Elimination of Investments
Where a holding company holds all the shares of a subsidiary or its assets belong to the holding company, which is also liable for all its debts. In other words, the investment by the holding company in the shares of subsidiary company represents excess of assets over liabilities or capital.
While preparing the consolidated balance sheet it is necessary to eliminate investment & its complement of the paid up capital of subsidiary company. Holding company’s investment which its subsidiary’s capital, which in turn is equal to the excess of assets over liabilities of the subsidiary, become internal items in the consolidated balance sheet. Hence, the two are cancelled against each other & substituted by the assets & liabilities of the subsidiary.
Pre Acquisition Period
Pre acquisition period is the period which falls on or before the date on which the shares of the subsidiary company are acquired by the holding company.
Post Acquisition Period
Post acquisition period is the period which falls on after the date on which the shares of the subsidiary company are acquired by the holding company.
The profit of the subsidiary may be divided into
1. Capital profit
2. Revenue profit
Pre & Post Acquisition of Profits
a. General Reserve & Profit & Loss Account (credit balance) appearing in the books of the subsidiary company on the date of acquisition are treated as pre – acquisition profits. Since, they were not earned by the holding company in the ordinary course of business they are capitalized & set off against the purchase price of the shares.
b. A pre – acquisition loss appearing in the books of the subsidiary company is treated as a capital loss & debited to goodwill account.
c. Post acquisition profits or losses are those that are made or suffered by a subsidiary company after its shares have been purchased by the holding company. Revenue profits are added to the profits of the holding company if it acquires all the shares of the subsidiary company or to extent of its share holding in the subsidiary company. A post acquisition loss is treated as a revenue loss & deducted from the profits of the holding company.
d. If the date of acquisition is during the course of the year it becomes necessary to make an estimate of pre acquisition & post acquisition periods on time basis so as to apportion profits.
Cost of Control
In practice the holding company may pay more or less than the net worth of the subsidiary company. If the holding company feels that a company the shares of which it wants to acquire enjoys considerable reputation or exceptionary favourable factor it may pay more than the paid up value of shares or net assets.
The excess of acquisition price over net assets represents goodwill or cost of control. If on the other hand the acquisition price is less than the paid up value of shares the difference is again to the holding company & is known as capital reserve.
When some of the shares in the subsidiary are held by outside shareholders they will be entitled to a proportionate share in the assets and liabilities of that company. The share of the outsider in the subsidiary is called minority interest.
In the consolidated balance sheet all the assets and liabilities of the subsidiary are consolidated with assets and liabilities of the holding company and the minority interest representing the interest of the outsider in the subsidiary is shown as a liability.
Revaluation of Assets and Liabilities
At the time of acquiring shares in a subsidiary it is usual for the holding company to revalue the assets and liabilities of the subsidiary in order to arrive at a fair price to be paid for the shares.
If the altered values are not taken in the books of subsidiary it is necessary to bring the assets and liabilities into the consolidated balance sheet at the altered values. The difference between the book values and revised values should be adjusted after ascertaining the share of the outsiders. Where the assets are shown in the consolidated balance sheet at the increase values depreciation provision should be increased and such increase should be deducted from capital reserve and minority interest.
If on the other hand the assets are brought in at reduced value depreciation value should be reduced and such reduction should be added to capital reserve and minority interest.
Treatment of Unrealized Profits
An unrealized inter-company profits exist where the company still holds (at the date of consolidation) stocks sold to it by the other company at a profit.
It is considered that only the holding company share of unrealized profit should be eliminated since for the minority shareholders the profit is nothing but a realized profit. Stock reserve is created whether the goods are sold by the holding company to the subsidiary and vice versa. The amount of unrealized profit (stock reserve) is deducted from the stock on the asset side and also the profit and loss account on the liability side of the consolidated balance sheet.
Example: A subsidiary sells goods to the holding company goods worth Rs 30,000 on which the subsidiary company made 20% profit on selling price (holding company share holds 3000 out of 4000 shares)
Unrealized profit = 20% of 30,000 = 6,000
Holding company’s share = ¾ *6,000 = 4,500.
1. Internal Debts
When loans are advanced to the subsidiary company by the holding and vice versa the same will appear on the asset side of the lending company’s balance sheet and on the liability side of the borrowing company’s balance sheet.
These being inter-company items they should be eliminated from the consolidated balance sheet.
2. Bills of Exchange
Bills drawn by the holding company on its subsidiary and vice versa appearing as bills payable in one balance sheet and bills receivables on the other, cancel each other. However bills discounted cannot get cancelled because of the liability in respect of bills payable by the accepting company and a contingent liability in the company getting the bills discounted.
a. The company discounting the bill will include the proceeds of the bills in its bank balance and will appear as a note to show the contingent liability.
b. In the consolidated balance sheet the total of bills discounted appear as bills payable representing actual liabilities.
Debentures issued by one of the companies in the group and held as investment by another in the same group gets cancelled in the consolidated balance sheet and should be eliminated.
4. Contingent Liability
Contingent liabilities which may or may not materialise into liabilities are shown in the usual way by appending a footnote in the individual balance sheet. For the purpose of consolidation the treatment depends upon whether they are internal or external.
External contingent liability between the company in the group and a third party continue to appear by way footnote.
Internal contingent liability between holding and subsidiary are eliminated without being shown in the consolidated balance sheet.
Dividends paid by Subsidiary Company: (no adjustments need be made in the books of subsidiary company)
Books of Holding Company
1. if the dividends has been paid out of pre-acquisition profits the dividends should be credited by the holding company to investment account but not profit and loss account.
2. on the other hand if the holding company has credited the dividend to profit and loss account then the dividend should be debited to profit and loss account and credited to the investment account.
3. if the dividend has been paid by subsidiary company out of post - acquisition profits the same should be credited by the holding company to its profit and loss account. If it has already credited the dividend to profit and loss account then no adjustment is required.
Dividends declared by the subsidiary company but not paid will appear as a liability in the balance sheet of the subsidiary company. In the consolidated balance sheet the proportion of unpaid dividend attributable to the holding company will be deducted from liability of subsidiary company & the balance payable to the outside shareholders will appear as a liability of the group.
Any interim dividend paid during the accounting period by the subsidiary company to the holding company should be added to the balance of profit & loss account of the holding company & deducted from the balance of profit & loss account of the subsidiary company if the adjustments have not taken place.
When a company issues bonus shares out of its accumulated profits it is necessary to distinguish between pre & post acquisition profits utilized for this purpose. In case bonus shares are issued out of pre – acquisition profits no adjustments are necessary for preparing the consolidated balance sheet because in such a case the holding company’s share of such profits gets reduced & the paid up value of the shares held by it will increase. As such the amount of goodwill remains the same.
Bonus shares issued out of post acquisition profits will reduce the holding company’s share in revenue profits & increase the paid up value of the shares held. Consequently, the amount of goodwill gets reduced.