or The implications of structure over financial consolidation calculations
The Hierarchical method performs the calculation in two steps; in the first step S is consolidated into H’s consolidated Balance Sheet using the direct ownership of H in S (60%) and then the results are further consolidated into G’s group Balance Sheet using the percentage of G in H (80%).
The two methods calculate the same contribution of S’s reserves to the consolidated reserves, but calculate different numbers for Goodwill and Minority Interest. In the following sections we demonstrate the schedules calculating the contributions of S, using the two methods, illustrating the differences in produced results.
A final observation is that the issue arises when the group’s percentage in the subgroup is not 100%. In the case of a fully owned subgroup the exhibited difference in calculation would zero out. It follows that the less the percentage owned the greater the calculated difference (and the greater the reconciliation amount).
There are a number of reasons why the Hierarchical method would be preferred over the Flat. First, the whole procedure of preparing consolidated financial statements with the most popular tool, the spreadsheet, needs a painful effort from finance staff therefore receiving ready consolidated statements from subgroups greatly minimizes the required effort. Second, an organization which invests in acquiring an existing group, will find out that the newly acquired form will already have reporting mechanisms in place, which is less costly to re-use than substitute.
However, the above reasons are no longer valid, if the organization uses special software to prepare its consolidated financial statements, rather than the commonly used spreadsheets.
Forward to the blog edition
I first considered the concepts and issues presented in this article, during early consolidation engagements back in 2004. There was a general assumption among financial reporting practitioners that financial consolidation calculations would arrive at the same numbers no matter what the consolidation structure of an indirect investment would be. However, this assumption turned out to be false. The differences became apparent during the elaboration of the mathematical formulation of financial consolidation I was working on at that time. Four years later, in August 2008 this material was first organized and published in print as a whitepaper, originally released only to my clients.
As you'll see, despite the fact that it is a product of a mathematical model, the article is written in finance terms, because my intention is to increase awareness of finance executives about the effect of choosing between different group configurations on their final consolidated numbers. Having decided to release this article to the wider audience, I hope it will be as useful as it has been to my clients.
As a final word, the reader may recognize that the calculations of the non-controlling interests (or NCI, formerly called the minority interest) in the article, are according to IFRS 3 (2004). While the measurement of NCI based on the share of the identifiable net assets of the acquiree is still valid, IFRS 3 (2008) provides with an alternative measurement based on the fair value of the NCI. I may be able to write something about this change in a later post.
As you'll see, despite the fact that it is a product of a mathematical model, the article is written in finance terms, because my intention is to increase awareness of finance executives about the effect of choosing between different group configurations on their final consolidated numbers. Having decided to release this article to the wider audience, I hope it will be as useful as it has been to my clients.
As a final word, the reader may recognize that the calculations of the non-controlling interests (or NCI, formerly called the minority interest) in the article, are according to IFRS 3 (2004). While the measurement of NCI based on the share of the identifiable net assets of the acquiree is still valid, IFRS 3 (2008) provides with an alternative measurement based on the fair value of the NCI. I may be able to write something about this change in a later post.
Overview
The purpose of this working paper is to
compare the results of the two commonly used methods for consolidating
indirectly owned fully controlled subsidiaries in forming the Group Balance
Sheet. In order to demonstrate the arising differences in calculated values, we
use a numeric example. Finally we attempt to explain the differences and suggest
ways to re-conciliate the two methods.
Setting the Stage
Our subject is a subsidiary company which
belongs to a multi-level group of companies. This means that the company in question is directly owned by another company which is itself owned by a group’s
holding company. It can be shown that
the same issues arise if we place our subsidiary company at an even lower
hierarchical level, but for simplicity we limit our discussion to a two level
hierarchy. The following figure exhibits the hierarchy in question.
Company H has acquired 60% of S and has the
full control of the company, therefore H consolidates S using the full
consolidation method. In the same fashion company G owns 80% of H and also uses
the full consolidation method to calculate H’s contribution to the consolidated
reports.
At the time of the first acquisition of S
by H, H spent 110.000 to acquire S’s net assets consisting of 100.000 Share
Capital and 50.000 Reserves. To simplify matters, ever since the first acquisition
there was no change in percentage owned, or the invested amount. Furthermore,
the percentage of G in H has never changed. Finally, at the time the
consolidated numbers are calculated, S reports 115.000 Reserves.
Flat and Hierarchical Methods
As mentioned in the introduction of this
article, we have observed that group financial reporting practitioners are
using two distinct methods for consolidating S in G’s consolidated Balance
Sheet. Apparently both of the methods are acceptable to the auditing
authorities.
The Flat
method ignores the fact that it is indirectly owned and consolidates S as if it
were a direct subsidiary using the effective
percentage which calculates as the product of the two percentages – i.e.
80% x 60% = 48%. It also calculates an effective
minority percentage – i.e. 100% - 48% = 52%.
The Hierarchical method performs the calculation in two steps; in the first step S is consolidated into H’s consolidated Balance Sheet using the direct ownership of H in S (60%) and then the results are further consolidated into G’s group Balance Sheet using the percentage of G in H (80%).
The two methods calculate the same contribution of S’s reserves to the consolidated reserves, but calculate different numbers for Goodwill and Minority Interest. In the following sections we demonstrate the schedules calculating the contributions of S, using the two methods, illustrating the differences in produced results.
The Flat Method Schedules
As mentioned above in the following
schedules we are using the effective
percentages for ownership and minority interests – i.e. 48% and 52%
respectively.
Schedule 1:
Goodwill calculation
|
||
Investment
(80% x 110.000)
|
88.000
|
|
Less:
|
||
Share Capital
|
100.000
|
|
Reserves at acquisition
|
50.000
|
|
150.000
|
||
Indirect
percentage (48%)
|
(72.000)
|
|
Goodwill
|
16.000
|
|
Schedule 2:
Reserves calculation
|
||
Reserves
|
115.000
|
|
Reserves at
acquisition
|
(50.000)
|
|
Effective
percentage (48%)
|
65.000
|
31.200
|
Consolidated
Reserves
|
31.200
|
|
Schedule 3:
Minority Interest calculation
|
||
Share Capital
|
100.000
|
|
Reserves
|
115.000
|
|
215.000
|
||
Effective
Minority Percentage (52%)
|
111.800
|
|
Investment
|
110.000
|
|
Group's
minority percentage (100% - 80%)
|
(22.000)
|
|
Minority
Interest
|
89.800
|
In Schedule 1 the consideration that there
is no exclusive right of G in the investment of 110.000, is taken into account
in the Goodwill calculation. Since we exclude the part of investment which is
attributed to the G’s minority from the Goodwill calculation, we have to
exclude the same amount from Minority Interests, therefore the adjustment at
the bottom of Schedule 3.
Clarification
An
alternative view of the above calculations would have been to calculate
Goodwill using the full investment and Minority Interest without the
adjustment. This calculation would yield Goodwill of 38.000 and Minority
Interest of 111.800. Then we should have posted a journal entry to eliminate
the part of the investment attributed to G’s minority as shown on the side.
|
|
Below is the contribution of S to the
Group’s consolidated Balance Sheet as a single journal entry.
Dr
|
Cr
|
|
Elimination of
Investment
|
110.000
|
|
Goodwill
|
16.000
|
|
Elimination
of Share Capital + Reserves
|
215.000
|
|
Consolidated
Reserves
|
31.200
|
|
Minority
Interest
|
89.800
|
|
231.000
|
231.000
|
The Hierarchical Method Schedules
Here we are going to follow two steps of
calculations; first for consolidating S in H and second for consolidating H in
G. This results in six schedules instead of three.
Step
One
Schedule 1:
Goodwill calculation
|
||
Investment
|
110.000
|
|
Less:
|
||
Share Capital
|
100.000
|
|
Reserves at acquisition
|
50.000
|
|
Direct
percentage (60%)
|
150.000
|
(90.000)
|
Goodwill
|
20.000
|
|
Schedule 2:
Reserves calculation
|
||
Reserves
|
115.000
|
|
Reserves at
acquisition
|
(50.000)
|
|
Direct
percentage (60%)
|
65.000
|
39.000
|
Consolidated
Reserves
|
39.000
|
|
Schedule 3:
Minority Interest calculation
|
||
Share Capital
|
100.000
|
|
Reserves
|
115.000
|
|
Minority
Interest percentage (100% - 60%)
|
215.000
|
86.000
|
Minority Interest
|
86.000
|
In the first step there is nothing special.
It is a consolidation schedule of a direct ownership.
Step
Two
Schedule 4:
Goodwill calculation
|
||
Goodwill from
previous step
|
20.000
|
|
Goodwill
|
20.000
|
|
Schedule 5:
Reserves calculation
|
||
Consolidated
Reserves from previous step
|
39.000
|
|
Percentage
owned in subgroup (80%)
|
31.200
|
|
Consolidated
Reserves
|
31.200
|
|
Schedule 6:
Minority Interest calculation
|
||
Minority
Interest from previous step
|
86.000
|
|
Consolidated
Reserves from previous step
|
39.000
|
|
Minority
Interest in subgroup (100% - 80%)
|
7.800
|
|
Minority
Interest
|
93.800
|
In the second step we adjust the values
calculated in the first by spreading the consolidated reserves of the first
step to the group and the minority. It could be viewed as a reclassification of
the amount 7.800 from the Consolidated Reserves account to the Minority
Interest account. One observation at this point is that the Goodwill calculated
in the first step is preserved in the second.
The contribution of S to the Group Balance Sheet as a single journal entry is:
The contribution of S to the Group Balance Sheet as a single journal entry is:
Dr
|
Cr
|
|
Elimination of
Investment
|
110.000
|
|
Goodwill
|
20.000
|
|
Elimination
of Share Capital + Reserves
|
215.000
|
|
Consolidated
Reserves
|
31.200
|
|
Minority
Interest
|
93.800
|
|
235.000
|
235.000
|
Comparing Results
The following table summarises the results
of the two methods:
Hierarchical
|
Flat
|
Difference
|
|
Goodwill
|
20.000
|
16.000
|
4.000
|
Consolidated
Reserves
|
31.200
|
31.200
|
0
|
Minority
Interest
|
93.800
|
89.800
|
4.000
|
It is evident that the Hierarchical method
overstates Goodwill and Minority Interest by the same amount. As a result the
Total Assets of the resulting Balance Sheet are also overstated by that amount.
It can be shown, although it is not in the scope of this article, that the
difference of the two methods can be calculated by multiplying the value of Goodwill
calculated in the first step of the Hierarchical method by the Group’s minority
percentage. In our case at hand this value is 20.000 x 20% = 4.000.
It is as though the Hierarchical method fails to take into account that there can be a claim in the Goodwill of the subgroup by the group minority, something that we took into account in the Flat method when we attributed part of the Investment to the group’s minority and subsequently excluded that part from calculations. Having all this in mind, we can attempt to reconciliate between the two methods. Goodwill and Minority Interest accounts resulting from the Hierarchical method can be adjusted to match the values resulting from the Flat method using the following journal entry:
It is as though the Hierarchical method fails to take into account that there can be a claim in the Goodwill of the subgroup by the group minority, something that we took into account in the Flat method when we attributed part of the Investment to the group’s minority and subsequently excluded that part from calculations. Having all this in mind, we can attempt to reconciliate between the two methods. Goodwill and Minority Interest accounts resulting from the Hierarchical method can be adjusted to match the values resulting from the Flat method using the following journal entry:
Reconciliation
Journal Entry
|
||
Dr
|
Cr
|
|
Minority
Interest
|
4.000
|
|
Goodwill
|
4.000
|
|
4.000
|
4.000
|
The amount posted can be calculated as
shown earlier. One view of the issue could be that the above adjustment should
be part of the schedules of the Hierarchical method in the first place, but as
we mentioned before the method demonstrated herein is based on common practices
that have been observed during real-world group reporting engagements.
Of course one can claim that the correct numbers are those calculated by the Hierarchical method. It is not the intention of the author to make such an argument, therefore if there is such a case, then a journal entry with inverted Debit and Credit can be posted to the Flat method results to reconcile to the Hierarchical method numbers.
Of course one can claim that the correct numbers are those calculated by the Hierarchical method. It is not the intention of the author to make such an argument, therefore if there is such a case, then a journal entry with inverted Debit and Credit can be posted to the Flat method results to reconcile to the Hierarchical method numbers.
A final observation is that the issue arises when the group’s percentage in the subgroup is not 100%. In the case of a fully owned subgroup the exhibited difference in calculation would zero out. It follows that the less the percentage owned the greater the calculated difference (and the greater the reconciliation amount).
There are a number of reasons why the Hierarchical method would be preferred over the Flat. First, the whole procedure of preparing consolidated financial statements with the most popular tool, the spreadsheet, needs a painful effort from finance staff therefore receiving ready consolidated statements from subgroups greatly minimizes the required effort. Second, an organization which invests in acquiring an existing group, will find out that the newly acquired form will already have reporting mechanisms in place, which is less costly to re-use than substitute.
However, the above reasons are no longer valid, if the organization uses special software to prepare its consolidated financial statements, rather than the commonly used spreadsheets.
Conclusion
In this article
we have demonstrated the two methods commonly used by companies to consolidate
indirectly owned subsidiaries and compared the results. Having isolated the
issue and being aware of the arising differences companies can select either method while at the same time apply due diligence and build
confidence in their published results.
