The principal of consolidation

Chapter The principles of consolidation Learning objectives Reference Consolidated financial statements LO6 Discuss the forms of business combinations LO6.1 Explain the concept of control and how the existence of control is determined LO6.4 Explain why transactions within a group must be eliminated Equity accounting LO6.6 Define 'significant influence' and briefly analyse the factors that may be used to determine whether significant influence exists LO7.1 LO7 Topic list Group accounts – an introduction Group companies IAS 27 Consolidated and separate financial statements Intra-group transactions 193 Introduction Consolidation is an extremely important area of your studies The key to consolidation questions in the examination is to adopt a logical approach and to practise as many questions as possible In this chapter we will look at the major definitions in consolidation These matters are fundamental to your comprehension of group accounts, so make sure you can understand them and then learn them 194 Financial Accounting and Reporting Before you begin If you have studied these topics before, you may wonder whether you need to study this chapter in full If this is the case, please attempt the questions below, which cover some of the key subjects in the area If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the Study Manual What is a subsidiary? (Section 2.1) What is an associate? (Section 2.1) How is control established? (Section 2.2) How is significant influence established? (Section 2.3) How are a subsidiary and an associate accounted for? Which subsidiaries may be excluded from a consolidation? (Section 2) (Section 3.4) 10: The principles of consolidation 195 Group accounts – an introduction Section overview • Many large businesses consist of several companies controlled by one central or administrative company Together these companies are called a group The controlling company, called the parent or holding company, will own some or all of the shares in the other companies, referred to as subsidiaries Introduction There are many reasons for one company to buy all or part of another: for the goodwill associated with the names of the subsidiaries, for tax or legal purposes and so forth In many cases, one company will grow by acquisition and so buy a number of other companies In traditional accounting terminology, a group of companies consists of a parent company and one or more subsidiary companies that are controlled by the parent company These terms are defined in more detail in Section of this chapter The need for group accounts The information contained in the individual financial statements of a parent company and each of its subsidiaries does not give a picture of the group's total activities Equally, where a group has a number of subsidiaries, users of the accounts will be unable to obtain an understanding of the overall position and performance of the group simply by looking at the numerous financial statements of the individual companies that make up the group Therefore, group accounts must be prepared from the individual financial statements Consolidated accounts are a form of group accounts which combines the information contained in the separate accounts of a holding company and its subsidiaries as if they were the accounts of a single entity 'Group accounts' and 'consolidated accounts' are terms often used synonymously Most parent companies present their own individual accounts and their group accounts in a single package The package typically comprises the following: • • Parent company financial statements, which will include 'investments in subsidiaries' as an asset in the statement of financial position, and income from subsidiaries (dividends) in the statement of comprehensive income Consolidated statement of financial position • Consolidated statement of comprehensive income • Consolidated statement of cash flows It may not be necessary to publish all of the parent company's financial statements, depending on local or national regulations Accounting standards We will be discussing three accounting Standards in this and the next three chapters: • IAS 27 Consolidated and separate financial statements • IFRS Business combinations • IAS 28 Investments in associates These standards are all concerned with different aspects of group accounts, but there is some overlap between them, particularly between IFRS and IAS 27 In this and the next chapter we will concentrate on IAS 27, which covers the basic group definitions and consolidation procedures of a parent-subsidiary relationship First of all, however, we will consider all the important definitions involved in group accounts, which determine how to treat each particular type of investment in group accounts 196 Financial Accounting and Reporting LO Group companies Section overview • A subsidiary is an entity that is controlled by another entity, its parent Control can usually be assumed to exist when the parent owns over 50% of the voting power of an entity Definitions We will look at some of these definitions in more detail later, but they are useful here in that they give you an overview of all aspects of group accounts Exam comments All the definitions relating to group accounts are extremely important You must learn them and understand their meaning and application Definitions • Control The power to govern the financial and operating policies of an entity so as to obtain benefits from its activities (IFRS 3, IASs 27, 28) • Subsidiary An entity that is controlled by another entity (known as the parent) (IFRS 3, IASs 27, 28) • Parent An entity that has one or more subsidiaries • Group A parent and all its subsidiaries • Associate An entity, including an unincorporated entity such as a partnership, in which an investor has significant influence and which is neither a subsidiary nor a joint venture of the investor (IAS 28) • Significant influence is the power to participate in the financial and operating policy decisions of an investee or an economic activity but is not control or joint control over those policies (IAS 28) (IFRS 3, IAS 27) (IAS 27) We can summarise the different types of investment and the required accounting for them as follows: Investment Criteria Subsidiary Control Required treatment in group accounts Full consolidation Associate Significant influence Equity accounting (see Chapter 13) Investment which is none of the above Asset held for accretion of wealth As for single company accounts Investments in subsidiaries LO The important point here is control In most cases, this will involve the holding company or parent owning a majority of the ordinary shares in the subsidiary (to which normal voting rights are attached) There are circumstances, however, when the parent may own only a minority of the voting power in the subsidiary, but the parent still has control IAS 27 states that control can usually be assumed to exist when the parent owns more than half (i.e over 50%) of the voting power of an entity unless it can be clearly shown that such ownership does not constitute control (these situations will be very rare) 10: The principles of consolidation 197 What about situations where this ownership criterion does not exist? IAS 27 lists the following situations where control exists, even when the parent owns only 50% or less of the voting power of an entity: (a) The parent has power over more than 50% of the voting rights by virtue of agreement with other investors (b) The parent has power to govern the financial and operating policies of the entity by statute or under an agreement (c) The parent has the power to appoint or remove a majority of members of the board of directors (or equivalent governing body) (d) The parent has power to cast a majority of votes at meetings of the board of directors IAS 27 also states that a parent loses control when it loses the power to govern the financial and operating policies of an investee Loss of control can occur without a change in ownership levels This may happen if a subsidiary becomes subject to the control of a government, court administrator or regulator (for example, in bankruptcy) 2.2.1 Accounting treatment in group accounts IAS 27 requires a parent to present consolidated financial statements, in which the accounts of the parent and subsidiary (or subsidiaries) are combined and presented as a single entity Investments in associates LO This type of investment is something less than a subsidiary, but more than a simple investment The key criterion here is significant influence This is defined as the 'power to participate', but not to 'control' (which would make the investment a subsidiary) Significant influence can be determined by the holding of voting rights (usually attached to shares) in the entity IAS 28 states that if an investor holds 20% or more of the voting power of the investee, it can be presumed that the investor has significant influence over the investee, unless it can be clearly shown that this is not the case Significant influence can be presumed not to exist if the investor holds less than 20% of the voting power of the investee, unless it can be demonstrated otherwise The existence of significant influence is evidenced in one or more of the following ways: (a) Representation on the board of directors (or equivalent) of the investee (b) Participation in the policy making process (c) Material transactions between investor and investee (d) Interchange of management personnel (e) Provision of essential technical information 2.3.1 Accounting treatment in group accounts IAS 28 requires the use of the equity method of accounting for investments in associates This method will be explained in detail in Chapter 13 Question 1: Treatments The section summary after this question will give an augmented version of the table given in Paragraph 2.1 above Before you look at it, see if you can write out the table yourself (The answer is at the end of the chapter) 198 Financial Accounting and Reporting Non-controlling S's profit after tax (PAT) interests Less: * unrealised profit * profit on disposal of non-current assets additional depreciation following FV uplift Add: ** additional depreciation following disposal of non-current assets Reason Reserves carried forward 260 X (X) (X) (X) X X NCI% X * Only applicable if sales of goods and non-current assets made by subsidiary ** Only applicable if sale of non-current assets made by subsidiary To show the extent to which profits generated through P's control are in fact owned by other parties As per the calculations for the statement of financial position Financial Accounting and Reporting Key chapter points • The consolidated statement of comprehensive income is produced by adding amounts in the individual accounts of the parent and subsidiary on a line by line basis • The non-controlling interest is brought in as a one-line adjustment at the end of the statement It is calculated as the NCI share of the profits of the subsidiary for the year, after any consolidation adjustments attributable to the subsidiary • Intra-group sales and purchases are eliminated from the consolidated statement of comprehensive income • Any unrealised profits must also be eliminated • Only the post-acquisition profits of the subsidiary are brought into the consolidated statement of comprehensive income In the case of a mid-year acquisition, the profits of the subsidiary must be pro-rated prior to consolidation • Where a non-current asset is the subject of a fair value uplift for consolidation purposes any extra depreciation charge should be added as a consolidation adjustment • Where goodwill has been the subject of an impairment in the period, the impairment loss must be charged to the consolidated statement of comprehensive income 12: The consolidated statement of comprehensive income 261 Quick revision questions At the beginning of the year a 75% subsidiary transfers a non-current asset to the parent for $500 000 At that date, its carrying amount was $400 000 and it had four years of useful life left What adjustment is made to total consolidated profit for the year in respect of the transfer? A B C D $25 000 credit $100 000 credit $75 000 debit $100 000 debit AB acquired a 60% holding in CD many years ago At 31 December 20X3 AB held inventory with a book value of $30 000 purchased from CD at cost plus 20% The effect on the consolidated statement of comprehensive income for the year is: A B C D Group profit reduced by $3 reduced by $3 reduced by $5 reduced by $6 000 600 000 000 Non-controlling interest by $2 reduced 000 reduced by $2 400effect no no effect The following information is relevant for questions and Hardy has a 90% subsidiary, Lawrence During the year ended 31 December 20X2 Lawrence sold goods to Hardy for $25 000, which was cost plus 25% At 31 December 20X2 $10 000 of these goods remained unsold In the consolidated statement of comprehensive income for the year ended 31 December 20X2, revenue will be reduced by: A B C D 750 000 500 000 In the consolidated statement of comprehensive income for the year ended 31 December 20X2, gross profit will be reduced by: A B C D $18 $20 $22 $25 $1 $2 $2 $2 800 000 250 500 Parent owned 80% of the issued equity share capital of Subsidiary For the year ended 31 December 20X6 Subsidiary reported a net profit of $55 million During 20X6 Subsidiary sold goods to Parent for $15 million at cost plus 20% At the year end half these goods are still held by Parent In the consolidated statement of comprehensive income for the year ended 31 December 20X6 the non-controlling interest is: A B C D $8 million $10.7 million $10.75 million $11 million Where the purchase price of an acquisition is less than the aggregate fair value of the net assets acquired, which one of the following accounting treatments of the difference is required by IFRS Business combinations? A deduction from goodwill in the consolidated statement of financial position B immediate recognition as a gain in the statement of changes in equity C recognition in profit over its estimated useful life D immediate recognition as a gain in profit or loss 262 Financial Accounting and Reporting GPT regularly sells goods to its subsidiary in which it owns 60% of the ordinary share capital During the group's financial year ended 31 August 20X7, GPT sold goods to its subsidiary valued at $100 000 (selling price) upon which it makes a margin of 20% By the group's year end all of the goods had been sold to parties outside the group What is the correct consolidation adjustment in respect of these sales for the year ended 31 August 20X7? A no adjustment required B DR Revenue $60 000; CR Cost of sales $60 000 C DR Revenue $80 000; CR Cost of sales $80 000 D DR Revenue $100 000; CR Cost of sales $100 000 On March 20X7, XPR acquired control of YQS, purchasing 60% of its issued ordinary share capital YQS is located in a country where compliance with most, but not all, IFRS is required by law For example, there is no requirement to discount liabilities No material fair value adjustments were identified at the date of acquisition of YQS, except in respect of a deferred liability to a supplier which will fall due on March 20X9 The amount payable on that date will be $300 000 The discount rate relevant to the liability is 8% YQS's profit for the period ended 29 February 20X8 was $67 600 before taking into account any unwinding of the discount in respect of the liability referred to above What is the share of YQS’s profit for the period attributable to equity shareholders of the parent, after taking into account any adjustment required in respect of the liability? A B C D 219 160 901 960 Lay Co acquired 90% of the ordinary shares in Hay Co on August 20X8 at a cost of $450 000 On that date the net assets of Hay Co amounted to $460 000 In the year ended 30 June 20X9, Lay Co reported a profit of $189 000 and Hay Co of $60 000 Trading conditions indicated that the goodwill in Hay Co may be impaired and a review found that it was indeed impaired by 50% It is Lay Co group policy to measure the non-controlling interest as a percentage of net assets What is the profit for the year ended 30 June 20X9 before allocation to the group owners and the non- controlling interest? A B C D 10 $28 $26 $52 $54 $213 $208 $231 $226 000 000 000 000 Radio Co acquired 85% of the ordinary shares in Stereo Co a number of years ago giving rise to $14 000 of goodwill calculated using the full fair value method The following is relevant to the year ended 31 December 20X8: – Radio Co has reported a profit of $90 000 – Stereo Co has reported a profit of $40 000 – Intercompany sales were made by Radio to Stereo amounting to $20 000 at cost plus 10% Half of the goods remain in inventory at the year end – Goodwill is impaired by $6 000 What is the non-controlling interest in profit for the year? A B C D $6 $5 $5 $4 000 100 091 191 12: The consolidated statement of comprehensive income 263 Answers to quick revision questions C $ 100 Unrealised profit 000 Additional depreciation (100 ÷ 4) 000) Net charge to statement of comprehensive income 000 (25 75 DR $ Non-current asset 000 Additional depreciation Group profit (75%) Non-controlling interest (25%) A CR $ 100 25 000 56 250 18 750 100 000 100 000 The provision for unrealised profit is $5 000 (30 000 × 20/120) The subsidiary has sold to the parent, therefore the unrealised profit has arisen in the accounts of the subsidiary and must be allocated between the group and the non-controlling interest D Revenue is reduced by the full amount of intra-group sales B Gross profit is reduced by the element of unrealised profit, which is 10 000 × 25/125 C $'000 55 000 (1 Subsidiary Less provision for unrealised profit (15 000 ì 20/120 ì ẵ) 250) 53 750 NCI share (20%) 10 750 D ‘Negative goodwill’ (referred to as a bargain purchase in IFRS 3) is reassessed and then recognised immediately in profit or loss D DEBIT CREDIT Revenue Cost of sales $100 000 $100 000 Intra-group revenue must be eliminated in full from revenue as income and costs are wholly intra-group As there is no unsold inventory at the year end and, therefore, no unrealised profit, the adjustment to costs is the same as the adjustment to revenue A The liability of $300 000 falls due two years after the acquisition date so the fair value of the liability at March 20X7 was: $300 000 × 1/1.082 = $257 100 The adjustment to unwind the discount for the year to 29 February 20X8 is: DEBIT CREDIT Interest ($257 100 × 8%) Liability $ 20 568 $ 20 568 Therefore after taking into account the adjustment for the unwinding of the discount the profit for the period for YQS is $47 032 (being $67 600 – $20 568) The share attributable to the equity shareholders of XPR is $28 219 (being 60% of $47 032) 264 Financial Accounting and Reporting D $ Profit of Lay Co Profit of Hay Co since acquisition 11/12 x $60 000 000 Goodwill impairment Consideration transferred NCI (10% x 460 000) Net assets of Hay Co 10 B Profit for the year NCI in Stereo’s profit ($40 000 x 15%) NCI share of impairment loss ($6 000 x 15%) 450 000 46 000 (460 000) 36 000 x 50% $ 189 000 55 (18 000) 226 000 $ 000 (900 )5 100 The unrealised profit is dealt with in the selling company’s books In this case that is Radio 12: The consolidated statement of comprehensive income 265 Answers to chapter questions The unrealised profit on disposal which must be added to cost of sales in order to eliminate it from profit is: $ Proceeds 26 000 Carrying amount at date of disposal 6/10 x $40 000 (24 000) 000 The increase in depreciation charge which must be deducted from cost of sales in order to increase profit is: months depreciation on historic cost 8/12 x $40 000/10 months depreciation on transfer price 8/12 x $26 000/6 667 88 22 Therefore, the overall adjustment to cost of sales is an increase of $1 778 ($2 000 – $222) The shares in S Co were acquired three months into the year Only the postacquisition proportion (9/12) of S Co's statement of comprehensive income is included in the consolidated statement of comprehensive income P CO CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X5 $ 230 000 (92 000) 138 000 (52 000) 86 000 (29 000) 57 000 Revenue (170 + 60) Cost of sales (65 + 27) Gross profit Administrative expenses (43 + 9) Profit before tax Income tax expense (23 + 6) Profit for the year Profit attributable to: Owners of the parent Non-controlling interest (18 × 40%) STATEMENT OF CHANGES IN EQUITY Balance at January 20X5 Dividends paid (6 000 x 40%) Total comprehensive income for the year Added on acquisition of subsidiary (W) Balance at 31 December 20X5 * All of S Co's profits brought forward are preacquisition Working Added on acquisition of subsidiary: Share capital Retained earnings brought forward Profits Jan-Mar 20X5 (24 000 – 18 000) Non-controlling share 40% 49 800 200 57 000 Retain earnin $ 81 000 (12 000) 49 800 – 118 800 Non-controlling interest $ – (2 400) 200 58 400 63 200 $ 100 000 40 000 000 146 000 58 400 266 Financial Accounting and Reporting BRODICK GROUP CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR TO 30 APRIL 20X7 $'000 600 (930) 670 (255) 415 (75) 340 Revenue (1,100 + 500) Cost of sales (630 + 300) Gross profit Administrative expenses (105 + 150) Profit before tax Income tax expense (65 + 10) Profit for the year Profit attributable to: $'000 332 340 Owners of the parent Non-controlling interest (W1) CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (extracts) Non-controlling interest $'000 Balance brought forward (W2, W3) 221.2 Dividends paid (30 000 – 24 000) (6) Total comprehensive income for the year Balance carried forward 223.2 Retained earnings $'000 500 (200) 332 632 Workings Non-controlling interests $'000 In Lamlash (20% × 40) Non-controlling interest brought forward $'000 000 106 106 Share capital Retained earnings Non-controlling share 20% 221.2 Retained earnings brought forward Brodick Co $'000 Lamlash Co $'000 Per question 460 106 Less pre-aqn (56) 50 Share of Lamlash: 80% × 50 500 Note: The carried forward figures can be proved as follows: Noncontrolli ng interest 20% × (1 000 + 116) = 223.2 Retained earnings 584 + 80% (116 – 56) = 632 40 ... but you should still skim through the chapter to ensure that you are familiar with everything covered There are references in brackets indicating where in the chapter you can find the information,... but you should still skim through the chapter to ensure that you are familiar with everything covered There are references in brackets indicating where in the chapter you can find the information,... examination is to adopt a logical approach and to practise as many questions as possible In this chapter we will look at the major definitions in consolidation These matters are fundamental to