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Methods of Consolidating Financial Statements
In recent decades, the developments in company law, and the issue of national and international accounting standards, has increased the amount of information that needs to be disclosed in financial statements. However, users of the financial statements should bear in mind the limitations of consolidated financial statements resulting from the legal requirements, accounting policies and limits on the information available at the time the financial statements were prepared.
Users of consolidated accounts should be aware of the laws and accounting conventions under which the accounts have been compiled, as these may affect the figures in the financial statements. For example, such consolidated accounts normally use more than one method to consolidate the results of subsidiaries, associates which are not controlled, and portfolio shareholdings. The user should be acquainted with the particular method of accounts preparation used in the jurisdiction whose laws and regulations are applicable.
The results of a subsidiary company would be consolidated with the results of the parent company. A subsidiary company would normally be defined as one which is controlled by the parent company of the group, by reason of shareholding above 50%, voting power or some other factor. This means that the assets and liabilities of the subsidiary would be incorporated with those of the rest of the group on the balance sheet, and the revenue and expenses consolidated in the group profit and loss account, with adjustments for intragroup revenue and expenses.
However, a company in which the parent company has significant influence, but does not have control, for example an associated company in which the parent company has at least a 20% shareholding, would normally be included in the consolidated financial statements using the equity method. Under this method, the investment in the associate would be initially recorded at cost, and then adjusted for the changes in the group’s net share of the assets of the company. There would not be full consolidation of the income, expenses and assets of the associated company with the group.
For those companies in which the parent company has less than a 20% shareholding, and does not have significant influence, only the investment made in the company would be shown on the balance sheet, and dividends from that company would be recorded in the profit and loss account as they arise, with no further consolidation.
Differences in methods of consolidation could give rise to a different result in terms of the profit and loss account and balance sheet. The user of the consolidated financial statements should therefore check the accounting policy, or the standard under which the financial statements have been compiled. There may, for example, be cases where the group has a less than 20% holding in a company, but consolidates using the equity method, as it nevertheless has significant influence in that company.
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Off Balance Sheet Financing
Off balance sheet financing, refers to the practice of incurring debt in situations where that debt does not appear on the balance sheet, by using special purpose vehicles that, although they are ultimately controlled by the parent company, are not required to be consolidated. This could be, for example, because of the type of entity involved, and the level of participation by the group. Off balance sheet financing also refers to the acquisition of assets through operating leases (as opposed to finance leases), so that the asset leased and the debt owed for the remaining period of the lease, do not need to be shown on the balance sheet.
Confidence in the use of consolidated financial statements by investors to assess the financial situation of a company, has been shaken in the last ten years by accounting scandals such as the Enron collapse which involved the use of off balance sheet financing to improve the appearance of the consolidated financial statements, ensuring that large amounts of debt were not shown in the financial statements. While reforms have been put into motion to ensure that such scandals are not repeated, this is a reminder to investors of the need to look very closely at the picture presented by consolidated financial statements, and to look, not just at what is in the figures, but to consider what factors have not been included in those figures. Investors should not forget the limitations of consolidated financial statements when looking at companies in which they may wish to invest.
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Users of the financial statements should be aware that one of the limitations of consolidated financial statements is that there may have been important events since they were finalised. Investors should therefore also examine more recent announcements of the group or the information in their quarterly returns.
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The user of consolidated financial statements should examine carefully the accounting policies used, in respect of important factors such as, the valuation and depreciation of fixed assets, the treatment of intangible assets, accounting policies relating to leased assets, and accounting treatment of provisions and contingencies. Some of these figures may be large enough to significantly affect the financial results and the balance sheet, and the accounting policies chosen are therefore significant. These policies will be declared in the notes to the financial statements, and these notes should be read carefully.
Another aspect of this is the accounting treatment of mergers, acquisitions and disposals, during an accounting period. The potential investor will want to know how the results of companies acquired during the period have been treated in the consolidated financial statements, what accounting policies have been used, and how this has affected the results reported in the financial statements. These policies will also be disclosed in the notes to the financial statements.
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Post Balance Sheet Events
Although the consolidated financial statements will have been audited, and the investor will feel that they can be relied upon, they are only a record of past events and should not in themselves be used to draw conclusions about future developments. Where the company is aware of post balance sheet events when the financial statements are being put together, there will be information in the financial statements about such events. These will then, if necessary, be incorporated into the figures in the form of provisions, or at least declared in a note to the financial statements as contingencies.
However in the fast moving world of modern business, the picture can change very quickly, and once the financial statements have been published, they can no longer be altered to take into account the latest developments. A reading of the latest consolidated financial statements should also be backed up, where possible, with an examination of quarterly returns for the Securities and Exchange Commission (SEC), or other more recent financial statements issued by the group. This ensures that the picture given by the consolidated financial statements has not been significantly changed by business, or economic developments, since they were published.
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Companies with Different Types of Business
Some companies within a group may have a completely different type of business to the parent company and the rest of the group. This is normally the case with a group finance company or captive insurance company. But there might also be certain companies that were acquired separately from the rest of the group, and are in an industry that does not fit in well with the rest of the group. In the 1980s it was quite common for unwieldy conglomerates to arise with a mix of companies engaging in diverse industries, including for example, construction, shipbuilding, engineering, and hotels all within the same group, and the consolidated accounts would give the results of this mixed bag of companies all thrown together.
The investor should be aware, that the fact that accounts are consolidated, does not mean that the group is homogeneous, and users should examine the notes to the financial statements to discover disparities within the group. The notes will give information about the profit from different sectors and geographical regions, and it will be possible to gain information about the different industries in which the group is involved. The investor should look at where the profits are being made and examine carefully, sectors where the group is engaged, but is not performing well.
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The information used by management must be up to date, and one of the limitations of consolidated financial statements for management purposes is that the information relates to an accounting period that has already ended some time before the financial statements are finalised. Management needs to consult the data from monthly, weekly or even daily accounts in order to make informed decisions about a business.
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Consolidated Accounts and Management
The management of the group will be very concerned to give investors an accurate picture of the group in the consolidated financial statements, and ensure that the strengths of the group are clearly highlighted. However the consolidated financial statements are not the main tool for the management of the group, which will be carried on with the help of up to date information from management accounts and exception reporting; which brings to the attention of management the most important developments and exceptional transactions arising. Management will use various tools, such as ratio analysis, information from the costing system, and information reporting systems, but the data produced by these will be based not on the historical figures in the consolidated financial statements from the previous accounting year end, but on the management accounts for the latest month, week or even day.
Reporting to management is unlikely to be based on legal entities within the group, but on departmental and activity reporting lines that are likely to cut across the legal entities within the group. The figures arriving on the desk of senior management will look very different to those appearing in the consolidated financial statements for the group, and reconciliation of the two where possible represents a sizeable task. This point is often not very well appreciated either, by the external auditors, who need to work along legal entity lines, or by the tax authorities, who also need to look at individual legal entity reporting rather than departmental, or activity based reporting. Management is far more concerned with results by department and product line than with the results reported by legal entities.
The annual audited consolidated financial statements of a group of companies are put together to comply with legal requirements and are not in themselves necessary for the management of the company. They are, however, useful for investors in the group who will want to look at ratios and figures, such as earnings per share, that are based on the statutory consolidated accounts, rather than on management reporting. Investors and other stakeholders, such as employees, should examine the financial statements carefully, but should bear in mind the limitations of consolidated financial statements.