Simona Catuogno » 6.Consolidation methods

Submission of consolidated financial statement

A consolidated financial statement shows the equity, economic situation and financial results of a group of companies as if it was one enterprise. The individual legal status of each member is superseded and individual companies are considered as divisions or subsidiaries of the one big parent company.
A consolidated financial statement gives an overall impression of a group’s performance and eliminates “intragroup” transactions and balances that do not involve third-parties. It is the single most important tool for giving information about a group, both to third-parties and to the shareholders in the controlling company. This is why it is also seen as a management control device.

Economic theory and consolidation methods

Submitting a consolidated financial statement means choosing the right method of consolidating and identifying third-party interests in equity, and overall company results in terms of value as well as representation.

The method of consolidation is a result of the theory underlying the choice of a consolidated financial statement. International practice is usually based on one of two competing approaches:

as a financial unit (the group is seen as an investment on the part of the parent company and only majority shareholders count).
as an operational unit (the group is a larger, single economic entity).

Economic theory and consolidation methods (cont.)

Proprietary theory and Parent Company theory both correspond to the financial unit approach.

The Economic entity theory corresponds to the operational unit approach.

Proprietary theory

No longer used in practice.

The consolidated financial statement only represents ownership rights of the controlling shareholders.

Only subsidiaries that are legally controlled (50% + 1) are included in the consolidation.

The parent company consolidates its proportionate share of the assets and liabilities of the subsidiaries.

The proportionate share of non-controlling shareholders’ assets are omitted from consolidated financial statements.

Intercompany balances and profits are eliminated proportionately.

Proportionate consolidation is currently only used for joint ventures.

Parent Company theory

The most popular system in Italy and abroad.
A consolidated statement is the “extended” version of the parent company’s statement.
The assets and liabilities of controlled companies are fully consolidated.
Net assets held by minority shareholders are shown on the consolidated balance sheet as equity, as if they were capital advanced by external financiers.
Earnings attributed to non-controlling shareholders are subtracted from group earnings.
Minority interest capital and income are not affected by consolidation rectification.
Any intercompany profits made by the controlling company are omitted in full. Those made by the subsidiaries are only eliminated in proportion to their holding (profits are considered realised for minority interests).
Differences in consolidation are accounted for in proportion to share interest.

Entity theory

This approach ignores the idea of ownership rights that underlies the previous theories.
Entity theory views the group as an economic institute. For this approach, the group is a corporation.
Full consolidation is applied..
Non-controlling capital is entered under group assets. Minority earnings are a fraction of group earnings.
Intragroup profits are eliminated.
Consolidation differences (revaluation, depreciation and goodwill) need to be included in the accounts.
This kind of accounting approach means that minority interest net assets are valued in relation to their quota of economic capital.

Theory and practice

What happens in practice is a kind of compromise between the parent company theory and the entity theory.
The full consolidation method is applied.
Minority interest capital is entered separately from group net assets.
Minority interest earnings are a fraction of the group earnings. Infragroup earnings are eliminated but are allocated pro-quota between majority and minority interests.
Consolidation difference are accounted for in proportion to share interest held.

Full consolidation

National and international accounting practice recognises three methods of consolidation: full consolidation, proportional consolidation and the equity method.
Legislative decree no. 127/1991 states that the full method has to be used for all companies encompassed in the scope of consolidation. On a practical level, this means that entries on the financial statement report overall values whether the controlling company owns 100% of shares or whether its quota is less than 100%

Proportional consolidation

The legislative decree no. 127/1991 also offered the possibility of consolidating Joint Ventures, i.e. those companies that one of the companies already included in the scope of consolidation has joint control over, as long as their quota is not less than that stated in article 2359, comma 3, C.C., in other words, 20% for non-listed companies and 10% for listed companies.

Proportional consolidation (cont.)

Proportionate consolidation involves reporting joint venture assets, liabilities, income and expenses as a percentage representing the proportion of ownership interest held.
The value of investment figure is replaced by one representing the share of assets and liabilities.
Minority interests are not included.
Intragroup profit and loss, credit and debt are also eliminated at the same percentage as their share quota.

Equity method

The “synthetic” or equity method is the accounting technique stipulated by law for those companies that fall outside the scope of consolidation and is also one of the possible criteria for evaluating a company’s share in another controlled or closely-linked company on the individual company’s financial statement.