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Accounting in the contemporary world is becoming complex as this phenomenon is very diversified and multi-dimensional. It endeavours to answer new queries but in the recent years organisation structures have brought in new-fangled notions. Accountants and accounting authorities, throughout the world, are very much apprehensive about the question, that is, who is actually controlling a firm, its decisions and policies? These questions are mainly related to multinational companies and big financial firms because not only they create new firms and overtake other firms but they also influence the decisions of many firms. These issues pave the way for the concept of control and consolidated accounts. These two concepts are vital because they safeguard investors, lenders and other stakeholders' rights and interests before they are left in a debacle situation (because managers do not take the right decisions). For instance, in recent years like in 1990s early 2000s, newspapers have published many financial scandal, such as of Enron, where the financial statements showed weak or no accounts related to consolidation and lack of knowledge of the concept of control was shown by the managers. Thus, the concept of control and consolidation are an integral part of accounting and accounting authorities such as International Accounting Standards Board (IASB) and Financial Accounting Standards Board give high significance to these matters.
Control is an imperative part of managerial function like planning, organizing, staffing and notifies management to take the correct actions so that the management does not deviate from the achievable goals of the organization. According to Henri Fayol, "Control consists of verifying whether everything occurs in conformity with the plan adopted, the instructions issued, and principles established. Its object is to point out weaknesses and errors in order to rectify them and prevent recurrence" (Fayol, 1916). But in recent years this concept has evolved with the desideratum of different firms activities and now control is a foreseeing process where as earlier concept of control was only used when errors were detected. Moreover, in financial reporting it is the concept of control which is used to determine which entities should be included in consolidated financial statements. IASB states "Control of an entity is the ability to check the financing and operating policies of an entity, so as to access benefits from that entity (or to reduce the incidence of losses) and increase, maintain or protect the amount of those benefits (or reduce the amount of losses)" (IAS, 2008). FASB on paragraph 6 of the exposure draft gives two new characteristic to the concept of control that are (i) A parent entity has the decision-making powers which are not shared by others and it directs the decision policies of its subsidiaries and (ii) a parent entity can increase the benefit and limit the losses delivered from the activities of that subsidiary. These concepts of control are also mentioned in the literature published by IASB. IASB broadly divides control into four parts. Firstly, the entity has a majority interest in the election of a corporation's governing body or it enjoys the right to appoint majority of its members. Secondly, the entity has a large minority voting interest in the election of a corporation's governing body but no other party has a significant voting interest. Thirdly, the entity may obtain a majority voting interest in the election of a corporation's governing body through the present through the present ownership of convertible securities or other rights that are currently exercisable at the option of the holder and expected benefits from converting those securities or exercising that right exceeds its expected costs( Ashwal, 2005). Fourthly, the entity is the only partner in a limited partnership and only this entity has the power to dissolve the limited partnership and allow new partners or remove the existing partners. Hence, the concept of control is about governing the assets of other entity and reaping economic benefits and risks from these governing decisions.
Besides, controlling a subsidiary firm, a parent firm may also control a Special Purpose Entities (SPEs). Before going any further, it is important to understand some basic characteristic of SPEs. Alex Ashwel interprets IAS 27 (about SPEs), which are now called Variable-interest Entities (VIEs), says that SPEs "are often created solely to carry out specific activities or a series of transactions directly related to conduct business activities. SPEs may be used to set up favourable operating lease arrangements (such as a synthetic lease), obtain debt financing at lower costs through securitizations and asset-backed commercial paper conduits, shelter certain assets from bankruptcy, hedge risks, achieve tax benefits or efficiencies and many other purposes" ( Alex, 2005, page 34). SPEs are important to a parent entity because SPEs would usually perform certain activities in ways that are directed by a parent entity. For instance, SPEs would lease assets on more favourable terms than a parent entity, because a parent entity may have a tarnished credit reputation or unconvincing financial statements, and then SPEs sell the same assets to parent entity with parent entity's terms and conditions. When external control and power influence SPEs decisions and policies then consolidated accounts should be created. The basic concept of control, that is the level of involvement, governance and the degree of risks and rewards attached with SPEs would determine if a parent entity should consolidate SPEs account. IAS 27, the concept of control for SPEs, Standing Interpretation Committee (SIC) 12, endorse the same notion and states "basically, an entity should consolidate a SPE when, in substance, the entity controls the SPEs" (IAS, 2008). IAS 27, SIC 12, affirms that if an entity can direct decision-making power of the SPEs, and also take benefits from the activities of SPEs, then this entity should consolidate SPEs. FASB also advocates the similar concept of control in their publication and is present in the FASB's proposed Statement on consolidation policy. Hence, SPEs are consolidated, when parent entities fulfil the criteria described in IAS 27.
Furthermore, The Company Act of 1985 (amended in 1989) implicit that consolidated accounts should be prepared by the management and are presented to the shareholders to declare a true and fair value of their entity, after combing profits and losses (Elliot, 2000). International accounting consolidation principles are mentioned in Consolidated and Separate Financial Statement by IAS 27. IAS 27 argues that those entities that are under the control of a parent entity should produce consolidated financial statements. And the consolidated result of a parent entity should also be included in these financial statements. One of the largest professional service firms like Deloitte also favours the similar notion and states "the financial statements should present the consolidated results of the controlling entity (that is the parent) and all subsidiaries (if any)" (Deloitte, 2010 page 9). Similarly, in September 2006, International Financial Reporting Standards (IFRSs) further argues that "a group entity for financial reporting purposes should be distinguished from the parent entity" (IFRSs, 2006). For instance, if a parent entity controls a subsidiary firm, then according to IFRSs three financial reports should be produced. One of a parent entity, one of a subsidiary and a group entity, this notion is a subject matter of General Purpose External Financial Reporting (GPEFR). And GPEFR believes that an entity that chooses, or is required (by legislation) to prepare GPEFR would be a reporting entity (GPEFR, 2006). KPMG, another large professional service firm, defines reporting entity as "a circumscribed arid of economic activities whose financial information has the potential to be useful to existing and potential equity investors, lenders and other creditors who cannot directly obtain the information they need in making decisions about providing resources to the entity and in assessing whether the management and the governing board of the entity have made efficient and effective use of the resources provided" (KPMG, 2010). Subsequently, IASB Exposure Draft Conceptual Frame Work for Financial Reporting, The Reporting Entity, maintains that when a reporting entity controls other entities, then the reporting entity should produce consolidated financial statements because it has the power to direct other entities activities. Simultaneously, under IAS 27, amended by IFRSs 5, Non Current Assets Held for Sale and Discontinued Operations, ask all subsidiaries (even not for profit subsidiaries) to be included in consolidated financial statement as their operation policies (such as policies on sales, human resource and manufacturing etc) and financial policies (such as policies on dividends and approval of budgets etc) are determined by a parent entity. However, The Company Act of 1989 gives some exemptions to prepare consolidate accounts, but IASB and FRS 2 take a strict notice of these exemptions and do not allow any exemptions. For example, IASB does not permit subsidiaries to be excluded only because the result of that subsidiary cannot be obtained (Elliot, 2000). Instead, IASB argues that subsidiaries should be taken as fixed assets or current assets but should not be exempted from consolidated accounts. As eluded earlier, IAS 27, SIC 12, explains that SPEs should be consolidated by a reporting entity when the decision power, control and risk and reward factors of SPEs are determined by a reporting entity. Hence, IASB and IFRS give great importance to SPEs and subsidiaries. And they have set up criteria for the reporting entity to know when to prepare consolidated accounts and consolidated financial statements.
Although, IAS has answered many queries regarding the concept of control as a determinant of the scope of consolidation but still there exist many unclear criteria and more evaluation must be done to subdue any problem in understanding. For instance, IAS draws inconclusive pictures that with whom the power lies or even if power actually exists. IAS should give more detailed answers about the treatment of not for profit subsidiaries. It is essential that concept of control should not be the sole reason to judge the composition of a group entity; in fact they should also be based on risks and rewards. IASB echoes the similar idea and states that "we are concerned that by choosing not to develop the risks and rewards model at the conceptual level the IASB will be narrowing the focus of the conceptual framework in general and the consolidation of reporting entities in particular at too early a stage and without fully considering all the potential implications of such a decisions" (IASB, 2008). Therefore, IAS should make some amendments at early stage and more evaluation should be given to assist accountants.
In the end, the concept of control and consolidation are an important part of Financial Reporting. The concept of control gives guidelines that who is actually controlling a firm and how it is been controlled? The concept of control has enlightened modern accountants and now they know how to treat subsidiaries' and SPEs' accounts. Now they create consolidated accounts of a reporting entity which shows a fair value of group entities, and neither these consolidated statements are overstated or understated. But critics still demand IAS to explain these concepts in more detail and they should include new aspects for better understanding. Hence, when these concepts are properly used then we can save future financial scandals and stakeholders would be confident about financial statements.
2. Providing examples explain how unrealised profits arise from transactions between companies in a group and why its impotant to remove them during consolidation procedures. In so doing, discuss what effect there could be on the reported group profit if they were not eliminated.
Unrealised profit is any profit that could be made when the price of an asset increases but the owner of that asset does not sell it. The positive difference between the current price and initial price of an asset, which is not been sold, is called an unrealised profit. These profits should not be reported in the accounting books until they are realised, or simply they should only be added in the accounting books once these profits are made. For instance, if Alif plc owns $1000 worth of stocks on 1 January 2010 and on 10 January 2010 the price of stocks goes up by $ 500 and its value is now $ 1500. Since Alif plc has no intention of selling it, he'll get an "unrealised profit" of $ 500 because Alif plc's position is profitable, but it has not sold its stocks. Unrealised profits are usually non taxable and they cannot be distributed among a group.
There are many ways in which unrealised profit can be made from transactions in a group. For example, an unrealised profit can be made when a parent firm sells goods to its subsidiary firm with an aim to make a profit. Similarly, an unrealised profit can be made when a subsidiary firm sells goods to its parent firm with an aim to make profit. Another epitome of unrealised profit is when a parent firm sells noncurrent assets to this subsidiary firm with an aim to make profit. Likewise, unrealised profit can be made when a subsidiary firm sells noncurrent assets to its parent firm with an aim to make profit.
Alif plc (parent entity) sells 100,000 T-shirts worth $10 each to Bay plc (its subsidiary) with a profit of $1 per T-shirt. If Bay plc has not sold these 100,000 T-shirts, then the group has not made any profit and the expected profit of $ 10,000 is an unrealised profit which should be deducted from the consolidated statements. Alif plc then should reduce its profit by $ 10,000 and Bay plc should reduce its stock by $ 10,000. Thus, the group has an unrealised profit of $ 10,000 until Bay plc sells T-shirts for $10 each. Suppose, Bay plc sells all T-shirts for $ 12 each then Bay plc has earned $ 200,000 profit and Alif plc has earned $ 100,000 profit. Hence, the group has earned a "realised profit" of $ 300,000 ($ 100,000+ $ 200,000).
ABC plc (subsidiary) sells 100 cars to XYZ plc (parent entity) for $ 10,000 each with a profit of $ 2000 per car. XYZ plc aims to sell each car for $ 15, 000. Suppose that XYZ plc is only able to sell 90 cars then ABC plc has an unrealised profit of $ 20,000 (10*$2000) and XYZ plc has an unrealised profit of $ 50,000 (10*$5000) which should be deducted from the consolidated statements. Hence, the group has an unrealised profit of $ 70,000 ($ 20,000 + $ 50,000).
Jubilee plc (parent entity) sells its plant worth $ 100,000 to Crescent plc (subsidiary) for $ 120,000, with accumulated depreciation of $ 10,000. Jubilee plc in this case has earned an unrealised profit of $ 30,000 ($ 120,000 - ($ 100,000 - $ 10,000)) and Crescent plc has gained $ 30,000 from carrying-value of plant. These unrealised profits should be deducted from the consolidated statements. Otherwise, the group would report an unrealised profit of $ 60,000 ($ 30,000 + $ 30,000).
Star plc (subsidiary) has given consulting services to K plc (parent entity) of worth $20,000. Here, Star plc makes an unrealised profit of $ 20,000 which should be deducted from the consolidated statements because it is an example of intergroup trading.
It is important to remove all unrealised profits from the consolidated statements because the main purpose of consolidated financial statements is to show parent entity and subsidiary as a single entity. If the unrealised profit is added then the financial statements would not show the fair value. In addition to this, this unrealised profit is earned from intra-group trading and it should be eliminated from consolidated statement because they belong to same home. For example, DSF plc (parent entity) sells a plant to SN plc (subsidiary) for $ 100,000 where the original cost is $ 90,000. There is a profit of $ 10,000 made by DSF plc and the carrying-value of plant is increased by $ 10,000 for SN plc. But this $ 10,000 is not reported in consolidated financial statements because it is earned from intra-group trading. They should only be included if they are realised profit and are earned from some third-party. Otherwise, the shareholders would notice higher profit and it would be misleading. The tax is paid on the overall profit which will include unrealised profit. If they are not eliminated then the actual profit is not reported and a higher group-profit is reported. Plus, group pays higher taxes on profit, where this profit includes unrealised profits which have not been made. If adjustments are not made then income or expensive would be overstated or understated which will cause an overstated or understated profit and tax would be implied accordingly. Hence it is always important to remove unrealised profit during consolidation procedures.