ACCA F7 (INT) Financial Reporting - Study text - 2010

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Chapter 18: Consolidated accounts

 The entity has power to appoint or remove a majority of the members of the

board of directors of the subsidiary, and the board of directors has control over

the entity.

 The entity has power to cast a majority of votes at meetings of the board of

directors of the subsidiary, and the board of directors has control over the entity.

1.2 Statement of financial position of the parent: accounting for a

subsidiary

A subsidiary is acquired by purchasing a controlling interest in its equity. The

parent makes a long-term investment in the subsidiary. In the statement of financial

position of the parent, there is a non-current asset:

‘Investment in subsidiary, at cost’

In some groups, the parent company has no assets at all except shares in the

subsidiaries in the group. A parent whose main assets (or only assets) are shares in

subsidiaries is sometimes called a holding company. You might see both terms,

‘parent’ and ‘holding company’: treat them as meaning the same.

1.3 Purpose and nature of consolidated financial statements

When a large part of the assets of the parent consists of investments in subsidiaries,

it is difficult for the users of the financial statements of the parent to understand

anything about its financial position or financial performance. If a parent company

only reported to its shareholders about the financial performance and position of

the parent itself, the statement of financial information might contain little more

than ‘investments in subsidiaries at cost’ and the profit for the year might consist of

little more than ‘dividends received’ from the investments.

To find out meaningful information about their investment, users of the parent’s

financial statements need to know about the financial position and performance of

the operating subsidiaries in the entire group of companies.

The purpose of consolidated financial statements is to provide financial statements

that have meaning and relevance to users. When a parent acquires a subsidiary,

both the parent and the subsidiary remain legally separate entities. However, in

practice they operate as if they were one organisation. Consolidated financial

statements reflect the reality (or substance) of the situation: the group is a single

economic unit.

In preparing consolidated financial statements:

 the profits of the parent and its subsidiaries, and their other comprehensive

income, are combined into a single in a consolidated statement of

comprehensive income

 the assets and liabilities of the parent and its subsidiaries are combined in a

single consolidated statement of financial position. (However, the share capital

and reserves for the consolidated balance sheet are not calculated simply by

adding the capital and reserves of all the companies in the group!).

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1.4 The effect of the parent/subsidiary relationship on the financial

statements

A parent and a subsidiary are related parties of each other, because the parent

controls the subsidiary.

This relationship often has an effect on the profit or loss, or on the financial position

of both entities, because they may enter into transactions with each other on terms

that other entities or individuals (unrelated parties) would not.

For example:

 an entity might sell goods to its parent or fellow-subsidiaries on more favourable

terms than it would sell to other customers

 a parent company may make supplies to a struggling subsidiary on more

favourable terms than it would to other companies. This would boost the

apparent profitability of that subsidiary.

 the only or main reason for a subsidiary’s existence might be to produce goods

or to provide services for the parent to use in its own operations.

In all these situations, the financial performance and financial position reported by

the separate financial statements of the subsidiary is affected, so that:

 the information could be misleading to users who not aware of the existence and

effect of the related party relationship; and

 it may not be possible to make meaningful comparisons between the

subsidiary’s financial statements and those of a similar entity that (for example)

makes all its sales to third parties on normal commercial terms (at ‘arm’s

length’).

The consolidated financial statements are also affected. Because they present the

activities of the group as a single entity, transactions between the subsidiary and the

parent are eliminated (not included). Amounts owed by one entity to another are

also eliminated.

1.5 International accounting standards and group accounts

There are three relevant IASs and IFRSs relating to the financial statements of

groups of companies:

 IAS27: Consolidated and separate financial statements

 IAS28: Investments in associates

 IFRS3: Business combinations. (IFRS 3 was revised in January 2008 and applies

to business combinations that occur in financial periods starting on or after 1

July 2009. However, the revised IFRS became examinable from December 2008.)

IFRS3 defines a business combination as ‘a transaction … in which an acquirer

obtains control of one or more businesses.’ The effect of business combinations is to

bring together separate entities or businesses into one reporting entity, which

produces consolidated financial statements for the group of entities as a whole.

Chapter 18: Consolidated accounts

The examination paper will include a question on preparing consolidated financial

statements. The question will involve a parent company, one subsidiary and

possibly also an associate.

1.6 The requirement to prepare consolidated accounts

IAS27 states that, with certain exceptions, a parent must present consolidated

financial statements in which it consolidates its investments in subsidiaries. In other

words, a parent must prepare consolidated financial statements for the group as a

whole.

Exception to this rule

There is an exception to this rule. A parent need not present consolidated financial

statements if (and only if) all the following conditions apply:

 The parent itself (X) is a wholly-owned subsidiary, with its own parent (Y).

Alternatively, the parent (X) is a partially-owned subsidiary, with its own parent

(Y), and the other owners of X are prepared to allow it to avoid preparing

consolidated financial statements.

 The parent’s debt or equity instruments are not traded in a public market.

 The parent does not file its financial statements with a securities commission for

the purpose of issuing financial instruments in a public market.

 The parent’s own parent, or the ultimate parent company (for example, the

parent of the parent’s parent), does produce consolidated financial statements

for public use that comply with International Financial Reporting Standards.

1.7 The requirement to include all subsidiaries

Consolidated financial statements should include all the subsidiaries of the parent

(IAS27).

There are several reasons why a parent may not wish to consolidate a particular

subsidiary, for example:

 The subsidiary’s activities are dissimilar from those of the parent, so that the

consolidated financial statements might not present the group’s financial

performance and position fairly.

 The subsidiary has been acquired only so that it can be resold within a short

time.

 Obtaining the information needed would be expensive and time consuming and

might delay the preparation of the consolidated financial statements.

 The subsidiary operates under severe long term restrictions, so that the parent is

unable to manage it properly. For example, a subsidiary might be located in a

country badly disrupted by a war or a revolution.

None of these is allowed as a reason for excluding a subsidiary from

consolidation. However:

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 Where a subsidiary is acquired exclusively with a view to subsequent resale, it is

accounted for in accordance with IFRS 5 Non-current assets held for sale and

discontinued operations.

 If a parent actually loses control over an entity which has been a subsidiary, it is

no longer a subsidiary, even if the parent still holds more than 50% of its equity

shares. This means that it does not have to be ‘consolidated’ (i.e. included within

the consolidated financial statements).

1.8 Common reporting date

Consolidated accounts combine the assets, liabilities, income and expenses of all the

entities in the group.

IAS27 therefore requires that the financial statements of the parent and its

subsidiaries that are used to prepare the consolidated financial statements should all

be prepared with the same reporting date (the same financial year-end date), unless

it is impracticable to do so.

If it is impracticable for a subsidiary to prepare its financial statements with the

same reporting date as its parent, adjustments must be made for the effects of

significant transactions or events that occur between the dates of the subsidiary's

and the parent's financial statements. In addition, the reporting date of the parent

and the subsidiary must not differ by more than three months.

1.9 Uniform accounting policies

Since the consolidated accounts combine the assets, liabilities, income and expenses of

all the entities in the group, it is important that the methods used for recognition and

measurement of all these items should be the same for all the entities in the group.

IAS27 therefore states that consolidated financial statements must be prepared

using uniform accounting policies. The policies used to prepare the financial

statements in all the entities in the group must be the same.

Chapter 18: Consolidated accounts

Consolidated statement of financial position: the basic rules

 The basic rules

 Acquiring a subsidiary after incorporation: pre- and post-acquisition profits

 Directly-related acquisition costs

2 Consolidated statement of financial position: the

basic rules

2.1 The basic rules

A consolidated statement of financial position brings together the assets and

liabilities of the parent company and all its subsidiaries. Some adjustments are made

to the assets and liabilities for the purpose of consolidation, but the assets of the

group minus its liabilities are the group’s equity.

The basic rules for preparing a consolidated statement of financial position can be

illustrated with a simple example. In this example:

 the parent owns 100% of the equity of the subsidiary

 the parent acquired its investment in the subsidiary when the subsidiary was

first established (so the acquisition date was the date that the subsidiary was

created)

 the cost of the investment in the subsidiary is exactly equal to the fair value of

the net assets in the subsidiary, as at the date of acquisition.

When all these conditions apply, a consolidated statement of financial position can

be prepared as at the acquisition date of the subsidiary by:

 adding the assets of the parent and the subsidiary, line by line

 however, excluding the item ‘investment in subsidiary’ in the statement of

financial position of the parent company

 adding the liabilities of the parent and the subsidiary, line by line.

The equity and reserves in the consolidated statement of financial position consist

of:

 the equity and reserves of the parent, and

 only the reserves of the subsidiary that have been earned since its acquisition. As

at the date of acquisition, these are zero.

Example

A parent entity P acquired 100% of the equity shares of a subsidiary entity S when

the subsidiary was first established. The net assets of S when it was first set up (total

assets minus total liabilities) were valued at $120,000 and P paid $120,000 to acquire

these net assets.

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The summary statements of financial position of both entities when S was

established and P acquired 100% ownership were as follows.

ParentP SubsidiaryS

$ $

Non‐currentassets:

Property,plantandequipment 640,000 125,000

InvestmentinS 120,000 ‐



–

––––––

–

––––––

 760,000 125,000

Currentassets 140,000 20,000



–

––––––

–

––––––

 900,000 145,000



–

––––––

–

––––––

Equity

Equitysharesof$1each 200,000 80,000

Sharepremium 250,000 40,000

Retainedearnings 350,000 ‐



–

––––––

–

––––––

 800,000 120,000

Currentliabilities 100,000 25,000



–

––––––

–

––––––

 900,000 145,000



–

––––––

–

––––––

A consolidated statement of financial position as at the date of incorporation can be

prepared as follows:

PGroup:consolidatedstatementoffinancalpositionasatthedateofacquiringS

Non‐currentassets: $

Property,plantandequipment (640,000+125,000) 765,000

Currentassets (140,000+20,000) 160,000

 –––––––

 925,000

 –––––––

Equity 

Ordinarysharesof$1each (parentcompanyonly) 200,000

Sharepremium (parentcompanyonly) 250,000

Retainedearnings 350,000

 –––––––

 800,000

Bankloans (100,000+25,000) 125,000

 –––––––

 925,000

 –––––––

Note: In practice, there is no reason to prepare a consolidated statement of financial

position when a subsidiary is acquired. However, it is used here to illustrate the

basic principles of consolidation, before going on to consider what happens after the

subsidiary has been acquired.

Chapter 18: Consolidated accounts

2.2 Acquiring a subsidiary after incorporation: pre- and post-acquisition

profits

Subsidiaries are often acquired after they have been incorporated or established,

and after they have been in business for some time. The acquired subsidiary will

have some accumulated profits (retained earnings) at the date of the acquisition.

These are called ‘pre-acquisition profits’.

Pre-acquisition profits of a subsidiary are not included as retained earnings in the

consolidated financial statements – they are dealt with as part of the purchased

goodwill calculation (see below).

However, post-acquisition profits of a subsidiary are included in group profits in

the consolidated statement of comprehensive income, as a part of the profits of the

entire group. They are also included in the retained earnings of the group, and so

are included in the consolidated statement of financial position.

Example

A parent P acquired 100% of the share capital of subsidiary S on 1 January Year 3.

The net assets of S (total assets minus total liabilities) were valued at $200,000 at the

date of acquisition and P paid $200,000 to acquire the shares in S.

(Note: This means that there is no purchased goodwill. Goodwill is explained later).

The summary statements of financial position of both entities at 1 January Year 3

and at 31 December Year 3 are as follows.



Attheacquisitiondate

1JanuaryYear3

 Attheendoftheyear

31DecemberYear3

$ $ $ $

Non‐currentassets:    

Property,plantand

equipment

670,000 170,000 680,000 245,000

InvestmentinS 200,000 ‐ 200,000 ‐



–

––––––

–

––––––

–

–––––– –––––––

 870,000 170,000 880,000 245,000

Currentassets 110,000 80,000 175,000 90,000



–

––––––

–

––––––

–

––––––– –––––––

 980,000 250,000 1,055,000 335,000



–

––––––

–

––––––

–

––––––– –––––––

Equity

Equityshares 150,000 30,000 150,000 30,000

Sharepremium 280,000 90,000 280,000 90,000

Retainedearnings 380,000 80,000 470,000 140,000



–

––––––

–

––––––

–

–––––– –––––––

 810,000 200,000 900,000 260,000

Currentliabilities 170,000 50,000 155,000 75,000



–

––––––

–

––––––

–

––––––– –––––––

 980,000 250,000 1,055,000 335,000



–

––––––

–

––––––

–

––––––– –––––––

Paper F7: Financial reporting (International)

During the year to 31 December Year 3, entity P made a profit after tax of $90,000

and entity S made a profit after tax of $60,000. Neither entity paid any dividend.

The consolidated profit for the year is $90,000 + $60,000 = $150,000, because all the

profits of S are post-acquisition profits. (S was acquired on 1 January).

The consolidated statement of financial position at the date of the acquisition of

S, at 1 January Year 3, is as follows. Note that none of the pre-acquisition retained

earnings of S are included in the consolidated statement of financial position.

P Group

Consolidated statement of financial position at the date of acquisition of S

1 January Year 3

Non-current assets:

Pro

ert

lant and e

ment

(670,000 + 170,000)

840,000

Current assets (110,000 + 80,000)

190,000

––––––––

1,030,000

––––––––

uit

shares (

arent com

onl

) 150,000

remium (

arent com

onl

) 280,000

Consolidated retained earnin

(

arent com

onl

) 380,000

––––––––

810,000

Current liabilities (170,000 + 50,000)

220,000

––––––––

1,030,000

––––––––

The consolidated statement of financial position at 31 December Year 3 is as

follows. Note that consolidated retained earnings of the group include both the

profits of the parent P and the post-acquisition profits of the subsidiary S. The post-

acquisition profit of S is its profit in the whole of Year 3, $60,000 – since it was

acquired on 1 January.

P Group

Consolidated statement of financial position at 31 December Year 3

Non-current assets:

Pro

ert

lant and e

ment

(680,000 + 245,000)

925,000

Current assets

(

175,000 + 90,000

)

265,000

––––––––

1,190,000

––––––––

uit

shares (

arent com

onl

) 150,000

remium (

arent com

onl

) 280,000

Consolidated retained earnin

In $000: (470 + 60)

530,000

––––––––

960,000

Current liabilities (155,000 + 75,000)

230,000

––––––––

1,190,000

––––––––

Other reserves

Sometimes a subsidiary has reserves other than retained earnings. The same basic

rules apply.

Chapter 18: Consolidated accounts

If a reserve existed in the acquired subsidiary at the acquisition date, it is included

in the goodwill calculation and treated in the same way as pre-acquisition profits.

If a reserve arose after the acquisition date, it is treated in the same way as post-

acquisition profits.

2.3 Directly-related acquisition costs

When a company acquires shares in a new subsidiary, the main cost of the

acquisition is the purchase price paid for the shares, to buy them from the existing

shareholders.

In addition, the acquiring company will incur some expenses that are directly

related to the acquisition, such as the costs of professional advisers, including legal

fees and accounting fees.

These directly-related acquisition costs or expenses must be written off to profit and

loss as an expense in the year of acquisition.

This will be explained in more detail in the section on purchased goodwill.

Paper F7: Financial reporting (International)

Consolidatedstatement of financial position: purchased goodwill

 The nature of purchased goodwill

 The cost of acquisition and directly-related acquisition costs

 Accounting for purchased goodwill: impairment

 Goodwill and mid-year acquisition

 Acquired intangible assets

 Contingent consideration

3 Consolidated balance sheet: purchased goodwill

3.1 The nature of purchased goodwill

When a parent company acquires a subsidiary company, the price it pays is

normally more than the fair value of the net assets of the subsidiary. This is because

the market value of a company is normally more than the value of its net assets.

The difference between the fair value of the purchase price paid and the fair value of

the net assets acquired is purchased goodwill (usually called simply ‘goodwill’).

Cost of the acquisition A

Fair value of net assets acquired B

–

––––

Goodwill A – B

–

––––

Purchased goodwill is included in the consolidated statement of financial position,

as an intangible asset. (In this respect, purchased goodwill differs from internally-

generated goodwill, which is not included in financial statements.)

An important point to note is that the initial cost of goodwill is measured at the

date of acquisition of the subsidiary.

3.2 The cost of acquisition and directly-related acquisition costs

Purchased goodwill is the difference between the cost of acquisition of a subsidiary

and the fair value of the net assets acquired.

It was stated in the previous section that in any acquisition there will be some costs

directly related to the acquisition, such as advisers’ fees. Until IFRS 3 was revised

from 2008, it was the accepted practice to include these directly-related costs in the

cost of acquisition: this meant that the costs were included in the calculation of

purchased goodwill.

With the revision of IFRS 3, this is no longer permitted.

ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing

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