Consolidated Accounting Policies

• Author: Risto Vahimets
• Pages: 90-99

Risto Vahimets

Consolidated Accounting Policies¹

Introduction

This paper discusses consolidation policies for consolidated accounting for investor-creditor information purposes. The goal is to establish some guidelines for the Estonian legislature. Obviously, it is in Estonia's best interests to use the experience and knowledge that other countries have acquired while developing and enforcing their consolidation policies. Estonia's geographical, political and economic situation will be taken into account. Estonia's primary political goal is to join the European Union ("EU"), and therefore the rules of the EU are of special value to its legislative development. However, as consolidated accounting is by its origin an American concept, the rules of the United States ("US") will be used for comparison. The International Accounting Standards ("IAS"), drafted by the International Accounting Standards Committee, will not be discussed in order to limit the scope of this paper.

Today, Estonia has no rules for preparing consolidated accounts². Many Estonian corporate groups do prepare consolidated accounts however. The ensuing information is conveyed to investors and the public. As will be seen, the lack of uniform requirements for consolidated accounting causes serious differences in the presentation of financial affairs of different groups. For example, it is possible to "hide" debts in a finance subsidiary that is exempted from consolidation because its activities are different from the rest of the group. This deceives investors and causes numerous incorrect investment decisions.

Consolidated accounting has two major components. These are consolidation policies and consolidation procedures. Consolidation policies deal with such issues as when should consolidated accounts be prepared and which entities should a consolidation encompass. These issues are the part of consolidated accounting which belongs within the sphere of company law³. Consolidation procedures are a set of rules which form the accounting part of consolidated accounting. These rules provide the methods for presenting the financial affairs of a corporate group as if it were a single entity⁴. For example, the elimination of intragroup sales, the goodwill of subsidiaries and minority interests in subsidiaries are issues that are covered by consolidation procedures. Only consolidation policies are analyzed in this paper.

One of the most important issues in this paper is the choice which Estonia and other countries have while drafting their consolidated accounting rules. This is a choice between consolidation policies that are based on the legal means of control and consolidation policies that are based on the effective means of control. Legal control means that the parent company has a legally enforceable right to direct the actions of a subsidiary. Effective control in turn, means that in addition to the legally enforceable means of control, economic means of control are considered while making decisions whether to consolidate or not consolidate a potential subsidiary.

This paper first discusses basic accounting principles and then discusses consolidation policies, which are discussed in two parts: firstly, general consolidation policies; and secondly, exemption rules.

Basic accounting principles

There are three basic accounting principles which are important for the purposes of this paper. These are comparability, relevance and representational faithfulness.

The basic principles of accounting for investor-creditor information purposes in the US are codified by the Financial Accounting Standards Board ("FASB") in the Concepts Statements No. 1-6⁵.

Representational faithfulness is the correspondence or agreement between a measure or description and the phenomenon it purports to represent. In accounting, the phenomena to be represented are economic resources and obligations and the transactions and events that change those resources and obligations⁶.

Relevance of financial statements means that such financial statements present information in a way that is most relevant to users. The Statement of Financial Accounting Standards ("SFAS") No. 94 states: "Information that is most relevant to investors, creditors and other users thus includes consolidated financial statements that present, primarily for the benefit of the shareholders and creditors of the parent company, the results of operations and the financial position of a parent company and its subsidiaries essentially as if the group were a single company with one or more branches or divisions."⁷ While this paper deals with consolidated accounting for investor-creditor information purposes, the information the consolidated accounts present must be most relevant to the shareholders and creditors of the corporate groups.

A significant aspect of both relevance and representational faithfulness is completeness. The inclusion in reported information of everything material is necessary for faithful representation of the relevant phenomena⁸.

Comparability means that the financial results of different enterprises are comparable⁹.

The basic principles of accounting in the EU developed initially in the individual member states separately. The codification of these principles into EU law took place with the Fourth Council Directive ("Fourth Directive").

The preamble of the Fourth Directive includes the principle of disclosing comparable and equivalent information (with regard to the valuation of assets and liabilities)¹⁰. The principle of representational faithfulness is formulated as the requirement for accounts to give a true and fair view¹¹ of the companies' assets and liabilities, financial position, and profit or loss. Provisions that allow omissions of irrelevant data and require the addition of relevant information, the disclosure of which is not required by the Fourth Directive itself, imply the principle of relevance. However to some extent, the principles of giving a true and fair view, and of comparability and equivalence of information cover relevance¹². Some European authors see relevance as a more basic principle, one that exists without specific enumeration in the Fourth or Seventh Council Directive ("Seventh Directive")¹³.

In Estonia, the basic accounting principles are in section 5 of the Accounting Act. The principle of representational faithfulness is in subsection 5 (3) of the Accounting Act, which states that the basis of accounting is the objective recording of economic transactions. The principle of relevance is fixed as an obligation to record all relevant business risks and opportunities. Relevant is the information that can affect decisions of the users of the accounts. The principle of completeness is separate from the principles of relevance and representational faithfulness. The law provides that accounts must present all information in a way that enables the presentation of a true and faithful picture of the assets, obligations etc. of the company. The principle of comparability is fixed in subsection 5 (11) of the Accounting Act¹⁴.

In conclusion, the basic principles of accounting in the US and the EU are very much the same. In Estonia, the wording of the principles is somewhat awkward, but the principles still exist. This gives a perfect basis for comparing the consolidation policies of the EU and the US. Through this comparison, solutions for Estonia can be found as well.

General consolidation requirement

A general consolidation requirement provides for circumstances where a corporate group must include a subsidiary in its consolidated accounts. In the case of a simple parent- subsidiary relationship, a general consolidation requirement sets forth circumstances where the parent company must prepare consolidated accounts.

In this part of the paper, the EU rules will first be compared with the Generally Accepted Accounting Principles ("GAAP")¹⁵ of the US (together with the Securities and Exchange Commission Regulation S-X ("Regulation S-X")) and then with the US Financial Accounting Standards Board Exposure Draft on Consolidated Accounts from 16 October 1995 ("Exposure Draft").

Under GAAP, the line between members of a corporate group for the purposes of consolidated accounting is over 50% ownership of the outstanding voting stock of the subsidiary held directly or indirectly¹⁶. While the same applies for Regulation S-X, the latter also requires the consolidation of subsidiaries where the parent-subsidiary relationship is established by a means other than the ownership of voting stock.

The GAAP rule is much simpler than the EU Seventh Directive rule. Article 1 (1) of the Seventh Directive makes it compulsory for all member states¹⁷ to require the preparation of consolidated accounts for certain corporate groups. Article 1 (2) permits, but does not make it compulsory, for member states to require corporate groups to prepare consolidated accounts.

The first section of Article 1 of the Seventh Directive includes five alternative grounds, upon which member states must require corporate groups to prepare consolidated accounts. According to Article 1 (1) of the Seventh Directive, a member state must require¹⁸ any undertaking¹⁹ governed by its national law to prepare consolidated accounts and a consolidated annual report if that undertaking (parent undertaking):

1. has a majority of the shareholders' or members' voting rights in the subsidiary; or

2. has the right to appoint or remove a majority of the members of the administrative, management or supervisory body of the subsidiary and is at the same time a shareholder in or member of that subsidiary; or

3. has the right to exercise a dominant influence over the subsidiary of which it is a shareholder or member pursuant to a contract...