Principles of Consolidation

Principles of Consolidation



Principles of Consolidation

Chapter 11 Principles of Consolidation


1.         Apply the method of accounting for business combinations (HKFRS 10).
2.         Account for the effects of intra-group trading in the statement of financial position.
3.         Determine appropriate procedures to be used in preparing group financial statements.
4.         Apply the equity method of accounting for associates and joint venture (HKAS 28 (2011)).
5.         Outline and apply the key definitions and accounting methods that relate to interests in joint arrangements (HKFRS 11).
6.         Understand and discuss the issues associated with disclosure of interest in other entities (HKFRS 12).


1.       Definitions

1.1       HKFRS 10 Consolidated Financial Statements amended some of the definitions. Note that there is no change to the basic principles or mechanics of how to prepare group accounts, rather it is the application of the definition of control which has changed.




(a)        Group – A parent and its subsidiaries.                                          (HKFRS 10)
(b)        Parent – An entity that controls one or more entities.                  (HKFRS 10)
(c)        Subsidiary – An entity that is controlled by another entity.         (HKFRS 10)
(d)        Control – An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through power over the investee.
(HKFRS 10)
(e)        PowerExisting rights that give the current ability to direct the relevant activities.                                                                                      (HKFRS 10)
(f)        Relevant activitiesActivities of the investee that significantly affect the investee’s returns.                                                                       (HKFRS 10)
(g)        Associate – An entity over which the investor has significant influence.
(HKAS 28)
(h)        Significant influence – is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control of those policies.                                                                             (HKAS 28)

1.3       Before we move on to discuss the principles of consolidation, the following table is useful in summarising different types of group investment and how they are accounted for.



Required treatment



Full consolidation (HKFRS 3 (revised) / HKFRS 10


Significant influence

Equity accounting (HKAS 28)

Joint arrangement
(joint venture)

Contractual arrangement

Equity accounting (HKFRS 11 / HKAS 28)

Investment which is none of the above

Asset held for accretion of wealth

As for single company accounts per HKFRS 9

1.4       Control

1.4.1    HKFRS 10, issued in June 2011 provides an amended definition, and identifies three separate elements of control. It states that an investor controls an investee if and only if it has all of the following:
(a)        Power over the investee,
(b)        Exposure, or rights, to variable returns from its involvement with the investee, and
(c)        The ability to use its power over the investee to affect the amount of the investor’s returns
1.4.2    If there are changes to one or more of these three elements of control, then an investor should reassess whether it controls an investee.

(a)       Power

1.4.3    Power is defined as existing rights that give the current ability to direct the relevant activities of the investee. There is no requirement for that power to have been exercised.
1.4.4    Relevant activities may include:
(a)        selling and purchasing goods or services
(b)        managing financial assets
(c)        selecting, acquiring and disposing of assets
(d)        researching and developing new products and processes
(e)        determining a funding structure or obtaining funding
1.4.5    In some cases assessing power is straightforward, for example, where power is obtained directly and solely from having the majority of voting rights or potential voting rights, and as a result the ability to direct relevant activities.
1.4.6    In other cases, assessment is more complex and more than one factor must be considered. HKFRS 10 gives the following examples of rights, other than voting or potential voting rights, which individually, or alone, can give an investor power:
(a)        Rights to appoint, reassign or remove key management personnel who can direct the relevant activities
(b)        Rights to appoint or remove another entity that directs the relevant activities
(c)        Rights to direct the investee to enter into, or veto changes to transactions for the benefit of the investor
(d)        Other rights, such as those specified in a management contract.
1.4.7    HKFRS 10 suggests that the ability rather than contractual right to achieve the above may also indicate that an investor has power over an investee.


Example 1


An investor acquires 48% of the voting rights of an investee. The remaining voting rights are held by thousands of shareholders, none individually holding more than 1% of the voting rights. None of the shareholders has any arrangements to consult any of the others or make collective decisions. When assessing the proportion of voting rights to acquire, on the basis of the relative size of the other shareholdings, the investor determined that a 48% interest would be sufficient to give it control.

In this case, on the basis of the absolute size of its holding and the relative size of the other shareholdings, the investor concludes that it has a sufficiently dominant voting interest to meet the power criterion without the need to consider any other evidence of power.


Example 2


Investor A holds 40% of the voting rights of an investee and twelve other investors each hold 5% of the voting rights of the investee. A shareholder agreement grants investor A the right to appoint, remove and set the remuneration of management responsible for directing the relevant activities. To change the agreement, a two-thirds majority vote of the shareholders is required.

In this case, investor A concludes that the absolute size of the investor’s holding and the relative size of the other shareholdings alone are not conclusive in determining whether the investor has rights sufficient to give it power. However, investor A determines that its contractual right to appoint, remove and set the remuneration of management is sufficient to conclude that it has power over the investee. The fact that investor A might not have exercised this right or the likelihood of investor A exercising its right to select, appoint or remove management shall not be considered when assessing whether investor A has power.

(b)       Returns

1.4.10  An investor must have exposure, or rights, to variable returns from its involvement with the investee in order to establish control.
1.4.11  This is the case where the investor’s returns from its involvement have the potential to vary as a result of the investee’s performance.
1.4.12  Returns may include:
(a)        dividends
(b)        remuneration for servicing an investee’s assets or liabilities
(c)        fees and exposure to loss from providing credit support
(d)        returns as a result of achieving synergies or economies of scale through an investor combining use of their assets with use of the investee’s assets

(c)        Link between power and returns

1.4.13  In order to establish control, an investor must be able to use its power to affect its returns from its involvement with the investee. This is the case even where the investor delegates its decision making powers to an agent.

(d)       Delegated power – principals and agents

1.4.14  When decision making rights have been delegated or are being held for the benefit of others, it is necessary to assess whether the decision-maker is a principal or an agent to determine whether it has control.


Principal and agent


(a)        HKFRS 10 introduces the concept of delegated power. If it has the power to direct the activities of an entity that it manages to generate returns for itself, then it is a principal.
(b)        If it is engaged to act on behalf and for the benefit of another party or parties, then it is an agent and does not control the investee when exercising its decision-making authority.
(c)        This is because if that decision-maker has been delegated rights that give the decision-maker power, it must be assessed whether those rights give the decision-maker power for its own benefit, or merely power for the benefit of others.
(d)        As an agent cannot have control over the investee, it does not consolidate the investee.
(e)        A principal may have control over the investee, and if so, would consolidate the investee.

2.       Exclusion and Exemption of Subsidiaries from Consolidation

2.1       Exclusion of subsidiaries from consolidation

2.1.1    Where a parent controls one or more subsidiaries, HKFRS 10 requires that consolidated financial statements are prepared to include all subsidiaries, both foreign and domestic other than:
(a)        those held for sale in accordance with HKFRS 5
(b)       those held under such long-term restrictions that control cannot be operated.
2.1.2    The rules on exclusion of subsidiaries from consolidation are necessarily strict, because this is a common method used by entities to manipulate their results. If a subsidiary which carries a large amount of debt can be excluded, then the gearing of the group as a whole will be improved. In other words, this is a way of taking debt out of the consolidated statement of financial position.
2.1.3    HKFRS 10 and HKAS 27 (revised) do not specify any other circumstances when subsidiaries must be excluded from consolidation.


Specific circumstances


(a)       Severe long-term restrictions
Previously, HKAS 27 permitted exclusion from consolidation where the subsidiary was subject to long-term restrictions on the ability to transfer funds to the parent; this exclusion is no longer permitted as it may still be possible to control a subsidiary in such circumstances
(b)       Acquired for resale
A subsidiary acquired exclusively with a view to disposal within 12 months will probably meet the conditions in HKFRS 5 Non-current assts held for sale and discontinued activities for classification as held for sale.

If it does; the effect is that all its assets are presented as a single line item below current assets and all its liabilities are presented as a single line item below current liabilities. So it is still consolidated, but in a different way.
(c)       Materiality
Accounting standards do not normally apply to immaterial items; therefore an immaterial subsidiary need not be consolidated. However, this would need to be kept under review from year to year, and the parent would need to consider each subsidiary to be excluded on this basis, both individually and collectively.

2.1.5    It is important to note that exclusion of subsidiaries from consolidation under the reasoning of dissimilar activities is not permitted under HKAS 27 (revised).

2.2       Exemption from preparing group accounts

2.2.1    A parent need not present consolidated financial statements if and only if:
(a)        it is a wholly-owned subsidiary or it is a partially owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not reject to, the parent not presenting consolidated financial statements;
(b)        its securities are not publicly traded;
(c)        it is not in the process of issuing securities in public securities markets; and
(d)        the ultimate or intermediate parent publishes consolidated financial statements that comply with Hong Kong Financial Reporting Standards.

3.       Different Reporting Dates and Different Accounting Policies

3.1       Reporting dates

3.1.1    In most cases, all group companies will prepare accounts to the same reporting date. One or more subsidiaries may, however, prepare accounts to a different reporting date from the parent and the bulk of other subsidiaries in the group.
3.1.2    If the subsidiary does not prepare conterminous financial statements to the same reporting date as the parent, the financial statements of that subsidiary should be adjusted for the effects of significant transactions or other events that occur between the two different dates.
3.1.3    HKFRS 10 includes a further restriction that the difference between reporting dates should not exceed three months.

3.2       Accounting policies

3.2.1    Consolidated financial statements should be prepared using uniform accounting policies for like transactions and other events in similar circumstances.
3.2.2    Adjustments must be made where members of a group use different accounting policies, so that their financial statements are suitable for consolidation.

4.       The Basic Consolidation of Statement of Financial Position

4.1       Steps in preparing the consolidated statement of financial position


Steps in preparing the consolidated statement of financial position


(W1) Shareholding in the subsidiary

(W2) Consolidation adjustments.

(W3) Net assets of subsidiary


At date of acquisition

At the reporting date




Share capital






Share premium



Retained earnings






(W4) Goodwill



Parent holding (investment) at fair value


NCI value at acquisition (*)






Fair value of net assets at acquisition (W2)


Goodwill on acquisition


Impairment of goodwill


Carrying goodwill


(*) If fair value method adopted, NCI value = fair value of NCI’s holding at acquisition (number of shares NCI own × subsidiary share price).

(*) If proportion of net assets method adopted, NCI value = NCI % × fair value of net assets at acquisition (from W2).

(W5) Group retained earnings



P’s retained earnings (100%)


P’s % of sub’s post-acquisition retained earnings


Less: Parent share of impairment (W3)




(W6) Non controlling interest



NCI value at acquisition (as in W3)


NCI share of post-acquisition reserves (W2)


NCI share of impairment (fair value method only)





4.2       Summary of basic consolidation adjustments


Basic consolidation adjustments


(a)       Current assets

Cash in transit
Dr. Group Bank/Cash (cash in transit)
Cr. Current account

Goods in transit
Dr. Group inventory
Cr. Current account

(b)       Unrealised profit in inventory

Parent sells to subsidiary
Dr. Group retained earnings
Cr. Group inventory

Subsidiary sells to parent
Dr. Group retained earnings (multiplying the shareholdings)
Dr. NCI (multiplying the proportion of NCI)
Cr. Group inventory

(c)       Unrealised profit in sale of non-current assets

Parent sells to subsidiary
Dr. Group retained earnings
Cr. Group non-current assets

Excessive depreciation
Dr. Accumulated depreciation
Cr. Group retained earnings

Subsidiary sells to parent
Dr. Group retained earnings
Cr. Group non-current assets

Excessive depreciation
Dr. Accumulated depreciation
Cr. Group retained earnings

(d)       Intra-group lending

Dr. Group loan
Cr. Group investments (or receivables)


(e)       Dividends out of pre-acquisition profits

Dr. Cash
Cr. Investment in subsidiary

4.3       Goodwill




Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized.

Goodwill arising on consolidation is the difference between the cost of an acquisition and the fair value of the subsidiary’s net assets acquired.


Treatment of Goodwill


(a)       Positive goodwill:
(i)         Capitalised as an intangible non-current asset.
(ii)        Tested annually for possible impairments.
(iii)       Amortisation of goodwill is not permitted by the standard.

(b)       Impairment of positive goodwill:
If goodwill is considered to have been impaired during the post-acquisition period it must be reflected in the group financial statements. Accounting for the impairment differs according to the policy followed to value the non-controlling interests.

(i)         Proportion of net assets method:

Dr Group reserves
Cr Goodwill

(ii)        Fair value method – the goodwill in the statement of financial position includes goodwill attributable to the non-controlling interest. In this case the double entry will reflect the non-controlling interest proportion based on their shareholding as follows:

Dr Group reserves (% of impairment attributable to the parent)
Dr NCI (% of impairment attributable to NCI)
Cr Goodwill

(c)       Negative goodwill:
(i)         Arises where the cost of the investment is less than the value of net assets purchased.
(ii)        HKFRS 3 does not refer to this as negative goodwill (instead it is referred to as a bargain purchase), however this is the commonly used term.
(iii)       Most likely reason for this to arise is a misstatement of the fair values of assets and liabilities and accordingly the standard requires that the calculation is reviewed.
(iv)       After such a review, any negative goodwill remaining is credited directly to the income statement.

4.4       Non-controlling interests


Computation of Non-controlling Interests


HKFRS 3 allows two alternative ways of calculating non-controlling interest in the group statement of financial position. Non-controlling interest can be valued at:
(a)    Proportion of net assets method – NCI value = NCI % × fair value of net assets at acquisition; or
(b)    Fair (full) value method – NCI value = fair value of NCI’s holding at acquisition (number of shares NCI own × subsidiary share price).

4.5       Fair value of consideration and net assets


Fair value of consideration and net assets


To ensure that an accurate figure is calculated for goodwill:
(a)       the consideration paid for a subsidiary must be accounted for at fair value;
(b)       the subsidiary’s identifiable assets and liabilities acquired must be accounted for at their fair values.


4.6       Calculation of cost of investment


The cost of acquisition


The cost of acquisition includes the following elements:
(a)       Cash paid; and
(b)       fair value of any other consideration, i.e. deferred/ contingent considerations and share exchanges.

4.6.2    Incidental costs of acquisition such as legal, accounting, valuation and other professional fees should be expensed as incurred. The issue costs of debt or equity associated with the acquisition should be recognized in accordance with HKAS 32.

(a)       Deferred and contingent consideration

4.6.3    In some situations not all of the purchase consideration is paid at the date of the acquisition, instead a part of the payment is deferred until a later date – deferred consideration.
(a)        Deferred consideration should be measured at fair value at the date of the acquisition, i.e. a promise to pay an agreed sum on a predetermined date in the future taking into account the time value of money.
(b)        The fair value of any deferred consideration is calculated by discounting the amounts payable to present value at acquisition.
(c)        Each year the discount is then unwound. This increases the deferred liability each year (to increase to future cash liability) and the discount is treated as a finance cost.

(b)       Share exchange

4.6.4    Often the parent company will issue shares in its own company in return for the shares acquired in the subsidiary. The share price at acquisition should be used to record the cost of the shares at fair value.


Example 3 – Calculation of cost of investment


H Ltd acquires 24 million $1 shares (80%) of the ordinary shares of S Ltd by offering a share-for-share exchange of two shares for every three shares acquired in S Ltd and a cash payment of $1 per share payable three years later. H Ltd’s shares have a nominal value of $1 and a current market value of $2. The cost of capital is 10% and $1 receivable in 3 years can be taken as $0.75.


(a)       Calculate the cost of investment and show the journals to record it in H Ltd’s accounts.
(b)       Show how the discount would be unwound.


(a)    Cost of investment



Deferred cash (at present value) [$0.75 x ($1 x 24m)]


Shares exchange [(24m x 2/3) x $2]




$50m is the cost of investment for the purposes of the calculation of goodwill.



Dr Cost of investment in subsidiary


Cr Non-current liabilities – deferred consideration


Cr Share capital (16m shares x $1)


Cr Share premium (16m shares x $1)


(b)    Unwinding the discount
$18m x 10% = $1.8m



Dr Finance cost


Cr Non-current liabilities – deferred consideration


For the next three years the discount will be unwound, taking the interest to finance cost until the full $24 million payment is made in Year 3.

4.7       Fair value of net assets acquired

4.7.1    HKFRS 3 (revised) requires that the subsidiary’s assets and liabilities are recorded at their fair value for the purposes of the calculation of goodwill and production of consolidated accounts.
4.7.2    Adjustments will therefore be required where the subsidiary’s accounts themselves do not reflect fair value.

5.       Associates and Joint Ventures

5.1       HKAS 28 was revised in 2011 to include accounting for both associates and joint ventures. Previously, HKAS 28 dealt with associates and HKAS 31 dealt with joint ventures. HKAS 31 has now been withdrawn and, where a joint arrangement (as defined by HKFRS 11) also meets the definition of a joint venture, HKAS 28 (revised) requires that any associates or joint ventures are equity-accounted in the group financial statements.
5.2       HKAS 28 (2011) requires that the carrying value of the associate or joint venture is determined as follows:

Investment in associate or joint venture




Add: Share of increase in net assets


Less: Impairment loss




6.       Joint Arrangements

6.1       HKFRS 11 Joint Arrangements was issued in 2011 to replace HKAS 31. HKFRS 11 provides new or updated definitions to determine whether there is a joint arrangement and, if so, the nature of that arrangement together with associated accounting requirements. It adopts the definition of control as included in HKFRS 10 as a basis for determining whether there is joint control.




(a)       Joint arrangements are defined as arrangements where two or more parties have joint control, and that this will only apply if the relevant activities require unanimous consent of those who collectively control the arrangement. They may take the form of either joint operations or joint ventures. The key distinction between the two forms is based on the parties’ rights and obligations under the joint arrangement.
(b)       Joint operations are defined as joint arrangements whereby the parties that have joint control have rights to the assets and obligations for the liabilities. Normally, there will not be a separate entity established to conduct joint operations.

HKFRS 11 requires that joint operators each recognize their share of assets, liabilities, revenues and expenses of the joint operation over which they have rights and obligations. This may consist of maintaining a joint operation account to record transactions undertaken on behalf of the joint operation, together with balances due to or from other parties to the joint operation.

A and B decide to enter into a joint operation to produce a new product. A undertakes one manufacturing process and B undertakes the other. A and B have agreed that decisions regarding the joint operation will be made unanimously and that each will bear their own expenses and take an agreed share of the sales revenue from the product.
(c)       Joint ventures are defined as joint arrangements whereby the parties have joint control of the arrangement and have rights to the net assets of the arrangement. This will normally be established in the form of a separate entity to conduct the joint venture activities. The equity method of accounting must be used in this situation.

A and B decide to set up a separate entity, C, to enter into a joint venture. A will own 55% of the equity capital of C, with B owning the remaining 45%. A and B have agreed that decision-making regarding the joint venture will be unanimous. Neither party will have direct right to the assets, or direct obligation for the liabilities of the joint venture; instead, they will have an interest in the net assets of entity C set up for the joint venture.
(d)       Joint control is defined as contractually agreed sharing of control of an arrangement which exists only when the decisions about the relevant activities require the unanimous consent of the parties sharing control. The key aspects of joint control are described as follows:
(i)        Contractually agreed – contractual arrangements are usually, but not always, written, and provide the terms of the arrangement.
(ii)       Control and relevant activities – HKFRS 10 describes how to assess whether a party has control, and how to identify the relevant activities.
(iii)      Unanimous consent – exists when the parties to an arrangement have collective control over the arrangement and no single party has control.

7.      Disclosure of Interest in Other Entities

7.1       HKFRS 12 was issued in May 2011 as part of the ‘package of five standards’ relating to consolidation. It removes all disclosure requirements from other standards of relating to group accounting and provides guidance applicable to the consolidated financial statements.
7.2       The standard requires disclosure of:
(a)        The significant judgments and assumptions made the determining the nature of an interest in another entity or arrangement, and in determining the type of joint arrangement in which an interest is held.
(b)        Information about interests in subsidiaries, associates, joint arrangements and structured entities that are not controlled by an investor.
7.3       The following disclosures are required in respect of subsidiaries:
(a)        The interest that non-controlling interests (NCI) have in the group’s activities and cash flows, including the name of relevant subsidiaries, their principal place of business, and the interest and voting rights of the NCI.
(b)        Nature and extent of significant restrictions on an investor’s ability to use group assets and liabilities.
(c)        Nature of the risk associated with an entity interests in consolidated structured entities, such as the provision of financial support.
(d)        Consequence of changes in ownership interest in subsidiary (whether control is lost or not).


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