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Advanced Financial Accounting: Chapter 2

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1 Advanced Financial Accounting: Chapter 2
Group Reporting I: Concepts and Context Tan & Lee Chapter 2 © 2009

2 Learning Objectives Understand:
The rationale for group reporting and the complementarity of reporting by legal and economic entities, and business units; The economic incentives for the provision of consolidated financial information; The economic context of group reporting – merger and acquisition as risk management strategy and the impact on financial reporting; The concept of “control” and the determination of the parent-subsidiary relationship; The concept of “significant influence” and the notion of “associates” The concept of a “business combination” and the scope of IFRS 3; The theories relating to consolidation; and The effects of parent versus entity theories of consolidation Tan & Lee Chapter 2 © 2009

3 Content 1. Introduction Introduction
Economic Incentive for the Preparation of Consolidated Information Economic Motives for Entering into Intercorporate Arrangement The Concept of Control The Concept of Significant Influence Accounting for Business Combinations Consolidation Theories Tan & Lee Chapter 2 © 2009

4 Components of Financial Reporting
Introduction A primary issue that underpins financial reporting is the identification of the reporting entity. Components of Financial Reporting Financial reporting Aggregated reporting for the economic entity Disaggregated reporting for business units within a legal or economic entity Separate financial statements for the legal entity Tan & Lee Chapter 2 © 2009

5 Relationship of control within legal entities
Introduction Relationship of control within legal entities Legal entity Legal Entity Control Shared ownership Contractual or statutory arrangements Effective relationship Individual financial statement Tan & Lee Chapter 2 © 2009

6 Incentive to extend economic boundaries
Introduction Incentive to extend economic boundaries Capitalizing on slack debt or operating capacity Increased market shares Tapping on growth opportunities Economies of scale and scope Reduced risk through diversification Tan & Lee Chapter 2 © 2009

7 Introduction A group of companies better able to deal with economic risk like Macro-economic risk Industry risk Firm-specific risk 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 Tan & Lee Chapter 2 © 2009

8 Disaggregated Information
Introduction Disaggregated Information Source of disaggregated information Separate financial statements Determine risk profile of individual segments Strength and weaknesses of specific operation and geographical Segment information Loss of information if only aggregated information is provided Tan & Lee Chapter 2

9 Introduction Parent Parent-Subsidiary Relationship Group Control
Consolidation: Process of preparing and presenting financial statements of parent and subsidiary as if they were one economic entity Tan & Lee Chapter 2 © 2009

10 Content Introduction Economic Incentive for the Preparation of Consolidated Information Economic Motives for Entering into Intercorporate Arrangement The Concept of Control The Concept of Significant Influence Accounting for Business Combinations Consolidation Theories 2. Economic Incentive for the Preparation of Consolidated Information Tan & Lee Chapter 2 © 2009

11 Information Perspective
Managers with a comparative advantage on information are compensated for their ability to provide information on the future cash flows of these firms (Holthausen and Leftwish, 1983) No Investors can duplicate “homemade” consolidated financial statements (Mian and Smith,1990) Are consolidated financial statements are more informative than separate financial statements? Yes The greater the interdependencies among group companies, the more informative combined earnings about future cash flows of the combined entity (Holthausen, 1990) Tan & Lee Chapter 2 © 2009

12 Efficient Contracting
Whittred (1987) suggests that consolidated information improves wealth for firms 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” Tan & Lee Chapter 2 © 2009

13 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 Managers are more likely to over-invest in companies that are specific and complementary to their skills Information asymmetry may arise by masking financial problems of individual companies within the group Tan & Lee Chapter 2 © 2009

14 Content Introduction Economic Incentive for the Preparation of Consolidated Information Economic Motives for Entering into Intercorporate Arrangement The Concept of Control The Concept of Significant Influence Accounting for Business Combinations Consolidation Theories 3. Economic Motives for Entering into Intercorporate Arrangement Tan & Lee Chapter 2 © 2009

15 Economic Incentives for Entering into Intercorporate Arrangement
Markets will not reward firm’s diversification if investors can replicate the firm’s strategies Corporate Diversification Individuals not able to diversify as efficiently because of indivisibility of assets and high transaction costs Firms involved in M&A have stakeholders who are not able to diversify their risks as well as shareholders Why Corporate Diversification? Tan & Lee Chapter 2 © 2009

16 Economic Incentives for Entering into Intercorporate Arrangement
Acquirer gains “control” over the operating and financial policies of the acquiree Two or more acquirers gain “joint-control” over the acquiree Reciprocal investments are held by each of the two firms, as both are deemed to be equally dominant Acquirer has “significant influence” over the operating and financial policies of the acquiree Arrangements in M&A Tan & Lee Chapter 2 © 2009

17 Economic Incentives for Entering into Intercorporate Arrangement
Uncertainty Risk mitigated by M&A strategies Risk management strategies Organic growth or acquisition Risk diversification Information Control Joint-control Significant Influence Value Risk Size effects Co-insurance effect Diversification Tan & Lee Chapter 2 © 2009

18 Continuum of intercorporate ownership
Investing Strategies, Ownership Levels and the Impact on Financial Reporting Continuum of intercorporate ownership Zero Ownership 20% Ownership 50% 100% Active Investment Passive Investment Trading securities Available- for-sale securities Associated company Joint-venture Partially-owned subsidiary Fully-owned subsidiary Earn dividend income Make capital gain Exert significant influence or control over investee’s operation Gain entry intro a new market Achieve synergistic benefits from complementary strengths Gain market dominance Tan & Lee Chapter 2 © 2009

19 Content Introduction Economic Incentive for the Preparation of Consolidated Information Economic Motives for Entering into Intercorporate Arrangement The Concept of Control The Concept of Significant Influence Accounting for Business Combinations Consolidation Theories 4. The Concept of Control Tan & Lee Chapter 2 © 2009

20 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 Tan & Lee Chapter 2 © 2009

21 Determination of control
The Concept of Control Determination of control 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 Ownership of less than 50% of voting power but there is : Power over more than one-half of the voting rights arising from an agreement with other investors; or Power to govern the financial and operating policies of an entity arising from a statute or an agreement; or Power to appoint or remove the majority of the members of the board of directors or equivalent governing body; or 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 Tan & Lee Chapter 2 © 2009

22 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 Affiliation structures X Co. Y Co. B Co. Z Co. A Co. 100% 50% 60% Situation 1 Situation 1: X Co. controls Y Co. and A Co. Break in control for Z Co. even though X.Co. indirectly owns 75% X Co. Y Co. B Co. Z Co. A Co. 60% 55% 50% 40% Situation 2 Situation 2: X Co. controls Y Co., B Co. and Z Co. Does not own A Co. (<51%) Tan & Lee Chapter 2 © 2009

23 Legal Ownership versus Effective Control
IAS 27 is principles-based, and all evidence must be considered for the existence of control IAS 27 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 Tan & Lee Chapter 2 © 2009

24 Potential Voting Rights in the Determination of Control
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, but not the intention of management and the financial ability to exercise or convert It is important that the potential voting rights must be currently exercisable or convertible to be included in the test of control Tan & Lee Chapter 2 © 2009

25 Potential Voting Rights in the Determination of Control
Illustration of potential voting rights 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 $20,000,000 62.50% Other investors 10,000,000 1,000,000 2,000,000 12,000,000 37.50% Total 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 Tan & Lee Chapter 2 © 2009

26 Potential Voting Rights in the Determination of Control
Sources of 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 Not relevant Management intention Financial ability Tan & Lee Chapter 2 © 2009

27 Impact of Potential Voting Rights on the Allocation of Profits
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) Tan & Lee Chapter 2 © 2009

28 Content Introduction Economic Incentive for the Preparation of Consolidated Information Economic Motives for Entering into Intercorporate Arrangement The Concept of Control The Concept of Significant Influence Accounting for Business Combinations Consolidation Theories 5. The Concept of Significant Influence Tan & Lee Chapter 2 © 2009

29 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 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 Tan & Lee Chapter 2 © 2009

30 What is 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 Number of directors representing investors on board Operational interdependencies Participation in policy-making processes Investor must disclose reasons for not complying with default assumption Tan & Lee Chapter 2 © 2009

31 Direct and Indirect Significant Influence
Multi-level structures Situation 1: P has significant influence over: Y (50% direct interest) Z (65% indirect interest) – P has no control over Y Situation 2: P has significant influence over: A (40% direct interest) C (50% direct interest) B (42% indirect interest) P 80% 50% X Z Y Situation 1 P 40% 80% A B C 50% 20% Situation 2 Tan & Lee Chapter 2 © 2009

32 Content Introduction Economic Incentive for the Preparation of Consolidated Information Economic Motives for Entering into Intercorporate Arrangement The Concept of Control The Concept of Significant Influence Accounting for Business Combinations Consolidation Theories 6. Accounting for Business Combinations Tan & Lee Chapter 2 © 2009

33 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 Tan & Lee Chapter 2 © 2009

34 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 the net assets of Assuming the liabilities of Purchasing some of the net assets of another entity that together form one or more business Business combinations result from Tan & Lee Chapter 2 © 2009

35 Purchase of Net Assets versus Purchase of Equity
Subsidiary Parent Acquires controlling interest Acquiree Acquirer Buys over net assets No Parent – Subsidiary relationship One legal and economic entity Parent – Subsidiary relationship Separate legal entities - separate FS Single reporting entity - Consolidated FS Tan & Lee Chapter 2 © 2009

36 Content Introduction Economic Incentive for the Preparation of Consolidated Information Economic Motives for Entering into Intercorporate Arrangement The Concept of Control The Concept of Significant Influence Accounting for Business Combinations Consolidation Theories 7. Consolidation Theories Tan & Lee Chapter 2 © 2009

37 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 Tan & Lee Chapter 2 © 2009

38 Consolidation Theories
Parent company sells part of its stake in a subsidiary to external shareholders Reasons why non-controlling interest arise Parent company buys a majority stake in a subsidiary from existing owners Parent and non-controlling shareholders are founding shareholders of newly incorporated entity Tan & Lee Chapter 2 © 2009

39 Consolidation Theories
Ownership of the combined entity involving a wholly owned subsidiary Joint-ownership of the combined entity involving a partially owned subsidiary 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 shareholders The parent company’s shareholders; and The non-controlling shareholders of the subsidiary Tan & Lee Chapter 2 © 2009

40 Comparison of issues Issues Entity Theory Parent Theory
Who are the primary users of the consolidated financial statements? Both non-controlling interest and majority shareholders Benefit of parent company shareholders Shown as equity based on: Shown as equity based on: How should non-controlling interests be reported in the consolidated balance sheet? Consolidated equity Consolidated equity - = NCI Consolidated assets = - Consolidated assets Consolidated liabilities - Consolidated liabilities Tan & Lee Chapter 2 © 2009

41 Comparison of issues Issues Entity Theory Parent Theory
Net assets of the subsidiary acquired be shown at full fair values or at the parent’s share of the fair value? Net asset at date of acquisition reported in full NCI net asset at date of acquisition shown at book value Do non-controlling shareholders have a share of goodwill? Asset of economic unit, and reflected in full Asset of parent and restricted to parent’s share Reported in full as both majority and non-controlling shareholders How should net profit of partially owned subsidiary be reported? NCI’s share of current profit is a deduction of final profit Tan & Lee Chapter 2 © 2009

42 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 equity Neither as equity or debt Goodwill Goodwill is an entity asset and should be recognized in full as at date of acquisition Goodwill is parent’s asset Tan & Lee Chapter 2 © 2009

43 Proprietary Theory Relevant to accounting for joint venture
Parent seen as having a direct interest in a subsidiary’s assets and liabilities resulting in proportional consolidation. Tan & Lee Chapter 2 © 2009

44 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 IFRS 3 (2008) permits the recognition of non-controlling interests’ share of goodwill Movement towards the full entity theory Tan & Lee Chapter 2 © 2009

45 Illustration 1: Parent versus Entity Theory
Scenario Consideration transferred: $1,200,000 NCI: 20% BV of equity 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 at 31/12/20x1: $1,270,000 Tan & Lee Chapter 2 © 2009

46 Illustration 1: Parent versus Entity Theory
Goodwill Parent Theory Goodwill = Investment in S – P’s ownership % X (Fair value of S’s identifiable net assets at date of acquisition) = $1,200 – (80% x $1,300) = $160 Entity Theory Parent’s share of goodwill = $160 = Fair value of NCI – Share of FV of identifiable net assets = $300 – (20% x $1,300) Non-controlling interests’ share of goodwill = $300 – $260 = $40 Tan & Lee Chapter 2 © 2009

47 Illustration 1: Parent versus Entity Theory
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 Parent Theory Non-controlling interests = Non-controlling interest % x BV of S’s equity = 20% x $1,270 = $254 Entity Theory 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 Tan & Lee Chapter 2 © 2009


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