International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning.

International Financial Reporting and Analysis, 5th editionDavid Alexander, Anne Britton and Ann Jorissen

ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA

Part three

Consolidated accounts and the multinational



Structure of part three

• Chapter 25: Introduction to consolidated financial statements

• Chapter 26: IFRSs and preparation of consolidated financial statements

• Chapter 27: Alternative methods of preparing consolidated financial statements

• Chapter 28: Accounting for associates, joint ventures, special purpose entities and related party transactions

• Chapter 29: Foreign currency translation



Chapter 25

Introduction to consolidated financial statements



Contents

• Control in groups• Need for group accounts• Goodwill in group accounts• Preparation of simple consolidated statements of financial position• Preparation of more complex consolidated statements of financial position• Preparation of consolidated statement of income



Learning objectives

• Outline the need for consolidated financial statements

• Explain a business combination

• Consider the mechanics of preparing consolidated financial statements

• Prepare consolidated statements of income for combinations of more than one subsidiary

• Prepare consolidated statements of financial position for more than one subsidiary



Different types of business combinations

• A new company may be formed in order to absorb one or more existing companies. The essential feature here is that the new company would physically take over the assets and liabilities of the companies absorbed and the latter would then cease to exist.

• A company may be taken over by another company, but in this case the company being taken over would continue to exist (and would still, of course, keep its own assets and liabilities).



Activity 25.1

• Company A, an engineering firm, owns buildings and plant and machinery with NBV of $500 000. Company B buys these assets on 1 January 200X from A at a cost of $650 000 and leases them back to A on an operating lease.

• Company C, on the 1 January 200X purchases 55% of the ordinary voting shares of Company A on the open market.

• Which company, B or C, has control of A?



Control

• Control is the power to govern the financial and operating policies of an entity or business so as to obtain benefits from its activities

• A parent is an entity that has one or more subsidiaries

• A subsidiary is an entity controlled by another entity



Group structure examples

B subsidiary of A S1 is not a subsidiary of H

S, S1 and S2 all subsidiaries of H S1 is not a subsidiary of H



Minority interest or non-controlling interest

• Minority interest is that part of the subsidiary that the holding (parent) entity does not own.

• Or ; is that portion of the profit or loss and the net assets of a subsidiary attributable to equity interests that are not owned, directly or indirectly through subsidiaries, by the parent



Need for group accounts

• To provide useful information to shareholders and other users of the holding enterprise’s financial statements about the group as a whole



Goodwill

• Goodwill is the difference between the revalued net assets and the investment (price paid at acquisition) of the parent

• Goodwill can be considered as a premium on acquisition



Negative goodwill

• Negative goodwill occurs when the investment (price paid at acquisition) of the parent is higher than the revalued net assets of the company

• Might occur when companies with e.g. recent history of losses are bought• Discount on acquisition



Preparation of simple consolidated statements of

financial position

• Statement of financial position at date of acquisition• Consolidated statement of financial position later than date of acquisition• Subsequent adjustments to purchase price• Inter-company trading and the elimination of unrealised profits• Reconciliation of inter-company balances• Consistency of reporting dates and accounting policies within the group



Example 25.1 the statements of financial position of H and S as

at 31 December 200X

H in € S in €

Tangible non-current assets

140 000 45 000

Investment in S 75 000

Net current assets 20 000 15 000

Total 235 000 60 000

Share capital 150 000 50 000

Reserves 85 000 10 000

Total 235 000 60 000



Example 25.1 (cont’d)

• H acquired the whole of the share capital of S for cash on 31 December 200X. The fair value of S’s net assets at this date were € 67 000. Prepare the consolidated statement of financial position of H group as at 31 December 200X. To do this consolidation there are several steps:

• 1. calculate goodwill• 2. revaluate the net assets of the subsidiary S to fair value• 3. Consolidate H and S



GOODWILL

• Fair value of purchase price 75 000• Fair value of 100% net assets acquired 67 000• Goodwill 8 000



Revalued Statement of financial position

• Net assets 67 000• Share capital 50 000• Reserves 10 000• Revaluation reserve 7 000



Group consolidated statement of financial

position

• Net assets (140 000+ 20 000+ 67 000) 227 000• Goodwill on acquisition 8 000

235 000• Share capital 150 000• Reserves 85 000

235 000



Example 25.2: A bought 75% of S at 31 December 200X at 72 000 (=equal to the fair value of

the net assets

A in € at 31.12.200X B in € at 31.12.200X

Net assets 403 000 87 000

Investment in B 72 000

475 000 87 000

Share capital 350 000 60 000

reserves 125 000 27 000

475 000 87 000



Goodwill calculation

Cost of control Non-controlled interest

Fair value of purchase price

72 000

Purchased 75% of shares 60 000

45 000 35% x 60 000 15 000

Plus 75% reserves at acquisition 27 000

20 250 25% x 27 000 6 750

65 250 21 750

goodwill 6 750



Consolidated statement of financial psoition for A group as

at 31 December 200X

Net assets 490 000

goodwill 6 750

496 750

Share capital (only A even though ownership not 100%)

350 000

Reserves (only A) 125 000

475 000

Non-controlling interest 25% x 87 000 21 750

496 750



Consolidated statement of financial position later than the

date of acquisition

• All reserves prior to acquisition belonging to the subsidiary are taken to the cost of control or belong to the non-controlling interest.

• We can only include the parent share of the reserves post acquisition in the consolidation



Activity 25.5

• The statements of financial position of H and S at the date H acquired 1 million 10p shares of S at a fair value of £ 120 000 for cash (the transaction has not yet been entered in H’s accounts). The fair value of S’s net assets at the date of acquisition were £ 142 000 (£108 000 land and buildings, £ 22 000 plant and equipment, £ 12 000 net current assets). Prepare the consolidated statement of financial position of H group as at 31.12.200X at acquisition



Statements of financial position at the date S acquired H

H £000s S £000s

Land and buildings 650 105

Plant and equipment 110 21

Net current assets 163 11

923 137

Share capital £1 shares 800

Share capital 10p shares 125

reserves 123 12

923 137



Activity feedback 25.5

Cost of control Non controlled interest

Purchase price FV 120

80% shares 100 20% shares 25

80% reserves 9.6 20% reserves 2.4

80% revaluation 4 20% revaluation 1

113.6 28.4

goodwill 6.4



Consolidated statement of financial position of H group as at

31 December 200X£ 000s

Land and buildings (650 + 108) 758

Plant and equipment (110 +22) 132

goodwill 6.4

Net current assets (163-120+12) 55

951.4

Share capital £1 shares (only H) 800

Reserves (only H, S either cost of control or non-controlled interest)

123

923

Non-controlled interest 28.4

951.4



Acquisition accounting later than the date of acquisition

(Activity 25.6)

• H Ltd purchased 80% of the equity share capital of S Ltd for cash at 31 December year 1 at a price of €1.50 per share, when the balance on S Ltd’s reserves stood at €2 000.

• The consolidation is required to be made at 31 December year 2, at which point the individual statements of financial position of the two companies are as follows:



Acquisition accounting later than the date of

acquisition (Activity 25.6)

H Ltd € S Ltd €

Sundry current assets 35 000 6 000

Investment in S Ltd 9 600 –

Plant and machinery 60 000 5 000

104 600 11 000

Represented by shares of €1 40 000 8 000

Reserves 64 600 3 000

104 600 11 000



Activity 25.6 feedback

Sundry current assets 41 000

Plant and machinery 65 000

Goodwill 1 600

107 600

Share capital 40 000

Reserves 65 400

105 400

Minority interests 2 200

107 600



Subsequent adjustments to purchase price

• Acquisition agreements often provide for adjustment to the cost of an acquisition depending on future events. These can be:

– The results of acquiree’s operations exceeding or falling short of an agreed level– The market price of securities issued as part of the purchase consideration being

made



Inter-company trading and the elimination of unrealized

profits

• In order for a group to realize profit, the sale must be made to a customer outside of the group

• In the underlying individual accounts intra-group profit is included in the profit figure of the individual income statement and result of the individual company



Fig 25.2 Inter-company trading and elimination of unrealized profits



Activity 25.9

Assets A €000s B €000s

Land and plant 1 000 200

Stock 600 400

Debtors 200 40

Investment in B 275 –

2 075 640

Liabilities

Creditors 30 16

2 045 624

Represented by Shares of €1 1 000 100

Reserves 1 045 524

2045 624



Activity 25.9 feedback Consolidated statement of financial position as at 30 June 200X

Assets €000s

Goodwill (note 1) 50

Land and plant 1 200

Stock (1000 – 10) 990

Debtors (240 – 2) 238

2 478

Liabilities

Creditors (46 – 2) 44

2 434

Represented by:

Shares of €1 1 000

Reserves 1 280.5

2 280.5

Minority interest (note 3) 153.5

2 434



Activity 25.9 feedback (cont’d)

Note 1

Cost of investment in B 275

Less ordinary shares acquired 75

Reserves acquired 75% x 200 150 225

50

Note 2

Reserves A 1 045

Reserves post-acquired B

75% (524 – 10 – 200) 235.5

1 280.5

Note 3

Minority interest 25

25% ordinary shares 128.5

25% reserves = 25% x 514 153.5



Activity 25.10

• The financial year-end of two entities A and B within the same group is 31 December. On 29 December A despatched goods to B to the invoice value of € 40 000 and charges B’s ledger account accordingly. B does not receive either goods or invoice until 4 January. Prepare the consolidation adjustment on B’s books and not any other adjustment that may be required on consolidation.




• B’s books as at 31 December

• B ledger books Dr Cr

• Goods in transit € 40 000

• A Current account € 40 000

• On consolidation the respective inner-company balances in the current accounts, which are now in agreement, will cancel out

• Remember this stock in transit contains unrealised profit



Reconciliation of inter-company balances

• In relation to the group’s position as regards the outside world, these balances are internal balances and will, therefore, not require to be shown in the group statement of financial position. They are, in fact, cancelled on consolidation across the individual statements of financial position of group members.

• These adjustments only affect the consolidated accounts



Preparation of more complex consolidated statements of

financial position

• Acquisition by stages• Reverse acquisitions• Adjustments to identifiable assets or liabilities• Disposal of part interest• Preparation of consolidated accounts involving more than one subsidiary



Acquisition by stages

• With staged acquisitions one needs to determine the date when a subsidiary relationship exists, what the cost was and what the fair value of the assets and liabilities acquired was.

• The date of acquisition = the date when control was transferred



Activity 25.12 Acquisition by stages

• H acquired an interest in S as follows: – 10% of the voting shares for $150 000 on 1.4.01 – 30% of the shares for $460 000 on 1.4.02 – 40% of the voting shares for $800 000 on 1.4.03 – the remaining 20% for $350 000 on 31.3.05. – The fair values of the recognized assets and

liabilities of S at these dates were $1m, $1.5m, $1.75m and $2m respectively. Accounts are drawn up as at 31 March.




$

FV at first stage 1 000 000

Acquired 10% 100 000

Cost 150 000

Goodwill Stage 1 50 000

FV at second stage 1 500 000


Cost 460 000

Goodwill stage 2 10 000




$

FV at third stage 1 750 000


Cost 800 000

Goodwill stage 3 100 000

Total goodwill after third purchase 160 000

FV at fourth stage 2 000 000


Cost 250 000

Negative goodwill stage 4 50 000




Stage FV

1 100 000

2 450 000

3 700 000

4 400 000

1 650 000



Reverse Acquisition

• When an enterprise obtains ownership of the shares of another enterprise but as part of the exchange transaction issues enough voting shares as consideration such that control of the combined enterprises passes to the owners of the enterprise whose shares have been acquired, then we have what has become known as a reverse acquisition. Although legally the enterprise issuing the shares may be regarded as the parent or continuing enterprise, the enterprise whose shareholders now control the combined enterprise is the acquirer.



Reverse acquisition: illustration

• Enterprise A with a share capital of €100 shares issues a further 50 shares to acquire the complete shareholding of enterprise B consisting of 200 €1 shares, a one A share for four B shares exchange. In this case A now owns all B shares, 200,and A’s shareholders hold 100 A shares. B shareholders hold 50 A shares. Thus A shareholders retain control of A. If, however, A had issued 200 A shares to acquire the 200 B shares then B shareholders would now hold two-thirds of the shareholding of A and in ‘substance’ the acquiree, B, becomes the acquirer.



Adjustments to identifiable assets or liabilities

• These can occur because:

– the acquirer was unaware of certain assets or liabilities of the acquiree

– the assets or liabilities did not satisfy recognition criteria

– or further information comes to light which enables more accurate estimation of fair values



Adjustments to identifiable assets or liabilities (cont’d)

• How these adjustments are dealt with depends on whether they occur before or after the first complete annual accounting period subsequent to acquisition: – before and the adjustment is reflected in goodwill

providing the amount will be recovered from expected future economic benefits, otherwise it would be recognized as an expense

– after and the adjustment is reflected in income or expense not goodwill



Disposal of part of an interest

• When a group disposes of part of an interest in a subsidiary undertaking a profit or loss on disposal will arise.

• Gain or loss= the difference between the carrying amount of the net assets of that subsidiary undertaking attributable to the group’s interest before the reduction and the carrying amount attributable to the group’s interest after the reduction together with any proceeds received



Activity 25.13

• The value of a subsidiary’s net assets at 31 March 200X is € 400 000. At this date the parent, which held a 100% share in the subsidiary, disposes of 40% for € 200 000. On the original acquisition of the subsidiary, goodwill of € 80 000 arose. This goodwill has not subsequently been impaired and is in addition to the net assets of € 400 000. Calculate the profit or loss on disposal.




€

Group share of net assets before disposal including goodwill (100% x (400 000+ 80 000))

480 000

Group share of net assets after disposal including goodwill (60% x(400 000 + 80 000))

288 000

Disposal proceeds 200 000

488 000

Profit on disposal 8 000



Preparation of consolidated accounts involving more than

one subsidiary – Activity 25.15

• A plc acquired 5m €1 shares of B Ltd five years ago when the reserves of B stood at € 6m. B Ltd acquired 2.25m € 1 shares in C Ltd four years ago when the accumulated reserves of C were € 0.5m. A plc also acquired 3 m € 1 share of D Ltd two years ago when D’s reserves were € 0.3m. At the date of acquisition the net book value of all assets equated to fair value. There has been no issue of shares in any of these companies throughout the five-year period. The statements of financial position relate to the group companies as at 31.12.200X



Activity 25.15

A €m B €m C €m D €m

Fixed assets 45 5 1.5 2

Investment in B 16

Investment in C 4.5

Investment in D 4

Net current assets 32 18 2.5 1

97 27.5 4 3

Share capital 18 7.5 3 4

reserves 79 20 1 (1)

97 27.5 4 3



Activity 25.15 – consolidated statement of financial position A

group

€ m

Goodwill 9.025

Fixed assets 53.5

Net current assets 53.5

116.025

Share capital 18

Reserves [79 +(20-6)2/3+(1-0.5)1/2+(-1-0.3)3/4]

87.605

Minority interest 10.42

116.025



Consolidated statement of income

• The total revenues and expenditures of the parent and the subsidiary are included in the consolidated statement of income

• Intra-group balances and results need to be eliminated



Consolidated statement of income: Example 25.4

High € Low €

Turnover 100 000 50 000

Cost of sales 75 000 30 000

Gross profit 25 000 20 000

Distribution expenses 4 000 3 000

Administration expenses 7 000 8 000

14 000 9 000

Investment income:

Dividends received 2 250

16 250

Taxation 7 000 3 000

Earnings 9 250 6 000

Retained earnings 22 000 4 000

31 250 10 000



Consolidated statement of income: example 25.4 (cont’d)

High Low

Cost of High’s control of Low 90 000

Bought 75% of Low’s shares 75 000

Bought 75% of Low’s retained profits 3 000 78 000

Goodwill 12 000



Consolidated statement of income: example 25.4 (cont’d)

Inter-company trading

Reduce High’s sales by 12 000

Reduce High’s profits by 1 000

Reduce Low’s stock by 1 000



Consolidated statement of income:

example 25.4 (cont’d)Consolidated statement of income for the year ended 31.12.0X

€ €

Turnover (150 000 – 12 000) 138 000

Cost of sales (105 000 – 12 000 + 1 000) 94 000

44 000

Distribution expenses 7 000

Administration expenses 15 000 22 000

22 000

Taxation 10 000

Consolidated earnings on ordinary activities after tax 12 000

less Minority interest (25% x 6 000 – Low’s profit after tax) 1 500

Consolidated earnings for the financial year 10 500

Retained earnings 22 000

32 500



Questions to be solved by regulators

• Definition of control• Method of accounting to be used for subsidiaries • How to account for other business relationships• Is merger accounting/pooling of interest a

suitable method?• Are there any other suitable methods available

e.g. fresh start method?



Questions to be solved by regulators (cont’d)

• Use of fair value for purchase consideration• How to deal with the goodwill within a business

combination• How and where should minority interests be

shown within the financial statements?• What other disclosure regulations are

required?

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning.

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