What is IFRS 10 and IAS 27 about?
International Financial Reporting Standard 10 and International Accounting Standard 27 – Consolidated and Separate Financial Statements
What is the need for consolidated financial statements?
Consolidated financial statements present information about a group of entities as a single economic entity. Preparing consolidated financial statements is an expression of one of the most important accounting principles—substance over form. Under this principle, if one entity (a parent) holds a majority of the shares of another entity that represents control (a subsidiary), then they form a single economic group, although these are two separate legal entities.
From this economic perspective, the assets, liabilities, income, expenses and cash flows of subsidiaries are under the control of the parent, just like the parent’s own assets, liabilities, income, expenses and cash flows. Therefore, they should be presented together in consolidated financial statements. The group therefore consists of the parent and its subsidiaries that are under its control. The information in the consolidated financial statements is insufficient for the various users of each subsidiary’s financial statements, such as creditors and non-controlling shareholders. Hence, consolidated financial statements are not a substitute for each subsidiary’s own financial statements, which remain relevant to those users.
How are non-controlling interests (NCI) presented?
When control exists but the subsidiary is not wholly owned by the parent, the guiding principle is that the parent still has full control over the subsidiary’s assets, liabilities, income, expenses and cash flows. Therefore, they are included in full in the consolidated financial statements. At the same time, the consolidated financial statements shall also present, in a single line, the interests of the other shareholders of the subsidiary (non-controlling shareholders) in the subsidiary’s net assets and profits (loses), i.e., non-controlling interests (NCI). Under the Conceptual Framework, NCI are part of the group’s equity rather than liabilities, since the group is not obligated to transfer economic benefits to the NCI, as long as the subsidiary is not obligated to distribute dividends. NCI are therefore presented within equity in the consolidated statement of financial position, separately from the equity attributable to owners of the parent. Consistently, the NCI’s share of profit (loss) is not an expense (income), but an allocation of consolidated profit (loss) to the non-controlling shareholders.
When shall consolidated financial statements be presented?
When consolidated financial statements shall be presented
What is control under IFRS 10?
A necessary condition for consolidation is control. Control’s definition is based on the investor’s power to direct the investee’s relevant activities. This definition is qualitative and requires judgment and an assessment of all facts and circumstances. Previously, control was defined as the power to govern the financial and operating policies of an investee. The definition changed to reflect a broader assessment of de facto control, i.e., control can exist even without the ability to set such policies explicitly. Determining whether control exists can materially affect a parent’s financial statements.
What are the approaches to interpreting control?
Historically, two approaches were used to interpret control:
What is legal/technical (“on paper”) control?
Legal/technical (“on paper”) control
Under this view, the “power to determine policy” is examined legally. To control another entity, one needs to hold more than half of the voting rights, including via agreements with other shareholders. For example, a 49% holding would not represent control, considering the theoretical possibility that all other shareholders might unite.
What is effective (de facto, practical) control?
Effective (de facto, practical) control
The “power to determine policy” under this approach is assessed in practice — who effectively has that power based on all facts and circumstances. For example, an entity may hold only 42% of the shares of the investee while the remainder are widely dispersed. In this case, the entity might effectively have the power to govern the investee’s financial and operating policies.
How did IFRS 10 change the concept of control?
Traditionally, GAAP leaned toward the legal/technical interpretation. IFRS 10 introduced a new consolidation model that in effect requires a broader de facto control assessment.
Moreover, although a voting-rights model has existed since the first half of the 20th century, the current century has seen significant development in determining control for certain entities. The trigger was the failure of the voting-rights model to identify the reporting entity that should consolidate special-purpose entities operating on “autopilot,” whose equity holders lack substantive decision-making power, i.e., voting rights exist but have no practical meaning. These were once called SPEs and are now called structured entities. The failure of the voting model led to severe distortions: many entities were not consolidated by any reporting entity (“off-balance-sheet entities”), even when economically they should have been consolidated. Some reporting entities exploited this vacuum to manipulate the establishment of off-balance-sheet entities, in order to “clean” their financial statements of unwanted items, defer loss recognition, or even report fictitious profits, the most famous case being Enron.
Consequently, use of a risks-and-rewards model was developed for consolidating special-purpose entities, replacing the traditional voting model (originating in IFRS before Enron and later, with modifications, in US GAAP).
What is the control model under IFRS 10?
Under IFRS 10, a single control model that favors substance over form shall be applied, based on three elements of control:
Power over the investee (ability to direct the relevant activities),
Exposure or rights to variable returns from the involvement with the investee, and
Ability to use power to affect the returns.
How are consolidated financial statements prepared?
Preparing consolidated financial statements
In simplified terms, to prepare consolidated financial statements, an entity combines each line item in the parent’s and subsidiaries’ financial statements by summing like items of assets, liabilities, equity, income, expenses and cash flows. The reporting entity shall also measure the non-controlling interests and account for intra-group transactions and balances, as well as transactions between the parent and non-controlling shareholders. Two conceptual views underlie the consolidation model:
What is the Proprietary Concept?
The Proprietary Concept
Under this view, consolidated financial statements are prepared from the parent’s perspective and are intended primarily for the parent’s shareholders (not the NCI). The group’s existence stems from the parent’s ownership rights in the subsidiary.
What is the Entity Concept?
The Entity Concept
Under this view, consolidated financial statements are prepared for the group as a single economic unit, without focusing on the parent shareholders’ perspective. This emphasises the group’s assets and liabilities rather than who controls it.
What is the traditional vs modern approach to consolidation?
Traditionally, GAAP used a mixed approach leaning toward the proprietary concept. For example, proprietary thinking guided fair-value measurement of the subsidiary’s identifiable assets and liabilities at acquisition and goodwill measurement, whereas elimination of intercompany transactions reflected the entity concept. Also, changes in ownership without a loss of control were commonly accounted for under the proprietary view, recognising gain/loss on a partial disposal even without losing control. Modern accounting standards trend more toward the entity concept (though not entirely), and this trend is expected to strengthen.
What are the relevant IFRS Accounting Standards?
Relevant IFRS Accounting Standards
Accounting for consolidated and separate financial statements spans four IFRS Accounting Standards:
IFRS 3 Business Combinations — accounting for business combinations and their impact on consolidated financial statements, including determining the acquisition date (from which consolidation starts) and recognising/measuring the acquiree’s identifiable assets and liabilities (as well as goodwill) at that date.
IFRS 10 Consolidated Financial Statements — includes main parts:
determining whether a reporting entity has control by applying the single consolidation model to all entities; and
consolidation procedures and subsequent accounting, including transactions with NCI (changes in ownership that do not result in a loss of control), accounting when control is lost, and intercompany transactions/balances.
IFRS 12 Disclosure of Interests in Other Entities — disclosure requirements for investments in subsidiaries, associates, joint arrangements and unconsolidated structured entities.
IAS 27 Separate Financial Statements — requirements for preparing separate (stand-alone) financial statements where required or elected.
What are the new concepts underlying consolidation requirements?
New concepts underlying the consolidation requirements
How does IFRS 10 apply the Entity Concept?
The Entity Concept
IFRS 10 largely adopts the entity concept, whereas previously the proprietary concept dominated. As a result, a decrease in ownership interest in a subsidiary due to a direct sale of shares or due to the subsidiary issuing new shares, without a loss of control, is accounted for as a transaction with owners recognised within equity, similar to accounting for a share issue. This is because the NCI are, under the entity concept, owners just like any other. Similarly, an increase in ownership in an existing subsidiary (without obtaining control) is also accounted for as an equity transaction, akin to a treasury-share transaction.
How are losses allocated under the Entity Concept?
In addition, under the proprietary concept, if losses caused a subsidiary’s equity to be negative, the parent typically did not attribute further losses to the NCI, unless the NCI guaranteed the subsidiary’s obligations. In contrast, under the entity concept losses are fully allocated to NCI. Any guarantees or other support are accounted for separately.
What is the conceptual approach to transitions between accounting models?
Conceptual approach to transitions between accounting models
Transitions between different accounting models for investments in shares trigger full notional derecognition/recognition accounting, not just for the executed leg. Thus, under IFRS 10, a decrease in ownership that results in a loss of control (previously accounted for as a partial sale) is accounted for as a deconsolidation of the subsidiary, and a gain/loss is recognised, including on the retained interest, which is then accounted for as a financial asset or under the equity method, as appropriate. This notional approach also applies when losing significant influence (or joint control), when an associate (or a joint venture) becomes a financial asset.
What are separate financial statements?
Separate financial statements
Although IFRS Accounting Standards require consolidated financial statements (with limited exceptions), there is no requirement to prepare separate financial statements alongside them. However, an entity may elect or be required by local regulation to prepare separate financial statements in addition to its consolidated financial statements. Under IAS 27, when separate financial statements are prepared, investments in subsidiaries, joint ventures and associates that are not classified (or included in a disposal group that is classified) as held for sale, are accounted for at cost, under the equity method or as a financial asset under IFRS 9.
What accounting policies apply to separate financial statements?
The entity shall apply consistent accounting policy for each category of investments, generally characterised by control, joint control and significant influence. Thus, an entity could measure all subsidiaries at fair value (IFRS 9), while measuring associates at cost.
What types of financial statements exist under IFRS?
IFRS Accounting Standards distinguish between three types of financial statements:
Individual Financial Statements
Financial statements of an entity that does not own one or more subsidiaries. In such financial statements, the equity method is applied when the reporting entity holds an associate or a joint venture not classified (or included in a disposal group that is classified) as held for sale.
Consolidated Financial Statements
Financial statements of an entity that include the consolidation of at least one subsidiary. If the group also holds an associate or a joint venture, the equity method is applied in the consolidated financial statements.
Separate Financial Statements
In separate financial statements, investments in subsidiaries, joint ventures and associates not classified (or included in a disposal group that is classified) as held for sale, are accounted for at cost, under the equity method or in accordance with IFRS 9.
When are separate financial statements prepared?
Separate financial statements are prepared in either of the following cases:
Financial statements of a parent that are presented alongside the consolidated financial statements, or
Financial statements of a reporting entity that owns a subsidiary, a joint venture or an associate, but does not consolidate or apply the equity method because it is an intermediate entity that meets an explicit exemption in the relevant standard.