F1: preparing consolidated financial statements

This article explains how to prepare basic consolidated financial statements for a group with one subsidiary. It’s the second in a two-part series by the F1 examiner.

Consolidated financial statements were not examined at the equivalent level in the old syllabus. They have now been included in F1 as an introduction to consolidated financial statements in preparation for the F2 exam.

The F1 syllabus excludes non-controlling interests, all subsidiaries must be 100% owned by the parent entity. Questions could include one or more subsidiaries. The syllabus includes associated entities but we will not be able to consider them in this article.

The F1 syllabus specifies that you should be able to prepare a consolidated statement of financial position and a consolidated statement of comprehensive income for a group in relatively straightforward circumstances. Questions could be set requiring either one of these consolidated statements or both of them.

Preparing consolidated financial statements
IAS 27 ‘Consolidated and separate financial statements’ defines a subsidiary as an entity that is controlled by another entity. An entity has control if it has the ability to direct the operating and financial policies of another with a view to gaining economic benefit. If an entity owns 100% of another entity it will usually have control.

When preparing consolidated financial statements:

1. We are replacing the cost of the investment in the holding entity’s accounts with the fair value of the assets and liabilities of the subsidiary.
2. Goodwill is likely to arise on acquisition. Shares purchased at the market price may not reflect the fair value of the assets and liabilities of the subsidiary. Any difference between the amount paid and the value of the assets is goodwill.
3. There must be no double counting. All items that relate to transfers within the group must be eliminated on consolidation.

Pre-acquisition and post-acquisition reserves
When preparing consolidated financial statements it is important to distinguish between pre-acquisition reserves and post-acquisition reserves. Pre-acquisition reserves are retained profits and other reserves that exist in a subsidiary’s statement of financial position at the date of acquisition. Pre-acquisition reserves are capitalised at the date of acquisition by including in the goodwill calculation. They must not be included in the consolidated income statement or consolidated statement of financial position.

Profits/losses (including unrealised gains and losses) made after acquisition that are shown in the subsidiary reserves can be included in the consolidated statement of comprehensive income and in reserves in the consolidated statement of financial position. 

Intra-group activities
The impact of any intra-group activities must be cancelled out in the consolidated financial statements.

1. Inter-entity trading. Sales and purchases figures need to be adjusted on the income statement to remove double counting of the sales. Any goods in closing inventory at the year end will include unrealised profit in the inventory value, this must be removed.
2. Current accounts should be reconciled, making adjustments for any items in transit and then cancelled out on consolidation.
3. Intra/inter-group dividends received are cancelled on consolidation against dividends paid.

Consolidated financial statements use the same underlying format as single entity financial statements, so you do not need to learn new formats for consolidated financial statements.

Consolidated financial statement preparation - checklist

1. Calculate group holdings and establish the status of each entity in the question (subsidiary, associate or investment), W1
2. Establish fair value of assets acquired and calculate net assets of the subsidiary, W2
3. Calculate goodwill arising on acquisition, W3
4. Adjust for any intra-group activities, W4
5. Calculate balance carried forward on consolidated retained earnings, W5
6. Calculate balance carried forward on consolidated reserves, W6
7. Prepare consolidated financial statements, statement of financial position and/or consolidated statement of comprehensive income.

Now, let us use this approach in answering a typical question. X holds shares in Y. On 1 April 2006 X purchased 600,000 shares in Y at a cost of $1.60 per share. The fair value of Y’s tangible assets at 1 April 2006 was $126,000 more than book value. The retained profits of Y at 1 April 2006 were $120,000. The excess of fair value over book value was attributed to buildings held by Y. At 1 April 2006 the buildings had an estimated remaining useful life of 21 years. The draft summarised financial statements for the two entities as at 31 March 2010 are given below:

Summarised statement of financial position at 31 March 2010

Summarised statement of comprehensive income for the year ended 31 March 2010

Additional information:

(i) Y paid an interim dividend of $50,000 on 31 December 2009

(ii) Y sent a cheque for £20,000 to X on 30 March 2010

(iii) X occasionally trades with Y. In November 2009 X sold Y goods for $90,000. X uses a mark up of 50% on cost. On 31 March 2010 Y had not paid for the goods and they were all still in Y’s closing inventory.

Required
Prepare a consolidated, summarised statement of comprehensive income for the year ended 31 March 2010 and a consolidated statement of financial position for the X group of entities as at 31 March 2010.

Solution
All figures are in $000

Workings (following the checklist above)

Note: Narrative and journal entries are shown here to aid understanding of the process of consolidation; they are not required in an exam answer.

1) Calculate group holdings:

X’s holding in Y is 600,000 shares out of 600,000, therefore treat Y as a wholly owned subsidiary of X.

2) Fair value of net assets of Y at acquisition

Fair value of the net assets is the same as the total of share capital plus all pre-acquisition reserves. As buildings are revalued upwards at acquisition it will create a revaluation reserve at the date of acquisition. This must be treated as a pre-acquisition reserve and included in the fair value of net assets at acquisition.

Shares 600

Retained earnings at 1 April 2006 120

Fair value adjustment 126

Total 846

The fair value of the buildings increased by 126 and has a useful life of 21 years. Assuming straight line depreciation with no residual value, that is, 126/21=6. Y was purchased four years ago, so the amount of extra depreciation since acquisition is 6 x 4 = 24.

Debit Credit

Consolidated retained earnings 24

Property, plant and equipment 24

3) Goodwill - Y

Cost of shares acquired 960

Fair value of net assets acquired (W2) 846

Goodwill 114

4) Intra/inter-group activities

(i) Current accounts Debit Credit

Y sent a cheque to X. When this is received and banked it will increase bank balance and reduce the current account. Entries are:

Sundry current assets (bank) 20

Current account with Y 20

Now the current accounts agree, so cancel current accounts on consolidation and ignore in the consolidated financial statements.

Current account with X 60

Current account with Y 60

The only item appearing in the consolidated statements is the adjustment to bank of 20.

(ii) Intra-group trading

As the mark up is given in the question we will have to convert it to the selling price margin.

Mark up on cost 50% = 33⅓% margin on selling price.

Selling price 90; unrealised profit = 90 x 33⅓% = 30

As all the goods are in closing inventory we need to cancel the unrealised profit of 30 from closing inventory in both the statement of comprehensive income and the statement of financial position.

Debit Credit

Consolidated revenue 90

Consolidated cost of sales 90

Consolidated cost of sales 30

Consolidated sundry current assets (inventory) 30

(iii) Interim dividend paid by Y

Cancel the other income item in X against the dividend paid by Y. Then ignore in the financial statements as it has no effect. Note that the dividend paid by Y would be shown in its statement of changes in equity.

5) Consolidated retained earnings

Make sure that you collect all the adjustments above that effect the post-acquisition profit of the group.

Balance - X, from question 400

Y – group share of post acquisition profits (300 – 120) 180

Deduct post-acquisition increase in depreciation due to fair value adjustment (W2) (24)

Cancel unrealised profit in inventory (4ii) (30)

Total 526

7) Prepare consolidated financial statements

The first part is to add together the parent and its subsidiary amounts for each line of the statements. The only exceptions to this are share capital, where you put in the parent entity’s share capital on its own and retained earnings where you use the figure calculated in W5. In the statements below the figures from the question are shown first, then the adjustments from the workings are shown with workings reference.

X group consolidated statement of comprehensive income

$000

Revenue (910+390-90 [w4ii]) 1,210

Cost of sales (461+171-90 [w4ii] +30 [w4ii] +24 [w2]) 596 614

Expenses (110+43) (153)

461

Finance cost (30+22) (52)

409

Taxation (43+12) (55)

Profit for the year 354

X group - consolidated statement of financial position as at 31 March 2010

$000

Non-current assets

Goodwill [W3] 114

Property, plant and equipment

(1210+700+126 [w2] -24 [w2]) 2,012

2,126

Current assets

Sundry assets

(1,780+620-30 [w4ii] +20 [w4i]) 2,390

4,516

Equity and reserves

Ordinary shares 2,000

Retained earnings [W5] 526

2,526

Current liabilities

Trade payables

(1,630+360) 1,990

4,516

Conclusion
If you follow this approach to the preparation of consolidated financial statements you should have no problem with the F1 questions and will be well prepared for the consolidated financial statements on F2.

Links
F1 study resources

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