The solutions manual for advanced financial accounting_10 ppt

Required a Prepare consolidated profit and loss accounts for the year ended 31 May 2000 and consolidated balance sheets as at 31 May 2000 for the AB group utilising: i Merger accounting;

Chapter 13 · Business combinations and goodwill 393

You are required to discuss the above statement stating, with reasons, whether there is a

need for two different methods.

CIMA, Advanced Financial Accounting, May 1994 (15 marks)

13.2 The balance sheets of Left plc and Right plc at 31 December 1999, the accounting date for

both companies, were as follows

Equity share capital (£1 shares) 30 000 20 000

On 31 December 1999, Left plc purchased all the equity shares of Right plc The purchase

consideration was satisfied by the issue of 6 new equity shares in Left plc for every 5 equity

shares purchased in Right plc At 31 December 1999 the market value of a Left plc share

was £2.25 and the market value of a Right plc share was £2.40 Relevant details concerning

the values of the net assets of Right plc at 31 December 1999 were as follows:

● The fixed assets had a fair value of £43.5 million

● The stocks had a fair value of £9.5 million

● The debentures had a market value of £11 million

● Other net assets had a fair value that was the same as their book value

The effect of the purchase of shares in Right plc is NOT reflected in the balance sheet of

Left plc that appears above

Requirements

(a) Prepare the consolidated balance sheet of the Left plc group at 31 December 1999

assuming the business combination is accounted for

● as an acquisition; and

(b) Discuss the extent to which the business combination satisfies the requirements of

FRS 6 – Acquisitions and mergers for classification as a merger You should indicate

the other information you would need to enable you to form a definite conclusion.

(6 marks)

13.3 AB, a public limited company manufactures goods for the aerospace industry It acquired

an electronics company CG, a public limited company on 1 December 1999 at an agreed

value of £65 million The purchase consideration was satisfied by the issue of 30 million

shares of AB, in exchange for the whole of the share capital of CG The directors of

AB have decided to adopt merger accounting principles in accounting for the acquisition,but the auditors have not as yet concurred with the use of merger accounting in the finan-cial statements

The following summary financial statements relate to the above companies as at 31 May2000

Profit and Loss Accounts for the year ended 31 May 2000

Creditors: amounts due after more than one year (2 000) (4 000)

(i) The management of AB feel that the adjustments required to bring the following assets

of CG to their fair values at 1 December 1999 are as follows:

Fixed Assets to be increased by £4 million;

Stock to be decreased by £3 million (this stock had been sold by the year end);

Chapter 13 · Business combinations and goodwill 395Provision for bad debts to be increased by £2 million in relation to specific accounts;

Depreciation is charged at 20% per annum on a straight line basis on tangible fixed

assets;

The increase in the provision for bad debts was still required at 31 May 2000 No

further provisions are required on 31 May 2000

(ii) CG has a fixed rate bank loan of £4 million which was taken out when interest rates

were 10% per annum The loan is due for repayment on 30 November 2001 At the

date of acquisition the company could have raised a loan at an interest rate of 7%

Interest is payable yearly in arrears on 30 November

(iii) CG acquired a corporate brand name on 1 July 1999 The company did not capitalise the

brand name but wrote the cost off against reserves in the Statement of Total Recognised

Gains and Losses The cost of the brand name was £18 million AB has consulted an

expert brand valuation firm who have stated that the brand is worth £20 million at the

date of acquisition based on the present value of notional royalty savings arising from

ownership of the brand The auditors are satisfied with the reliability of the brand

valu-ation Brands are not amortised by AB but are reviewed annually for impairment, and

as at 31 May 2000, there has been no impairment in value Goodwill is amortised over a

10 year period with a full charge in the year of acquisition

(iv) AB incurred £500 000 of expenses in connection with the acquisition of CG This

figure comprised £300 000 of professional fees and £200 000 of issue costs of the

shares The acquisition expenses have been included in administrative expenses

Required

(a) Prepare consolidated profit and loss accounts for the year ended 31 May 2000 and

consolidated balance sheets as at 31 May 2000 for the AB group utilising:

(i) Merger accounting;

(b) Discuss the impact on the group financial statements of the AB group of utilising

merger accounting as opposed to acquisition accounting (Candidates should discuss

at least three effects on the financial statements.) (6 marks)

ACCA, Financial Reporting Environment (UK Stream), June 2000 (25 marks)

13.4 There are currently two possible methods of preparing consolidated financial statements when

two or more separate legal entities combine to form a single economic entity in the form of a

group The most commonly used method is the acquisition method However, another method

is sometimes appropriate when two or more separate legal entities unite into one economic

entity by means of an exchange of equity shares This method is known as the merger method

Recent developments suggest that Standard setters are considering a change that would prevent

the merger method ever being used and require that the acquisition method be used to prepare

consolidated financial statements following a business combination

Top plc and Bottom plc are two listed companies that operate in the same sector The

two sets of directors have been speculating for some time that it would be in the mutual

inter-est of the two companies to combine together to form a single economic entity while

maintaining the separate legal status of the two companies Accordingly, on 30 April 2001 Top

plc made an offer to all the equity shareholders of Bottom plc to acquire their shares The

terms of the offer were 4 equity shares in Top plc for every 3 equity shares in Bottom plc The

offer was accepted by all the equity shareholders in Bottom plc and the exchange of equity

shares took place on 31 May 2001 The directors of Top plc wish to use merger accounting

to prepare the consolidated financial statements for the year ended 31 January 2002 Any

computational work in this question should assume that merger accounting principles will

be adopted

The relevant profit and loss accounts and balance sheets of Top plc and Bottom plc aregiven below:

Profit and loss accounts – year ended

Called-up share capital – £1 equity shares 84 000 30 000

Note 1 – investment in Bottom plc

The investment in Bottom plc comprises:

£000

Merger expenses (including £500 000 issue costs of shares) 800

–––––––

40 800–––––––

Chapter 13 · Business combinations and goodwill 397

Note 2 – accounting policies

Both companies have the same accounting policies in all respects other than valuation of

stock Bottom plc uses the LIFO method whereas Top plc uses the FIFO method The

directors of Top plc wish to use the FIFO method in preparing the consolidated financial

statements Details of the stocks of Bottom plc are as follows:

valuation valuation under FIFO under LIFO

In preparing your answers to this question you should assume that the directors of Top

plc wish to maximise the profit and loss reserve that is reported in the consolidated

balance sheet

Required

(a) Prepare the consolidated profit and loss account of the Top plc group for the year

ended 31 January 2002, starting with turnover and ending with retained profit

(b) Prepare the consolidated balance sheet of the Top plc group at 31 January 2002.

(c) Explain the concepts underpinning acquisition accounting and merger accounting

and suggest why merger accounting might be considered invalid. (10 marks)

CIMA, Financial Reporting – UK Accounting Standards, May 2002 (20 marks)

13.5 Growmoor plc has carried on business as a food retailer since 1900 It had traded

prof-itably until the late 1980s when it suffered from fierce competition from larger retailers Its

turnover and margins were under severe pressure and its share price fell to an all time low

The directors formulated a strategic plan to grow by acquisition and merger It has an

agreement to be able to borrow funds to finance acquisition at an interest rate of 10% per

annum It is Growmoor plc’s policy to amortise goodwill over ten years

1 Investment in Smelt plc

On 15 June 1994 Growmoor plc had an issued share capital of 1 625 000 ordinary shares of

£1 each On that date it acquired 240 000 of the 1 500 000 issued £1 ordinary shares of

Smelt plc for a cash payment of £164 000

Growmoor plc makes up its accounts to 31 July In early 1996 the directors of Growmoor plc

and Smelt plc were having discussions with a view to a combination of the two companies

The proposal was that:

(i) On 1 May 1996 Growmoor plc should acquire 1 200 000 of the issued ordinary shares

of Smelt plc which had a market price of £1.30 per share, in exchange for 1 500 000

newly issued ordinary shares in Growmoor plc which had a market price of £1.20p per

share There has been no change in Growmoor plc’s share capital since 15 June 1994

The market price of the Smelt plc shares had ranged from £1.20 to £1.50 during the

year ended 30 April 1996

(ii) It was agreed that the consideration would be increased by 200 000 shares if a gent liability in Smelt plc in respect of a claim for wrongful dismissal by a formerdirector did not crystallise.

contin-(iii) After the exchange the new board would consist of 6 directors from Growmoor plcand 6 directors from Smelt plc with the Managing Director of Growmoor plc becom-ing Managing Director of Smelt plc

(iv) The Growmoor plc head office should be closed and the staff made redundant and theSmelt plc head office should become the head office of the new combination

(v) Senior managers of both companies were to re-apply for their posts and be viewed by an interview panel comprising a director and the personnel managers fromeach company The age profile of the two companies differed with the average age ofthe Growmoor plc managers being 40 and that of Smelt plc being 54 and there was anexpectation among the directors of both boards that most of the posts would be filled

inter-by Growmoor plc managers

2 Investment in Beaten Ltd

Growmoor plc is planning to acquire all of the 800 000 £1 ordinary shares in Beaten Ltd on

30 June 1996 for a deferred consideration of £500 000 and a contingent considerationpayable on 30 June 2000 of 10% of the amount by which profits for the year ended 30 June

2000 exceeded £100 000 Beaten Ltd has suffered trading losses and its directors, who arethe major shareholders, support a takeover by Growmoor plc The fair value of net assets

of Beaten Ltd was £685 000 and Growmoor plc expected that reorganisation costs would be

£85 000 and future trading losses would be £100 000 Growmoor plc agreed to offer fouryear service contracts to the directors of Beaten Ltd

The directors had expected to be able to create a provision for the reorganisation costsand future trading losses but were advised by their Finance Director that FRS 7 requiredthese two items to be treated as post-acquisition items

Required (a) (i) Explain to the directors of Growmoor plc the extent to which the proposed terms of the combination with Smelt plc satisfied the requirements of the Companies Act

1985 and FRS 6 for the combination to be treated as a merger; and (ii) If the proposed terms fail to satisfy any of the requirements, advise the directors

on any changes that could be made so that the combination could be treated as a

(b) Explain briefly the reasons for the application of the principles of recognition and measurement on an acquisition set out in FRS 7 to provisions for future operating

(c) (i) Explain the treatment in the profit and loss account for the year ended 31 July

1996 and the balance sheet as at that date of Growmoor plc on the assumption that the acquisition of Beaten Ltd took place on 30 June 1996 and the consideration for the acquisition was deferred so that £100 000 was payable after one year, £150 000 after two years and the balance after three years Show your calculations.

(ii) Calculate the goodwill to be dealt with in the consolidated accounts for the years ending 31 July 1996 and 1997, explaining clearly the effect of deferred and con- tingent consideration.

(iii) Explain and critically discuss the existing regulations for the treatment of

ACCA, Financial Reporting Environment, December 1996 (20 marks)

Chapter 13 · Business combinations and goodwill 399

13.6 FRS 10 – Goodwill and Intangible Assets – was issued in December 1997 At the same time,

SSAP 22, the previous Accounting Standard which dealt with the subject of accounting

for goodwill, was withdrawn SSAP 22 allowed purchased goodwill to be written off

directly to reserves as one amount in the accounting period of purchase FRS 10 does not

permit this treatment

Invest plc has a number of subsidiaries The accounting date of Invest plc and all its

sub-sidiaries is 30 April On 1 May 1998, Invest plc purchased 80% of the issued equity shares

of Target Ltd This purchase made Target Ltd a subsidiary of Invest plc from 1 May 1998

Invest plc made a cash payment of £31 million for the shares in Target Ltd On 1 May

1998, the net assets which were included in the balance sheet of Target Ltd had a fair value

to Invest plc of £30 million Target Ltd sells a well-known branded product and has taken

steps to protect itself legally against unauthorised use of the brand name A reliable

esti-mate of the value of this brand to the Invest group is £3 million It is further considered

that the value of the brand can be maintained or even increased for the foreseeable future

The value of the brand is not included in the balance sheet of Target Ltd.

For the purposes of preparing the consolidated financial statements, the Directors of Invest

plc wish to ensure that the charge to the profit and loss account for the amortisation of

intan-gible fixed assets is kept to a minimum They estimate that the useful economic life of the

purchased goodwill (or premium on acquisition) of Target Ltd is 40 years

Requirements

(a) Outline the key factors which lay behind the decision of the Accounting Standards

Board to prohibit the write-off of purchased goodwill to reserves. (11 marks)

(b) Compute the charge to the consolidated profit and loss account in respect of the

goodwill on acquisition of Target Ltd for its year ended 30 April 1999. (5 marks)

(c) Explain the action which Invest plc must take in 1998/99 and in future years arising

from the chosen accounting treatment of the goodwill on acquisition of Target Ltd.

(4 marks)

13.7 Islay plc has acquired the following unincorporated businesses:

(1) ‘Savalight’, a business specialising in the production of low-cost, energy efficient light

bulbs, acquired on 1 June 1996 for £580 000 The identifiable assets and liabilities of

the business had a book value of £550 000 and were valued at £500 000 on 1 June

1996 The company estimated the useful economic life of the goodwill arising at five

years and has been amortising this through the profit and loss account It was

antici-pated that the goodwill would have a residual value of £20 000

(2) ‘Green Goods’, a business specialising in the distribution of a range of

environmen-tally friendly products, acquired on 1 June 1997 for £1.8 million The identifiable

assets and liabilities of the business had a book value of £1.1 million and were valued

at £1.3 million on 1 June 1997, including goodwill of the business of £150 000 The

company estimated the useful economic life of goodwill arising at 25 years and has

been amortising this through the profit and loss account

(3) ‘Smart IT’, a business specialising in the distribution of computers, acquired on 1 June

1998 for £900 000 The identifiable assets and liabilities of the business had a book

value of £1 million and were valued at £1.2 million on 1 June 1998 Assume the major

non-monetary assets in these amounts have a useful economic life of 15 years

Islay plc revalued its tangible fixed assets during the year ended 31 May 1999 and created a

revaluation reserve of £600 000 In addition, the company believes the goodwill arising on

the purchase of ‘Savalight’ is now worth £350 000 and intends to reflect this in the financialstatements for the year ended 31 May 1999.

The company’s capital and reserves (before reflecting any adjustments for the above acquisitions) in the draft financial statements as at 31 May 1999 show:

Called up share capital (5 000 000 ordinary shares of £1 each) 5000

Profit and loss account (£200 000 for the year ended 31 May 1999) 700

–––––6300––––––––––

Requirements (a) Calculate and disclose the amounts for goodwill to be included in the financial state- ments for Islay plc for the year ended 31 May 1999, providing the following disclosures:

Balance sheet extracts Disclosure note for goodwill

(b) Explain the accounting treatment you have adopted for any goodwill arising in sitions (1) to (3) above, referring to the provisions of FRS 10, ‘Goodwill and Intangible Assets’, and noting any current or future action Islay plc will have to take

13.8 Elie plc acquired 80% of the £1 million ordinary share capital of Monans Ltd on 1 July

2001 by issuing 200 000 £1 ordinary shares Elie plc’s ordinary shares were quoted at £17

on 1 July 2001 Expenses of the share issue amounted to £90 000

A further amount of £94 500 is payable in cash on 1 July 2002 Elie plc’s borrowing rate

is 5%

A further contingent consideration of shares with a value of £500 000 is dependent onMonans Ltd achieving a 10% increase in turnover in the year ended 31 October 2002 Thiswould become due on 1 July 2003 Monans Ltd has achieved an increase in turnover over thepast five years of 11%, 8%, 10%, 11% and 12% (from the earliest to the most recent year).The net assets of Monans Ltd in its accounts as at 1 July 2001 were £3 million withfair value being £1 million higher than book value Monans Ltd had the following reserves

at 1 July 2001:

£000

A further acquisition of shares took place on 1 September 2001 when Elie plc purchased60% of the £500 000 preference shares of Monans Ltd for £390 000

Elie plc is intending to write off any goodwill arising over 9 years, charging a full year inthe year of acquisition

Elie plc has identified the following matters not reflected in the financial statements ofMonans Ltd as at 1 July 2001:

Chapter 13 · Business combinations and goodwill 401

(1) A contingent asset amounting to £200 000 existed at 1 July 2001; the company’s

lawyers consider it is probable this will be received in the near future

(2) Operating losses of £300 000 are expected after acquisition

(3) Reorganisation costs of £100 000 are to be incurred to bring Monans Ltd’s systems

into line with those of the group

(4) A fall in stock value of £50 000 on 5 July 2001 due to a fire at a warehouse The stock

now has a net realisable value of £5000

Requirements

(a) Calculate the amount of goodwill arising on the acquisition of Monans Ltd that

would be shown in the group accounts of Elie plc for the year ended 30 June 2002.

(8 marks)

(b) Explain your calculation of the goodwill arising in (a) including your treatment of

items (1) to (4) above, referring to appropriate accounting standards. (12 marks)

13.9 FRS 11 – Impairment of fixed assets and goodwill requires that all fixed assets and goodwill

should be reviewed for impairment where appropriate and any impairment loss dealt with

in the financial statements

The XY group prepares financial statements to 31 December each year On 31 December

1998 the group purchased all the shares of MH Ltd for £2 million The fair value of the

iden-tifiable net assets of MH Ltd at that date was £1.8 million It is the policy of the XY group to

amortise goodwill over 20 years The amortisation of the goodwill of MH Ltd commenced in

1999 MH Ltd made a loss in 1999 and at 31 December 1999 the net assets of MH Ltd – based

on fair values at 1 January 1999 – were as follows:

£000Capitalised development expenditure 200

–––––

1750–––––

An impairment review at 31 December 1999 indicated that the value in use of MH Ltd at

that date was £1.5 million The capitalised development expenditure has no ascertainable

external market value

Requirements

(a) Describe what is meant by ‘impairment’ and briefly explain the procedures that must

be followed when performing an impairment review. (12 marks)

(b) Calculate the impairment loss that would arise in the consolidated financial statements

of the XY group as a result of the impairment review of MH Ltd at 31 December 1999.

(4 marks)

(c) Show how the impairment loss you have calculated in (b) would affect the carrying

values of the various net assets in the consolidated balance sheet of the XY group at

13.10 Acquirer plc is a company that regularly purchases new subsidiaries On 30 June 2000,

the company acquired all the equity shares of Prospects plc for a cash payment of £260million The net assets of Prospects plc on 30 June 2000 were £180 million and no fairvalue adjustments were necessary upon consolidation of Prospects plc for the first time.Acquirer plc assessed the useful economic life of the goodwill that arose on consolidation

of Prospects plc as 40 years and charged six months’ amortisation in its consolidatedprofit and loss account for the year ended 31 December 2000 Acquirer plc then charged

a full year’s amortisation of the goodwill in its consolidated profit and loss account forthe year ended 31 December 2001

On 31 December 2001, Acquirer plc carried out a review of the goodwill on tion of Prospects plc for evidence of impairment The review was carried out despite thefact that there were no obvious indications of adverse trading conditions for Prospectsplc The review involved allocating the net assets of Prospects plc into three income-generating units and computing the value in use of each unit The carrying values of theindividual units before any impairment adjustments are given below:

consolida-Unit A Unit B Unit C

£ million £ million £ million

It was not possible to meaningfully allocate the goodwill on consolidation to the individualincome-generating units, but all the other net assets of Prospects plc are allocated in thetable shown above The patents of Prospects plc have no ascertainable market value but allthe current assets have a market value that is above carrying value The value in use ofProspects plc as a single income-generating unit at 31 December 2001 is £205 million

Required (a) Explain why it was necessary to review the goodwill on consolidation of Prospects

(b) Explain briefly the purpose of an impairment review and why the net assets of Prospects plc were allocated into income-generating units as part of the review of

(c) Demonstrate how the impairment loss in unit A will affect the carrying value of the net assets of unit A in the consolidated financial statements of Acquirer plc.

Investments and groups

c h a p t e r

14

Investments by one entity in another take many different forms, ranging from simple or

pas-sive investments at one end of the spectrum to investments which command control of the

investee’s activities, assets and liabilities at the other end of the spectrum.

This chapter is divided into two sections The first distinguishes different levels of investment

and explains the treatment of investments in the financial statements of an investing company.

The second examines accounting for groups using the acquisition method of accounting and

pays particular attention to the treatment of acquisitions and disposals We therefore draw upon

the relevant provisions of the following UK and international accounting standards:

● FRS 2 Accounting for Subsidiary Undertakings (1992)

● FRS 6 Acquisitions and Mergers (1994)

● FRS 7 Fair Values in Acquisition Accounting (1994)

● IAS 22 Business Combinations (revised 1998)

● IAS 27 Consolidated Financial Statements and Accounting for Investments in Subsidiaries

(revised 2000)

In the first section we also refer to the relevant parts of a number of other international

accounting standards, namely:

● IAS 28 Accounting for Investments in Associates (revised 2000)

● IAS 31 Financial Reporting of Interests in Joint Ventures (revised 2000)

● IAS 39 Financial Instruments: Recognition and Measurement (revised 2000)

The international standards IAS 22, IAS 27, IAS 28 and IAS 39 are at present under review

so we draw attention to likely changes where appropriate.

Introduction

Many companies hold investments in other entities and it is therefore necessary to

deter-mine how these investments are to be treated in the financial statements of the reporting

entity As we shall see, the treatment of investments in the financial statements of an

individ-ual company is relatively straightforward but, as soon as an investment is sufficient to give

influence or control over the affairs of the investee, things become more complicated

Investments may range from simple or passive investments, held to obtain dividends and

potential capital growth, to those which give the investing company control over the

activi-ties, assets and liabilities of the investee The ASB Statement of Principles for Financial

Reporting distinguishes four different categories of investment, as shown in Table 14.1.1

1Statement of Principles for Financial Reporting, ASB, London, December 1999: Chapter 8, ‘Accounting for interests

in other entities’ In drawing up this table, we have assumed that all four categories involve investment in entities.

FRS 9 Accounting for Associates and Joint Ventures (November 1997) also identifies a Joint Arrangement which is

Not an Entity, a ‘JANE‘, which we discuss briefly in the following chapter.

We start by examining the accounting treatment of investments in the individual financialstatements of the investing company In the UK at present, this treatment is the same what-ever the degree of control or influence the investor exercises over the investee However, as

we shall see, international accounting standards at present specify different possible ing treatments for investments with different levels of influence

account-We next move to the other end of the spectrum and, in the second section of the chapter,

‘Accounting for groups’, we focus on situations where the investment is large enough to givecontrol Where this occurs, the investee is a subsidiary undertaking and, subject to certainexceptions, the investing company must prepare group accounts that, since the enactment ofthe Companies Act 1989, must be consolidated accounts.2The relevant UK standard

accounting practice is contained in FRS 2 Accounting for Subsidiary Undertakings We

exam-ine the definition of a group and the possible exclusion of subsidiaries from the consolidatedaccounts before turning to some of the questions which must be answered in accounting forthe purchase and sale of subsidiaries As we have seen in Chapter 13, the use of mergeraccounting is extremely rare and likely to disappear completely in future so, in this chapter,

we are concerned only with acquisition accounting

In this section, we also examine the provisions of the relevant international accountingstandards and draw attention to the main differences between UK and international pro-nouncements As the relevant international standards are at present under review, we drawattention to changes which are likely to occur

We will, in the following chapter, consider the intermediate categories of investmentwhich give partial influence over the investee, that is investments in associates and joint ven-tures, as well as joint arrangements that are not entities

Investments Individual company financial statements

The key to determining the treatment of an investment in the shares of another company in

the financial statements of the investing company is intention If the investment is intended

to be for the long term, it will be treated as a fixed asset; if for the short term, it will betreated as a current asset In a traditional historical cost balance sheet, a fixed asset invest-ment is shown at its historical cost unless its value has been impaired, in which case it iswritten down to its recoverable amount A current asset investment is shown at the lower ofcost and net realisable value The carrying value used for an impaired fixed asset investment

Table 14.1 Four categories of investment

Degree of Control Joint Significant Lesser or no

influence control influence influence

Resulting Subsidiary Joint Associate Simple or

investment

2 Companies Act 1985, s 227, Para 2.

Chapter 14 · Investments and groups 405

will differ from that of a current asset investment when its value in use, or present value,

exceeds its net realisable value and this sensibly reflects the management decision to retain,

rather than to sell, the investment

For both types of investment it is usual to take credit in the profit and loss account of the

investing company for dividends received and receivable, although dividends receivable are

only recognised to the extent that they are in respect of accounting periods ended on or

before the accounting year end of the investing company and have been declared prior to

approval of the investing company’s own financial statements Some companies are even

more prudent and take credit only for dividends received in an accounting period

The above accounting treatments provide limited information to users of the investing

company’s financial statements and, in order to remedy this, some companies have taken

advantage of the alternative accounting rules to show investments at their current value.3 In

such cases, any revaluation surplus must be taken to a revaluation reserve and any

revalu-ation deficit must be taken to the revalurevalu-ation reserve to the extent that that reserve contains

a revaluation surplus in respect of the same investment but otherwise must be charged to the

profit and loss account Amounts credited or debited to a revaluation reserve account must,

of course, be reported in the Statement of Total Recognised Gains and Losses

In its death throes in July 1990, the ASC issued Exposure Draft 55 Accounting for

Investments, and this made proposals in respect of both fixed asset and current asset

invest-ments It proposed that, where a company adopts the alternative accounting rules to show

fixed asset investments at a valuation, that amount should be kept up to date by an annual

revaluation However, its major proposal for change was in accounting for certain current

asset investments, namely those which are ‘readily marketable’ It was the view of the ASC

that such investments should be stated in a balance sheet at their quoted current value and

that any difference between that current value and the previous carrying value should be

reflected in the profit and loss account Hence the profit and loss account would reflect not

only the dividends receivable but also any changes in the value of such an investment during

an accounting year In the view of the ASC any such change would be a realised profit or loss

on the grounds that it has been reliably measured by reference to a quoted price.4

While many accountants applauded the ASC for attempting to ensure that such changes

in value are reflected in a profit and loss account, there were severe doubts about the legality

of the proposed method of accounting for readily marketable current asset investments.5The

method which was proposed did not comply with the historical cost accounting rules, which

require such current asset investments to be shown at the lower of cost and net realisable

value, nor with the alternative accounting rules which require any revaluation surplus to be

taken, not to the profit and loss account, but to a revaluation reserve The ASC was well

aware that its proposals could only be introduced by relying on the true and fair override or

if there were to be a change of law.6 These were, of course, the days before FRS 3, the

‘Statement of Total Recognised Gains and Losses’ and the Statement of Principles for

Financial Reporting but, even with this help, the ASB has not yet been able to resolve this

3 The rules on what is an acceptable current value differ for fixed assets and current assets respectively (See

Companies Act 1985, Schedule 4, s C, Paras 31(3) and 31(4).) Thus, a current asset investment may be shown at

its current cost, while a fixed asset investment may be shown at its market value or any other value which the

directors consider to be appropriate In the latter case, the method of valuation adopted and the reasons for

adopting it must be stated.

4ED 55 Accounting for Investments, July 1990, Para 43 As we have seen in Chapter 4, there are different ways of

defining realisation ED 55 took the view that a profit or loss made due to a change in value of a readily

mar-ketable current asset investment is realised because the value of that investment can be reliably measured In its

view, the investment did not have to be converted into cash by sale before the profit could be treated as realised.

5R Macve, ‘Investments: conceptual clarity v legal muddle’, Accountancy, March 1991, pp 84–5.

6 ED 55, Preface, Paras 1.17 and 1.18.

matter although it is seeking to move matters forward with the issue of FRED 30 Financial

instruments: Disclosure and presentation; recognition and measurement in June 2002.

However, as we have explained in Chapter 8, implementation of the proposals of FRED 30would have to await changes in company law

Considerable changes will be required if convergence is to be achieved because there are atpresent a number of significant differences between the UK and international standards, towhich we now turn

The international accounting standards

The position under international accounting standards is more complex as various standardslay down different rules for different levels of investment

If we start with a simple passive investment, an investment which would be classified as an

available-for-sale financial asset under IAS 39 Financial Instruments: Recognition and Measurement,7this should be stated at fair value provided such a value may be measuredreliably The company must then decide, as a matter of policy, whether gains or losses should

be taken to the profit and loss account or direct to reserves and, as we have explained above,only the latter would appear to be possible at present under UK law If the fair value cannot

be measured reliably, then the investment should be shown at its cost

IAS 27 Consolidated Financial Statements and Accounting for Investments in Subsidiaries,

specifies the treatment of investments in subsidiaries in the investor’s own financial ments It gives a choice of three methods, requiring that investments in subsidiaries should be:(a) carried at cost;

state-(b) accounted for using the equity method as described in IAS 28 Accounting for Investments

in Associates and explained in the following chapter; or

(c) accounted for as an available-for-sale financial asset as described in IAS 39 Financial

Instruments: Recognition and Measurement and discussed in Chapter 8 and summarised

briefly above

IAS 28 Accounting for Investments in Associates provides exactly the same choice of valuation

bases in the financial statements of the investing company for investments in associates, thuspermitting them to be valued at cost, by using the equity method or at fair values The use ofthe equity method in the financial statements of an investing company is not permittedunder present UK law

The final type of investment, the joint venture, is at present covered by IAS 31 Financial

Reporting of Interests in Joint Ventures, but this is silent on the treatment of investments

car-rying joint control in the financial statements of the investing company

Clearly, the current international accounting standards are more flexible than UK practicebut this looks likely to change as a consequence of the convergence programme As weexplained in Chapter 3, the IASB issued exposure drafts of its proposals to amend 12 inter-national accounting standards in May 2002 and, in the same month, the UK ASB publishedsix FREDs together with a Consultation Paper that deals with the remaining six of theseIASB exposure drafts One of the latter international exposure drafts addresses IAS 27, which

it proposes to retitle ‘Consolidated and Separate Financial Statements’ while another addresses IAS 28 Accounting for Investments in Associates.

The revised IAS 27 would prohibit the use of the equity method of accounting for the uation of investments in the separate financial statements of the investing company

val-7 See Chapter 8

Chapter 14 · Investments and groups 407

Investments in subsidiaries, associates and joint ventures would then have to be shown in the

financial statements of the investing company either at cost or at fair value and the same

method would have to be applied for each category of investments

The IASB plans to introduce the changes for accounting periods commencing on or after

1 January 2003 and this would bring the international practice on accounting for

invest-ments closer to UK practice However, the treatment of changes in the fair values of

investments, that is whether they should be included in the profit and loss account or in the

statement of total recognised gains and losses, is still likely to give rise to differences for some

time to come for the reasons which we have discussed

Accounting for groups

What is a group?

Subject to certain exceptions which we discuss below, any UK company which is a parent

company at its year end must prepare group accounts in addition to its individual accounts

Since the Companies Act 1989, these group accounts must be a set of consolidated accounts

for the parent company and its subsidiary undertakings.8

Prior to the Companies Act 1989, a subsidiary had to be a company, and a parent

com-pany/subsidiary relationship was defined as existing when the parent company was a

shareholder and controlled the composition of the board of directors of the other company

and/or when it held more than half of the equity share capital of that other company.9

This definition was thus based on both control and ownership and betrayed some

confu-sion about why group accounts were required While ownership and control usually go hand

in hand, this is not always the case and, because the definition of ‘equity share capital’ was

widely drawn, it was possible for a company to be simultaneously the subsidiary of more

than one parent company In response to the EC Seventh Directive, which we discussed in

Chapter 3, the Companies Act 1989 introduced a much clearer concept of a group for

accounting purposes

First, it required that consolidated accounts include the parent and all subsidiary

undertak-ings The latter is a new term which is not restricted to companies but includes partnerships

and ‘unincorporated associations carrying on trade or business with or without view to

profit’.10

Second, it introduced a new definition of a parent/subsidiary relationship based not upon

ownership but upon control Thus the relationship between a parent undertaking and a

sub-sidiary undertaking is now defined as follows:11

(2) An undertaking is a parent undertaking in relation to another undertaking, a subsidiary

undertaking, if –

(a) it holds a majority of the voting rights in the undertaking, or

(b) it is a member of the undertaking and has the right to appoint or remove a majority

of its board of directors, or

8 Companies Act 1985 (as amended by the Companies Act 1989), s 227 Before the Companies Act 1989,

consoli-dated accounts were just one possible form which group accounts could take.

9 Companies Act 1985, s 736.

10 Companies Act 1985 (as amended by the Companies Act 1989), s 259.

11 Companies Act 1985 (as amended by the Companies Act 1989), s 258.

(c) it has the right to exercise a dominant influence over the undertaking – (i) by virtue of provisions contained in the undertaking’s memorandum or articles, or

(ii) by virtue of a control contract, or

(d) it is a member of the undertaking and controls alone, pursuant to an agreement with other shareholders or members, a majority of the voting rights in the undertaking.

definition which rests on the existence of the de facto control rather than de jure control.

The more precise definition of a group introduced by the Companies Act 1989 helps us tokeep clearly in our minds that the purpose of consolidated accounts is to show the assets andliabilities under common control and how these are being used It also helps accountants toensure that some of the many off-balance-sheet finance schemes which have exploited theprevious definition of a subsidiary do now find their way on to the consolidated balance

sheet Indeed, as we have seen in Chapter 9, FRS 5 Reporting the Substance of Transactions,

has attempted to go even further than this in requiring the inclusion of quasi-subsidiaries inthe consolidated accounts.12Accountants in the UK are now much more aware of the needfor such provisions following the collapse of the US corporation Enron in 2001 This spec-tacular collapse was undoubtedly delayed because of the company’s use of numerous SpecialPurpose Entities which were not included in the consolidated financial statements

The compass of group accounts

Group accounts must take the form of a set of consolidated accounts, the only exception nowbeing where such a set of consolidated accounts would not give a true and fair view.13Thus aparent company must usually prepare a set of consolidated accounts showing the results andstate of affairs of itself and all its subsidiary undertakings as a single economic entity.14

The law does, however, exempt the parent company from preparing group accounts incertain circumstances and permits the exclusion of subsidiary undertakings from the consol-idated accounts in other circumstances We shall deal with each in turn

In view of the stated desire of successive governments to reduce the burdens on business,the law exempted a parent company from the need to prepare group accounts where thegroup qualifies as a small or medium-sized group, provided that it is not what is described as

an ineligible group.15As with the definitions of small and medium-sized companies, the initions for small and medium-sized groups are framed by reference to turnover, balancesheet total (assets) and number of employees.16

def-12 See Chapter 9, pp 212–13.

13 Companies Act 1985, s 227.

14 Companies Act 1985, s 228.

15 Companies Act 1985, s 248 A group is ineligible if any of its members is a public company, a banking company,

an insurance company or an authorised person under the Financial Services Act 1986.

16 Companies Act 1985, s 249

Chapter 14 · Investments and groups 409

In addition to these exemptions based on size, a parent company does not have to prepare

group accounts where it is itself an intermediate holding company with an immediate parent

company in the EU, provided consolidated financial statements are prepared at a higher level

in the group There are a number of conditions which must be satisfied if this exemption is

to apply, in particular, the higher-level consolidated accounts must be prepared in

accor-dance with law based on the EC Seventh Directive and must be filed with the UK parent’s

individual accounts together with certified translations, where appropriate.17

Where a parent company is not able to take advantage of the above exemptions, it must

prepare consolidated accounts for all the companies in the group which are under the

con-trol of the parent company However, the law permits the exclusion of subsidiary

undertakings from the consolidated accounts in the following circumstances:18

(3) a subsidiary undertaking may be excluded from consolidation where –

(a) severe long-term restrictions substantially hinder the exercise of the rights of the parent

company over the assets or management of that undertaking, or

(b) the information necessary for the preparation of group accounts cannot be obtained

without disproportionate expense or undue delay, or

(c) the interest of the parent company is held exclusively with a view to subsequent resale

and the undertaking has not previously been included in consolidated group accounts

prepared by the parent company.

…

(4) Where the activities of one or more subsidiary undertakings are so different from those of

other undertakings to be included in the consolidation that their inclusion would be

incom-patible with the obligation to give a true and fair view, those undertakings shall be

excluded from consolidation.

This subsection does not apply merely because some of the undertakings are industrial,

some commercial and some provide services, or because they carry on industrial or

com-mercial activities involving different products or provide different services.

FRS 2 takes a more restricted view and specifically states that neither disproportionate

expense nor undue delay can justify excluding material subsidiary undertakings from the

con-solidated accounts However, whereas the law permits the exclusion of subsidiary

undertakings from the consolidated accounts, FRS 2 requires their exclusion in certain

cir-cumstances and specifies the required accounting treatment for such excluded subsidiaries.19

Thus, Para 25 of FRS 2 states that a subsidiary should be excluded from consolidation in

three circumstances:

(a) where severe long-term restrictions substantially hinder the exercise of the rights of the

parent company over the assets or management of the subsidiary undertaking;

(b) where the interest in the subsidiary undertaking is held exclusively with a view to

sub-sequent resale and the subsidiary undertaking has not previously been consolidated in

group accounts prepared by the parent company;

(c) where the subsidiary undertaking’s activities are so different from those of other

under-takings to be included in the consolidation that its inclusion would be incompatible with

the obligation to give a true and fair view

17 Companies Act 1985, s 228.

18 Companies Act 1985, s 229

19FRS 2 Accounting for Subsidiary Undertakings, Paras 25–30.

All three of these required exclusions follow from the legal provisions quoted above,except that the circumstances envisaged under (c) are in practice, extremely rare In particu-lar, the explanation to the standard emphasises that any differences between banking andinsurance companies/groups and other companies/groups, or between profit and not-for-profit undertakings, is not sufficient of itself to justify non-consolidation.20

Having specified the circumstances under which subsidiary undertakings should be excluded,FRS 2 specifies the accounting treatment to be applied to such subsidiaries and the information

to be disclosed The required accounting treatment may be summarised as follows:21

(a) Severe long-term restrictions If the parent company is denied control but retains

signifi-cant influence over the excluded subsidiary, use the equity method of accounting Theequity method of accounting, which is the required method of accounting for associatesand joint ventures, is described in the following chapter

If the parent does not even retain significant influence, treat the excluded subsidiary

as a fixed asset investment showing it at the carrying value at which it would haveappeared if the equity method had been in use when the restrictions came into force.22

Subsequently take credit only for dividends actually received

In either case, it is essential to write down the investment if there has been impairment

(b) Subsidiary held exclusively with a view to resale This should be treated as a current asset

and shown at the lower of cost and net realisable value

(c) Different activities In the rare circumstances where a subsidiary undertaking is excluded

for this reason, the investment should be recorded in the consolidated financial ments using the equity method of accounting, and a separate set of financial statementsfor the subsidiary should be included with the consolidated financial statements.23

state-Changes in the composition of a group

Consolidated accounts for a group are prepared to show the results of the group as a singleeconomic entity It follows that, subject to the cancellation of intercompany balances and theremoval of unrealised intercompany profit, the consolidated profit and loss account shouldinclude the profits or losses of all companies in the group for the relevant periods during

Table 14.2 Attitude to exclusion of subsidiary

Companies Act 1985 FRS 2

Disproportionate expense or undue delay Permits Forbids

Different activities where inclusion would be incompatible with true and fair view Permits Requires*

*But extremely rare in practice.

20 FRS 2, Para 78e.

21 FRS 2, Paras 27–32.

22 This carrying value may be the cost of the investment if the restriction existed at the date of acquisition (FRS 2, Para 27).

23 Certain other disclosures are required in respect of subsidiaries, both included and excluded Readers are referred

to the Companies Act 1985, Schedule 5 and to FRS 2, Paras 31–34.