AS-21 provides for the use of equity method of consolidation

Jayant M Thakur

THIS is the second part in a series of three on the new accounting standard 21 on consolidated financial statements. The first part discussed that consolidated statements are not an option for separate statements. Also, AS 21 does not require the preparation of consolidated statements. It only provides that if consolidated statements are made then they have to be in consonance with it.

Let us consider some other aspects of this new accounting standard.
The accounting standard adopts the so called equity method of consolidation of accounts. This implies two aspects. Firstly, an adjustment is warranted to the cost of the investment in the subsidiary. This is complicated enough to warrant a separate discussion. The second aspect is that the consolidation is done on a line by line basis.

AS 21 requires that the substance behind the formal investment in terms of holding of shares should be recognized in the accounts of the parent in consolidated statements

JAYANT M THAKUR Chartered Accountant, Mumbai

This is done as follows. Each like item in the accounts such as assets, liabilities, etc is aggregated and the total figure is shown in the consolidated accounts. Thus, the value of the machinery of the parent company is added to the value of the machinery of the subsidiaries and the total amount is displayed in the consolidated financial statements.

Similarly, sales of the parent is added to the sales of the subsidiary. This should normally result in the net profits being added - though this may not happen for various reasons, particularly for share of minority shareholders, as explained later herein.

While making the line by line additions, certain adjustments are warranted. Inter-group transactions are to be eliminated. Thus, sales by the parent to the subsidiary which are included in the sales of the parent but the purchases of the subsidiary are to be set off and thereby eliminated. The need for this is obvious - to avoid double counting and inflated volume of figures. Needless to add, inter-group balances are also to be set off and eliminated.

A question arises here. While the revenue items may be set off against each other, what about the consequences of such transactions? An obvious example may make this point clear. If the parent company has sold certain goods at above cost to the subsidiary, and the subsidiary has not sold the full of such goods by the year-end, how should such goods be valued?

Presently, the subsidiary may have accounted for such stock in hand at the cost to it, which is the price at which the parent has sold to it, above its own cost. The objective of consolidation is to recognize that effectively, in view of the element of control and 50 per cent plus holding, the assets and performance of the subsidiary is effectively that of the parent.

Conservative principles of accountancy require that profits should not be recognized until realized - in this case, by sale to a party outside the group. Thus, an adjustment would be warranted to the value of stock so as to eliminate the unrealized profits. This is required to be done by the accounting standard.

The line by line addition will result in two major group of items being left out. First is the net profit. Second is the items relating to owners funds, ie share capital and reserves. The parent is not entitled to the full of these values - it would be entitled only to the extent of its holding of the equity shares.

The shareholders in the subsidiaries other than the parent are referred to as minority shareholders and these would be entitled to the balance of the amounts of net profits and net worth. Hence, to recognize this, the net profit is required to be bifurcated into the profits for the parent which is added to the group profits and the profits belonging to such minority shareholders which is shown as a liability. The net worth is similarly bifurcated.

The equity method warrants another adjustment or group of adjustment. This is the accounting for and elimination of the amount of investment in the subsidiary. A little background to this may be first necessary. It may be recollected that this accounting standard is actually a spin off from the standard on Accounting for Investments (AS 13). Till the issuance of the present accounting standard, AS 13 applied.

Essentially, the treatment required by AS 13 was that investments should be disclosed at cost (where the investments are held for the long term). This is irrespective of the extent of holding and irrespective of the happenings in the investee company. The investment may have been made at a inflated value or at a bargain. The investee company may have made huge profits or losses after the investment has been made. The accounting standard required recognition of none of these aspects. It is only when the investee company declared a dividend and paid it that the investor company had to recognize it in its accounts.

Another situation when an adjustment was required was when there was a permanent decline in the value of the investment - in which case, an appropriate portion of the value of the investment was to be written off.

The present accounting standard however requires a total change in approach to the accounting for investments in subsidiaries. It requires that the substance and performance behind the formal investment in terms of holding of shares should be recognized in the accounts of the parent in consolidated financial statements.

Accordingly, in line with other consolidation, adjustments have to be made in the figures of the cost of investment. These are explained as follows.

First of all, the amount paid for the investment is taken as the starting point. It is compared with the “equity” in the subsidiary - essentially the share of the parent in the net worth of the subsidiary, at the time of making of the investment.

If this amount of “equity” is lower than the cost paid, the excess is deemed to be the goodwill and if higher, the surplus is recognized as capital reserve. This brings the cost of the investment in line with the equity. This is necessary not only for this reason but also by doing this, it will automatically get adjusted against the figure of equity being consolidated.