Preparation of Consolidated Financial Statements Essay Example

Introduction

Businesses can be structured in different forms. These forms may include a business as a holding company conducting its operations through other separate entities called subsidiaries. In such circumstances then a group structure exists. In the Australian economy it is not bizarre for one company to control the operations of a group of other entities or companies. These controlled entities or companies are called subsidiaries and the controlling entity is the holding company. Normally structures of businesses forming groups will result due to a number of reasons. For instance a competitor may have been taken over by another competing company or a company may take over its purveyor or client or it may take over businesses in other industries for diversification reasons. In this entire scenario the holding company is required to provide complete financial information involving the whole group (Ron, Wines and Cecilia, 2008: 244).

The holding company is therefore required to prepare a set of consolidated financial statements through a consolidation process. The consolidation process entail taking the accounts of the controlling entity (holding company) and then adding them to the accounts of the entities that are being controlled by the entity (subsidiary entities). However inter-entity transactions and shareholdings should be eliminated. That is transactions that involve entities within the group should be purged during the consolidation process. This process is undertaken as per the requirements of both the Corporations Act 2001 section 295 and the Australian Accounting Standard (AASB) 127 titled “Consolidated and Separate Financial Statements.” Before an entity prepares consolidated financial statements, there are certain basic requirements that must be fulfilled by the entity as defined by the two documents. This paper provides insights on the basic principles or requirements that must be met by the entity before it prepares the consolidated financial statements (Locke, 2011: 60).

Requirements for consolidation

Australian Accounting Standards Board provides guidelines on when and how consolidation should be undertaken by an entity. The main objective of the standard is to promote the relevance of the information provided in the separate financial statements and the consolidated statements of the entity. It also enhances the reliability and the comparability of the information in the financial statements. The standard outlines the circumstances under which an entity prepares consolidated financial statements. The concept of control is of significant meaning to an entity when determining whether to prepare or not the consolidated financial statements in which the accounts of the subsidiary companies will be combined with the accounts of the holding company. The standard shades more light on the concept and how it determines the consolidation of the financial statements of the controlling and the controlled entities (CCH Editors, 2009: 624).

The concept of control

The concept of control is critical in the determination of the entities that should be consolidated. AAS 127 provides an express indication of the entities that are supposed to consolidate their accounts. These entities are the subsidiaries of the parent or holding entity. In defining what a subsidiary is the concept of control also comes in handy. The standard in paragraph 4 defines a subsidiary as “an entity, including an unincorporated entity such as a partnership that is controlled by another entity known as the parent” (AASB 127) (Picker, Leo, Loftus, Clark and Wise, 2010: 356). An examination of this definition vividly indicates that the level of control of an entity by another entity will determine whether the entity is a subsidiary or not. It is therefore with no denial that the concept of control and subsidiary are important in the consolidation process since the definition of a subsidiary entirely relies on control (Deegan, 2010: 860).

Control is defined by the standard in terms of the power that an entity exhibits to govern the policies both financial and operating of another entity with the end result being that the governing entity obtains some benefits from the entity it governs. From this definition there are four vital things that must be in place for control to be proven. It is the existence of this control that necessitates the preparation of the consolidated financial statements. Firstly it is a must for the parent entity to govern the processes of making decision in the subsidiary entity. This power of governing the decision making is exercisable both indirectly and directly by the parent entity. Indirect power means that the parent entity has gained the power through other entities in which it has some controlling power (Jubb, Haswell and Langfield-Smith, 2010: 25).

Secondly the parent entity must have the capacity to control the subsidiary. This means that the entity must have the power to decide on the subsidiary entity’s policies both financial and operating with the ability to gain benefits from the subsidiary entity’s activities. The entity should be able to significantly influence what the subsidiary entity does so as to benefit from the activities. Where this power exists then control can be assumed to exist. Thirdly the power to govern that the parent entity shoulders may either be actively practiced or passive. Therefore whether the entity makes use of its existing power to govern the entity’s policies is immaterial for the purposes of deciding whether to consolidate the accounts or not. Finally the parent entity must be governing the subsidiary in a manner that elicits benefits to the governing entity or the parent entity. These four elements are very vital in determining existence of control and hence consideration for consolidation of the accounts of the parent and the subsidiary entities (Leo, Hoggett, Sweeting and Radford, 2010: 500).

Control is therefore an exhaustive criterion when it comes to the determination of whether two companies can be referred to as parent and subsidiary entities. According to the standard there is a presumption that control exist where the parent entity owns 50 plus 1 percent of the voting power of the controlled entity. That is if the company controls more than half of the power then there is evidence for the existence of control. This ownership can be either direct or indirect through other entities. However where it is expressly provided that ownership of this kind does not constitute control, then control will not be in existence (Deegan, 2010:860).

There is also existence of control where there is an agreement or statute even if the parent entity controls half or less of the entity’s voting power. The agreement will be conferring power to the entity to have more than fifty percent power over the voting rights and also conferring power over the government of the entity’s policies both operating and financial (Shying and Ngiam, 2010: 102). The agreement may also give power to the entity to either remove or appoint majority of the members of the governing body which controls the entity. Finally the agreement may confer to the entity the power to cast a majority of votes at the governing body’s meetings. When determining the voting rights of an entity, the potential voting rights need to also be considered. Potential voting rights include; share options and other convertible financial instruments. The financial instruments should be convertible to equity (Deegan, 2010: 861).

State of Slowsilver Limited with Regard To Consolidation

From the above exploration it is now possible to determine whether there is parent entity- subsidiary relationship that would warrant Slowsilver Limited to prepare consolidated accounts. Slowsilver Limited Company owns thirty percent of the voting rights of Quickgold Limited Company. The voting rights are represented by the ordinary shares of the company. Firstly thirty percent is less than half percent of the voting right of the company. It therefore does not indicate existence of control that would necessitate the preparation of consolidated financial statements. The basic threshold for consolidation as provided by AASB 127 is not met in this case. Given this circumstance control could exist if there was an agreement with the other investors allowing the company to have power over more than half of Quickgold Limited Company’s voting rights. Therefore Slowsilver Limited will not be required to prepare consolidated financial statements (Deegan, 2010: 860-861).

Conclusion

Preparation of consolidated financial statements is a requirement of both the Australian Accounting Standards Board (AASB) 127 and the Corporations Act 2001. The decision on whether to consolidate accounts of the parent and the subsidiary entity is dependent on the establishment of the existence of a parent-subsidiary relationship between the two entities. This is determined through prove of existence of control. Control is assumed to exist where the parent company owns more than half of the voting rights of the subsidiary company. In determining the ownership the potential voting rights are also considered. Where a company owns either half or less of the voting rights of the subsidiary, there must be an agreement with the other investors conferring power to control to the company for control to exist. When control is proved to exist, a parent entity-subsidiary entity relationship is said to exist and therefore preparation of consolidated financial statements is required. In summary, given this circumstance control could exist if there was an agreement with the other investors allowing the company to have power over more than half of Quickgold Limited Company’s voting rights. Therefore Slowsilver Limited will not be required to prepare consolidated financial statements (Deegan, 2010: 860-861).

References

CCH Editors, (2009), Australian Master Accountants Guide 2008/2009, McPherson’s Printing Group, Australia.

Deegan C., (2010), Australian Financial Accounting, 6th edition, McGraw-Hill, North Ryde, University of New South Wales Press Ltd, Sydney.

Jubb P., Haswell S., & Langfield-Smith I., (2010), Company Accounting, 5th edition, Cengage, South Melbourne, Victoria.

Leo K., Hoggett J., Sweeting J. & Radford J., (2010), Company Accounting, 8th edition, John Wiley, Milton, Queensland.

Locke C., (2011), Financial Reporting Handbook 2011 Volume 1, John Wiley & Sons, Milton, Queensland and ICAA.

Picker R., Leo K., Loftus J., Clark K. & Wise V., (2010), Australian Accounting Standards, 2nd edition, John Wiley & Sons, Milton, Queensland.

Ron D., Wines G., & Cecilia L., (2008), Corporate Accounting in Australia, University of New South Wales Press Ltd, Sydney.

Shying M. & Ngiam J. (2010), Accounting Handbook 2011, Pearson Education Australia, Australia and CPA Australia.