The question of consolidation typically arises after an acquisition. Your company might have purchased another business in New Zealand, or it has expanded into Australia or the Pacific Islands by acquiring a smaller company. Or perhaps your business has been acquired by a parent company, or a complicated new ownership arrangement has been entered into.
Consolidated accounts may be required, but there are a few questions to consider before you start the process.
Should you consolidate?
We are often asked by our clients, ‘How do I consolidate?’, but they should really be asking, ‘Should I consolidate?’ This is when the question of control arises. If your business doesn’t control the related entity, you do not need to consolidate from a financial reporting perspective.
Establishing control may not be as straight forward as you think. Voting shares are a great place to start – if one entity owns 100% of the shares in the related entity, that would probably indicate the majority shareholding company has control over that arm of the business. In contrast, if the two related entities each hold 50% of the shares, they may have joint control.
Other critical questions are, ‘Who can make decisions?’ Who makes decisions that significantly affect returns? ‘Who is charged with governance?’ NZ IFRS 10 provides further guidance about establishing control but in summary the majority of acquisitions fall into one of three categories:
- Subsidiary
The parent company has control over the subsidiary business. If your report under NZ IFRS, consolidation is the right choice. If the parent company does not own 100% of the shares, the financial statements will also need to show an accounting adjustment for the non-controlling interest.
- Associate
The business has significant influence over the related entity, but not control, and it owns more than 20% of the voting shares. If you report under NZ IFRS, then equity accounting is the right choice. Joint ventures also do not require consolidation. This is where neither party has control, and treatment is the same as an associate. We often see examples of these types of arrangements between major co-corporations. For example, two completely independent entities might establish a business for a specific project or cause and own 50% of the shares each; this means neither one is the controlling entity.
- Investment
A business invests in another entity but has no significant influence or control over it. Financial statements would present this as an investment, and consolidation would not be appropriate. If you report under NZ IFRS, assets are measured at fair value through profit or loss (FVTPL) or fair value through other comprehensive income (FVTOCI).
Down the consolidation rabbit hole
Here’s an example of a complex situation which illustrates how tricky the question of consolidation can be: An Australian company purchased a New Zealand business which is operating out of a building and using a plant both owned by the company in Australia.
The two businesses created a new company. The Australian entity tipped in the building and plant, while the New Zealand company tipped in its operating business. In consideration of what was being tipped in, the Australians received 75% of the shares and the Kiwis got 25%. On the face of it, control looked cut and dried – the Australian company controlled the New Zealand entity as a subsidiary and should therefore produce consolidated accounts.
But the transaction gives both companies joint control because the Australian company can’t make any major decisions without the New Zealand entity agreeing, and if a consensus couldn’t be reached, mediation was required. It was, in fact, an associate situation, so consolidated accounts were not the right choice.
If you do consolidate, IFRS has a framework
In New Zealand only one accounting framework covers consolidation: NZ IFRS 10. Therefore, when the term consolidation is used it implies the principles of this standard are being followed. If you are already preparing financial statements that comply with NZ IFRS and you need to consolidate, you then follow the NZ IFRS 10 concepts and come up with a consolidation approach.
But if you are not preparing NZ IFRS financial statements, what do you do? If you are preparing financial statements under IRD’s Tax Administration (Financial Statements) Order 2014 or Chartered Accountants Australia New Zealand (CAANZ) Special Purpose Financial Reporting Framework for use by For-Profit Entities, consolidation is not in scope for either of these frameworks. So, when your stakeholders request consolidated financial reports, you need to create special purpose reports that are a mish-mash of different frameworks which may not technically be consolidated financial statements.
According to NZ IFRS 10, consolidated financial statements represent a group in which the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a single economic entity. A parent is an entity that controls one or more entities, and a subsidiary is an entity that is controlled by another entity. This means the “group” you are trying to report on may not meet this definition.
That is not to say that a combined view isn’t valuable. These are often requested by banks who are looking for a simpler set of accounts when assessing an organisation’s lending. From the bank’s point of view, they want to take out the intercompany complexity so it’s clear to see how much money the business (and its security) is making. Combining won’t change how much profit you make but depending on your inter-entity charges, interest expense and sales may decrease, so there will likely be a few differences in calculating bank covenants.
Also, in a structure where there are a lot of inter-entity transactions, having to the ability to effectively combine your results is a useful way to check on the financial health of the business as a whole. Like the bank covenants, financial ratio and analysis may look different with the inter-entity transactions eliminated. Therefore, a combined view could help with your decision making and strategic vision.
The moral of what can be a complicated story
The concept of control is relatively complex and if you are consolidating for the purpose of your IFRS financial statements, it pays to make sure that you do control the entity before putting unnecessary effort into a consolidation that may not be required. However, if the purpose of the consolidation is not for your IFRS financials statements, then it is best to understand what you are trying to achieve and then tailor the approach accordingly to maximise the use and value of the output.
