Session-2: CFS Analysis

A.

B.
C.
D.
E.

Analysis of group performance- CFS, Case: ICICI

Bank Ltd. & State Bank of India Ltd.
Consolidation of Profit and Loss Account
Theories on consolidation
Consolidation of Associates
Consolidation of joint ventures

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Some Implication
2

1.

2.

3.

4.

Change of disclosure regulation favouring consolidation is

more proactive in nature and consistent with the international
practices than changes in the operations of Indian companies.
It was perceived that the move towards CFS was more to
decrease the opportunity for accounting manipulation i.e.
earnings management through subsidiary companies.
Serious problems in one division can be masked by the strong
cash-generating activities in another.
When non-homogeneous subsidiaries are consolidated, the
CFS may result in a different situation. Depending upon the
financial characteristics of the subsidiary, consolidation may
result in financial statements that look better or worse than
the actual results. Prof.Seshadev Sahoo * IIM Lucknow 6/19/2016

A. Some facts
3

A.

B.

C.

Reporting Date: Financial statements of the parent and its

subsidiaries used in the consolidation are usually should be
drawn up to the same reporting date as that of the parent.
Even for differing dates (difference between reporting dates)
does not exceeding 06 months can be taken for consolidation.
Otherwise subsidiary will have to prepare its statements as at
the reporting date of the parent for consolidation purposes.

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Some facts
4

D.

Uniform accounting policies: Group companies

must adhere to uniform accounting policies. If it is
not practicable to use uniform accounting policies,
that facts needs to be disclosed.

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Some facts
5

E.

F.

G.

Format of consolidated financial statements: as far

as possible, the CFS are presented in the same
format in which the parent prepares its financial
statements.
CFS don't replace the stand-alone financial
statements of the parent.
Application of other accounting standards: For
example, the disclosures required by AS-17
Segment Reporting are also to be made in CFS.
Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Analysts point
6

The appropriate reporting for NCI in the consolidated

financial statements has been a perplexing problem
for accountants,
because it only represents interest in the
subsidiaries and is recognized only in the
consolidation process;
it does not result from a business
transaction or event of either the parent company or
the subsidiary.
Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

C. Theories on consolidation
7

a)
b)

Consolidations of financial statements presentation

are derived from two theories:
Parent company theory and
Economic unit theory- Entity theory.

Note: Each view is different and they reflect how the noncontrolling interests, profit, value of assets, liabilities and goodwill
are reflected in the financial statements.

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

a: Parent company theory

8

Under the parent company theory, consolidated financial

statements are primarily prepared for the benefit of the
shareholders of the controlling parent company.
Equity reflected in consolidated financial statements includes
only the equity owned by the shareholders of the parent
company, net of the interest of NCI, which is considered an
outside shareholder/interest.
NCIs is in the subsidiaries only and cannot be considered
parallel to that of the controlling parent. NCI is therefore not
presented on the balance sheet as an element of equity, but as
a mezzanine item between liabilities and equity.
Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

a: Parent company theory

9

In the income statement, profit attributable to NCI is

presented as an expense-like deduction and the
bottom line (consolidated profit) represents profit
attributable to the shareholders of the parent
company.

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

a: Parent company theory

10

Because the interest of the parents shareholders is

emphasized, goodwill under the parent company
theory includes the parents portion only and is
measured as the difference between the cost of the
parents investment and its proportionate interest in
the net fair value of the subsidiarys assets and
liabilities.
NCI therefore plays no part in the goodwill
recognized in consolidated financial statements.
Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

b: Economic unit theory

11

Also commonly known as the entity theory,

emphasizes the control of the whole group by a
single management.
Emphasis is thus on the consolidated unit itself, with
the controlling parents shareholders and noncontrolling NCI shareholders viewed as two
separate shareholder groups, both providers of
capital and each having an equity stake in the
consolidated unit (although NCI shareholders
interest is in the subsidiaries only).
Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Economic unit theory

12

Neither of the two shareholder groups is

emphasized over the other or over the consolidated
unit.
As a result, the equity section of the consolidated
balance sheet contains both the parent
shareholders and NCI shareholders ownership
interests.
NCI is therefore presented on the balance sheet as
a component of equity.
Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Economic unit theory

13

In the income statement, the bottom-line

(consolidated profit) represents the total profit
earned on all of the net assets controlled by the
management of the parent company, which is then
allocated between the controlling interest and NCI.
Profit attributable to NCI is therefore presented in
the income statement as a component of earnings.

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Economic unit theory

14

The other part of the economic unit theory involves

recognizing the imputed/implied full goodwill of
the subsidiary to include not just the parents portion
but also the imputed/implied NCIs portion.
Because NCI is part of equity, subsequent increases
and decreases of NCI after acquisition are to be
treated as transactions among owners and no gains
or losses on these changes are to be recognized in
profit or loss.
Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Indian Practice
15

1.

2.

3.

4.

Indian Accounting Standard (AS-21) follows Parent company

theory. Refer- RIL, and ITC Annual Report-2014
The subsidiaries assets and liabilities are taken at the historical
cost. The assets and liabilities are added line by line.
The consolidation process in the International Financial Reporting
Standards (IFRS) is similar to the Indian accounting standards.
However, the assets and liabilities are to be measured at the fair
value for the purpose of arriving at the goodwill.
The US GAAP requires the parent view of consolidation and does
not allocate goodwill that belong to the minority interest.

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Implication
16

Consolidated financial statements do not present information

from the perspective of the NCI shareholders. Rather, because
they are shareholders of a subsidiary, the subsidiarys
separate financial statements are the ones that provide the
information in which the NCI shareholders have a direct
interest.
Managers have discretion in following any theory for
reporting CFS.
IAS 27 mandates every parent, other than an exempt parent,
to prepare consolidated financial statements.
Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Financial Analysis Considerations

17

While using CFS it is wise to keep several points in

mind:
There may be restrictions on the ability of consolidated
subsidiaries to pass cash up to the parent.
2.
Financial ratios may not make a lot of sense if a consolidated
subsidiarys business is very different from the other
businesses included in the consolidated statements.
Example: operating ratios based on data in a consolidated
income statement for a finance company and a manufacturing
company would be meaningless. Revenue items are not
compatible. However, if a consolidated finance subsidiary
primarily finances the Prof.Seshadev
groups accounts
receivable, the CFS is more
Sahoo * IIM Lucknow 6/19/2016
useful.
1.

What Research says?

18

1.

2.

3.

CFS is of limited use for any analytical purpose when a company is

highly diversified. The diversified business may generate revenue
which may be valued differently.
Similarly, if there is a concealment of financial distress or
underlying solvency problem in a subsidiary company, the same
will not be reflected.
On the other hand, consolidation will be desirable when a
company uses subsidiary for geographical reasons and all
subsidiary companies are by and large performing same kind of
operations.
Example: CIL, Affiliates of MNCs.

____________________________________________
Stella So and Malcom Smith (2009) Journal of International Financial Management and
Accounting, Blackwell Publishing, Vol.20
Issue 2,
pp.166-198.
Prof.Seshadev
Sahoo
* IIM Lucknow 6/19/2016

Analysts point
19

4.

5.

For a ratio analysis focusing to evaluate managements

operating performance , such as measuring managements
ability to generate profits from sales activities, the
consolidated profits before NCI deduction is the appropriate
figure. It reflects management operating activities and is not
influenced by ownership arrangements.
Firms operating identical operating activities and parent
having absolute control over decision CFS.

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

What Research says?

20

Ishikawa (2000) shows that consolidated earnings are more

important than parent-only earnings, in cases where the ratio
of consolidated to non-consolidated figures is high.
A study by Niskanen et al. (1998) shows that consolidated
earnings have a significant incremental explanatory power for
stock returns and not the parent-only earnings for Finland
companies, suggesting that the CFS improves the information
content.
____________________________

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

D. Analysis of Group Performance

21

Do Subsidiaries Create Value for the Holding

Company.?
Case: ICICI Bank Ltd.

For detailed analysis refer Excel sheet.

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Analysts point
22

1.

2.
3.

4.

5.

Whether group (subsidiaries) contribute towards

the value of the firm.
Is the group smooth the earnings volatility?
Is the group performance helps to improve key
performance indicators?
Is the dividends from subsidiaries (affiliates) is
increasing?
Are the groups complementing parents business
operations.
Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Analysts point
23

1.
2.
3.

4.

Banking sector characteristics from viewpoint of

consolidation-as group behavior.
Incremental investment is minimum
Integrate the operations very efficiently
To get the access to market is relatively easier
than manufacturing firm i.e. ITC ltd. creating
subsidiary in unrelated sectors- see details at ITC
Annual report 2014.
Compare segment reporting with nature of
subsidiaries. Prof.Seshadev Sahoo * IIM Lucknow 6/19/2016

Analysts point
24

Sl.No.

ICICI Bank Segment

SBI Segment

Primary: Retail banking,

wholesale/corporate
banking/treasury, and other
banking

Primary: Treasury, Corporate/Wholesale

banking, Retail Banking, other banking
operation

Secondary: GS, Domestic and

Foreign

Secondary- Domestic and Foreign

ICICI Bank affiliates operated in Subsidiary: Bank format + NBFC in

Insurance, investment, securities, investment, insurance and others.
VCs, AMCs, and pension Funds
(domestic- NON Bank-NBFC)
International-Bank and
securities.

Total of 17 subsidiaries

Total of 28 subsidiaries

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Prof.Seshadev Sahoo * IIM Lucknow

25

ANALYSIS OF MINORITY INTEREST

6/19/2016

IN CONSOLIDATED FINACIAL STATEMENT

Analysis of Minority Interest

26

1.

2.

3.

4.

5.

Keeping with the emphasis on effective control, MI refers as noncontrolling interest.

Balance in the MI account shown on the B/S and the MI in net
income are necessarily related.
If the subsidiary pays no cash dividends, then the change in the
balance sheet account equals the MI in net income.
If a cash dividend is paid , then B/S change equals the MI in net
income less the dividends paid to minority owners (B/S change by
amount of undistributed earnings for the period).
Capital contributions or withdrawals also affect the MI shown on
the parent company B/S.
Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Example: ITC Ltd.

27

(All figures are in Rs.Crores)

Opening balance sheet liability: MI

179.89

Income statement: MI

109.81

Financing cash flow: Dividends paid to minority shareholders

-86.67

Closing B/S Liability : MI

203.03

MI in P& L- Dividend paid to MI = Change in MI at B/S

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Analysis
28

MI reflects the minority shareholders investment in

the consolidated subsidiary.
Assets of a less than wholly owned subsidiary are
not freely available to the parent as those of a
100%-owned subsidiary because of the minority
investor.

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Implication
29

Minority shareholders have only a residual claim on the

assets of the subsidiary.
Generally, creditors and shareholders of the parent cannot
benefit from the assets of the subsidiary without
respecting the claims of its creditors and minority
holders.
Thus MI occupies a special position and should not be
mechanically aggregated with either liabilities or equity.

Note: MI has the characteristics of a preferred shareholder.

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Consolidation Practices outside USA

30

A.
B.

C.

D.

Non-US standards differ from US practices:

Japan and part of Western Europe: Parent-only financial
statements are still considered to be the primary set of statements.
Parent-only statements may exclude significant operating
subsidiaries.
Germany: CFS normally include only domestic subsidiaries. In UK
and Canada firms may exclude nonhomogeneous subsidiaries
from CFS.
Netherlands, Germany, Belgium, Italy and France allow firms to
exclude nonhomogeneous subsidiaries from CFS.

Note: Western European Countries: United Kingdom, Ireland, Belgium, France,

Prof.Seshadev Sahoo * IIM Lucknow 6/19/2016
Netherlands, Luxembourg, Monaco

Consolidation of Associates
31

An associate company represents one on which the investor has

significant influence i.e. the power to participate in the
financial and or operating policy decisions of the investee but
not control over those policies and which is neither a subsidiary
nor a joint venture of the investor.
Significant influence is basically characterized by the investor
owning directly or indirectly, 20% or more of the voting power
of the investee company.
Applicable method: Equity method.
(Note: Detailed discussion in Session-16)

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016

Consolidation of Joint Ventures

32

Goodwill/capital reserve are determined and

disclosed just as in the case of subsidiaries.
Proportionate consolidation method.

Prof.Seshadev Sahoo * IIM Lucknow

6/19/2016