Market transformations in Russia, the globalization of business, the development of multinational companies, the processes of privatization and reconstruction of large enterprises, as well as industry complexes have led to the formation of holding structures, associations of enterprises, which include parent and subsidiary organizations. As a result of mergers and acquisitions, new and existing groups of companies based on control relationships are being created and expanded. The organizations belonging to the groups carry out coordinated production, financial and marketing policies, which gives reason to consider them as a single economic entity. In this regard, users are interested in information about the financial performance not of an individual company, but of the group as a whole. The source of such data is the consolidated financial statements.
Of particular interest, which determines the relevance of the topic under consideration, is the analysis of the requirements for the preparation of this type of reporting set out in international standards.
The International Financial Reporting Standard (IFRS) 10 «Consolidated Financial Statements» defines the principles for the presentation and preparation of consolidated financial statements in cases where an entity controls one or more others.
IFRS 10 defines the concept of «consolidated financial statements» as the financial statements of a group in which the assets, liabilities, capital, income, expenses and cash flows of the parent company and its subsidiaries are presented as assets, liabilities, capital, income, expenses and cash flows of a single economic entity [5].
The standard is based on the definition of the concept of control over the object of investment and its valuation, as well as accounting requirements. The investor must independently determine whether he has control over the object of investment, and, if so, he is the parent company. At the same time, three conditions must be met simultaneously:
– having authority over the investment object;
– the presence of a risk of changes in income from participation in the investment object or the right to receive such income;
– the ability to use their powers in relation to the object of investment to influence the amount of their income.
If an organization has several investors, none of them can manage its activities without interacting with the others. At the same time, the shares of participation in the investment object should be reflected.
IFRS 10 states that an investor must have the rights to manage significant activities, in other words, «the activities of an investee that have a significant impact on income from it» [5].
Powers can be exercised through either voting rights, or on the basis of contractual agreements between shareholders or the practical ability to manage significant activities.
There are several options for authorization in the first case:
- An investor who holds more than 50% of the voting rights, i.e. a controlling stake, has the authority in situations where:
– management of significant activities is carried out through voting;
– most of the members of the governing body are appointed by voting.
Consequently, an investor who owns a controlling stake in voting rights, in the absence of any other factors, has control over the company being invested.
- Controlling interest in the absence of authority – voting rights are not real, and the management of significant activities is carried out, for example, by a court, liquidator or regulatory body.
- Powers without a controlling package of voting rights appear to the investor in the following cases:
– a contractual agreement between the investor and other voting rights holders;
– the rights provided for by other contractual agreements;
– the investor has a practical opportunity to manage significant activities and his rights are sufficient;
– potential voting rights (e.g. related to convertible instruments or options, including forward contracts);
– the shareholder has a special relationship with the object of investment (key personnel are employees of the investor, or the investor owns critical licenses or brands, has the right to receive more than 50% of income and is exposed to risks in this regard, etc.);
– other shareholders are widely dispersed and cannot act together [1].
The rights that an investor has can be divided into real and protection rights. In the first case, the investor has a practical opportunity to exercise such a right. The factors determining the existence of real rights may be:
– the absence of any barriers (legal requirements, financial sanctions, operational barriers) in their implementation;
– the existence of an established mechanism (provided that the consent of several parties is required), which gives the parties the practical ability to exercise their rights on a collective basis;
– other factors.
The real rights that other parties can exercise can prevent the investor from exercising control over the object of investment.
The rights of protection are related to the introduction of fundamental changes in the activities of the investment object or are applied in exceptional circumstances. An investor with only protection rights cannot have the authority or prevent the other party from having the authority.
The rights of protection include:
– the right of the lender to impose restrictions on the actions of the borrower;
– the right of the lender to seize the assets of the borrower;
– other rights.
Consider the relationship between authority and income.
Sometimes the investor (principal) may delegate to the agent the authority to make decisions on his behalf concerning certain specific issues or significant activities in general. The decision–maker should analyze the relationship between the investment object managed by him and other parties, first of all considering the following factors:
— limits of decision-making authority on the investment object;
– the rights of other parties (for example, the real right of suspension);
– remuneration (the higher its value, the higher the probability that the decision-maker is the principal);
– risks associated with variable income (the greater the magnitude of economic interests, the higher the probability that the decision-maker is the principal) [8].
The limits of the decision-maker’s powers are established on the basis of a management agreement based on the following factors:
- The right of removal – if in the management agreement any of the parties has the right to remove the decision-maker from management without specifying a reason, then such a party will be an agent. If, in fact, the investor has such a right of suspension, then he will be the principal, and the decision-maker will be the agent.
- The amount of remuneration of the decision–maker — in a situation where the amount of remuneration is market-based, and the decision-maker is exposed to minor risks, then it is the agent. The more variable the remuneration received by the decision maker, the greater the risks it carries in connection with the management of the investment object, the higher the probability that it is a principal.
- The decision–maker has other interests in the investment object other than remuneration — the more similar interests the decision-maker has, the higher his exposure to risks and the more likely it is that this is the principal [11].
Despite the fact that the management company receives a market fee that is commensurate with the services rendered, its investments, coupled with remuneration, may lead to exposure to the risk of changes in income from activities that will be so significant that it will indicate that it is a principal.
When assessing the existence of control, the investor should consider the nature of his relationship with other parties, as well as whether these parties are de facto agents (i.e., whether they act on behalf of the investor).
The investor should also consider whether he regards any part of the investment object as a conditionally independent enterprise, and whether he has control over it. Assets, liabilities and capital of such companies are protected from the object of investment as a whole. If the investor has control over a conditionally independent enterprise, he must consolidate the corresponding part of the investment object. In this case, the other parties exclude it, assessing the presence of control.
In case of a change in the rights of the investor and other parties, he must reconsider his status as a principal or agent. In this case, the investor’s acquisition or loss of authority in relation to the investment object may occur as a result of an event in which he himself does not participate.
IFRS imposes the following requirements on the accounting report on consolidated financial statements, fixing the need for the following operations:
– combining items of assets, liabilities, capital, income, expenses and cash flows of the parent company with similar items of the subsidiary;
– offset of the book value of investments and the share of the parent company in the capital of the subsidiary;
– complete exclusion of intra-group assets and liabilities, capital, income, expenses and cash flows related to transactions between the group’s enterprises [3].
Thus, a single accounting policy should be used in the group. If any member of the group uses different policies, appropriate adjustments should be made in its financial statements when preparing consolidated financial statements to account for similar transactions and events in similar circumstances.
The Company includes the income and expenses of the subsidiary in the consolidated financial statements from the moment of acquisition of control over it until the moment of its loss.
The financial statements of the parent company and its subsidiaries must be prepared on the same reporting date. If the end of the reporting period differs in them, the subsidiary prepares additional financial information as of the same date as the parent company. If this is not feasible, the latest version of the financial statements should be used, adjusted for the impact of significant transactions or events that occurred during the period between the date of such financial statements and the date of the consolidated financial statements. The discrepancy should not exceed three months, and along with the duration of the reporting periods, it should coincide from time to time.
The parent company may lose control over the subsidiary when two or more agreements (operations) are concluded. However, sometimes circumstances indicate that several such agreements should be accounted for as a single transaction. In case of loss of control, the parent company must make certain adjustments to its accounting.
Another important standard for the consolidation of financial statements is IFRS 3 «Business Combination». Based on the information in this document, a business combination is an association of individual companies into one reporting company, including taking into account the acquisition of other enterprises. The standard describes transactions in which organizations merge, and applies to all types except for joint activities, the acquisition of an asset that does not constitute a business, business combinations or businesses under common control.
Accordingly, IFRS 3 «Business Combination» applies if the organization has acquired a business, and not a group of assets. The main difference is that goodwill may arise in the first case, but not in the second. Also, when buying a profitable business, the indicators of financial results from its acquisition increase, and when buying assets, deferred tax assets and liabilities are taken into account [6].
According to the above standard, the acquisition method is used when combining a business. In a business combination, the purchasing company allocates the purchase amount to assets and liabilities carried at fair value. Based on this, it is necessary:
– determine the value of assets and liabilities;
– determine the purchase price;
– to attribute to goodwill the difference between the purchase costs and the amount attributed to assets and liabilities.
When combining a business according to IFRS 3, the following stages are distinguished by the acquisition method:
- Identification of the buyer. If two or three organizations are involved in the transaction, it will not be difficult to determine the buyer. When combining a large number of companies, this process will be more time-consuming, since control over the business can be obtained in several ways:
– transfer of funds or other assets;
– commitment;
– issue of equity shares;
– providing more than one refund;
– consolidation by means of a contract without transfer of compensation.
It must be remembered that control takes place if the parent organization (buyer):
– owns half or more of the voting rights by agreement with other investors;
– has the ability to determine financial and economic policy in accordance with the charter or agreement;
– appoints and displaces management personnel;
– represents the majority of votes at meetings of the board of Directors exercising control over the enterprise.
Thus, at the first stage, control is expressed in the acquisition by the buyer of a controlling interest in shares of other organizations, valued in assets and financial results.
- Having identified the buyer, you can proceed to determining the date of acquisition of the business. According to IFRS 3, it should be the date when the buyer gained control of the purchased organization. Most often, this is the closing date of the transaction. However, there are situations when the buyer gains control of the organization sooner or later than the transaction is completed. In this case, professional judgment is applied. It is necessary to pay attention to when the decision was approved by the other parties and whether all legal formalities have been observed. It is best to choose the end of the reporting period (month, quarter, year) for the convenience of reflecting transactions in accounting statements. In accordance with IFRS, the acquisition date may differ from the actual date if this does not lead to significant changes in the recognized amounts.
This stage is of great importance, since the fair value of assets and liabilities will be determined at this date in the future.
- Recognition and measurement of identifiable acquired assets, liabilities and non-controlling interests. The International standard requires the identification of acquired assets and liabilities at fair value at the date of acquisition. To determine it, it is necessary that they meet the recognition criteria, that is, they are accounted for at the date of receipt and are part of the acquired business.
However, for example, contingent liabilities, income tax, compensating assets, employee benefits, etc., are not measured at fair value and, accordingly, should not meet the recognition criteria. IFRS 3 «Business Combination» contains detailed advice on accounting for individual objects.
As mentioned earlier, assets should be valued at fair value, that is, at current market prices. Organizations have the right to involve professional appraisers to determine it. For such types as intangible assets, biological and others, it is proposed to use an active market.
- The last step in the acquisition method is the recognition and valuation of goodwill or profit from a profitable transaction. It occurs separately from the identification of acquired assets and liabilities. Goodwill is measured as the difference between the transferred consideration, the amount of non-controlling interests in the acquired entity and the amount of identifiable assets acquired less liabilities assumed. If the business combination takes place in stages, the valuation of goodwill also takes into account the value of the equity interest at the acquisition date that the buyer previously owned [4].
In a business combination by transferring non-controlling interests to a buyer, if the fair value of the non-controlling interests of the acquired entity can be estimated with a higher degree of reliability than the fair value of the non-controlling interest of the buyer at the acquisition date, he himself determines the amount of goodwill.
To determine the amount of goodwill in a business combination in which no consideration has been transferred, the buyer will use, at the acquisition date, the fair value of the buyer’s non-controlling interest in the acquired entity, instead of the fair value of the transferred consideration.
It should be remembered that goodwill is not amortized and is checked annually for impairment. Moreover, the buyer must evaluate it at its fair value at the date of acquisition, less accumulated impairment losses.
In order to establish the principle of preparing and presenting financial statements to organizations that have an interest in joint activities, IFRS 11 «Joint Arrangements» should guide them. According to this document, there are the following types of joint activities:
– A joint operation is a joint activity that involves the presence of parties referred to as participants in a joint operation and having joint control, having rights to assets and being responsible for obligations under the agreement. Assumes recognition of assets, liabilities, revenue, expenses and shares in them;
– A joint venture is a joint activity that assumes that the parties having joint control over the activity have rights to the net assets of the activity. Such parties are referred to as participants in the joint venture. The equity method is used, or in other words, the equity method [9].
To determine the type of joint activity, an enterprise evaluates its rights and obligations by analyzing the structure and organizational and legal form of joint activity, the conditions agreed between the parties under a contractual agreement, and, if necessary, other factors and circumstances, and then makes a judgment regarding the definition of the type of joint activity.
Let’s take a closer look at what the difference between these types is.
First, it is necessary to determine exactly whether joint activities are being discussed or not: whether joint control over the agreement is provided for all parties, whether a single consent is required. After that, the type of joint activity should be determined. However, it must be remembered that the economic essence of the agreement is of decisive importance, and not its formal structure. When determining the type of joint activity, other factors and circumstances should also be assessed:
– responsibilities regarding the manufactured product;
– obligations under obligations in joint activities.
Exactly how the above factors are taken into account in both types of joint activities is shown in table 1.
Table 1
Comparison of responsibilities in joint operations and joint ventures [10]
Joint operation | Joint venture |
The sale of the manufactured product to third parties is prohibited | The manufactured product may be sold to third parties |
The parties to the agreement are obliged to purchase almost the entire manufactured product | The manufactured product may be purchased by third parties |
Cash flows for repayment of obligations provided by the parties to the agreement | Cash flows for repayment of obligations come from third parties when they sell the manufactured product |
It is designed to carry out activities at the break-even level or even with losses, which are financed by the parties to the agreement | Designed to generate profit |
In the case of a joint operation, the participant acknowledges the following in its financial statements:
– assets, including a share in jointly controlled;
– obligations, including a share in jointly incurred;
– own revenue from the sale of shares in products produced within the framework of joint operations;
– a share in the revenue from the sale of products of the joint operation itself;
– expenses, including the share of jointly incurred [2].
In the case of a joint venture, the participant recognizes its share as an investment and accounts for it using the equity method in accordance with IFRS 28 «Investments in Associates and Joint Ventures», unless the organization is exempt from the requirement to apply this method. There may be a situation when a party, being a participant in a joint venture, does not have control. In this case, it accounts for its share in accordance with IFRS 9 «Financial Instruments».
Summing up, it should be noted that the analysis of international standards governing the formation of consolidated financial statements allows us to study this issue in more detail and, as a result, avoid significant errors in providing users with useful, meaningful and reliable information about the financial position and performance of the group of companies for the reporting period.
References
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