Consolidated accounts in the UK: a quick guide

In the UK, the Companies Act 2006 (CA06) now requires medium-sized groups to prepare consolidated (group) accounts.  Under s399 of CA06, group accounts only have to be prepared where, at the end of a financial year, an undertaking is a parent company.  A common question asked is whether this includes overseas subsidiaries.  If a company is registered in the UK, those subsidiaries would need to be included within the consolidated financial statements.

Thresholds

CA06, which is effective for financial periods beginning on or after 6 April 2008, specifies benchmarks for groups to qualify as a ‘small’ group where 2 out of the following 3 conditions must be met:

• Aggregate turnover must not be more than £6.5m net (£7.8m gross);
• The aggregate balance sheet total must not be more than £3.26m (£3.9m gross); and
• The aggregate average number of employees must not be more than 50.

Exemptions

CA06 at section 405 permits a subsidiary to be excluded from consolidation where its inclusion is not material for the purposes of giving a true and fair view.  Be careful with this exemption!  If you have 2 or more undertakings which, in isolation, are immaterial, but become material when taken together, they must be consolidated.

There are also further exemptions from consolidation where:

• there are severe long-term restrictions which substantially prohibit the exercise of the rights of the parent company over the assets or management of the subsidiary; or
• the interest of the parent is held exclusively with a view to subsequent resale.

Key requirements

FRS 2 Accounting for Subsidiary Undertakings requires the following:

• Uniform accounting policies should be used throughout the group.  Subsidiaries should be adjusted on consolidation and if this is not possible, full disclosure of the different policies and their effects should be made within the financial statements.
• The financial statements of all group companies should be prepared to the same accounting period-end; subsidiaries can prepare three months before, where necessary and with appropriate adjustments and disclosures.
• Disclosure is required of a material purchase of a subsidiary and its results to enable shareholders to appreciate its effect.
• The effective date for acquisition and disposals of a subsidiary should be the date on which control passes (this date can often be significantly different than the date in a legal agreement).

Recap of the fundamentals

It is important to remember that ‘control’ for the purposes of establishing whether (or not) there is a parent/subsidiary relationship is determined by either share of ownership (i.e. where parent owns more than 50% of the shares in subsidiary) or the dominant influence approach (i.e. where control is not obtained by share ownership, but by virtue of the fact that parent can influence the financial and operating policies of the investee).  Where the parent does not influence the financial and operational policies of the investee, or where share ownership is less than 51%, the investor shall account for the investee using FRS 9 Associates and Joint Ventures as appropriate, or the FRSSE (effective April 2008) equivalent.

The primary purpose of consolidated financial statements is to present the group financial statements as that of a single reporting entity.  It is for this reason, that:

• Intra-group transactions and balances are eliminated.
• Profits from intra-group transactions are eliminated (e.g. where parent sells goods to subsidiary at a profit that are still in subsidiary’s stock at the year-end).
• The cost of the investment in the subsidiary is eliminated and forms part of the goodwill calculation.
• Only post-acquisition profits of the subsidiary are included in the consolidated reserves of the group financial statements.

Goodwill

Goodwill may arise on the acquisition of a subsidiary when the purchase price is more than the fair value of the subsidiary’s net assets.  Goodwill is accounted for under the provisions in FRS 10 Goodwill and Intangible Assets and must also be reviewed for impairment in accordance with FRS 11 Impairment of Fixed Assets.  The rebuttable presumption in FRS 10 (specifically paragraph 19) is that the useful economic life of purchased goodwill and intangible assets are limited to periods of twenty years or less.  Annual impairment tests are required on goodwill and other intangible assets where this presumption is rebutted, but the criteria in paragraphs 19 (a) and (b) to FRS 10 must be met.

There are situations when negative goodwill may arise.  This is due to a ‘bargain purchase’ i.e. where the purchase price is less than the fair value of the subsidiary’s net assets.  When negative goodwill arises, it should be disclosed separately on the face of the balance sheet, immediately below goodwill and followed by a sub-total showing the net amount of positive or negative goodwill.  Negative goodwill is written off to the profit and loss account in the periods in which the non-monetary assets in the acquisition are recovered, either through depreciation or sale.  Any negative goodwill in excess of the fair values of the non-monetary assets are recognised in the profit and loss account in the periods when the benefit is expected to flow to the entity.

Figure 1

The Facts

Parent company (P) has owned 80% of subsidiary (S) for a number of years.  P’s year end is 31 December 2010 and it is preparing consolidated financial statements.  The draft accounts of both companies for the year-ended 31 December 2010 are as follows:

Balance sheets

Note 1

Parent sold goods which cost £80,000 to its subsidiary on 31 December 2010 for £100,000.  These goods reached Subsidiary Co on 4 January 2011 at which point the subsidiary recorded the transaction.

The consolidation schedule which will be used to produce the consolidated financial statements of the group can be drawn up as follows:

* Minority interests = 20% x £55,000 (profit after tax of subsidiary) = £11

** Profit and loss reserves are calculated as:

*** Minority interests (20% x £300) = £60

Merger accounting

FRS 6 Acquisitions and Mergers stipulates 2 methods of accounting:

• Acquisition accounting; and
• Merger accounting.

Acquisition accounting is essentially where one business acquires another business.  Merger accounting, however, is a business combination whereby the parties come together to share in future risks and benefits of the combined entity i.e. no one party controls another in the combination.  In merger accounting there is no issuance of shares and any difference which arises on consolidation does not represent goodwill, instead any such difference is added to, or deducted from, reserves.  In order to meet the eligibility criteria for merger accounting, 5 criteria must be met which are set out in paragraphs 6 to 11 of FRS 6.  Where a business combination meets these criteria, acquisition accounting is prohibited as the standard recognises that this method would not fairly present the effect of the business combination.  The international equivalent in IFRS 3 does not recognise the concept of merger accounting (referred to in the superseded IAS 22 as the ‘pooling of interests method’) which was banned following the issuance of IFRS 3.

Conclusion

This article has looked at group accounting from a simple perspective.  Of course, there will be instances where consolidated financial statements are not as simple as this article has covered, however, this article has covered the “basic” approach to producing consolidated financial statements.  Many accounts production software programmes do enable the production of consolidated accounts, but may require ‘tweaking’ which is where an understanding of the basic concepts of group accounts is needed.  For those that need further guidance, the provisions in FRS 2 should be consulted.

Category: Accounting and standards