Consolidation of Financial Statements - Research Paper Example

?Consolidation of Financial ments Introduction The acquisition method is predominantly applied to consolidation of financial ment from 2009. Prior to that Purchase Method of consolidation was in vogue. Pooling of interest method was adopted for consolidation prior to 2002. This paper seeks to analyze how the acquisition method compares with the earlier two methods in consolidation of financial statements, its impact on financial statement reporting quality, potential Impact on decision making and International implications of consolidation of financial statements. The paper also discussed the differences between the standards of IFRS and GAAP in respect of consolidation of financial statements with a view to resolve the differences for enhancing uniformity, comparability and transparency in consolidation of financial statements. Acquisition Method Primarily there are two types of treatment under this method. In the first one, the investor acquires assets (and often liabilities) and investee goes out of business and the investor continues to do the business with the controlling interest. The investee company becomes a subsidiary and the stock of investee is shown as investment in the investor’s books of accounts. This process involves accounting for the fair value of the company acquired by ascertaining fair value of the assets and liabilities including contingencies based on risks associated as well as the consideration in line with the international standards. If the consideration is not equal to fair value either it is treated as good will where consideration exceeds fair value or as gain on acquisition where the consideration is less than the fair value. Direct costs associated with the acquisition are expensed. It may include fees payable to legal advisors, appraisers, auditing firms and investment bankers. Indirect costs of acquisition such as secretarial and managerial efforts are expensed. However, fair value is reduced by the costs associated with registration and issue of securities. In the second case, the acquired company continues to function as a separate entity without dissolution. In this case, the financial statements of such entity are considered in the accounts / financial statements of the acquired company. The balances are consolidated separately without formal entries in the books of accounts. Assets with indefinite life are reviewed periodically for impairment in line with the accounting / reporting standards. How Purchase Method differs from Acquisition Method Application of fair-value principle is common to both the purchase method and the acquisition method. However, under Purchase Method transactions costs are included in the purchase price in the books of accounts of the subsidiary. The transaction costs and restructuring costs included in fair value under purchase method are considered as business expenses under acquisition method. Also, fair value is measured as on acquisition date under acquisition method. The acquisition method is based on recognition and measurement of the assets. The acquisition method takes into account non-controlling interests and contingencies, whereas purchase method ignores this aspect. Pooling of interest method The investor records investment in sub account and consolidation is outside the books of accounts by eliminating investment account and equity account in subsidiary’s accounts. Book values of the companies are simply combined together in consolidation of financial statements. Goodwill is not recorded in the books of accounts. Revenues and expenses are added together with retrospective effect. Rezaee, Z. (2001, p. 291) stated “Under the pooling of interest method: (1) carrying amounts on the books of combining entities should be carried forward; (2) no goodwill should be recognized; and (3) prior financial statements should be restated as if the combining entity had always been combined.” Acquisition method has significant improvements over this method to suit the needs of the businesses. Impact on financial statement reporting quality There are concerns voiced about the difficulty of estimating contingencies in acquisition method. Similarly there is controversy in respect of ‘in-process research & development’ with regard to its treatment in this method. The revised acquisition method published by FASB has improved the application of this method. Acquisition method reflects true and fair view and takes into consideration non-controlling interests and contingencies. This has made accounting of intangible assets and good will more relevant and transparent for taking decisions by the management. Potential Impact on decision making and International implications In pre-acquisition stage “the relationship between firm-level measures of financial performance and the strategic fit between buying and selling firms” (Weber, Y. 2012 p. x) is very important for decision making. The revised methods are in line with the IASB requirements that facilitate uniformity and thereby comparability which is very important under globalization phenomenon for harmonising international accounting practices. Increasing level of cross border acquisitions and mergers calls for efficiency in accounting and consolidation of financial statements with uniform standards across the globe. Acquisition method has several advantages over the historical methods in financial reporting. “Based on our research and discussion of some of the pros and cons of the two methods, we conclude that the acquisition method of accounting for business combinations is superior to the purchase method” (Aghimien, P. n.d.). Consolidation standards under current U.S. GAAP and IFRS “IFRS 10 Consolidated Financial Statements outlines the requirements for the preparation and presentation of consolidated financial statements, requiring entities to consolidate entities it controls. Control requires exposure or rights to variable returns and the ability to affect those returns through power over an investee. IFRS 10 was issued in May 2011 and applies to annual periods beginning on or after 1 January 2013.” (Deloitte, 2013) IFRS standard is similar in several respects to the Standards published earlier by US Generally Accepted Accounting Principles (GAAP) for consolidation of financial statements. These standards were followed without much change for almost 50 years. Under IFRS, “Focus is on the power to control, with control defined as the parent’s ability to govern the financial and operating policies of an entity to obtain benefits. Control is presumed to exist if the parent owns more than 50% of the votes, and potential voting rights must be considered. Notion of - de facto control also may be considered” (Ernst & Young 2012, p. 7). In the case of GAAP the focus is on controlling financial interests. Under IFRS, the consolidated financial statements are prepared as of the same date for all the companies. The companies can have different year ends within three months under GAAP. Under IFRS accounting policies adopted by the investor and investee companies should be uniform. But, it is not required so in the case of GAAP. The important differences between IFRS and GAAP are in respect of effective control, potential voting rights and minority valuation. There are similarities noticed between Purchase Method under GAAP and IFRS. The acquisition method under GAAP agrees with the Purchase Method of IFRS on many points. Consolidation becomes a difficult process if the accounting policies adopted by the subsidiary are different from that of the parent company. Similarly, changes in the accounting periods between the parent company and the subsidiaries give rise to several adjustments in the books of accounts. The differences between the standards as discussed above can be resolved by adopting single IFRS standard applicable to all the countries. This could be achieved by making suitable amendments in IFRS standards for incorporating the issues from the view point of GAAP after deliberations. This will enhance comparability and transparency in consolidation of financial statements for the benefit of the various stakeholders. IASB proposed amendments to IFRS 10, Consolidated Financial Statements, and IAS 28(Amended), Investments in Associates and Joint Ventures. However, convergence of US GAAP and IFRS is uncertain which causes accounting and consolidation problems to the companies. PwC (2013, p. 16) stated “those differences might cause some companies either to deconsolidate entities or to consolidate entities that were not consolidated under US GAAP. Subsidiaries that previously were excluded from the consolidated financial statements are to be consolidated as if they were first-time adopters on the same date as the parent. Companies also will have to consider the potential data gaps of investees to comply with IFRS informational and disclosure requirements.” Adoption of IFRS standards uniformly by all the countries enhances transparency and comparability with other similar consolidations for decision making by various stakeholders. Pologeorgis. N. (2013) states “Arguments against accounting standards convergence are (a) the unwillingness of the different nations involved in the process to collaborate based on different cultures, ethics, standards, beliefs, types of economies, political systems, and preconceived notions for specific countries, systems and religions; and (b) the time it will take to implement a new system of accounting rules and standards across the board.” Conclusion Sherman, A. J. and Hart, M. A. (2006, p. 2) stated “Mergers and acquisitions have played a variety of roles in corporate history, ranging from the ‘‘greed is good’’ corporate raiders buying companies in a hostile manner and breaking them apart, to today’s trend to use mergers and acquisitions for external growth and industry consolidation.” Acquisition method used for consolidation of financial statements has several advantages over the historical methods. The IASB and FASB are working towards convergence of IFRS and GAAP. Quality global standards for the world countries as a whole are very important in the era of globalisation. Common global standards envisage effective implementation of the global standards. This will form the strong foundation for adoption of uniform accounting policy by enhancing comparability and transparency in consolidation of financial statements. References Aghimien, P. An Analysis of the Acquisition and Purchase Methods. Indiana University South Bend. OC09106 – Accounting/Finance. Available at: [Accessed 29 November 2013]. Deloitte, 2013. IFRS 10 Consolidated of Financial Statements. Available at: [Accessed 29 November 2013]. Ernst & Young, 2012. US GAAP versus IFRS: The Basics. November, 2012. Available at: [Accessed 29 November 2013]. Pologeorgis. N. (2013) The Impact Of Combining The U.S. GAAP And IFRS. 21 January 2013. Investopedia. Available at: [Accessed 29 November 2013]. PricewaterhouseCoopers, 2013. IFRS and US GAAP: similarities and differences. October 2013. Available at: [Accessed 29 November 2013]. Rezaee, Z., 2001. Financial Institutions, Valuations, Mergers, and Acquisitions: The Fair Value Approach. Second Edition. New York: John Wiley & Sons. Sherman, A. J. and Hart, M. A., 2006. Mergers &Acquisitions: From A to Z. Second Edition. Ney York: American Management Association. Weber, Y. 2012. Handbook of Research on Mergers and Acquisitions. Cheltenham: Edward Edgar Publishing. Read More