A Company prepares financial statements to indicate the performance and position of assets and liabilities and cash flows. Financial statements are prepared at each legal entity level not only from an accounting perspective but also from regulatory and company law requirements. The Company may have varied business interests in different companies (i.e., legal entities) through various modes including having a subsidiary, joint venture, strategic partnerships etc., While it would be good to know the individual performances, how would one evaluate the business as a whole not withstanding number of legal entities or other form of association it may have with other entities. For example, X is company may be in the business of manufacturing. It has investments in Y company which does trading activity and another investment Z which does exports. Why should X not include the results of Y and Z in its performance assessment, since it is also a business done where they are directly interested? Therefore, one has to look at the 'business' in a more holistic manner than just by a legal entity.
Different legal entities
Any business invites various risks as well. There are various reasons as to why different legal entities are incorporated or floated to do business:
- Legal / Regulatory requirements: Businesses like banking, insurance, asset management, etc., which are highly regulated require separate entity to be created to do the business.
- Special Purpose Vehicle (SPV): To ensure that a particular project or an activity is monitored and ring fenced from other activities a separate legal entity is incorporated for a specific task. This is quite common in companies handling infrastructure projects, where each project is handled by a SPV. Once the project is completed and handed over the SPV is wound down.
- Tax benefits: The tax authorities may give tax relief to entities doing business in an earmarked zone. Hence, it would be a good idea to set up a separate entity to do the business.
- Result of restructuring exercise: During the course of restructuring exercise, the business could have been split up or consolidated. The valuation of each business could also be identified if it is a separate legal entity having own assets and liabilities, else the valuation of carving out assets and liabilities from the consolidated business could be a challenging task.
- Family business arrangements: Where there is family business, and the members have decided to run the business in a particular manner, more often than not the business are identified through separate entities.
These are just some of the reasons why separate entities are set up. But the business as a whole should be looked into holistically, hence the requirement to evaluate everything at a consolidated level or aggregated level.
Classification of investments
Any legal entity is formed only by incorporation which requires investment from another entity or another business. Normally, when a business invests in another business, the classification is normally done as follows:
- Subsidiary: Where the investments are significant normally more than 50%, of the capital, but not necessary always. These are entities who are expected to be 'controlled' by another entity.
- Associates: Where the investments normally range between 25% to 50%, of the capital, and though the business may not be 'controlled', at least the investor has significant say in the operational and financial decision making (significant influence).
- Joint Ventures: These are typically investments wherein there more than business come together for a common cause and share their expertise / resources etc., Say one company may contribute from technology side and the other company may have manufacturing capabilities. The investor has not only invested money but is also bringing to the table other tangible or intangible resources which is essential for the venture to be successful.
- Plain investments: These are investments made only for returns or capital appreciation and no real interest in running the business.
Let's understand each of these investments a bit more in detail:
Subsidiaries: As per Section 2(87) of the Companies Act, 2013, defines the term subsidiary as, where another company (i.e., investor or holding company controls the composition of the Board of Directors or exercises or controls more than one-half of the total voting power either at its own or together with one or more of its subsidiary companies. But the accounting requirements are slightly different. Section 2(27) defines control to include the right to appoint a majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner.
Under AS 21: The definition is more or less similar to the Companies Act.
Under Ind AS 110: The definition of subsidiary is very different from AS 21 or Companies Act. As per Ind AS 110, a subsidiary is 'an entity that is controlled by another entity'. Such other entity should be able to 'control', 'relevant activities' of another entity in a manner that it 'can influence variable returns'. These three phrases are discussed elaborately, which is summarized as following:
Control: Need not be by mere investments. Take an example of a company where 30% is held by a foreign partner, and 70% is held by a local business. The local business has invested in the majority stake. But these are the other factors:
- The foreign partner's involvement is essential. Without their participation the entity may not have even existed. The contribution in terms of technology, expertise, branding, marketing etc., is so critical that the domestic partner is fully dependent on these factors for the success of business.
- In the member's meeting, historically, the decision moved by the foreign partner has not been opposed by the other shareholders in the past. The other shareholders are so dispersed that they have no arrangement to unify and opposed the decision of 30% shareholders.
- The foreign partner is involved in critical decision-making process of say expansion programs, budgeting, key financial and operational decisions and the domestic partner has indicated that without the 'go-ahead' from the foreign partner no decision would be taken (formally or informally).
These are just some of the factors which would indicate that whether an entity is 'controlled' by another entity or otherwise. If the answer is 'yes', then the other entity is set to be a subsidiary. Where, the investments are less than 50%, but it still establishes control by other means, then such control is also called as 'de-facto control'.
Relevant activities - These activities could include:
- Strategic decisions like continuing or discontinuing a product / expansion programs / restructuring;
- Financial decision making including raising of funds;
- Major operational decisions.
These activities are not the ones in routine in nature, but are decisions which could shape the existing or future business of the company.
Influencing variable returns: Returns need not be only dividend or interest. Returns could also include various benefits that is arising out of cost reduction, expansion in business, economies of scale, tax and synergy benefits etc.,
Hence, under Ind AS 110 it becomes more critical to evaluate factors other than investment to classify as subsidiary or otherwise. A detailed review of the business model of an entity with other entities (often called as 'group') has to be done to establish whether the relationship is subsidiary or otherwise.
Associate: An associate is an entity wherein there is significant influence in the decision-making process but not a control. It is a one-step lower than control, where yes, your voice is heard and considered but you cannot direct another entity's decision-making process. Investments in such activities are treated as an Associate. It is normally presumed that investment above 25% to 50% are considered to be Associate, unless proved otherwise that despite holding so much of stake, it either has control or has no say in another entity.
Joint Venture: Joint ventures can be in different forms. It could be forming a separate entity or it could be within an existing entity. Where a separate entity is formed, it is called as 'jointly controlled entity' ('JOE'), wherein the aspect of 'control' applies to venturers who have invested in the entity. Where no separate entity is formed, but the activities are jointly carried out then it is called as 'jointly controlled operations' ('JCO') or 'jointly controlled asset' ('JCA'). In case of JOE, the consolidation is essential since these are two or more separate entities, jointly controlled by another entity. In case of JCO or JCA, each venturer will account for their share of activities in the arrangement within the respective entities.
Plain investments: Where investments are made with an objective to returns and capital appreciation or dispose it off on a later date, etc., but not with an objective to do business; then such investments are not classified in above categories.
Accounting in the standalone books of accounts
- Subsidiary / Associate / Joint Controlled Entity: Ind AS 27 permits the subsidiary to be valued either at historical cost or at fair value. However, these investments are subject to be tested for impairment under Ind AS 36.
- Other Investments: All other investments are classified as financial assets and have to be subjected to valuation principles as required under Ind AS 109. Any fair valuation will be carried out as per Ind AS 113.
Consolidated Financial Statements
- All line items of Balance Sheet, Statement of Profit and Loss are consolidated after eliminating any inter-company transactions like purchases, sales, etc.,
- Goodwill is accounted for the difference between cost of investment in standalone books versus the value of investments on consolidation.
- It is expected that all the subsidiaries comply with all the accounting policies of the controlling entity (also called as 'holding company' or 'parent company').
Associate and Jointly Controlled Entities
Consolidation is based on equity method. This is a method, wherein each venturer or investor's share of profit or loss in the business is consolidated. The difference between the cost of the investment and value of investment is treated as Goodwill or Capital Reserve on consolidation.
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