Single Economic Entity Concept

Consolidated financial statements of a group of companies are prepared on the basis of single economic entity concept.

Definition

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.

Explanation

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.

Example

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.