Consolidated financial statements of a group of companies are prepared on
the basis of single economic entity concept.
Single Economic Entity Concept suggests that companies associated with
each other through the virtue of common control operate as a single economic
unit and therefore the consolidated financial statements of a group of companies
should reflect the essence of such arrangement.
Consolidated financial statements of a group of companies must be
prepared as if the entire group constitutes a single entity in order to avoid
the misrepresentation of the scale of group's activities.
It is therefore necessary to eliminate the effects of any inter-company
transactions and balances during the consolidation of group accounts such as
the following:
Inter-company sales and purchases
Inter-company payables and receivables
Inter-company payments such as dividends, royalties & head office
charges
Inter-company transactions must be eliminated as if the transactions had
not occurred in the first place. Examples of adjustments that may be required
to eliminate the effects of inter-company transactions include:
Elimination of unrealized profit or loss on the sale of assets member
companies of a group
Elimination of excess or deficit depreciation expense in respect of a
fixed asset purchased from a member company at a price that was higher or lower
than the net book value of the asset in the books of the seller.
XYZ PLC is a company specializing in the manufacturing of fertilizers. At
the start of the current accounting period, XYZ PLC acquired DEF PLC, a
chemicals producer.
Following is a summary of the financial results of the two companies
during the year:
|
XYZ
|
DEF
|
|
|
$m
|
$m
|
|
|
Sales
|
120
|
50
|
|
Cost
of Sales
|
(60)
|
(20)
|
|
Gross
Profit
|
60
|
30
|
|
Operating
Expenses
|
(20)
|
(10)
|
|
Net
Profit
|
40
|
20
|
XYZ PLC purchased chemicals worth $20m from DEF PLC which it used in the
manufacture of fertilizers sold during the year.
Consolidation of XYZ Group's financial results will require an adjustment
in respect of the inter-company sale and purchase in order to conform to the
single entity principle.
Consolidated financial results of the two companies will be presented as
follows:
|
XYZ
Group
|
||
|
$m
|
||
|
Sales
|
(120
+ 50 - 20)
|
150
|
|
Cost
of Sales
|
(60
+ 20 - 20)
|
(60)
|
|
Gross
Profit
|
90
|
|
|
Operating
Expenses
|
(20
+ 10)
|
(30)
|
|
Net
Profit
|
60
|
Since XYZ Group, considered as a single entity, cannot sell and purchase
to itself, the sales and purchases in the consolidated income statement have
been reduced by $20 m each in order to present the sales and purchases with
external customers and suppliers.
If we ignore the single entity concept, XYZ Group's financial results
will present sales of $170 m and cost of sales amounting $80 m. Although the
net profit of the group will be unaffected by the inter-company transaction,
the size of the Group's operations will be misrepresented due to the
overstatement.
Following diagram summarizes the implications of the single entity
principle on group financial reporting.
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