Chapter 10

Considering Consolidated Financial Statements

In This Chapter

Understanding consolidation

Figuring out how companies buy companies

Exploring consolidated financial statements

Turning to the notes for details

Like couples who marry and work to combine two incomes – two sets of financial obligations and two ways of managing money – things get complicated when companies decide to join forces or buy other companies and their financial statements become one. This new arrangement makes finding out how each of the pieces of this new entity perform financially much harder for you. In this chapter, we discuss how to read the more complex financial reports that arise when companies consolidate.

Getting a Grip on Consolidation

One of the ways companies grow is by buying or merging with other companies. When a company is bought by another, it gets gobbled up in the new company and loses all its independence. But when companies decide to merge, they usually decide jointly on how the new company operates.

In the past, when companies combined their operations in a merger, they were permitted to use the method known as merger accounting. This method simply added together the accounts of the two separate entities and was, for a time, very popular. The problem was that the standard setters saw it as an area where abuse could occur because companies might use merger accounting when the reality of the business combination was that an acquisition had taken place rather than a merger. The UK Accounting Standards Board brought in stringent conditions to try to stem the abuse way back in 1994 but the International Accounting Standards Board thought that the easier approach was to simply ban the merger accounting method which they did in 2005.

Now, under international standards, if two entities combine in what would previously have been referred to as a merger, then one of them quite simply must be designated to be the acquirer.

Small companies in the UK are still permitted to use merger accounting subject to a set of stringent conditions designed to ensure that the merger accounting technique is only used in appropriate circumstances.

Major corporations produce consolidated accounts that include all or part of the results of any other entity in which they own a share. These entities include subsidiaries, associates, and joint ventures. Here are some details:

Subsidiaries are entities controlled by another entity, usually a company. The company controlling the subsidiary is called the parent company. We discuss the various ways a company can become a subsidiary in the next section ‘Looking at Methods of Buying Up Companies’.

Joint ventures are entities in which venturers (usually two or more companies) share joint control over the economic activity of the entity.

Associates are entities over which the parent company has significant influence but which are not subsidiaries or joint ventures.

The parent company’s financial report gives considerable detail about subsidiaries, associates, and joint ventures in the notes to the financial statements (refer to Chapter 9 for more on notes). However, you know immediately that a company has subsidiaries, associates, or participates in joint ventures if you look at the balance sheet (refer to Chapter 6) or income statement (refer to Chapter 7) and see ‘Consolidated’ noted at the top of the page.

The European Union (EU) requires all listed companies in the European Economic Area to prepare their consolidated accounts using International Accounting Standards (IAS) as approved by the EU. In reality, this means that almost all listed companies use IAS because almost all listed companies have subsidiaries. Where a listed company has no subsidiaries it can still prepare its accounts using local Generally Accepted Accounting Principles (GAAP) – in other words, a UK company can still follow UK standards.

One other thing, UK corporation tax is based on the accounts of the individual company, not the group. Therefore, the parent company, and every other company within the group, can choose to prepare their own individual accounts using UK GAAP if they think that this will be advantageous from a tax point of view. All of these accounts would then have to be converted to IAS as part of the consolidation into group accounts.

If you look at Tesco’s or Marks and Spencer’s statements in Appendix A, you see that each statement indicates that it represents the financial results of the parent company and its subsidiaries. Tesco refer to the income statement as ‘group income statement’ whereas Marks and Spencer refer to it as ‘consolidated income statement’. These two phrases mean exactly the same thing.

You don’t see any listing of what those subsidiaries are on the balance sheet or income statement. In fact, unless a company discusses an acquisition or sale of a subsidiary in the notes to the financial statements, you probably won’t see them mentioned individually in the current year’s financial report. If no financial transactions occur in the year being reported, the company probably highlights only some of its subsidiaries’ successes in the narrative pages in the front of the financial report.

However, UK company law requires that the parent company prepares its own individual accounts as well as consolidated accounts. These accounts are simpler than the group accounts and are subject to some exemptions – most notably that the company does not have to prepare a separate income statement or cash-flow statement because its own income and cash flow have been included in the group figures. The separate accounts of the parent company will include a listing of significant investments in subsidiaries, joint ventures, and associates.

Both Tesco and Marks and Spencer include the financial statements of the parent company at the back of the annual report for the group. Marks and Spencer include a list of significant subsidiaries in the notes to the accounts of the parent company. By contrast, Tesco include such a list in the group accounts and simply cross-refer to it in the accounts of the parent. Both companies make the point that the list of subsidiaries contains only the principal subsidiaries but a full list can be obtained by examining the annual return filed at Companies House.

In some parts of the world (including the UK until 2005), groups can exclude subsidiaries from consolidation on the grounds that the business activities of the subsidiary are so different from the parent that to consolidate the results would be potentially misleading. However, IAS 27 addresses this issue explicitly and says that consolidation must occur and where activities of a subsidiary are significantly different then this should be dealt with by disclosing additional information.

Looking at Methods of Buying Up Companies

One of the most common ways companies grow is by buying up smaller businesses. These smaller businesses either get completely gobbled up with no outward sign that they ever existed, or they become subsidiaries, operating under the umbrella of the company that bought them.

Companies can take control over another business by two methods: They can acquire the assets and liabilities of the other business or they can acquire a majority of its shares. Only when a company buys another by acquiring a majority of its shares does that other company become a subsidiary. Here’s a brief overview of the ways one company can buy another:

Acquisition of the business: This occurs when one company acquires all the assets of another and accepts the responsibilities of all the liabilities of that company. As part of this deal, the acquiring company will take over the business activities of the other entity and this will usually involve the payment of an agreed amount for goodwill. This is known as purchased goodwill and appears in the balance sheet as an intangible non-current asset. If the entity being taken over is a sole trader or partnership then this is the only way to acquire the business.

Share acquisition: In this case, two companies combine, but both companies remain separate legal entities after the transaction. The company that buys the shares of the other merges as the parent company, and the other company becomes the subsidiary. The financial statements of the two are consolidated into the parent company’s financial statements.

Two types of share acquisition exist:

• Majority interest: When a company buys more than 50 per cent of another company’s equity shares, the company has what is termed a majority interest. When a company buys 100 per cent of another company’s equity shares, the subsidiary is called a wholly-owned subsidiary.

• Minority interest: When a company owns less than 50 per cent of another company’s equity shares, the company has a minority interest. When a consolidated balance sheet indicates minority interest, a consolidated balance sheet shows the interests of minority shareholders as a part of total equity but distinguished from the equity interests of the shareholders in the parent company.

Subsidiaries are the entities that are left in place after a company is acquired by another company using the share acquisition method. If you were a shareholder in the subsidiary before it was bought out, you are still able to track the results of the company that you originally owned because the company is still required to prepare its own separate financial statements.

When an individual or a company wants to acquire a listed company they may first buy shares on the open market. Once they own 3 per cent of that target company they need to notify the company of their holding. They must also notify the company every time their holding increases by another percentage point. Obviously, the financial press show interest in the intentions of the entity which is building up such a substantial holding. As the holding of shares increases, the City code on takeovers and mergers takes effect when the percentage of shares owned passes the 30 per cent mark. At that point the acquirer of the shares is required to make an offer for the rest of the share capital of the company on terms no less favourable than the recent acquisitions.

Reading Consolidated Financial Statements

Most major corporations are made up of numerous companies bought along the way to create their empires. The consolidated financial statements reflect the financial results for all these entities that it bought as well as the original assets of the company.

After a share acquisition by the parent company, the subsidiary continues to maintain separate accounting records. But in reality, the parent company controls the subsidiary, so it no longer operates completely independently.

Because the parent company now fully controls the subsidiary, by accounting rules, the parent company must present its subsidiary’s, and its own, financial operations in a consolidated manner (even though the two companies are separate legal entities). The parent company does so by publishing a consolidated financial statement, which combines the assets, liabilities, revenue, and expenses of the parent company as well as those of its subsidiaries, associates, and joint ventures.

If you hold a minority interest (see the previous section for more information on minority interest) in the subsidiary of a parent company, the consolidated financial statement won’t give you the information you need to make decisions about your holdings. A subsidiary with minority shareholders must report its financial results separately from its parent company’s in addition to having its report included in the consolidated financial statements.

When a company owns all the equity shares of its subsidiaries, the company doesn’t really need to publish reports about its subsidiaries’ individual results for the general public to peruse. Shareholders don’t even need to know the results of these subsidiaries. However, the requirement to file accounts at Companies House still applies to wholly-owned subsidiaries just as it does to individual companies which are not part of a group.

In preparing consolidated financial statements, the parent company must eliminate those transactions that have taken place between the parent and its subsidiaries (or between one subsidiary and another) before presenting the consolidated financial statements to the public. Key transactions that a parent company must eliminate when preparing consolidated financial statements are:

Investments in the subsidiary: The parent company’s books show its investments in a subsidiary as an asset account. The subsidiary’s books show the shares that the parent company holds as shareholders’ equity. The parent company must eliminate these amounts in the consolidated accounts by matching the investment off against the share capital and reserves in the subsidiary at the date of acquisition. The cost of the investment in the parent’s books probably doesn’t exactly balance with the total of the share capital and reserves in the subsidiary’s books at the time of acquisition. The difference between them is goodwill.

Advances to subsidiary: If a parent company advances money to a subsidiary or a subsidiary advances money to its parent company, both entities carry the opposite side of this transaction on their books (that is, one entity gains money while the other one loses it, or vice versa). Again, on consolidation, these two balances are matched against each other and are thus cancelled out.

Interest revenue and expenses: Sometimes a parent company lends money to a subsidiary or a subsidiary lends money to a parent company; in these business transactions, one company may charge the other one interest on the loan. On the consolidated statements, any interest revenue or expenses that these loans generate must be eliminated.

Dividend revenue or expenses: If a subsidiary declares a dividend, the parent company receives some of these dividends as revenue from the subsidiary. Any time a parent company records revenue from its subsidiaries on its books, the parent company must eliminate any dividend expenses that the subsidiary recorded in its books.

Management fees: Sometimes a subsidiary pays its parent company a management fee for the administrative services it provides. These fees are recorded as revenue on the parent company’s books and as expenses on the subsidiary’s books. Again, both must be cancelled out.

Sales and purchases: Parent companies frequently buy products or materials from their subsidiaries, or their subsidiaries buy products or materials from them. In fact, most companies that buy other companies do so within the same industry as a means of getting control of a product line, a customer base, or some other aspect of that company’s operations.

However, the consolidated income statements shouldn’t show these sales as revenue and shouldn’t show the purchases as expenses. Otherwise, the company would be earning a profit just by moving goods about within the group. Accounting rules require that parent companies eliminate these types of transactions.

Whilst preparing consolidated accounts may appear complicated, all that we are doing is preparing accounts for the group as if it were a single entity and so any transactions between members of the group must be cancelled out.

Looking to the Notes

The eliminations to adjust for reporting subsidiary results mentioned in the previous section don’t show up in the group’s financial reports unless some portion of the share acquisition took place in the year that’s being reported. When the acquisition or some financial impact of that acquisition did take place in the year that’s being reported, you need to look to the notes to the financial statements to get details about any financial impacts (refer to Chapter 9 for more about notes).

In the accounting policies note in the consolidated financial statements, the company indicates that the financial statements represent the results of the parent company and the companies within the group. The notes also include some statement about the transactions that were eliminated. Just to give you an example of how this is worded, here’s the information from Tesco’s notes:

The Group financial statements consist of the financial statements of the ultimate parent company (Tesco plc), all entities controlled by the company (its subsidiaries) and the group’s share of its interests in joint ventures and associates.

Note that you don’t find out what subsidiaries fall under Tesco in this explanation – the principal subsidiaries are listed in note 13 to the accounts.

A further extract from the Tesco accounting policies:

Intragroup balances and any unrealised gains and losses or income and expenses arising from intragroup transactions are eliminated in preparing the consolidated financial statements.

You can see that the note mentions eliminations, but it doesn’t provide much detail, and just by looking at the notes, you don’t really know what was eliminated. In fact, even if you had the financial statements of the parent and all the subsidiaries, you’d have a very difficult time unwinding the information to figure out the eliminations. And doing so probably isn’t worth your time: It could take hours and probably won’t help you make any decisions about whether the company is a good investment. We don’t explain how to calculate eliminations, but some analysts do attempt to do so in their reports about the company and its subsidiaries.

Mergers and acquisitions

If a company completed a merger or acquisition in the year that’s reported in the consolidated financial statements, you’ll find a special note in the notes to the financial statements. Otherwise, if you want to find out any details about how the mergers and acquisitions may still be impacting the company financially, you have to start digging.

For example, if a company issued additional shares to buy a subsidiary, the value of the shares held by shareholders before the acquisition is diluted, which means that the same earnings or assets must be divided among a greater number of shareholders. To see how this works, imagine an example involving 100 shares and a company profit of £100. In this scenario, each share claims £1 of earnings. If, after the acquisition, 150 shares are outstanding, each share of stock can claim only 67p of the £100 of earnings. This diluted ownership impacts the amount of dividends or the portion of ownership you have in the company for the rest of the time you own those shares. However, with any luck, as a result of the acquisition, the profits of the group will have increased to compensate for the dilution in your shareholding!

You can see how you need to play a game of cat-and-mouse to find all the little pieces of cheese laid out in the financial statements. Companies don’t necessarily make information easily accessible, and might even hide the financial impact of an acquisition or merger on the value of your shares by writing the notes to the financial statements in such a convoluted way that you have to be a detective to sort out the relevant details.

Goodwill

Another important note you can check out to find the impact of mergers and acquisitions on the consolidated financial statements is the note that explains ‘goodwill’. Goodwill is the amount of money a company pays in excess of the value of the assets when it buys another company (go to Chapters 4 and 6 for more details).

For example, suppose that a company has £100 million in net assets, but another company offers to buy it for £150 million. That extra £50 million does not represent tangible assets like inventory or property, but instead represents extra value because of customer loyalty, store locations, or other factors that add value.

Liquidations or discontinued operations

Whenever a company sells a subsidiary or significant joint venture or associate, or discontinues its operations, a note to the financial statement regarding this transaction appears in the year in which the sale or discontinuance first occurred. After the first year, any impact that a sale or a discontinuance of operations has on a company’s operating results is usually buried in other notes. Just like with mergers and acquisitions, you have to play detective to find out any ongoing impact that these changes have had on the company.

The company includes information about any profits or losses related to the liquidation of an asset or discontinued operations in the notes to the financial statement. Because these transactions can impact financial statements over a number of years, the detail includes financial impacts for the years prior to the year being reported, as well as future financial impacts anticipated.

When reading the consolidated financial statements and their related notes, be sure you look for any mention of the impact of previous acquisitions or disposals and how those transactions may still be impacting the financial statements.

You may find notes related to impacts on the balance sheet, income statement, shareholders’ equity, or cash flows. Transactions involving acquisitions and disposals can impact any of these statements.