsidiary income. If a noncontrolling interest exists, the non-controlling interest share of net income is deemed to be an expense. The non-controlling interest in the subsidiary is reported as a liability on the consolidated financial statements. Unrealized gains and losses from upstream sales are eliminated to the extent of the parent company’s ownership percentage in the subsidiary. The existence of a non-controlling interest also impacts the way the assets acquired in the business combination are presented in consolidated financial statements. While the parent company theory uses fair values of the acquired assets and liabilities, the theory is implemented using a hybrid approach to reporting the fair values. Thus, the parent-company theory initially consolidates subsidiary assets at their book values, plus the parent company’s share of any excess fair value over book values. However, the non-controlling interest share of net assets is not adjusted to reflect their share of the excess between fair value and book value

While this theory may be appropriate to use when the parent company acquires 100% of the subsidiary, the information it provides loses relevance when a noncontrolling interest is present. First, shareholder interests, whether controlling or noncontrolling, are not liabilities under any of the accepted concepts of a liability, and income to shareholders does not meet the requirements for expense recognition. Another weakness is that the amount of acquired assets and liabilities reported in the consolidated financial statements falls short of fair value reporting. Although this approach reflects the cost principle from the viewpoint of the parent company, it leads to inconsistent treatment of controlling and non-controlling interests in the consolidated financial statements and to a balance sheet valuation that reflects neither historical cost nor fair value. Two other theories sought to improve on these weaknesses as accounting applications of the acquisition method of business combinations evolved

2) Contemporary/Entity Theory

The contemporary/entity theory differs from the parent-company theory in that the consolidated financial statements prepared under this approach take into account the total entity created by the parent company and the subsidiary. This theory creates consolidated financial statements that will provide value to various groups including the parent company shareholders, non-controlling shareholders of the subsidiary, and creditors. Under the entity theory, the controlling shareholders, non-controlling shareholders, and consolidated entity are considered equal, with no preference or emphasis given to group. The contemporary/entity theory differs from the parent-company theory in that the consolidated financial statements prepared under this approach take into account the total entity created by the parent company and the subsidiary. This theory creates consolidated financial statements that will provide value to various groups including the parent company shareholders, non-controlling shareholders of the subsidiary, and creditors. Under the entity theory, the controlling shareholders, non-controlling shareholders, and consolidated entity are considered equal, with no preference or emphasis given to group. There are additional differences between the parent company theory and the entity theory in the manner in which assets of the subsidiary are valued. The entity theory consolidates subsidiary assets and liabilities at their fair values, and it accounts for the controlling and non-controlling interests in those net assets consistently. The fair value of the subsidiary’s assets is derived from the purchase price paid for a given percentage of ownership in the subsidiary

3) Traditional/Hybrid Theory

The traditional theory of consolidation incorporates characteristics of the parent company theory and the contemporary/entity theory. The consolidated statements prepared using the traditional theory are intended to benefit the parent company shareholders, as is the case with the parent company theory, and a wider audience that includes the parent company’s creditors. However, the non-controlling interest of the subsidiary that is highlighted by the entity theory is still lost. The traditional theory improves on the parent company theory’s accounting for the non-controlling interest. While the traditional theory calculates consolidated net income using a similar process as used in the parent company theory, it avoids reporting the non-controlling interest as an expense and a liability. The preferred accounting practices under traditional theory report non-controlling interest as a reduction of consolidated net income and an increase to equity that is essentially a wash to overall equity.The traditional theory also implements characteristics of both parent company theory and entity theory in its approach to valuing assets of the acquired subsidiary and the elimination of unrealized gains and losses from upstream sales. When the assets of the acquired subsidiary are consolidated, the traditional theory follows the same process as the parent company theory and consolidates subsidiary assets at their book values, plus the parent company’s share of any excess fair value over book values. However, elimination of unrealized gains and losses arising from upstream sales under the traditional theory follows a process similar to that used under the entity theory.

Accounting theories of Business Combination

IFRS 3 establishes principles and requirements for how an acquirer in a business combination:

• recognises and measures in its financial statements the assets and liabilities acquired, and any interest in the acquiree held by other parties;
• recognises and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and
• determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination.

The core principles in IFRS 3 are that an acquirer measures the cost of the acquisition at the fair value of the consideration paid; allocates that cost to the acquired identifiable assets and liabilities on the basis of their fair values; allocates the rest of the cost to goodwill; and recognises any excess of acquired assets and liabilities over the consideration paid (a ‘bargain purchase’) in profit or loss immediately. The acquirer discloses information that enables users to evaluate the nature and financial effects of the acquisition.

Measurement Methods Of Consolidations

1) Full Consolidation Method

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 Expenses to the Parent company's Income statement. The accounts of a Subsidiary are fully consolidated if it is controlled by its parent.

2) Equity Method

The equity method is a type of accounting used for intercorporate investments. This method is used when the investor holds significant influence over the investee but does not exercise full control over it, as in the relationship between a parent company and its subsidiary. In this case, the terminology of “parent” and “subsidiary” are not used, unlike in the consolidation method where the investor exerts full control over its investee. Instead, in instances where it’s appropriate to use the equity method of accounting, the investee is often referred to as an “associate” or “affiliate”.

Although the following is only a general guideline, an investor is deemed to have significant influence over an investee if it owns between 20% to 50% of the investee’s shares or voting rights. If, however, the investor has less than 20% of the investee’s shares but still has a significant influence in its operations, then the investor must still use the equity method and not the cost method.Unlike with the consolidation method, in using the equity method there is no consolidation and elimination process. Instead, the investor will report its proportionate share of the investee’s equity as an investment (at cost). Profit and loss from the investee increase the investment account by an amount proportionate to the investor’s shares in the investee. This is known as the “equity pick-up.” Dividends paid out by the investee are deducted from this account.

3) Propotionate Consolidation Method

An accounting method that includes income, expenses, assets and liabilities as items in proportion to the company or firm’s percentage of participation in the business venture, Proportionate Consolidation is used in accounting for joint ventures.It was originally favoured by the International Financial Reporting Standards (IFRS) in their accounting standards but has been recently replaced by the Equity Method. Proportionate consolidation is favoured by those who maintain that the said accounting method allows for more detailed information, as it breaks joint venture interest performance down to component parts. On the other hand, the Equity Method is favoured because of its simpler and more straightforward accounting approach on outside investments.

Method of accounting for business combinations

Acquisition method

The acquisition method (called the 'purchase method) is used for all business combinations. [IFRS 3.4]

Steps in applying the acquisition method are:

1. Identification of the 'acquirer'

The guidance in IFRS 10 Consolidated Financial Statements is used to identify an acquirer in a business combination, i.e. the entity that obtains 'control' of the acquiree

If the guidance in IFRS 10 does not clearly indicate which of the combining entities is an acquirer, IFRS 3 provides additional guidance which is then considered:

• The acquirer is usually the entity that transfers cash or other assets where the business combination is effected in this manner
• The acquirer is usually, but not always, the entity issuing equity interests where the transaction is effected in this manner, however the entity also considers other pertinent facts and circumstances including:
  • relative voting rights in the combined entity after the business combination
  • the existence of any large minority interest if no other owner or group of owners has a significant voting interest
  • the composition of the governing body and senior management of the combined entity
  • the terms on which equity interests are exchange
  • The acquirer is usually the entity with the largest relative size (assets, revenues or profit)

For business combinations involving multiple entities, consideration is given to the entity initiating the combination, and the relative sizes of the combining entities.

2)Determination of the 'acquisition date'

An acquirer considers all pertinent facts and circumstances when determining the acquisition date, i.e. the date on which it obtains control of the acquiree. The acquisition date may be a date that is earlier or later than the closing date

3) Recognition and measurement of the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquire

IFRS 3 establishes the following principles in relation to the recognition and measurement of items arising in a business combination:

• Recognition principle. Identifiable assets acquired, liabilities assumed, and non-controlling interests in the acquiree, are recognised separately from goodwill
• Measurement principle. All assets acquired and liabilities assumed in a business combination are measured at acquisition-date fair value.

4) Recognition and measurement of goodwill or a gain from a bargain purchase

Goodwill is measured as the difference between:

• the aggregate of (i) the value of the consideration transferred (generally at fair value), (ii) the amount of any non-controlling interest (NCI, see below), and (iii) in a business combination achieved in stages (see below), the acquisition-date fair value of the acquirer's previously-held equity interest in the acquiree, and
• the net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed

Goodwill

=

Consideration transferred

+

Amount of non-controlling interests

+

Fair value of previous equity interests

-

Net assets recognised