ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)
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Chapter 4: Group financial statements
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Under the rules of IFRS 3 (revised), contingent consideration must be recognised at
fair value at acquisition, even if it is not probable that the consideration will actually
have to be paid.
Example
Company P acquired 80% of the shares of Company S when the fair value of the
net assets of S was $800,000. The purchase price was $300,000 in cash plus 100,000
new shares in Company P. The market value of P’s shares at the time was $4 each.
The costs of making the acquisition were $80,000.
The cost of the investment in the shares of S = $300,000 + (100,000 × $4) = $700,000.
The costs of making the acquisition should be written off to profit or loss.
The parent company’s share of the net assets of S at the acquisition date was
$640,000 (80% × $800,000). Purchased goodwill attributable to owners of the parent
company is therefore $60,000 ($700,000 - $640,000).
Example
Company X purchased 100% of the issued capital of Company S on 1 January Year
4.
The purchase agreement required Company X to pay $300,000 in cash immediately
and an additional sum of $100,000 on 31 December Year 6 if the earnings of
Company S increase at an annual rate of 25% per year in each of the three years
following the acquisition.
How should the contingent payment be recognised in calculating the goodwill
arising at the date of acquisition?
Answer
The contingent consideration should be included in the cost of investment (the
purchase consideration) Whether or not it is probable that it will have to be paid.
The contingent consideration of $100,000 should be measured at fair value.
If it is fairly certain that the contingent consideration will have to be paid, an
appropriate measure of fair value might be the present value of the future payment,
discounted at an appropriate cost of capital. The purchase consideration is therefore
$300,000 plus the present value of the contingent (deferred) consideration.
If there is still contingent consideration at the end of an accounting period, it might
be necessary to re-measure it.
If the contingent consideration will be payable in cash, it should be re-measured
to fair value at the end of the reporting period. Any gain or loss on re-
measurement should be taken to profit or loss.
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If the contingent consideration will take the form of debt, the amount of the debt
is re-measured at fair value at the end of the reporting period and the change in
value is recognised in profit or loss in the period.
If the contingent consideration will take the form of equity, it is not re-measured
at the end of the reporting period. The eventual settlement of the payment will
be accounted for as an equity transaction (i.e. a transaction between the entity
and owners of the group in their capacity as owners).
A reason for re-measuring the contingent consideration is that the amount payable
might depend on the performance of the subsidiary after its acquisition.
If the profits are higher than expected, the contingent consideration might be re-
measured to a higher value, increasing the liability (the contingent payment) and
reducing the reported profit for the period.
Similarly if the profits are lower than expected, the contingent consideration
might be re-measured to a lower value, reducing the liability (the contingent
payment) and increasing the reported profit for the period.
(Note: Under the previous accounting rules, before the introduction of IFRS 3
(revised), any increase in the value of contingent consideration was charged to
goodwill.)
Share options given to the previous owners
When an entity acquires a subsidiary that was previously managed by its owners,
the previous owners might be given share options in the entity as an incentive to
stay on and work for the subsidiary after it has been acquired. IFRS 3 states that the
award of share options in these circumstances is not a part of the purchase
consideration. The options are post-acquisition employment expenses and should
be accounted for as share-based payments in accordance with IFRS 2.
3.5 Fair value adjustments in a subsequent period
Fair value adjustments continue to affect the consolidated statement of financial
position after the acquisition date.
Sometimes this is simply a matter of including the original fair value adjustment in
the calculation of the subsidiary’s net assets at the end of the subsequent reporting
period.
At end of current
reporting period
At
acquisition
Post
acquisition
$
Equity shares X
X -
Retained earnings X
X X
Fair value adjustments X
X -
X
X
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Occasionally the situation is more complicated. For example:
Where a non-current asset in the acquired subsidiary has been revalued
upwards for the purpose of consolidation, extra depreciation must be charged
on the difference between the asset’s book value and its fair value.
Where a long-term loan has been discounted to net present value, the discount
unwinds and the net present value of the loan increases in subsequent periods.
The unwinding of the discount is an additional expense (a finance charge).
In both these cases:
the amount of the fair value adjustment changes after the acquisition date, and
post-acquisition reserves are affected.
At end of current
reporting period
At
acquisition
Post
acquisition
$
Equity shares X
X -
Retained earnings X
Y X – Y
Fair value adjustments X
Y X - Y
X
Y X – Y
Example
Entity P acquired 100% of the shares of Entity S on 1 January Year 1, when S had
equity share capital of $500,000 and retained earnings of $200,000.
The summarised statement of financial position of S at 31 December Year 1 is shown
below.
S
Statementoffinancialpositionat31DecemberYear1
$
Non‐currentassets:
Property,plantandequipment 1,200,000
Currentassets 300,000
1,500,000
Equity
Ordinaryshares 500,000
Retainedearnings 300,000
800,000
Non‐currentliabilities:loan 500,000
Currentliabilities
200,000
1,500,000
At 1 January Year 1 the fair values of S’s property, plant and equipment exceeded
their book value by $200,000. They had a remaining useful life of five years at this
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date. The long-term loan of $500,000 is repayable on 31 December Year 5. The loan is
interest-free, but the interest rate on a similar borrowing would be 10%.
The book values of the other assets and liabilities of S were approximately equal to
their fair values at 1 January Year 1.
The effect of the fair value adjustments is as follows:
Property, plant and equipment increases by $200,000 at the acquisition date. In
Year 1, additional depreciation of $40,000 is charged. At 31 December Year 1, fair
values exceed book values by $160,000.
At 1 January Year 1 the long-term loan is discounted to $310,500 (500,000 ×
0.621). At 31 December Year 1 the loan is discounted to $341,500 (500,000 ×
0.683). The unwinding of the discount is the difference between these two
amounts: $31,000. Discounting the long-term loan increases the net assets of S by
$189,500 at acquisition and by $158,500 at the end of the current reporting
period.
The net assets of S are calculated below.
Atendofcurrent
reportingperiod
At
acquisition
Post
acquisition
$ $ $
Equityshares 500,000 500,000 ‐
Retainedearnings 300,000 200,000 100,000
Fairvalueadjustments:
Non‐currentassets 160,000 200,000 (40,000)
Longtermloan 158,500 189,500 (31,000)
––––––––––––––––––––––– ––––––––––––––––––––––– –––––––––––––––––––
1,118,500 1,089,500 29,000
––––––––––––––––––––––– ––––––––––––––––––––––– –––––––––––––––––––
3.6 Fair value adjustments in profit or loss
If the subsidiary’s assets and liabilities have been adjusted to their fair values, this
may affect the consolidated profit or loss.
For example, if a non-current asset has been revalued upwards, the depreciation
expense is also increased.
Example
Entity P acquired 100% of the shares of Entity S on 1 January Year 1.
At 1 January Year 1 the fair values of S’s property, plant and equipment exceeded
their book value by $200,000. They had a remaining useful life of five years at this
date.
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S also had a long-term loan of $500,000 which was repayable on 31 December Year
5. The loan is interest-free, but the interest rate on a similar borrowing would be
10%.
The book values of the other assets and liabilities of S were approximately equal to
their fair values at 1 January Year 1.
Two adjustments are made to the consolidated profit or loss for Year 1:
Property, plant and equipment increases by $200,000 at the acquisition date and
so there is an additional depreciation expense of $40,000 (200,000/5). This is
included either in cost of sales or in administrative expenses, depending on the
nature of the assets that have been re-valued.
At 1 January Year 1 the long-term loan is discounted to $310,500 (500,000 ×
0.621). During Year 1 the discount unwinds by $31,050 (310,500 × 10%).
Therefore there is an additional finance cost, which represents the amount by
which present value of the loan has increased during the year.
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Revision of intra-group adjustments
Types of intra-group transaction
Intra-group sales
Intra-group balances
Intra-group balances: items in transit
Unrealised profit in inventory
Intra-group loans and interest
4 Revision of intra-group adjustments
4.1 Types of intra-group transaction
In many groups, business and financial transactions take place between entities
within the group. These ‘intra-group’ transactions might be:
the sale of goods or services between the parent and a subsidiary, or between
two subsidiaries in the group
loans by one entity in the group to another, and the payment of interest on intra-
group loans.
Intra-group transactions should be eliminated on consolidation. The purpose of
consolidated accounts is to show the financial position and the financial
performance of the group as a whole, as if it is a single operating unit. If intra-group
transactions are included in the consolidated financial statements, the statements
will show too many assets, liabilities, income and expenses for the group as a single
operating unit.
4.2 Intra-group sales
Consolidated profit or loss shows the total sales and the total cost of sales for the
group as a whole during a financial period. If entities within the same group sell
goods or services to each other, these intra-group transactions will be included:
in the revenue of the entity making the sale
as a cost of sale of the entity making the purchase.
Looking at the group as a single operating unit, however, there has been no sale and
no purchase. The intra-group sale, for the group as a unit, is simply a transfer of
goods or services within the group.
The revenue from intra-group sales and the cost of intra-group purchases must
therefore be eliminated from consolidated profit or loss.
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No inventories of intra-group sales items
Provided that the items sold and bought internally have been used to make a sale
outside the group, so that there are no inventories of intra-group sales items, the
adjustment is made in consolidated profit or loss by:
deducting the revenue from intra-group sales from the total revenue for the
group, and
deducting the same amount from the cost of sales.
Example
A parent company and its subsidiary had the following revenue and cost of sales in
the year just ended. The parent has owned the subsidiary for several years.
ParentP SubsidiaryS
$000
$000
Revenue 800
400
Costofsales
500
250
Grossprofit
300
150
Included in these figures are sales of $50,000 by subsidiary S to parent P. The cost of
these sales for subsidiary P was $30,000. P has used all the items it bought from S to
make sales outside the group.
The revenue of subsidiary S includes $50,000 of sales within the group to P. The cost
of sales of P includes $50,000 for the items bought from S. The total profit of the
group is unaffected, but the double-counting in revenue and the cost of sales must
be eliminated.
The figures for including in consolidated profit or loss are calculated as follows:
ParentP SubsidiaryS
Adjustforintra‐
groupsales
Consolidated
profitandloss
$000 $000 $000 $000
Revenue 800 400 ‐50 1,150
Costofsales
500 250 ‐50 700
––––––––––––– ––––––––––––– –––––––––––––––––––––––––
–
–––––––––––
–
Grossprofit 300 150 nochange 450
––––––––––––– ––––––––––––– ––––––––––––––––––––––––
–
–––––––––––
–
The gross profit of the group is unaffected, because all the intra-group items have
been sold outside the group. However the group revenue and the group cost of
sales must exclude the intra-group transactions.
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When there are inventories of intra-group sales items
A slightly different situation arises when, at the end of the financial year, some intra-
group sales items are still held as inventory by the group entity that bought them. This
is because the inventory includes some ‘unrealised profit’. This problem is explained
later.
4.3 Intra-group balances
When entities within a group sell goods to other entities in the same group, the terms of
trading are normally similar to those for sales to external customers. The selling group
company will expect payment in cash for the goods sold, but will give credit terms to
the buying group company.
When this happens, group entities will include other group entities within their
trade receivables (for intra-group sales) and trade payables (for intra-group
purchases).
The trade receivables of the selling group entity should equal the trade payables of
the buying group entity. These ‘intra-group balances’ must be eliminated on
consolidation and excluded from the consolidated statement of financial position.
For example, if subsidiary S sells goods to parent P for $6,000 and P has not paid for
the goods as at the end of the financial year, the statement of financial position of
parent P will have a trade payable for $6,000 and subsidiary S will have a trade
receivable for $6,000. These intra-group balances should be eliminated, and neither
of them should appear in the consolidated statement of financial position.
4.4 Intra-group balances: items in transit
At the year-end, there might be a difference in the intra-group balances, due to
goods in transit or cash in transit. When cash or goods are in transit, they are in the
process of being transferred from one group entity to another. The entity sending
the cash or goods will have recorded the transaction in its ledger accounts.
However, the entity receiving the cash or goods has not yet received anything, and
so has not yet recorded the transaction in its accounts.
Goods in transit
One group entity might have sent goods to another entity in the group. The entity
making the sale will therefore have recorded the sale, the cost of goods sold and a
profit. It will also have reduced its inventory and recorded a trade receivable. If the
goods are in transit, the entity making the purchase will not yet have recorded the
purchase, the inventory received or the trade payable in its ledger accounts.
Cash in transit
One group entity owing money to another group entity might have made a
payment and recorded the payment in its accounts, by crediting cash and debiting
the trade payable. However, the other group entity might not yet have received the
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payment, and so will not have recorded the cash received or the reduction in its
total trade receivables.
Differences in the intra-group balances caused by items in transit must be removed
for the purpose of consolidation.
Adjusting for items in transit
When the transaction is between a parent and a subsidiary, the difference will be
due to goods in transit or cash in transit either from the parent to the subsidiary or
from the subsidiary to the parent. The adjustment should be made in the accounts
of the parent, regardless of the direction of the transfer.
For example:
If cash is in transit from the parent to a subsidiary, the following adjustment
should be made to the statement of financial position of the parent:
− Debit: Cash (increase cash in the parent’s statement of financial position)
− Credit: Amount payable to the subsidiary (increase the total amount payable
to the subsidiary)
The parent therefore reverses the transaction for the cash in transit, as though
the payment has not yet been made.
If cash is in transit from a subsidiary to the parent, in the statement of financial
position of the parent:
− Debit: Cash (increase cash in the parent’s statement of financial position).
− Credit: Amount receivable from the subsidiary (reduce the total amount
owed to the parent as trade receivables from the subsidiary).
The parent therefore records the receipt of the cash payment from the
subsidiary, even though the cash has not yet been received.
Having made the adjustment for the item in transit, the normal rules can then be
applied to prepare the consolidated financial statements.
Example
The statements of financial position of a Parent and its Subsidiary at 31 December
Year 6 are as follows:
Parent Subsidiary
Assets $
$
Property,plantandequipment 400,000
300,000
InvestmentinSubsidiary
260,000
‐
Currentassets
Receivables:BalanceontheaccountwithParent ‐
25,000
Othercurrentassets
40,000
65,000
Totalassets
700,000
390,000
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Equityandliabilities
Sharecapital:equityshares$1 150,000
100,000
Accumulatedprofits
450,000
270,000
600,000
370,000
Liabilities
Payables:BalanceonaccountwithSubsidiary 15,000
‐
Otherliabilities
85,000
20,000
Totalequityandliabilities
700,000
390,000
A parent acquired 80% of the equity shares of a subsidiary some years ago, when
the net assets of the subsidiary were $250,000. (The partial goodwill method of
accounting is used for this acquisition, and non-controlling interest is valued at a
proportionate share of the net assets of the subsidiary.)
The difference in the intra-group balances is due to a cash payment by the parent to
the subsidiary, which has been recorded in the accounts of Parent but has not yet
been recorded in the accounts of the subsidiary.
There has been no impairment in goodwill since the acquisition of the subsidiary.
Required
Prepare a consolidated statement of financial position as at 31 December Year 6.
Answer
First, eliminate intra-group balances
The parent has recorded a payment to the subsidiary, but the receipt of the payment
has not yet been recorded by the subsidiary. The cash in transit is $10,000 ($25,000 –
$15,000). Adjust for the cash in transit in the statement of financial position of the
parent as follows:
Debit: Cash $10,000
Credit: Payables: Balance on account with Subsidiary $10,000.
The intra-group balances (in the statements of financial position of the parent and
the subsidiary) are now both $15,000 and are eliminated on consolidation.
The current assets of the parent increase by $10,000 (cash).
Having eliminated the intra-group balances, carry out the normal five steps for
preparing a consolidated statement of financial position.