Advanced Financial Accounting: Chapter 2 Group Reporting I: Concept and Context Tan, Lim & Lee Chapter 2© 20151.

© 2015 1

Advanced Financial Accounting: Chapter 2

Group Reporting I: Concept and Context

Tan, Lim & Lee Chapter 2

Learning Objectives

Understand:

1. The rationale for group reporting and the complementarity of reporting by legal and economic entities, and business units;

2. The economic incentives for the provision of consolidated financial information;

3. The economic context of group reporting – merger and acquisition as risk management strategy and the impact on financial reporting;

4. The concept of “control” and the determination of the parent-subsidiary relationship;

5. The concept of “significant influence” and the notion of “associate”

6. The concept of a “business combination” and the scope of IFRS 3;

7. The theories relating to consolidation; and

8. The effects of parent versus entity theories of consolidation

Tan, Lim & Lee Chapter 2 2© 2015

Content

Tan, Lim & Lee Chapter 2 © 2015 3

1. Introduction

2. Economic Incentives for the Preparation of Consolidated Information

3. Economic Motives for Entering into Intercorporate Arrangements

4. The Concept of Control

5. The Concept of Significant Influence

6. Accounting for Business Combinations

7. Consolidation Theories

1. Introduction

Introduction

• A primary issue that underpins financial reporting is the identification of the reporting entity.


Financial information

Aggregated reporting for the economic

entity

Disaggregated reporting for business units within a legal or

economic entity

Separate financial statements for the

legal entity

Financial information may be reported at three levels

Introduction


Legal entityLegal Entity Control

• Shared ownership• Contractual or

statutory arrangements

Effective relationshipIndividual financial

statement

Individual financial

statement

Relationship of control within legal entities

Introduction


Reduced risk through

diversification

Economies of scale

and scope

Capitalizing on slack debtor operating

capacity

Tapping on growth

opportunities

Increasedmarket shares

Incentive to extend economic boundaries

Introduction

• Principle of substance over form:– Notion of a reporting entity extends beyond the legal entity to that of an

economic group of related companies

• The need for consolidated financial statements by the reporting entity– If separate financial statements are the only source of information

• FS users will not be able to properly assess extent of the size, profitability, cash flows and risks of the larger economic entity

• May not be able to obtain a clear picture of group performance as a whole (i.e. not seeing the forest for the trees)

– Consolidation FS allows investors to asses the risk-return profile of the combined entity


Introduction

• A group of companies better able to deal with economic risk like– Macro-economic risk (e.g changes in government policies)– Industry risk (e.g. technological risks)– Firm-specific risk (e.g. over-reliance on specific human capital)

• Corporate acquisition and diversification may be sub-optimal and value-destroying if– Motivate by managers’ self-interest to invest in size rather than value

(Jensen, 1986, Shelefier and Vishny, 1990)– Costs and risks that arise from acquisition strategies, particularly in

unrelated diversification

• Synergistic benefits potentially reduced by direct and indirect costs arising from these strategies


Introduction

• Corporate regulations may require separate financial statements to be prepared by each legal entity

Tan & Lee Chapter 2 © 2015 9

Purpose of separate

Financial Statements

Provide information for legal and tax purposes

Determine the financial solvency of individual

entities

Prevent weakness of individual companies to be masked by strengths

of other group companies

Introduction

Tan, Lim & Lee Chapter 2 10

Source of disaggregated

information

Separate financial statements

Determine risk profile of individual segments

Strength and weaknesses of specific operation and geography

Segment information

Loss of information if only aggregated information is provided

Need for disaggregated Information

Introduction


Parent(Controlling

entity)Control

Subsidiary

Subsidiary

Subsidiary

Control

Control

Group

Consolidation:Process of preparing

and presenting financial statements of parent and subsidiary

as if they were one economic entity

Parent-Subsidiary Relationship

Consolidated FS:Artificial creations

Content


1. Introduction

2. Economic Incentive for the Preparation of Consolidated Information







Information Perspective

• Managers with a comparative advantage on information about their firms are compensated for their ability to provide information on the future cash flows of these firms (Holthausen and Leftwish, 1983)


Are consolidated financial statements more

informative than separate financial statements?

No (Mian and Smith, 1990)Investors can duplicate “homemade” consolidated financial statements [Assumption: intragroup transactions are small]

Yes (Holthausen, 1990)The greater the interdependencies among group companies, the more informative combined earnings about future cash flows of the combined entity

Information Perspective

• According to Mian and Smiths’ views, a firm is more likely to choose consolidated reporting when:– There are greater interdependencies between parent and subsidiaries– Foreign rather than domestic subsidiaries– Parent provides direct guarantee of the subsidiary’s debt– Parent is in the financial services industry

• Under Holthausen’s view:– The greater the interdependencies among the group companies, the

higher the likelihood of intragroup transactions– Difficult for external users to replicate the consolidation process– Managers have incentives to voluntarily provide consolidated FS that

will enable investors to better predict group’s future cash flows


Efficient Contracting

• Whittred (1987) suggests that consolidated information improves wealth for firms

• Reason: reduced information asymmetry between lenders and borrowers– Lenders fear that borrowers will transfer assets to related companies– Borrowers expropriate a considerable larger sum than what they stand to lose

because of limited liability

• Hence, lenders required cross-guarantees issued by parent companies. Whittred suggests a set of consolidated financial statements performs the same function as a “cross guarantee”

• Hence, a set of consolidated FS performs the same function as a “cross-guarantee issued by a parent company

– Undo the effect of separately incorporated companies within the group (e.g. if Sub A is not able to pay its debt as legal entity, its shortfall is compensated by net assets of other entities within the group [“Co-insurance” effect])

– Implicit assurance to lenders that debt is financially backed by assets of combined entity


Opportunism

• Consolidated financial statements lead to wealth transfers to managers at the expense of other stakeholders if the acquisition is motivated by managerial self-interest– Managers enjoy higher compensation, perks and power through

managing a larger group of companies sheer increase in size will result in higher pay out for managers notwithstanding their competency.

– Managers are more likely to over-invest in companies that are specific and complementary to their skills (Shleifer and Vishny, 1990)

• Information asymmetry may arise by masking financial problems of individual companies within the group

• Conclusion: Both aggregated (consolidated) and disaggregated (segment) information are required


Content


1. Introduction


3. Economic Motives for Entering into Intercorporate Arrangement






Economic Incentives for Entering into Intercorporate Arrangements


• Individuals not able to diversify as efficiently because of indivisibility of assets and high transaction costs

(i.e. to achieve economies of scale)

• Firms involved in M&A have stakeholders (i.e. managers and employees) who are not able to diversify their risks as well as shareholders

• Corporate diversification may mitigate the problem of under-investment by risk-averse managers

Why Corporate Diversification?

Markets will not reward firm’s diversification with a higher price for its shares if investors can replicate the firm’s strategies

Corporate Diversification

Sub-optimal consequence

Other reasons



Acquirer gains “control” over the operating and financial policies of the

acquiree (Consolidation)

Two or more acquirers gain “joint-control” over the

acquiree (Joint venture)

Reciprocal investments are held by each of the two firms, as both are deemed to be equally dominant (Pooling of

interests)

Acquirer has “significant influence” over the

operating and financial policies of the acquiree

(Equity accounting)

Arrangements in M&A



UncertaintyRisk mitigated by M&A strategies

Risk management strategies• Organic growth or acquisition• Risk diversification

Information

Control (Acquisition method)

Joint-venture (Equity accounting)

Significant Influence(Equity accounting)

Value• Combined risks • Size effects• Co-insurance effect• Diversification effect

Investing Strategies, Ownership Levels and the Impact on Financial Reporting

Zero Ownership

20%Ownership

50%Ownership

100%Ownership

Active Investment

Active Investment

PassiveInvestment

• Trading securities

• Available- for-sale securities

• Associated company

• Joint-venture

• Partially-owned subsidiary• Fully-owned subsidiary

i. Earn dividend income

ii. Make capital gain

i. Exert significant influence or control over investee’s operation

i. Gain entry intro a new marketii. Achieve synergistic benefits from

complementary strengthsiii. Gain market dominance


Continuum of intercorporate ownership (under previous accounting standards such as IAS 27, IFRS 12, IAS 28, IFRS 13 and IAS 31)

purpose

Investing Strategies, Ownership Levels and the Impact on Financial Reporting

• New accounting standards– IFRS 10: Consolidated Financial statements– Revised IAS 27: Separate Financial statements– IAS 28 Investments in Associates and Joint Ventures– IFRS 11: Joint Arrangements

• Definition of control


Under old IAS 27 IFRS 10

Control is determined by the following:1. Power to govern financial and

operating policies 2. Benefits derived therein, or risk and

rewards

Investor controls an investee when:1. It is exposed, or has rights to the

variable returns from an investee2. Has power over investee and ability

to affect those returns3. Relevant facts and circumstances

Content


1. Introduction








The Concept of Control


Control Power to govern the financial and operating

policies of an entity so as to obtain benefits from its activities (IAS 27:4)

Power to decide on the financial and operating

policies of an entity

Enjoy the benefits from the exercise

of the power

Example of a scenario where there is no control: Agent or trustee acting on behalf of a beneficiary

The Concept of Control under old IAS 27

Ownership of more than 50% of voting power: Control is presumed to exist when the parent owns directly or indirectly through subsidiaries, more than one-half of the voting power of an entity unless, in exception circumstances, it can be clearly demonstrated that such ownership does not constitute control ( *note: use of quantitative criterion is only a guide)

Ownership of less than 50% of voting power but there is :a) Power over more than one-half of the voting rights

arising from an agreement with other investors; orb) Power to govern the financial and operating

policies of an entity arising from a statute or an agreement; or

c) Power to appoint or remove the majority of the members of the board of directors or equivalent governing body; or

d) Power to cast the majority of votes at meetings at the board of directors or equivalent governing body that has control over the entity

Control Subsidiary

25

Determination of control

The concept of control under IFRS 10

• Under IFRS 10, the following qualitative factors are set out to determine if investor has control


Power

Ability

Returns

Control


• Determining Power– The sources of power could be

• Existing rights obtained from shares’ voting rights• Management contractual arrangements• Potential voting rights via ownership of convertibles and share options• Control over key management • Control over entity that directs the investee’s relevant activities• Special relationships that could indicate control over investee (e.g.

investee’s key management are current or former employees of investor)

– Rights of minority shareholders need to be considered

– The purpose and design of investee should be considered to identify relevant activities and decisions over those activities to assess control

• Relevant activities include operating and financial activities• Decisions over those activities include operating and capital decisions of

investee and appointment etc.Tan, Lim & Lee Chapter 2 © 2015 27


• Determining Power (continued)– Investors need to consider which relevant activity most significantly affects the

investee’s return when two investors each control relevant activities• Ability

– Investor must have:• Substantive rights (i.e. practical ability to exercise those rights) • Unilateral ability to direct the most significant activities• NOT be acting as an agent

– The ability to use the power must be current even though it need not be currently exercisable

– Little barriers that prevent the exercise of those rights – Investors holding the rights must benefit from exercising those rights

• Returns– Variable returns that investors is exposed to could be (i) all positive (ii) all

negative (iii) either positive or negative



• Examples:1. Investor owns 46% in investee but 54% remaining shares are dispersed

among many investors• Conclusion: investor has sufficient dominant voting interest (de facto

control) to meet power criterion

2. Investor holds 46% shares, while two other investors own 27% each. • Conclusion: the two investors hold relatively more voting rights than

investor holding 46%

3. Investor holds 45% interest, while five investors individually hold 11% interest• Conclusion: investor has contractual right to appoint, remove and

set remuneration of key management of investee power over investee


Direct and Indirect Control

• For the test of control, IAS 27 requires consideration of the percentage of voting rights held “direct or indirectly through subsidiaries”

• Control must be demonstrated at each intermediate level before the ultimate holding company is said to have control over the lowest-level company

X Co.

Y Co.

B Co. Z Co. A Co.

100%

50% 50% 60%

50%

Situation 1

Situation 1:X Co. controlsY Co. and A Co.Even though X.Co. indirectly owns 75% Break in control at B and hence no control over Z Co.

X Co.

Y Co.

B Co. Z Co. A Co.

60%

55% 60% 50%

40%

Situation 2

Situation 2:X Co. controlsY Co., B Co. and Z Co.Does not own A Co. (<51%)

30© 2015

Affiliation structures

Tan, Lim & Lee Chapter 2

Legal Ownership versus Effective Control

• IAS 27 is principles-based, and all evidence must be considered for the existence of control

– Legal ownership is not the only criterion for determining the existence of control (> 50%)

– Power to govern operating financial policies– Obtain benefits from activities of the other entity

• Steps in consolidation (IAS 27)– 1st: Determine if control exists through the levels of investment holding– 2nd: Once control is established, determine the economic boundaries of the group

and consolidation procedures that should be applied to combined the FS of parent and subsidiaries

– 3rd: Use the effective percentage ownership to determine the non-controlling interests’ share (further discussed in chapter 4)


Potential Voting Rights in the Determination of Control• IAS 27 and IFRS 10 requires potential voting rights, which are currently exercisable or

convertible, to be considered when determining the existence of control

• IAS 27:14: Potential voting rights arise from “share warrants, share call options, debt or equity instruments that are convertible into ordinary shares, or other similar instruments that have the potential, if exercised or converted, to give the entity voting power or reduce another party’s voting power over the financial and operating policies of another entity

– In IFRS 10: potential voting rights (must be substantive) is a factor to consider in determining if investor has power, and hence control over investee

• IAS 27:15: In determining whether potential voting rights contribute to control, the investor examines all facts and circumstances, such as terms of exercise of the potential voting rights and any other contractual terms such as exercise price and date

• It is important that the potential voting rights must be currently exercisable or convertible to be included in the test of control


Potential Voting Rights in the Determination of Control

Issued ordinary shares

Percentage of ordinary shares

Issued share warrants

Potential shares from warrants

Total shares (issued and potential)

Percentage of total shares

Company A $10,000,000 50% $5,000,000 $10,000,000 $20,000,000 62.50%

Other investors

10,000,000 50% 1,000,000 2,000,000 12,000,000 37.50%

Total $20,000,000 100% $6,000,000 $12,000,000 $32,000,000 100.00%

• Although Company A owns only 50% of the total issued ordinary shares, its holding of the share warrants gives it de facto control over Company B.

• If company A wishes, it can exercise its share warrants immediately and assume 62.5% ownership over Company B.


Illustration of potential voting rights

Potential Voting Rights in theDetermination of Control


Situations where potential voting rights may determine control

Currently exercisable share options even though they are currently “out of the money”

When one investor has the right to increase its voting power or reduce other investors’ voting power

Impact of Potential Voting Rightson the Allocation of Profit

• Potential voting rights that are currently exercisable or convertible are considered in determining control BUT excluded in determination for allocation of profit to parent and NCI

• IAS 27:19: The proportion of profit or loss and changes in equity allocated to the parent and non-controlling interests are determined on the basis of present ownership interests and do not reflect the possible exercise or conversion of potential voting rights”.

• However, if the potential voting rights, in substance, gives the holder access at present to the economic benefits associated with an ownership interest should be considered( IAS 27:IG 5-6)

• Generally, the holding of option, warrant, debt or equity instrument does not give the holder a present right to the economic benefits arising from actual ownership of shares


Principal-agent Relationships

• An investor is an agent when he exercises power on behalf of another investor (IFRS 10)

– Agent does not control investee and does not need to consolidate investee

• Factors to consider if an investor is a principal or agent (IFRS 10):– Rights of other parties– Principal’s exposure to variable returns from other interests held– Scope of decision making authority of the principal– Remuneration entitled by principal– Principal’s rights to remove the decision maker without cause

• Determining de facto agents– Need not be contractual relationships between parties and investors– Examples include: (i) related parties of investor, (ii) parties with close business relationships,

(iii) parties that receive interest in investee as loan from investor and (iv) parties whose key management are same as that of investor


Content


1. Introduction








The Concept of Significant Influence

• An investor may participate in the policy-making processes of an investee, although they may not have the power to govern the final outcome of decision-making process

• IAS 28 describes such an investor as having “significant influence”, and the investee is deemed an “associate” of the investor

• Special accounting procedures described as the “equity method” are applied


What is Significant Influence?


Significant influence Power to participate in the financial and operating policy decisions of the investee but is less than control and is not equivalent to joint control over those policies (IAS 28:2)

Default assumption:An investor has ownership of 20% or more of the voting power and equal to or less than 50% of the voting power in an investee, including “potential voting rights”

Other evidences (IAS 28:7)

Number of directors representing investors

on board

Operational interdependencies

Participation in policy-making

processes

Investor must disclose reasons for not complying with default assumption

Definition of associate

• “An associate is an entity in which the investor has significant influence and which is neither a subsidiary nor a joint-venture of the investor” (IAS 28:2)

• If investee is an associate, the investor is not referred to as the “parent”– “parent” applies only to relationships where investor has control over

investee


Direct and Indirect Significant Influence

P

80%

50%

X

Z

Y

50%

50%

Situation 1

P

40%

80%

A

B

C

50%

20%

Situation 2

Situation 1:P has significant influence over:i) Y (50% direct

interest)ii) Z (65% indirect

interest) – P has no control over Y

Situation 2:P has significant influence over:i) A (40% direct

interest)ii) C (50% direct

interest) iii) B (42% indirect

interest)


Multi-level structures

Content


1. Introduction






7. Consolidation Theories6. Accounting for Business Combinations

Accounting for Business Combinations


IFRS 3 Business Combination (deals with business combination generally)

IAS 27 Consolidated and Separate Financial Statements ( applies specifically to the preparation and presentation of consolidated financial statements for parent-subsidiary combinations)

Standards relevant to the preparation and presentation of consolidated financial statements

Overview of the Scope of the IFRS 3• Objective of IFRS 3

– Specify the requirements governing the method of accounting, disclosure and presentation of the financial statements of a reporting entity comprising one or more separate entities that are brought together in a business combination


Purchasing the equity of another entity

Purchasing the net assets of

another entity

Assuming the liabilities of

another entity

Purchasing some of the net assets of another

entity that together form one or more business

Business combinations result from

Purchase of Net Assets versus Purchase of Equity

• Parent – Subsidiary relationship• Separate legal entities

- separate FS• Single reporting entity

- Consolidated FS

Subsidiary

Parent

Acquires controlling interest in equity of

Acquiree

Acquirer

Buys over net assets

• No Parent – Subsidiary relationship• One legal and economic entity• Do not require consolidated

financial statements


Content


1. Introduction






7. Consolidation Theories7. Consolidation Theories

Consolidation Theories

• Theories relating to consolidation are critical when the percentage of ownership in a subsidiary is less than 100%

• Termed “partially owned subsidiary”, where the remaining percentage is owned by shareholders who are collectively referred to as “non-controlling interest” (NCI)

Parent

90%

Subsidiary

Non-controlling interests

10%

Both parent and non-controlling interest have a proportionate share of the subsidiary’s:

• Net profit;• Dividend distribution;

• Share capital• Retained profits and changes in equity




Parent company sells part of its stake in a subsidiary to external shareholders

Parent company buys a majority

stake in a subsidiary from existing owners

Parent and non-controlling shareholders are founding

shareholders of newly incorporated entity

Reasons why non-controlling

interest arise


Parent company’s shareholders

Parent company

Subsidiary

100% ownership

Parent company’s shareholders

Parent company

Subsidiary

70% ownership

Non-controlling shareholders of a subsidiary

30% ownership in subsidiary

Wholly owned by the parent company’s

shareholders

2 groups of shareholders1) The parent company’s shareholders; and2) The non-controlling shareholders of the

subsidiary


Ownership of the combined entity involving a wholly owned subsidiary

Joint-ownership of the combined entity involving a partially owned subsidiary

Comparison of issues


Who are the primary users of the consolidated financial statements?

Both non-controlling interest and majority shareholders

Parent company shareholders

How should non-controlling interests be reported in the consolidated balance sheet?

Shown as equity in BS based on:

Consolidated equity=

Consolidated assets-

Consolidated liabilities

Shown as equity in BS based on:

Consolidated equity

=Consolidated assets

-Consolidated liabilities

+NCI

Issues Entity Theory Parent Theory

Comparison of issues


Issues Entity Theory Parent Theory

Should net assets of the subsidiary acquired be shown at full fair values or at the parent’s share of the fair value?

Fair value of net assets of subsidiary at date of acquisition reported in full

NCI net assets of subsidiary at date of acquisition shown at book value

Do non-controlling shareholders have a share of goodwill?

Asset of parent and restricted to parent’s share

Goodwill = asset of economic unit, and reflected in full

How should net profit of partially-owned subsidiary be reported?

Reported in full as accruing to both majority and NCI

NCI’s share of current profit is a deduction of final profit

Summary of differences


Attributes Entity Theory Parent Theory

Fair value differences in relation to identifiable

assets and liabilities at date of acquisition

Recognized in full, reflecting both parent’s and NCI’s share of fair

value adjustments

Recognized only in respect of parent’s

share

Presentation of NCI As part of equityNeither as equity or

debt

Goodwill

Goodwill is an entity’s asset and should be

recognized in full as at date of acquisition

Goodwill is parent’s asset

Proprietary Theory

• Relevant to accounting for joint-ventures

• Parent seen as having a direct interest in a subsidiary’s assets and liabilities– Resulting in proportional or pro-rata consolidation (parent’s interest

is directly multiplied to each individual asset or liability of subsidiary and combined with parent’s assets and liabilities).


The Implicit Consolidation Theory Underlying IFRS 3

• Previously, IAS 22 allowed an acquirer to either recognize or ignore non-controlling interests’ share of fair value adjustments of a subsidiary’s identifiable assets and liabilities (mix of parent and entity theories)

• IFRS 3 (2008) permits the recognition of non-controlling interests’ share of goodwill

• Movement towards the full entity theory– IFRS 3 (2008) permits the inclusion of NCI’s share of goodwill as at date

of acquisition– FASB through SFAS 141 requires the recognition of the NCI’s share of

goodwill


Illustration 1: Parent versus Entity Theory

Scenario• P Co purchased 80% interest in S Co on 1/1/20x1• Consideration transferred: $1,200,000• NCI: 20%• BV of equity of S Co at acquisition date (1/1/20x1): $1,200,000• (FV – BV) of property: $100,000

(Ignore tax effect and depreciation)• FV of NCI: $300,000• BV of equity of S Co at 31/12/20x1: $1,270,000• Net profit after tax (NPAT) of S Co: $ 70• Net profit after tax (NPAT) of P Co: $350



Net profit after tax and NCIParent theory

NCI’s share of net profit is after tax completed as follows:= 20% x S’s net profit after tax= 20% x $70= $14

Entity Theory NCI are not shown as a deduction but included in entity-wide NPAT. Disclosure is made of the amount of NPAT that relates to NCI

= (100% x P’s NPAT) + (80% x S’s NPAT)= (100% x $350) + (80% x $70)= $406



Good willParent Theory

Goodwill = Investment in S – P’s ownership % X (FV of S’s identifiable net assets at date of acquisition) = $1,200 – (80% x $1,300) = $160

Entity theoryParent’s share of goodwill = $160NCI’s share of goodwill = Fair value of NCI – share of FV of identifiable

net assets = $300 – (20% x $1,300)

= $40



Presentation of NCI

Non-controlling interests are shown separately from equity

Non-controlling interests are deemed to have an equity interest and are thus presented as a component in equity

Non-controlling interests = Non-controlling interest % x BV of S’s equity= 20% x $1,270= $254

Non-controlling interests = Non-controlling interest % x (BV of S’s equity + FV adjustments)+ NCI’s share of goodwill= 20% x ($1,270 + $100) +$40= $314

Parent Theory

Entity Theory


Advanced Financial Accounting: Chapter 2 Group Reporting I: Concept and Context Tan, Lim & Lee Chapter 2© 20151.

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