The position of the IASB is to do its best to ensure by codification and obligatory compliance that comparisons can be drawn between different entities embracing the faithful representation concept.
Where Have We Been?
Having now progressed to IAS 27 (Separate Financial Statements) we need to address a couple of important areas, how certain IAS’s and IFRS’s need to be viewed as a package and secondly the concept of consolidation. Many accounting standards are geared to address the issue of comparability. The standards codify what and cannot be capitalized thus enabling entities across the globe to be compared providing they’re in full compliance with IFRS. As you may recall, comparability is a critical component of the Framework along with faithful representation and transparency. If you look back to what we have addressed so far, IAS 1 dealt with presentation format, IAS 2 with inventories both with respect to capitalization and identifying the cost of sales. Moving on we looked at IAS 7 on cash flow statements that identified the three components of cash flow, operations, investments and financing along with an option between the direct and indirect method. Next, we looked at IAS 8 on accounting policies and IAS 10 on subsequent events. Again these both targeted consistency and comparability. IAS 16 on property plant and equipment combined with IAS 40 on investment property address the definition of PP&E along with permitted valuation methodologies that provided an option between depreciation and fair value.
Consider at all times the position of the IASB is to do its best to ensure by codification and obligatory compliance that comparisons can be drawn between different entities embracing the faithful representation concept. IAS 21 addressing foreign exchange was to facilitate what FX rates to use by line item and to be sure to differentiate between the balance sheet and income statement items. If the market has experienced high volatility in the presentation currency that it is very likely to have a marked impact on net income. It thus becomes imperative that transactions have been correctly coded between capitalization and expensing. Last week we looked at borrowing costs IAS 23 which aims to differentiate between financing capital investments which can be capitalized versus straightforward borrowing which is expensed as a cost of funds; and IAS 24 pertaining to related party transactions at above or below market rates that distorts net income and creates a conflict of interest.
All of the above and some still to follow fall under the category of standalone accounting standards. They are necessary to ensure compliance with the Framework providing rules and regulations towards comparability and faithful representation. However when it comes to IAS 27, the topic of this week, we need to consider other IAS’s and IFRS’s that are also very pertinent and relevant.
Within the IAS’s we have IAS 28 addressing investments in Associates and joint ventures and then we need to examine IFRS 3, business combinations, along with IFRS 10 consolidated financial statements and IFRS 12 disclosure of interests in other entities.
Getting a little ahead of ourselves, be aware that where the concept of fair value comes into play then IFRS 13 on fair value provides guidance. Actually, IFRS 13 was specifically created given the frequency of fair value options and/or requirements despite the absence of a standard that defined what is fair value and how it is computed depending upon the circumstances. But that is still a little way ahead.
The next major package of standards pertains to financial instruments. Under IAS’s we have IAS 32 addressing financial instruments presentation and IAS 39 on financial instruments. Given the complexity of those two standards and the considerable difficulties in interpretation, the IASB moved to create IFRS 7 on financial instruments disclosures and IFRS 9 on financial instruments. When it comes to financial instruments two areas contribute to its complexity, i.e. embedded derivatives and hedging activities. Eventually, IAS 32 and IAS 39 will be replaced or superseded by IFRS’s, most likely 7 and 9. It is not unusual given adoption deadlines, sometimes a year or two out, those older standards such as IAS’s will still remain in effect. Other examples here are IFRS 16 on leases and 17 on insurance will still require the replaced standards to remain in effect.
The Concept of Consolidation
Now let’s discuss, by way of introduction, the concept of consolidation. Conceptually, consolidation is very straightforward, i.e. you take the parent, add in the subsidiary or multiple subsidiaries and you theoretically have a consolidated statement. However, that is a far cry from the truth for there are many multiple adjustments that must take place. If you examine a pre-consolidation financial statement, say company ABC, namely the balance sheet you will see a line item referring to investment in company XYZ. Let’s also assume that ABC owns 100% of company XYZ. Thus when you examine the company XYZ the equity section will reflect the ownership of company ABC. Of course, since acquisition company XYZ, will have earned net income or post-acquisition profits or losses. Logically if you consider what an addition, a consolidation, would look like by retaining ABCs investment and XYZ’s equity section then you will effectively be reporting investments in yourself i.e. both assets and liabilities/equity will be grossed up incorrectly. Additionally, there may be many transactions that take place between a parent and its subsidiaries and these need to be eliminated unless for example it is legitimized by an actual sale outside the group. It is also very common for owners to be less than 100% and this gives rise to minority interests. As owners of share capital, minority interests are also entitled to their share of post-acquisition profits and losses. Often times the acquisition price includes what is termed goodwill or a premium over market value. Specifically, there are standards pertaining to the treatment of goodwill and additionally, not only the parent but the minority interest is also allocated its share and/or adjustments to goodwill.
What Will Come?
Next week we will address IAS 27 and consider what the IASB considers to be the standard here.
4 The following terms are used in this Standard (IAS 27) with the meanings specified:
- Consolidated financial statement
- Separate financial statements
(…and then IAS 28 after that)
Lucubrate Magazine, Issue 46, November 9th, 2018
The photo on top: Flamingo Images