Knots in consolidation

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Indian GAAP and international GAAP vary in several ways with regard to consolidation of financial statements. IndAS should be implemented to plug these gaps.

Under Companies Act 2013, it is not just the listed companies that have to prepare consolidated financial statements. It may be useful to recall some of the implementation issues related to consolidation accounting under generally accepted accounting principles in India (Indian GAAP).

Under the current Indian GAAP — AS-21, the parent company’s consolidated statement includes entities controlled by it, with control defined as ownership of more than 50 per cent of the voting power of another entity, or control of the Board composition to obtain economic benefit from its activities. It is theoretically possible that an entity can be controlled, and therefore consolidated, by both parents if each can find a trigger. This is an area in which, by adopting a qualitative, principle-based definition of control, only one parent should be able to control, and therefore consolidate, another entity in line with international GAAP.

Under some shareholder arrangements, the minority shareholder may have substantive participative or veto rights in significant business decisions of the investee entity, or the ability to block significant decisions proposed by the majority shareholder. Such decisions may include establishing operating and capital plans, hiring/ firing of senior management, and so on. From a reading of AS-21, the intuitive answer would be for the majority shareholder to consolidate the investee based on voting interest. However, the pertinent question is: Does the majority shareholder truly control the investee entity, given the substantive participative rights of the minority shareholder? The answer may well be that such an investee entity is not controlled by any one shareholder, in line with international GAAP.

Another interesting concept is that of temporary control. Under AS-21, a parent entity should exclude its subsidiary from consolidation if control is intended to be temporary — that is, it is acquired and held for disposal in the near future (ordinarily not exceeding 12 months). This is in divergence with international GAAP, which does not recognise such an exception, thereby averting abuse through the “cherry picking” of entities for consolidation.

With special-purpose entities designed to achieve narrowly-defined activities — including leasing, securitisation, research and development, and so on — sometimes the voting interest-based control model of AS-21 may not be effective in identifying the parent that must consolidate the entity. Also, certain off-balance sheet structures can avoid triggering the AS-21 consolidation rules, thus hiding significant liabilities, losses, or negative cash-flows — as was witnessed during the Enron scandal.

In other cases, entities may be thinly capitalised with insufficient equity to finance their operations, and therefore requiring additional subordinated financial support, perhaps in the form of borrowings, guarantees, or service arrangements from related parties, management, or others. Accordingly, the majority equity investors may not necessarily have the controlling interest as they may lack the power to direct the activities that significantly impact the investee’s economic performance, or may not need to absorb losses or the right to receive benefits (variable returns) potentially significant to the investee. In such cases, parties other than equity investors providing subordinated financial support, guarantors or service providers may need to consolidate that entity. This is, by far, the most important area in which current consolidation guidance under Indian GAAP needs to evolve so that investors clearly know who the real parent is and its actual exposures to such entities.

There are several other areas of differing principles between Indian and international GAAP with regard to consolidated statements — including consideration of potential equity shares for determining control. Until some of these gaps are plugged through IndAS, the users of consolidated financial information should be aware of them in order to gain a better understanding.

The author is Partner – Price Waterhouse

Published on October 20, 2013

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