The preparation of consolidated financial statements is a key element of the Financial Reporting (FR) exam. It can be an area where candidates perform extremely well but can also be an area where candidates make simple mistakes which could prove costly.
This article will not focus on the more technical, difficult adjustments that can arise within consolidated financial statements but will instead look at the most common errors that candidates make. These are the items that the FR examining team see repeatedly. Many of these errors are easy to make in a time-pressured exam. The good news is that they are also quite simple to fix. By avoiding these errors, candidates will be able to significantly improve their mark and their chances of progressing to the next stage.
This article also looks at equity accounting for associate accounting and is a reminder of how it differs from consolidation.
Before we look at these errors, we need to remind ourselves of some key principles surrounding the preparation of consolidated financial statements. If candidates are able to keep these key principles in mind, then hopefully they can avoid some of the most common (and costly) errors that we will outline below.
Control – We show control by adding in 100% of the items of the parent and the subsidiary. There are no exceptions to this. Even in a mid-year acquisition in the consolidated statement of profit or loss (where we time-apportion the results of the subsidiary), we still bring in 100% of the subsidiary’s income and expenses but restrict it for the period owned.
Ownership – We must remember that there are two owners of the group. The parent’s shareholders own the majority of the group (owning 100% of the parent, and therefore a majority holding in the subsidiary) and the non-controlling interest. Candidates are very good at remembering to reflect the amounts attributable to the different owners in the consolidated statement of financial position, but are generally quite poor in remembering to do this in the consolidated statement of profit or loss (see error 2)
So, here are our top five errors. A candidate that avoids just one of these simple errors could potentially gain up to four marks in their exam, so they are worth being aware of. We have ranked these in order of how common they are.
An important thing to note immediately is that the top two errors noted here have big impacts on the consolidated statement of profit or loss. Of the two types of consolidated financial statements preparation questions, the marks awarded on the consolidated statement of profit or loss are always lower and the questions less well done. By avoiding errors 1 and 2 here, you could improve your score on this question by up to 7 marks – this is significant in terms of your total FR score. This is essential and shows the importance of good technique and applying the principles of control and ownership noted above.
When candidates have previously been asked to prepare a consolidated statement of profit or loss (CSPL) in an exam, it has often been that the company has acquired the subsidiary during the year. If this is the case, a fundamental principle of the CSPL is that the income and expenses are only consolidated from the date of acquisition.
This is easy to overlook but be ready for it. Dates are given in the scenario for a reason and should always be considered. A key part of preparing a CSPL is to check the date of acquisition before you attempt the question. Be ready for it to have been acquired during the year, as this is the case more often than not.
If it is a mid-year acquisition, instead of adding all of the income and expenses of the parent and subsidiary company, you add all of the parent’s income and expenses to the time-apportioned income and expenses of the subsidiary. So, if the parent acquired the subsidiary on 1 October 20X1 and the year-end is 31 December 20X1, you should only include three months of the subsidiary’s results.
This is deemed as a fundamental error. If you fail to do this, you can lose all marks for the basic principle of consolidating the results of the parent and subsidiary. You will still be able to gain marks for the adjustments made, but you will lose the simple ‘adding up’ marks for consolidating the income and expenses of the parent and subsidiary.
This has become increasingly common, leading to students dropping numerous marks for failing to apply a core principle in the CSPL. The two major functions of the CSPL are:
Generally, students recognise the importance of point (1) above, but increasingly neglect point (2). This is an essential part of a CSPL and can be worth up to four marks. These marks are gained through showing the knowledge that profit is split between the two parties, and then identifying which adjustments impact the NCI.
A frustration noted from the FR examining team is with strong candidates who clearly know how to process technical adjustments, producing excellent answers but then not including the split of profits at the bottom of the CSPL. This means that even strong candidates are dropping some of the more achievable marks available.
This error could be applied across any question where candidates are preparing financial statements, and where the principles of double entry are forgotten. In recent years it has been noted that fewer candidates make single entries in the preparation of single-entity accounts, but it has become an increasing problem in the preparation of the consolidated statement of financial position (CSFP).
Often, we see candidates calculate the correct figure for an adjustment and place that adjustment into one of the correct places. This means that candidates who understand adjustments can be losing up to half of the marks available for that item.
As a quick guide, here is a reminder of some of the key adjustments where this error occurs and the candidates should identify the two correct sides to the entry. The side most commonly omitted by candidates is shown in bold:
The fourth error is the opposite of what we have seen in error 1, and it is less common. It is essential that students note the difference between a statement of profit or loss and a statement of financial position.
A statement of profit or loss has income and expenses accruing over a period, so requires time-apportionment of the subsidiary results.
A statement of financial position shows the assets and liabilities controlled by the entity at the reporting date. If the parent has control of the subsidiary at the reporting date, then ALL of the assets and liabilities of the subsidiary must be added in. If we consider it logically, it makes no sense to time-apportion receivables or cash or other assets. At the year-end, the group control 100% of these assets and so all of them must be included.
The golden rule is this – NEVER time-apportion the assets and liabilities in consolidation. The only element of time-apportioning would come with any depreciation on a fair value adjustment, but you would still add 100% of the assets and liabilities of the subsidiary into the CSFP.
Of all the errors, this is the one that frustrates the FR examining team the most as it seems to signify a lack of practice of past questions. A few years ago, this error was in dramatic decline, which was pleasing to see. Sadly, recent diets have shown a resurgence in this error.
A student who applies proportionate consolidation does not include 100% of the assets and liabilities of a subsidiary in a CSFP, or income and expenses in a CSPL. Instead they only apply the percentage that the parent owns in the subsidiary. Therefore, if the parent owns 80% in the subsidiary, these candidates add in 80% of the subsidiary’s assets, liabilities, income or expenses.
This is never a correct way to prepare consolidated financial statements and any candidate doing this is making a severe and fundamental error. Students will never have seen an example of this, as it is not acceptable practice and so they will lose significant marks for doing this.
It is also important to note that consolidation refers to the accounting required where the parent company controls another entity (subsidiary). Candidates should not confuse this with equity accounting which is related to associate companies where significant influence is presumed with a shareholding between 20-50%. The following is a summary of equity accounting but you should refer to other learning materials for further detail.
CSPL
Do not consolidate a proportion of income and expenses line by line (common error) but present a single ‘Share of profit of the associate’ line in the CSPL. This is presented above the consolidated profit before tax. This is the parent’s share of the associate’s profit for the year (time apportioned if appropriate).
CSFP
As for the CSPL, do not consolidate a proportionate share of assets and liabilities line by line (common error) but instead include in the CSFP a single ‘Investment in associate’ line under non-current assets. This is calculated as follows:
| Cost of associate (may have to calculate) | |
| Group % of post-acquisition reserves | |
| Less: group % of impairment losses on associate to date | |
| Less: group % of unrealised profit | |
| Investment in associate |
Another common error with equity accounting relates to the adjustment for unrealised profit where trade has occurred between the parent and the associate. A distinction is made between upstream and downstream transactions with the following adjusting journal entries required for an intercompany sale of inventories between a parent and its associate:
Upstream:
DR Share of profits of associate
CR Inventories
Downstream:
DR Cost of sales
CR Investment in associate
However, a common error is to calculate and adjust the unrealised profit in the same way as you would for a subsidiary. Candidates must remember to only adjust for the group % of the unrealised profit.
In conclusion, the preparation of consolidated financial statements is a key area for the Financial Reporting exam. There are many technical aspects to these questions, and question practice is crucial. There is no short-cut to scoring a good mark, but there are some key principles to remember. If you keep these in mind, you will avoid dropping marks on the more basic areas:
So, take those tips away and know that you are protected from some of the more costly individual errors. Ensure you practice the CSPL, as these questions are commonly less well done. This topic is important for both Financial Reporting and Strategic Business Reporting, so it is essential to lock in the fundamentals.
Written by a member of the FR examining team