CRISIL’s Criteria for Consolidation

Executive Summary
A company may choose to tap into new business opportunities within the ambit of its own operations.
Alternatively, for legal, tax, and regulatory considerations, it may choose to conduct these businesses
through a separate legal entity -- a subsidiary, a special purpose vehicle (SPV), or associate/ group
company.

Indian companies have increasingly diversified into new lines of business, markets, or countries through
complex corporate structures. Several acquisitions by Indian companies have been leveraged buy-outs,
undertaken through SPVs. Other expansions have been through leveraged project finance structures.
Both structures permit the deployment of considerable debt, without weighing down the acquirer’s own
balance sheet. These entities may also isolate or ring-fence the cash flows of the target company from
those of the acquirer. Companies have also resorted to cross-investments and interlocking of equity in
related entities1. In the absence of a clear definition by the parent of the rated company’s obligations and
liabilities, intra-group transactions may have a bearing on its financial position, and, therefore, its ability
to repay debt.

CRISIL believes that in analysing the credit risk profile of a company that has direct or indirect controlling
interest in another entity, it is important that the financials of the company and its related entity be
considered on a consolidated basis. Consolidation of accounts makes for a fair representation of the
group’s financial health, net worth, and leverage levels. Consolidated accounts are important in
assessing the liabilities that the rated company needs to honour in the event of exigencies in a related
entity, which the standalone financials will not capture.

Scope
This criteria document highlights the need for consolidating the company being rated and its related
entities, and outlines CRISIL’s approach to consolidation. It articulates how CRISIL’s criteria on
consolidation takes into consideration the continuum of support extended by the parent to all its related
entities. The criteria goes beyond the situation of full consolidation or no consolidation, and factors all
other forms of support in its analysis. It also assists in determining whether or not to consolidate a
particular related entity and elaborates on the framework to be used in order to assess the integration
between the parent and its related entities.

1
Related entities include subsidiaries, Special Purpose Vehicles (SPVs), associate companies, group companies and
companies under the same management.
 CRISIL’s Criteria for Consolidation
Criteria for Consolidation
Criteria for Consolidation
CRISIL’s approach to consolidation
CRISIL’s approach, however, extends beyond financial consolidation; CRISIL analyses the business risk
of the group and not just the company being rated. The analysis covers each business the group has a
presence in – or is likely to have a presence in -- during the period of analysis. The approach adopted by
CRISIL in analysing the business and management risks of the group will be the same as the one it
would adopt if the businesses were conducted as divisions of the company being rated (Refer example
presented in Box 1)

Box 1: The case for consolidation

Consider a parent company, P Ltd, which has a subsidiary S Ltd. The subsidiary markets more than 80 per cent of
P Ltd’s products. It is clear that S Ltd’s existence is critical to the operations of the parent, as it accounts for a
significant share of the sales of the parent. It is, therefore, reasonable to expect that P Ltd will support its subsidiary
in the event of financial distress. P Ltd’s standalone business risk profile, which does not factor in S Ltd’s marketing
network, will, thus, not be comparable to the networks of P Ltd’s competitors. Also, P Ltd’s standalone financial
statements will not reflect the actual sale price to end customer, or the related marketing and selling costs, and will
thus present an incomplete picture. Therefore, it is necessary that P Ltd’s consolidated operations and financials be
taken into account to capture all these factors, and make the analysis of P Ltd’s credit risk profile comparable with
that of its competitors. This example highlights the importance of consolidation in the rating process.

Pooling of interests: CRISIL’s method of consolidation

There are several ways to consolidate accounts, as per the international accounting standards: these
are the equity method, the pooling of interests method, and purchase method. The choice of method
will depend on the facts of the case, and the purposes for which the consolidation is carried out. By
consolidating, all related entities are treated as a single economic entity.

CRISIL adopts the method of consolidation called pooling of interests, which is also the one adopted by
Accounting Standard 21 (AS21, issued by the Institute of Chartered Accountants of India, refer box 5 for
background on AS21), to assess a group’s overall financial risk profile and its impact on the rated
company. The consolidating process cancels out all off-setting reciprocal pairs such as assets and
liabilities, revenues and costs, and investment and equity accounts, which appear in the financial
statements of the related entities. For instance, the pooling of interests method nullifies all intra-group
transactions. In the balance sheet, investments in related entities are netted off from the group’s net
worth, and borrowings within the group are netted off from advances/investments. One advantage of this
method is that it does not necessitate a valuation exercise or creation of goodwill. (Please refer example
in box 2)
 Box 2: Consolidation by pooling of interests

Consider a company P Ltd having a share capital of Rs.200 million with an investment of Rs.80 million in the share
capital of S Ltd, its subsidiary. If the share capital of S Ltd is Rs.100 million, then the share capital of P Ltd on
consolidation will be Rs.220 million; this is calculated as follows:
Rs. (in million)

Share capital of P Ltd (Parent company) 200

Add: Share capital of S Ltd (Subsidiary company) 100
Less: Investment by P Ltd in S Ltd 80
____
Share capital of P Ltd on consolidation 220
____
Each item of the balance sheet and income statement is consolidated in a similar manner, after adjusting for inter-
company transactions.

Thus, a clear picture of the economic resources controlled by the group, its obligations, and the results it
has achieved with the given resources, are available for assessment. The consolidated financials
indicate the exact nature of group liabilities, the group’s profitability and interest cover, and performance
on other parameters. Finally, key parameters such as the group’s debt, gearing, interest cover, and
profitability are estimated; these are crucial inputs that CRISIL requires in assessing a company’s
financial risk profile.

Identifying entities for consolidation

The primary criterion in determining whether or not to consolidate a related entity is the willingness
and/or compulsion of one entity to support another in exigencies. Hence, while AS21 stipulates
consolidation of subsidiaries in specific cases, CRISIL assesses consolidated financials based on its
analytical judgement of the parent’s willingness and /or compulsion to support the subsidiary in the event
of distress.

CRISIL generally consolidates all subsidiaries, with the following exceptions:

 Where the subsidiary does not operate in the same sector as the parent (for example, a
manufacturing parent entity having a finance or insurance subsidiary, or a bank having an
insurance subsidiary); or

 Where the subsidiary is explicitly ring-fenced (typically in the case of SPVs)

However, even in such cases, CRISIL factors in the potential impact of cash flow support to the
unconsolidated subsidiary. For instance, if the subsidiary and the parent entity operate in different
sectors, a capital allocation approach is followed to determine the rating of the parent and the
unconsolidated subsidiary (Refer box 3 for details on capital allocation approach). The potential impact
of support is also considered for associate companies or other investments.
 CRISIL’s Criteria for Consolidation
Criteria for Consolidation
Criteria for Consolidation
Box 3: Capital allocation approach

Where there is a finance subsidiary of a manufacturing parent or an insurance subsidiary of a bank,

in some instances, CRISIL may decide to notch up the rating of the unconsolidated subsidiary on
account of a stronger parent (Please refer to our detailed criteria present on the CRISIL website
under the ‘Criteria and Methodology’ section - ‘Criteria for Notching up Stand Alone Ratings of
Companies based on Parent Support’). In such instances, CRISIL internally follows a capital
allocation approach to determine the appropriate rating of the parent and the unconsolidated
subsidiary based on the capital allocated to the subsidiary.

Under the capital allocation approach, some amount of capital, objectively assessed through the
level of parent support envisaged, is deducted from the parent’s net worth and is allocated to the
unconsolidated subsidiary. The capital support from the parent uplifts the subsidiary’s rating from its
standalone level to its final rating assigned by CRISIL. Accordingly, as this capital is no longer
deemed to be available with the parent for its own operations, the parent’s net worth is adjusted to
the extent of the capital allocated to the subsidiary and is appropriately factoring in its rating.

CRISIL believes that the willingness or compulsion of one entity to support another in the event of
exigencies is largely driven by the linkages between them; which can take various forms. In some cases,
the rated company may have no major shareholding in group companies, and yet transactions between
them may have cash-flow implications for both. For instance, three companies all held by the same
promoter, and performing specific parts - such as raw material sourcing, production, and marketing – of
the value chain for the same product, will necessitate consolidation to evaluate the creditworthiness of
any one entity in the value chain. Or, companies may hold substantial equity but have no management
control over other entities; as a result, transactions between them may be limited to arm’s length
dealings. It is therefore critical to assess the possibility and extent of cash flow transactions between the
two entities.

Evaluation of inter-linkages between rated entity and any related entity

The approach that CRISIL adopts to evaluate the linkages or perceived relationships between the
company being rated and the related entity, focuses on the extent and likelihood of support from parent
to the related entity, reflecting the economic risks that remain with, or will come upon, the parent. This
analysis involves the following steps:

 Step 1: CRISIL evaluates the extent of linkages between the parent and the related entities
based on the economic importance of the related entity for the parent, the extent to which cash
flows of one entity can be used by another, the stated posture of the management, extent of
shareholding of one entity in the other, and the presence of a shared name. (Refer Box 4 for the
detailed framework used for this assessment)
 Box 4: CRISIL’s Framework for assessing level of integration

CRISIL uses the following parameters in assessing the integration between the parent and the related entity:

1. Economic importance of related entity for parent: CRISIL believes that this is the strongest factor affecting
the extent of linkage between related entities and their parent companies. CRISIL evaluates the magnitude of
the economic importance based on various factors, which include the related entity’s strategic importance to
the parent, the level of the parent’s exposure in the related entity in relation to its own net worth, and the
expected financial returns from the entity.

2. The extent to which cash flows are fungible: Movement of cash across entities indicates a stronger
likelihood of support from parent to related entities. Cash flows across entities may include inter-corporate
deposits, advances and loans, or equity infusions. Such groups will generally have common treasury
operations; but the presence of a common treasury does not necessarily mean that cash flows move freely
through the group.

3. Documentary support: The documentary support (such as guarantees, letters of comfort, or letters of
awareness) provided by the parent to related entity’s lenders, brings out the intent of the promoter to support
the entity. It thus provides an insight into the level of integration between the two entities.

4. Management’s stated posture: CRISIL evaluates the parent’s stated posture on support (or otherwise) to a
related entity, and its track record in similar situations. It is also important to think ahead to potential stress
scenarios, and assess how the parent may act in such circumstances.

5. Percentage of ownership: Large holdings by the promoter or group companies reflect a high level of
commitment to the related entity. CRISIL assesses current and prospective shareholding patterns to make the
analysis forward-looking.

6. Shared name: CRISIL believes that a common name between the parent and a related entity obligates the
parent to support the entity in times of financial distress. A common group logo or name and other forms of
association with the group are manifestations of strong integration of the entity with the group.

 Step 2: Based on its assessment of the level of integration, CRISIL categorises related entities
into one of three classes (See Chart 1): fully integrated with parent, moderately integrated with
parent, or held as a financial investment by parent.
 CRISIL’s Criteria for Consolidation
Criteria for Consolidation
Criteria for Consolidation
Chart 1: The Three Classes of Associates

FULLY INTEGRATED INVESTMENTS

Moderately Financial
Full Moderate
Integrated – No – No
Financial Investment
Investment
Integration Integration No consolidation.
Full analytical
consolidation. Factor
No consolidation. consolidation.
CRISIL analyses the
consolidation with parent in additional
CRISIL factors in Analyse the value of
value of investment for
investment and
additional investment investment. Factor in
impairment
supportand support dividend income

 Step 3: Based on the classification of the related entity, CRISIL adopts the appropriate analytical
treatment for factoring in the potential impact of support to the entity, from the company being
rated. This is as follows:

Fully integrated with parent: Related entities that are fully integrated are consolidated with the
parent company: the business and financial risk profiles of the parent fully incorporate those of
these entities. The operations of these entities are critical to the parent. CRISIL, therefore,
believes that there is significant economic incentive for the parent to provide full support to such
related entities in times of distress.

Moderately integrated with parent: In the case of moderately-linked entities, CRISIL estimates
the level of additional investment or support that may be required in the event of distress; these
are then factored into the analysis of the parent company. CRISIL also tests the value of
investments held by the parent in the entity for impairment, and adjusts the parent’s net worth if
required. No consolidation is done in such cases even though the related entity may legally be a
subsidiary. Consider, for instance, a construction company with an investment 15 per cent of its
net worth in an SPV with limited recourse that is executing a toll road project. The SPV may
legally be a subsidiary of the parent company. However, considering the limited recourse that the
lenders to the SPV have to the parent company in this project, CRISIL will not consolidate the
financials of the SPV while analysing the parent company. The level of additional investment or
support that may be required in the event of distress will be factored into the analysis of the
parent company.

Held as a financial investment by parent: CRISIL treats a related entity as a financial

investment if it is

- of little strategic importance to the parent; and/or

- offers minimal economic incentive for the parent to provide distress support; and/or
- features adequate ring fencing, and is insulated by an explicit public stated posture of
non-support.

In such cases, the parent’s credit risk profile is assessed independently, without factoring in the
debt obligations of the related entity. However, the value, volatility, and liquidity of the investment
by the parent in a related entity are analysed as CRISIL would analyse any other equity
investment; this includes testing the investment for any impairment in value.
 Box 5: Consolidation in India – AS21

Under AS21, a company is deemed to have control over another company in two specific cases:

When one company has a majority stake (of more than 50 per cent) in another
When management control of one entity vests with another entity, which has the voting
power or the power to appoint or remove members on the board of directors of the first
entity.

Consolidation of group company accounts is mandatory for parent companies that satisfy either
of these criteria.

AS21 requires the controlling or parent company to present consolidated financials for the entire
group, together with its own standalone financials. Consolidated financial statements need to be
in the same format as ordinary financial statements, and need to include a consolidated profit
and loss account, balance sheet, and cash flow statement.

Even finance subsidiaries of a manufacturing parent need to be consolidated under AS21;

CRISIL believes that this does not present a true picture of the parent's financial risk profile, and
therefore excludes finance subsidiaries when evaluating a manufacturing parent's financial
profile.
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Last updated: May, 2013

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