Consolidation and segmented information
Author: Allen White, Sigma Conso Co-founder and Administrator
The process of consolidation consists in establishing a financial picture of a group of companies as if they were a single company. During this process, some operations eliminate the shareholders’ equity of companies and, simultaneously, the value of shareholders’ financial holdings. Likewise, inter-company balances are eliminated from both companies and partners.
The consolidation process also sometimes includes adjustments for two companies involved in certain intra-group transactions such as, for example, the elimination of profits during an asset transfer.
However, since the application of IFRS standards, groups have been asked to produce segmented information when companies have very different activities from each another. This segmented information is applicable to the balance sheet and to the income statement, and although it isn’t compulsory, groups also try to apply segmentation to the consolidated cash flow statement.
We felt that it would be helpful in this article to cover the basic principles of segmentation and to draw the reader’s attention to the various difficulties inherent to the technique.
The principles of segmentation
There are three principles, which can be summarised as follows:
First principle: Unique activity of companies in the perimeter
It is assumed that once a segmentation criterion has been established, companies will be associated with a single criterion. This means that if a company has multiple activities, it will have to set up separate accounts by segment within the legal entity.
Second principle: Removal of each company’s shareholder role
Consider the following example.
In a traditional consolidation process, the level of consolidated reserves is calculated for each company, that is
CR(A) = 90% * SE(A) – 100% * Part.(M/A)
CR(B) = 72% * SE(B) – 90% * Part.(A/B)
where CR = Consolidated Reserves
SE = Shareholders’ Equity
Part.(X/Y) = Participation of company X in company Y
The percentages used in this formula should be seen as indirect percentages.
The consolidated reserves of the consolidating company are statutory reserves which are potentially adjusted. We’ll call them CR(M).
We can therefore say that the group’s reserves are equal to
CR(M) + CR(A) + CR(B).
In order to prepare the segmented information, a so-called intrinsic situation must be calculated for each company. This consists of the difference between shareholders’ equity and the holdings in the companies of the perimeter, which should be understood as the company’s indirect holding percentage.
In our example, this is
IS(M) = SE(M) – Part.(M/A)
IS(A) = 90% * [SE(A) – Part.(A/B)]
IS(B) = 72% * SE(B)
This approach calls for a few comments.
First, the shareholder role of each company is removed by eliminating their holdings from their assets, even if they are related to companies belonging to the same segment.
Next, from a more technical standpoint, we avoid the difficult issue of using so-called linked accounts via which the value of a holding, held by the shareholder, is transferred to the shareholders’ equity of the company held, although the two companies may not belong to the same segment.
Lastly, the intrinsic situation expresses the “intrinsic” value of a company independently of the value expressed through the companies held. We’ll assume that company A in our example is a sub-holding. Let’s even assume that A’s capital is allocated to a holding in company B in an amount equal to the capital. In this case, A’s intrinsic situation will be 0. The real value of A is determined by its holding B. However, if we assume that A and B belong to different segments, it becomes obvious that the value brought by A to its segment will be 0.
We must reassure readers that the intrinsic situation calculated for the group is no more than the consolidated reserves established according to the statutory consolidation process.
Let’s go back to the group’s consolidated reserves, that is
CR(M) + CR(A) + CR(B)
= CR(M) + [90% * SE(A) – 100% * Part.(M/A)] + [72% * SE(B) – 90% * Part.(A/B)]
By modifying the factor order we obtain the following
= [CR(M) – Part.(M/A)] + 90% * [SE(A) – Part.(A/B)] + 72% * SE(B)
= IS(M) + IS(A) + IS(B),
which proves the statement.
Third principle: Non-elimination of inter-company balances between different segments
In the statutory consolidation process, the elimination of inter-company balances is also done with linked accounts which are cleared for the consolidated total but not necessarily for the various segments. In fact, we remove this difficulty by assuming that inter-company balances between companies in different segments are no longer considered as such and are, therefore, not eliminated. Therefore, only inter-company balances between companies belonging to the same segment are eliminated. As a result, the balances of linked accounts are 0 in each segment.
This practice has an impact on the reconciliation of the sum of segments and the statutory consolidated total. For example, the total turnover for all of the segments can be higher than the statutory consolidated turnover, with the difference consisting of the turnover for all companies in different segments.
Here is an illustration
Given the group above, we’ll assume that companies M and B belong to an “Industry” segment and that company A belongs to a “Finance” segment.
The table below shows the accounts used for our illustration.
Let’s calculate the consolidated reserves of each company using the traditional statutory process, that is
|M||2.000 + 600||2.600|
|A||90% * 3.300 – 2.000||970|
|B||72% * 2.700 -90% * 3.500||– 1.206|
Now, let’s calculate the intrinsic situation of each of the companies, as indicated above
|M||2.600 – 2.000||600|
|A||90% * (3.300 – 3.500)||– 180|
|B||72% * 2.700||1.944|
If the total reserves are the same using both approaches, the contribution of the companies isn’t comparable or, a fortiori, that of the two defined segments. This is summarised below
|Statutory approach||Segmented approach|
Note that company A, belonging to the Finance segment, becomes irrelevant when the segmented approach is used. On reviewing its accounts, it becomes clear that most of its shareholders’ equity is reallocated to a holding in the Industry segment. Its intrinsic value shows this particularity.
The statutory approach, on the other hand, shows a real value for company A.
This shows a group in two different lights but doesn’t, however, provide a choice.
IFRS standards require that segmented information be created for groups that are active in different sectors. This must be done in line with the rules described in this article.
As for bankers who might have to decide on a loan to company A, the segmented vision clearly demonstrates the need to obtain guarantees from the parent company.