ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 4: Group financial statements

Changes in equity arising from these ‘other reasons’ are known collectively as ‘total

comprehensive income’ during the period. Total comprehensive income should be

separated into:

 profit or loss in the period, and

 other comprehensive income.

Entities are required by IAS 27 revised to present as part of their financial

statements either:

 a statement of comprehensive income, which reports profit or loss during the

period, followed by other comprehensive income and total comprehensive

income for the period, or

 a separate income statement that reports profit or loss, followed by a statement

of comprehensive income that begins with profit after tax for the period, and

then presents other comprehensive income and total comprehensive income for

the period.

Financial statements are therefore required to distinguish between:

 profit or loss for the period

 other comprehensive income, which consists of gains or losses that are not

reported in profit or loss – such as gains on asset revaluations

 transactions between the entity and its owners in their capacity as owners, which

are called ‘equity transactions’ and reported in the statement of changes in

equity, but not in the statement of comprehensive income.

These changes affect the reporting and presentation of consolidated accounts (group

accounts). This chapter and subsequent chapters in the text will therefore usually

refer to:

 ‘profit and loss’ or ‘profit or loss’ instead of ‘income statement’. This is because

entities may now include the components of profit and loss within a statement of

comprehensive income rather than as a separate income statement, and

 ‘equity transactions’ which are transactions between an entity and its owners

(shareholders) in their capacity as owners and which are accounted for directly

in equity and are not reported through the statement of comprehensive income.

1.2 Parent company and subsidiaries

A group consists of a parent entity and one or more subsidiary entities. (There may

also be ‘associates’ or ‘joint ventures’ in a group).

 An entity is a subsidiary of another entity if it is controlled by that other entity.

‘Control’ usually means that more than 50% of its equity shares are owned by

that other entity.

 Within a group, Company C might be a subsidiary of Company B, which is a

subsidiary of Company A. Company C is then a sub-subsidiary of Company A.

Group structures with sub-subsidiaries are not examinable.

 The entity that ultimately controls all the entities in the group is called the

parent.

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A parent is defined as ‘an entity that has one or more subsidiaries’ (IAS 27).

Definition of ‘control’

Deciding whether a company is a parent depends on the existence of control.

IAS 27 (revised) defines control as ‘the power to govern the financial and operating

policies of an entity so as to obtain benefits from its activities.’

Control is assumed to exist when the parent owns directly, or indirectly through

other subsidiaries, more than 50% of the voting power of the entity, unless in

exceptional circumstances it can be clearly demonstrated that such control does not

exist.

Control also exists when the entity (parent) owns 50% or less than 50% of the voting

power of the entity but any of the following circumstances also applies:

 The entity has power over more than 50% of the voting rights in the subsidiary

by virtue of an agreement with other investors.

 The entity has power to govern the financial and operating policies of the

subsidiary entity under a statute or agreement.

 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.

1.3 The nature and purpose of consolidated accounts

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.

When a large part of the assets of a parent company 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. 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.

The purpose of consolidated accounts is to provide financial statements that have

meaning and relevance to users.

Chapter 4: Group financial statements

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. Consolidated accounts are

financial statements of all the entities in the group combined. The parent and its

subsidiaries:

 combine their profits in a consolidated statement of comprehensive income, or a

separate consolidated income statement and a statement of comprehensive

income (IAS revised)

 combine their assets and liabilities in a consolidated statement of financial

position. (However, the share capital and reserves for the consolidated statement

of financial position are not calculated simply by adding the capital and reserves

of all the companies in the group!)

Consolidated accounts should include all the subsidiaries of the parent (IAS 27).

1.4 The requirement to prepare consolidated accounts

IAS 27 states that, with certain exceptions, a parent must present consolidated

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

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

as a whole.

The requirement to include all subsidiaries

Consolidated financial statements should include all the subsidiaries of the parent

(IAS 27).

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 re-sold 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:

 Sometimes a subsidiary is acquired with a view to its sale in the short term. An

example of this is when the parent company acquires a group but does not wish

to keep all the subsidiaries within that group and intends to dispose of the

subsidiaries it does not want. The accounting treatment for this is to consolidate

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the subsidiary and treat it as a discontinued operation 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. This may be the case

where there are long-term restrictions in place that make it impossible to control

the entity. IAS 27 states that it should not be consolidated. This may happen if

the subsidiary is located in a foreign country and the laws of that country do not

allow the repatriation of funds to the parent company.

Exception to the 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.

Special purpose entities (SPEs) and consolidation

A group may include companies that are known as special purpose entities (SPEs)

or special purpose vehicles (SPVs). These companies are established in such a way

that the ‘parent’ company does not have legal control over the SPE, although some

form of effective control does exist. SIC Interpretation 12 states that special purpose

entities (SPEs) should be consolidated in the normal way for subsidiaries where the

substance of the relationship between the reporting entity and the SPE indicates that

the SPE is controlled by the reporting entity (even though legally a parent-

subsidiary relationship does not exist).

 The term ‘special purpose entity’ is not defined by SIC 12.

 SIC 12 provides examples of circumstances in which control of an SPE may exist

in substance:

− the SPE carries on activities on behalf of the reporting entity

− the reporting entity has decision-making powers over the SPE, and

− the reporting entity has rights to the majority of the benefits and has

exposure to significant risks of the SPE.

Chapter 4: Group financial statements

Revision of principles of consolidation: the basic calculations

 The consolidated statement of financial position: basic rules

 Preparing a consolidated statement of financial position: partial goodwill

method

 Fair value method of accounting for NCI (full goodwill method)

 Preparing a consolidated statement of comprehensive income: basic rules

2 Revision of principles of consolidation: the basic

calculations

IAS 27 states that consolidated financial statements are the financial statements of a

group presented as those of a single economic entity. This means that groups must

present their financial statements in the form of consolidated accounts.

In order to present financial statements as those of a single economic entity, assets,

liabilities, income and expenses of subsidiaries are aggregated with the

corresponding items of the holding company.

The following notes deal with the consolidated statement of financial position first;

then the consolidated statement of comprehensive income

2.1 The consolidated statement of financial position: basic rules

A consolidated statement of financial position is prepared as follows:

Most of the assets and liabilities in the consolidated statement of financial position

are calculated by adding together the assets and liabilities of the parent and the

assets or liabilities of its subsidiaries. (Adjustments are required to eliminate inter-

company debts between the parent and subsidiaries, and unrealised profit is

eliminated at the year end from inventory that has been sold between group

companies.)

Costs of acquisition: transaction costs

IFRS3 (revised) introduced a change in the rule for measuring the cost of an

acquisition. Transaction costs incurred in making an acquisition, such as the cost of

the fees of advisers and lawyers, must not be included in the cost of the acquisition.

These costs must be treated as an expense as incurred and written off to profit or

loss.

The amount of transaction costs associated with an acquisition and written off

during the period to profit or loss must be disclosed in a note to the financial

statements.

However, if an entity borrows money to finance an acquisition, the costs associated

with arranging the borrowing are treated in accordance with the rules of IAS 39.

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These costs are deducted from the value of the debt and amortised over the term of

the debt using the effective rate of interest (i.e. the amortised cost method).

Measuring goodwill: acquiring 100% of a subsidiary

Purchased goodwill arises on the acquisition of a subsidiary. When 100% of the

equity of a subsidiary is acquired, purchased goodwill is the difference between:

 the cost of the investment in the subsidiary and

 the fair value of the net assets acquired in the subsidiary.

Fair value of net assets of subsidiary at acquisition $A

Percentage of equity shares acquired h%

Purchase consideration for the shares acquired X

Fair value of net assets attributable to parent entity shareholders = $A × h%

Goodwill at acquisition attributable to parent entity shareholders X – Y

Purchased goodwill is not amortised, but may be subject to impairment. When

goodwill has been impaired, it cannot subsequently be re-valued upwards.

Non-controlling interest

The term ‘non-controlling interest’ has replaced the previously-used term ‘minority

interests’.

IAS 27 (revised) has adopted an ‘economic entity’ model for groups, by which all

providers of equity capital are owners or shareholders of the group, including the

non-controlling interests (NCI) in subsidiaries.

The previous accounting practice had been the ‘parent company approach’, by

which the consolidated financial statements were seen from the perspective of the

shareholders in the parent company.

In most respects this change in approach does not affect the preparation of

consolidated financial statements. However, there are some changes in the rules

affecting the partial disposal of shares in a subsidiary by the parent, or the

acquisition of additional shares in an existing subsidiary. These are explained later.

Measuring goodwill when there is a non-controlling interest

The parent company may acquire and own less than 100% of the equity shares of

the subsidiary, so that there is a non-controlling interest in the subsidiary. A non-

controlling interest is included in the consolidated statement of financial position as

a part of total equity, but is shown separately from the parent company’s equity

interest in the group.

Chapter 4: Group financial statements

 With the revision of IFRS 3 (2008) two methods are permissible to account for

non-controlling interests in the consolidated statement of financial position.

− Method 1: the ‘partial goodwill‘ method. The non-controlling interest

reflects the carrying value of the net assets of the subsidiary at the end of the

reporting period that are attributable to the external (non-group)

shareholders in the subsidiary.

− Method 2: the ‘full goodwill’ method or full fair value method. This is the

same as Method 1, except that the non-controlling interests also include an

amount for goodwill in the subsidiary that is attributable to the non-

controlling interests. This goodwill is measured when the subsidiary is

acquired, and subsequently may be subject to impairment.

IFRS3 (revised) allows either method to be used for any acquisition. The choice of

method is on a transaction-by-transaction basis, and the same method does not have

to be used for every acquisition by the parent company.

The ‘full goodwill method’, also called the ‘full fair value method’, is consistent with

the ‘economic entity model’ for reporting the financial results of a group of

companies, and it is likely to be examined regularly.

Pre-acquisition profits and measuring purchased goodwill

A group comes into existence as a result of a ‘business combination’ when the

parent company acquires one or more subsidiaries. If the subsidiary acquired is an

existing entity that has already been trading, and is not a newly-incorporated entity,

some of the subsidiary’s net assets at the date of the business combination will

represent the accumulated retained profits of the subsidiary that have been earned

up to that date, before the combination occurred. These profits are reflected in the

net assets purchased by the parent and in the price that it pays. They are treated as

‘pre-acquisition’ profits, and are not reported as group profits in the consolidated

financial statements.

The net assets acquired are adjusted to their fair values at the date of acquisition.

The difference between the fair value of the net assets acquired and the purchase

cost of the subsidiary is the purchased goodwill attributable to equity holders in the

parent company recognised on the combination.

Measuring equity in the group statement of financial position

In the consolidated statement of financial position, equity consists of the equity

attributable to owners of the parent company plus the non-controlling interests in

subsidiaries.

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The equity attributable to shareholders of the parent company consists of:

The equity share capital of the parent A

The reserve accounts of the parent B

The parent’s share of the post-acquisition reserves of the subsidiary:

these are the parent’s share of the post-acquisition retained profits of the

subsidiary, and any other post-acquisition movements in the

subsidiary’s reserves, such as its revaluation reserve

Plus or minus any ‘consolidation adjustments’ D

For example, accumulated impairment of the purchased goodwill

(attributable to equity holders in the parent company) is deducted

Equals: Equity attributable to the shareholders of the parent A + B + C,

+ or - D

The non-controlling interests are calculated as follows:

 If the partial goodwill method is used:

NCI = Carrying value of net assets of Subsidiary × % equity in Subsidiary held

by NCI

 If the full goodwill method is used:

Carrying value of net assets of Subsidiary × % equity in Subsidiary

held by NCI

Plus: Goodwill attributable to NCI at acquisition B

Minus: Subsequent impairment off goodwill (C)

Equity attributable to non-controlling interests A + B – C

2.2 Preparing a consolidated statement of financial position: partial

goodwill method

We recommend a five-step approach to preparing a basic consolidated statement of

financial position, where there is just one subsidiary and where the accounting

policy is that non-controlling interests in the subsidiary should not include an

element for goodwill. (If there is more than one subsidiary, the same steps apply to

each subsidiary in turn.)

 Step 1. Calculate the parent’s percentage share and the non-controlling interest

percentage share in the subsidiary.

 Step 2. Calculate the net assets of the subsidiary (1) at the date of acquisition and

(2) at the end of the reporting period. The net assets at the date of acquisition are

revalued to their fair value. The difference between the net assets of the

subsidiary at these two dates is used to calculate the post-acquisition

accumulated profits of the subsidiary.

Chapter 4: Group financial statements

At end of

reporting

period

acquisition

Post acquisition

accumulated

profits

$ $ $

Equity shares X X -

Accumulated profits Y Z Y – Z

–––––––––––––––

X + Y X + Z

–––––––––––––––

 Step 3. Calculate the purchased goodwill on acquisition. Then reduce this

goodwill by any accumulated impairments to date, to calculate the figure for

goodwill to include in the consolidated statement of financial position.

 Step 4. Calculate the non-controlling interest, as an appropriate percentage of

the net assets of the subsidiary at the end of the reporting period. (For non-

controlling interests, there is no need to distinguish between pre-acquisition and

post-acquisition profits.)

 Step 5. Calculate consolidated accumulated profits, using the post-acquisition

profits of the subsidiary now identified in Step 2 and any impairments to

goodwill from Step 3.

Parent accumulated profits A

Parent’s share of subsidiary’s post-acquisition profits B

Minus: Impaired goodwill since acquisition (C)

A+ B – C

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

rules apply. If a reserve existed 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.

You can then prepare the consolidated statement of financial position.



Example

The statements of financial position of a parent company P and its subsidiary S at 31

December Year 6 are as follows:

Parent P Subsidiary S

$ $

Non-current assets:

Property, plant and equipment

620,000 120,000

Investment in S

188,000 -

–

––––––––––––––– –––

–

––––––––––––––– –––

808,000 120,000

Current assets

112,000 60,000

–

––––––––––––––– –––

–

––––––––––––––– –––

920,000 180,000

Paper P2: Corporate Reporting (International)

Capital and reserves

Equity shares of $0.50 each

100,000 40,000

Share premium

200,000 30,000

Accumulated profits

480,000 90,000

–––––––––––––––– –––

780,000 160,000

Bank loan

140,000 20,000

–––––––––––––––– –––

920,000 180,000

–––––––––––––––– –––

P acquired 64,000 shares in S on 1 January Year 6 when the accumulated profits of S

were $65,000. The values for assets and liabilities in the statement of financial

position of S represent fair values.

The accounting policy of P is to measure non-controlling interests (NCI) at their

proportionate share of the net assets of the subsidiary (and not to measure NCI by

the ‘fair value’ method, including some goodwill).

Neither company has paid any dividends during the year. A review of goodwill at

31 December Year 6 found that goodwill had been impaired, and was now valued at

$50,000.

Required

Prepare a consolidated statement of financial position as at 31 December Year 6.



Answer

Step 1

Calculate the group share (parent company’s percentage share) and the NCI

percentage share in the subsidiary.

The total number of shares in the subsidiary is $40,000/$0.50 per share = 80,000

shares. P acquired 64,000 shares.

Parent: (64,000/80,000) × 100% 80

Non-controlling interest: (balancing figure) 20

100

ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)

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