Accounting for equity interests in other entities Chapter 24 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Learning objectives Understand the reasons for preparing consolidated financial statements Understand the basics involved in preparing consolidated financial statements Be able to use a consolidation worksheet to perform relatively simple consolidations (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Learning objectives (cont.) Understand that control, and not legal form, is the criterion for determining whether or not to consolidate an entity Be able to explain what control means, and be able to explain what factors should be considered in determining the existence of control (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Learning objectives (cont.) Be able to provide the journal entries necessary to account for any goodwill or discount that arises on consolidation Be aware of some of the history behind the development of the accounting standards pertaining to consolidated financial statements Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Introduction Common for groups of companies to combine in pursuit of common goals Where a reporting entity controls another entity, NZ IAS 27 ‘Consolidated and Separate Financial Statements’ requires that consolidated financial statements be prepared Key issues addressed in this topic: Rationale for presenting consolidated financial statements Brief review of history of NZ consolidated accounting requirements The importance of control to the decision to consolidate an entity The basic mechanics of the consolidation process, together with consideration of how to account for any goodwill or discount that might arise on consolidation Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Rationale for consolidating the accounts of different legal entities Purpose of providing consolidated accounts is to show the results and financial position of a group as if it were operating as a single economic entity Following the consolidation process, the consolidated income statement will show the result derived from operations with parties external to the group of entities Effects of all inter-group transactions are eliminated, since from the economic entity’s perspective (controlling or parent entity) income will not be derived as a result of transactions within the group, only from transactions from external parties (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Rationale for consolidating the accounts of different legal entities (cont.) The consolidated balance sheet will show the total assets controlled by the economic entity and the total liabilities owed to parties outside the economic entity Liabilities owing to organisations within the group (economic entity) by other group members will be eliminated in the consolidation process and will not be shown in the consolidated balance sheet Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

History of New Zealand Accounting Standards that govern the preparation of consolidated financial statements (cont.) SSAP-8, issued August 1978 by the New Zealand Society of Accountants SSAP-8 amended in 1987 and 1990 The 1990 amendment combined SSAP-8 and SSAP-2 ‘Accounting for Associated Companies (Equity Accounting)' to form a new standard called ‘Accounting for Business Combinations’ Issued to eliminate practice of using partnerships and trusts to keep debt off consolidated balance sheet Subsidiaries were defined as companies — any entity that was not a company could not be legally consolidated as it could not be included within the ‘group’ Nor could entities controlled by a non-corporate entity be consolidated, even if the controlled entities happened to be companies (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

History of New Zealand Accounting Standards that govern the preparation of consolidated financial statements (cont.) Before amendments to the Corporations Law in 1993, group consolidated accounts could only include entities that were companies Results in a ‘partition effect’ caused by, for example, interposing a unit trust within a group structure (refer to Fig 24.2, p. 965), everything from the trust down was partitioned off and excluded from the consolidation process Often had the effect of providing a consolidated balance sheet with lower debt ratios than would otherwise have been the case — not a ‘true and fair’ view of the financial position of the group (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

History of New Zealand Accounting Standards that govern the preparation of consolidated financial statements (cont.) Amendments to the Corporations Law deleted previous definitions of ‘group’ and ‘group accounts’ Financial Reporting Act 1993 requires the preparations of group financial statements consisting of: Consolidated balance sheet Consolidated income statement Consolidated statement of cash flows together with any notes or documents giving information relating to the balance date The financial statements must comply with GAAP. (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Alternative consolidation concepts Generally speaking, there are three major consolidation concepts: 1. The entity concept (NZ IAS 27) All assets and liabilities of the parent entity and subsidiaries included Minority interests are treated as part of consolidated equity Minority interests (previously outside equity interests) defined by NZ IAS 27 (par. 4) as the portion of the profit or loss and net assets of a subsidiary attributable to equity interests that are not owned, directly or indirectly through subsidiaries, by the parent (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Alternative consolidation concepts (cont.) Example of minority interest: Company A owned 80 per cent of Company B — remaining 20% owned by unrelated entity, from perspective of Company A, minority interest is 20% 2. The proprietary concept All assets and liabilities of the parent entity and only a proportionate share of the subsidiaries’ assets and liabilities included Minority interest is not included (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Alternative consolidation concepts (cont.) 3. The parent entity concept (adopted by SSAP-8) All assets and liabilities of the parent and subsidiaries are included Minority interest typically treated as a liability NZ IAS 27 requires adoption of the entity concept Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Concept of control Requirement to consolidate based upon existence of control: The power to govern the financial and operating policies of an entity so as to obtain benefits from its activities (NZ IAS 27, par. 4) Note: The capacity to control both the financial and operating policies must exist prior to establishing the existence of control Substance-over-form considerations are required to be used in determining the existence of control, a process that calls for the exercise of professional judgment (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Concept of control (cont.) Factors that might indicate the existence of control (NZ IAS 27, par. 13) Control is assumed to exist when the parent entity owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity unless, in exceptional circumstances, it can be clearly demonstrated that such ownership does not constitute control (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Concept of control (cont.) Factors that might indicate the existence of control (NZ IAS 27, par. 13) (cont.): Control also exists when the parent owns half or less of the voting power of an entity when there is: power over more than half of the voting rights by virtue of an agreement with other investors; power to govern the financial and operating policies of the entity under a statute or an agreement; power to appoint or remove the majority of the members of the board of directors or equivalent governing body and control of the entity is by that board or body; or power to cast the majority of votes at meetings of the board of directors or equivalent governing body and control of the entity is by that board or body (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Concept of control (cont.) Subsequent loss of control (NZ IAS 27, par. 21): A parent loses control when it loses the power to govern the financial and operating policies of an investee so as to obtain benefit from its activities. The loss of control can occur with or without a change in absolute or relative ownership levels. It could occur, for example, when a subsidiary becomes subject to the control of a government, court, administrator, or regulator. It could also occur as a result of a contractual agreement (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Concept of control (cont.) Summary Subsidiaries are considered to be entities that are under the control of a parent entity —theoretically, control can exist in the absence of any equity-ownership interest Holding of an ownership interest usually entitles the investor to an equivalent percentage interest in the voting rights of the investee, and consequently a majority ownership interest would normally, though not necessarily, be accompanied by the existence of control (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Concept of control (cont.) Summary (cont.): Note: Control can be passive — it might be possible to exert control over another entity, even though the option to exert such control might never have been exercised — the power to govern is sufficient to require consolidation Adoption of criteria of control for defining economic entity will enable a complete economic entity to be reflected in consolidated accounts even though, for example, some of the subsidiaries might be in the form of partnerships or trusts Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Accounting for the consolidation of separate legal entities Need to consider: the determination of goodwill the elimination of the pre-acquisition shareholders’ equity of the controlled entity (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Accounting for the consolidation of separate legal entities (cont.) Goodwill defined (NZ IFRS 3 ‘Business Combinations’): Future economic benefits arising from assets that are not capable of being individually identified and separately recognised NZ IFRS 3 (par. 51) requires the following: The acquirer shall, at the acquisition date: recognise goodwill acquired in a business combination as an asset; and initially measure that goodwill at its cost, being the excess of the cost of the business combination over the acquirer’s interest in the net fair value of the identifiable assets, liabilities and contingent liabilities recognised in accordance with par. 36. (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Accounting for the consolidation of separate legal entities (cont.) Goodwill (cont.) NZ IFRS 3, par. 52, states: Goodwill acquired in a business combination represents a payment made by the acquirer in anticipation of future economic benefits from assets that are not capable of being individually identified and separately recognised (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Accounting for the consolidation of separate legal entities (cont.) Determination of goodwill Only purchased goodwill, not internally generated goodwill, to be recognised for accounting purposes Goodwill is determined as the excess of the cost of acquisition over the fair value of the identifiable net assets acquired Fair value is defined as the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length transaction (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Accounting for the consolidation of separate legal entities (cont.) Determination of goodwill (cont.) internally generated goodwill cannot be brought to account in the separate accounts of a reporting entity or in the consolidated financial reports — purchased goodwill will, however, be brought to account in the consolidation process Prior to 2005, goodwill acquired also had to be amortised systematically over the periods in which the benefits were expected to be provided (maximum of 20 years) Goodwill amortisation now prohibited and goodwill is now required to be subject to impairment testing (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Accounting for the consolidation of separate legal entities (cont.) Goodwill impairment testing NZ IFRS 3, par. 54: After initial recognition, the acquirer is to measure goodwill acquired in a business combination at cost less any accumulated impairment losses NZ IFRS 3, par. 55: Goodwill acquired in a business combination is not to be amortised. Instead, the acquirer is to test it for impairment annually, or more frequently if events or changes in circumstances indicate that it might be impaired, in accordance with AASB 136 ‘Impairment of Assets’ (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Accounting for the consolidation of separate legal entities (cont.) Goodwill impairment testing (cont.) NZ IAS 36 ‘Impairment of Assets’ (par. 60) states: An impairment loss shall be recognised immediately in the profit and loss, unless the asset is carried at revalued amount in accordance with another standard (e.g. in accordance with the revaluation model in NZ IAS 16). Any impairment loss of a revalued asset shall be treated as a revaluation decrease in accordance with that other standard Note: As goodwill cannot be revalued, an impairment loss pertaining to goodwill is to be recognised in the profit and loss NZ IAS 36 (pars 80–99) offer additional guidance in relation to impairment testing of goodwill (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Accounting for the consolidation of separate legal entities (cont.) First step in consolidation process: Substitute the assets and liabilities of the subsidiary for the investment account, which currently exists in the parent company Where the net assets do not equal the value of the investment, this will lead to a difference on consolidation, i.e. the goodwill acquired (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Accounting for the consolidation of separate legal entities (cont.) Elimination of pre-acquisition shareholders’ equity: The investment account in the subsidiary will be eliminated in full against the pre-acquisition shareholders’ funds of the subsidiary This will avoid the double counting of assets, liabilities and shareholders’ funds of the subsidiary Procedural details contained in NZ IAS 27, pars 22–25 Refer to Worked Example 24.1, 'Calculation of goodwill on acquisition', pp. 975–6 Refer to Worked Example 24.2, 'A simple consolidation', pp. 997–80 Consolidation worksheet used to facilitate consolidation process (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Accounting for the consolidation of separate legal entities (cont.) Journal entry to eliminate investment in subsidiary Recorded in a consolidation journal and posted to a consolidation worksheet Journal entry: Dr Share capital Dr Retained earnings Dr Goodwill Cr Investment in Subsidiary Ltd Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Recognition of excess on acquisition Possible for a company to gain control of an entity for an amount less than the fair value of the proportional share of the net assets acquired (acquired at a discount) Where an entity is acquired at a discount NZ IFRS 3 (par. 56) requires the following: If the acquirer’s interest in the net fair value of the identifiable assets, liabilities and contingent liabilities recognised exceeds the cost of the business combination, the acquirer shall: reassess the identification and measurement of the acquiree’s identifiable assets, liabilities and contingent liabilities and the measurement of the cost of the combination; and recognise immediately in profit and loss any excess remaining after that reassessment. (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Recognition of discount on acquisition (cont.) Current treatment pursuant to NZ IAS 27 is to treat the discount on acquisition as a gain Eliminate investment in subsidiary acquired at discount Journal entry to eliminate Dr Share capital Dr Retained earnings Cr Gain on acquisition of subsidiary Cr Investment in Subsidiary Ltd Refer to Worked Example 24.3, 'Acquisition of subsidiary at an excess', pp. 981–2 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Subsidiary’s assets not recorded at fair values If subsidiary’s assets not recorded at fair value adjustments will be required so that a reliable figure for goodwill (or discount) can be calculated NZ IFRS 3 stipulates either: revalue the identifiable assets in the accounting records of the subsidiary before consolidation — all the non-current assets of the subsidiary are revalued to their fair values in the accounting records of the subsidiary; or recognise the necessary adjustments on consolidation — an adjustment would be processed to eliminate the investment and the corresponding equity in the subsidiary and to recognise any increments or decrements to the revaluation reserve to restate the carrying amounts of the identifiable net assets acquired to their fair values as at the date of acquisition (to the extent that accounting standards allow particular classes of assets to be revalued) (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Subsidiary’s assets not recorded at fair values (cont.) Adjustment on consolidation: To revalue assets to fair value: Dr Non-current assets Cr Revaluation reserve To eliminate the investment in the subsidiary, as well as the revaluation reserve created in the previous entry: Dr Share capital Dr Retained earnings Dr Revaluation reserve Dr Goodwill Cr Investment in subsidiary (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Subsidiary’s assets not recorded at fair values (cont.) Refer to Worked Example 24.4, 'Subsidiaries’ assets not recorded at fair value', pp. 983–4 Refer to Worked Example 24.5, 'Revaluation to fair value involving an excess', pp. 985–7 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Consolidation after the date of acquisition Pre-acquisition shareholders’ funds of the subsidiary are eliminated on consolidation Typically provides for goodwill on consolidation In period following acquisition, subsidiary will generate profits or losses — to the extent that these results have been generated in the period after acquisition, they should be reflected in the results of the economic entity (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Consolidation after the date of acquisition (cont.) Result Post-acquisition earnings (unlike pre-acquisition earnings) are considered to be part of the earnings of the economic entity Refer to Worked Example 24.6, 'Consolidation in a period subsequent to the acquisition of the subsidiary', pp. 987–9 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Summary Consolidated financial statements: present aggregated information about the financial performance and financial positions of various separate legal entities provide a single set of financial statements that represent the financial position and performance of the group as if it were operating as a single economic entity Control is the determining factor in deciding which organisations should be included in the consolidation process All controlled entities now to be included in the consolidation process regardless of legal form and field of activities Investment in subsidiary must be offset on consolidation against the pre-acquisition capital and reserves of the subsidiary (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Summary (cont.) An adjustment may be required to reflect the fair value of the subsidiary’s assets as at the date of acquisition, and any difference will be either goodwill or discount on acquisition If balance represents goodwill, goodwill must be periodically reviewed for any impairment losses in accordance with NZ IAS 36 ‘Impairment of Assets’ If a discount arises on consolidation, the discount is to be treated as a gain in the consolidated financial reports Following consolidation, the consolidated retained earnings balance represents the parent entity’s retained earnings plus the economic entity’s share of the post-acquisition earnings of the controlled entities (subsidiaries) (Continues) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider

Summary (cont.) The balance in the various consolidated reserve accounts will represent the balance of the parent entity’s reserve accounts plus the parent entity’s share of the post-acquisition movements of the subsidiaries’ reserve accounts Consolidation entries are to be performed in a separate consolidation worksheet/journal Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin Slides prepared by Grant Samkin and Annika Schneider