CHAPTER 12 Group financial statements

Contents Introduction – Company groups Rationale for group financial statements Current practice Acquisition accounting Associated companies Joint ventures

Group financial statements Group (or consolidated) financial statements are the financial statements of a set of two or more enterprises organised as an economic entity Group is defined according to concept of “control” Control = power (de jure or de facto) to govern the financial and operating policies of an entity so as to obtain benefits from its activities (IFRS)

Company groups Company group characteristics Group expansion Vertical group Horizontal group Conglomerate Group expansion Development of new subsidiaries Acquisition by takeover of other companies Meger between companies

Shares - Rights Membership rights : Equity rights: Influence on management, voting power Equity rights: Right to participate in distribution of profits + equivalent part of liquidation balance In principle: rights are proportional to capital share Exceptions: preferent shares, limitations to voting power, multiple votes per share,...

Types of participating shareholdings Type of relationship Amount of voting rights Qualification of shareholdings 1 Control 50% +1 Subsidiary 2 Significant influence >= 20% Associated company 3 Only financial < 20% Financial investment

Group structure Enterprise A Enterpise B Enterprise C Enterprise D 100% 25% 51% Enterpise B Enterprise C Enterprise D 9% 100% Enterprise E Enterprise F

Rationale for group financial statements Interdependent relationships within a group (patrimonial, contractual, personal ties) Loss of part of their independence of individual entities Common or unified management Economic interest of the group > individual interests of legal entities involved It is economically more relevant to present the financial statement of the economic whole as an aggregate of all assets and liabilities under unified control

From individual to group accounts Co. W Co. X W Group €’000 Tangible assets 500 1000 1500 Investment in subsidiary - Current assets 250 350 600 Totals 1250 1350 2100 Shares Reserves 300 (50) 800 450 750 LT debt 700 Trade creditors 150 200 Debt/Equity ratio 37.5% 155% 133%

Current practice IAS 27 Consolidated and Separate Financial Statements IFRS 3 Business Combinations IAS 28 Investments in Associates IAS 31 Investments in Joint Ventures Seventh EC Company law Directive

Offsetting the investment in a subsidiary Holding S Co. Elimination Group €m Net fixed assets 100 20 - 120 Investment in subsidiary 25 (25) Current assets 30 10 40 Totals 155 160 Share capital 70 Reserves Current liabilities 15 5 Long-term liabilities

Acquisition accounting Purchase method of accounting Fair value adjustments of acquired assets and liabilities Subsequent measurement of goodwill Minority interests Merger accounting Group income statement

Purchase method of accounting Acquisition (or purchase method of) accounting is the method used to account for business combinations Goodwill arises as a consolidation difference if the purchase cost of the investment is not equal to the book value of equity in the subsidiary

Goodwill as consolidation difference Holding S Co. Elimination Group €m Net fixed assets 100 20 - 120 Investment in subsidiary 38 (38) Goodwill 13 Current assets 17 10 27 Totals 155 30 (25) 160 Share capital 70 (20) Reserves 5 (5) 25 Current liabilities 15 Long-term liabilities 40

Fair value adjustments of acquired assets and liabilities The individual assets and liabilities of the acquired company have to be revised to their fair value at acquisition date This exercise may imply (de-)recognition of new (old) assets and liabilities Goodwill will be the difference between the revalued net assets and the investment by the parent The fair value at acquisition date is considered to be the historical cost from the point of view of the parent

Fair value adjustments applied Book value of S Adjustment Fair value balance sheet €m Fixed assets - Intangible - 10 - Tangible 20 Current assets Totals 30 40 Share capital Reserves 5 15 25 35 Current liabilities

Goodwill after fair value adjustments Holding Revised S Elimination Group €m Net fixed assets - Goodwill - Other intangibles - Tangibles - 100 10 20 3 120 Investment in S 38 (38) Current assets 17 27 Totals 155 40 (35) 160 Share capital 70 (20) Reserves 30 15 (15) 35 Current liabilities 5 Long-term liabilities

Subsequent measurement of goodwill IAS before 2004 + European Accounting Directives: Amortise goodwill on a systematic basis over the best estimate of its useful life Rebuttable assumption of a maximum of 20 years IFRS 3 “Business Combinations” (2004): Test goodwill for impairment annually (or more frequently if indications)

Minority interests Minority interests (or non-controlling interests) appear if the group does not own 100% of the shares in a subsidiary They represent the part of the net assets and profit or loss of the subsidiary attributable to the equity interests that are not owned

Minority interests applied L Co. M. Co Elimination Group €’000 Intangibles - 280 Tangibles 1200 300 1500 Investment in M 600 (600) Current assets 550 225 775 Totals 2350 525 (320) 2555 Share capital 800 (300) Reserves 1150 100 (100) Minority interests 80 1950 400 2030 Current liabilities 200 125 325 LT Creditors

Merger accounting Two companies can combine by merging their activities and managements without one of them acquiring the other Two types of merger Fusion Pooling of interests IFRS3 Business Combinations (2004) banned merger accounting methods

Illustration - Merger accounting Company A before merger Issue shares after merger Company B Adjust Group €m Assets Tangibles 1200 900 2100 Investment in B +500 500 - -500 Current assets 420 350 770 Totals 1620 2120 1250 2870 Financing Share capital 300 800 -300 Reserves 730 -730 +530 950 Debt 600 Trade payables 220 520

Illustration - Acquisition accounting Company A before merger Issue shares after merger Company B Adjust Group €m Assets Goodwill - + 470 470 Tangible assets 1200 900 2100 Investment in B +1500 1500 -1500 Current assets 420 350 770 Totals 1620 3120 1250 -1030 3340 Financing Share capital 300 +500 800 -300 Reserves +1000 1420 730 -730 Debt 600 Trade payables 220 520

Group income statement In the group income statement, the effect of intra-group transactions has to be eliminated Only income and expenses recognized with regard to parties outside the group will be retained Follow-up effects of fair value adjustments over time have to be integrated Amortization of goodwill or impairment losses on goodwill may also significantly impact the group income statement

Intra-group transactions Subsidiary A Expenses 1200 Sales to B 1500 Profit 300 Subsidiary B Purchases from A Other expenses 5000 Sales to C 7500 1000 Subsidiary C Purchases from B 500 Sales to retailers 8500 Totals 15700 17500 1800

Fig.12.1 Consolidation procedures Adjust recognition criteria / measurements of financial statements of subsidiaries to uniform principles (IFRS) Aggregation of financial statements of all subsidiaries Fair value adjustments / Remove investment in subsidiaries / Identify goodwill and minority interests Deduct amortization/ impairment losses on goodwill / Follow-up of fair value adjustments Remove intra-group transactions and balances Group financial statements

Associated companies Associated companies are companies in which the investor company has “significant influence” Different types of relationships between investor company and investee company mainly according to voting rights under control Accounting rules differ according to the type of relationship

Types of participating shareholdings (bis) 1 Control 50% +1 Subsidiary Acquisition accounting 2 Significant influence >= 20% Associated company ? 3 Only financial < 20% Financial investment “Fair Value” Or “At Cost (Locom)”

Illustration - Associated company Company C ASSETS Tangible fixed assets 600 Current assets 300 Total 900 FINANCING Share capital 400 Reserves 50 450 Payables 200 Debt 250 Company A buys 20% of Company C

Illustration - Equity method Co A Co C Group Net fixed assets 1050 Investment in C 150 - 150 Goodwill - +60 60 Equity value +90 90 Current assets 420 Totals 1620 Share capital 300 Reserves 720 Payables Debt 600

Illustration - Proportionate consolidation Co A Co C (20%) Eliminations Group Net fixed assets 1050 120 - 1170 Investment in C 150 -150 Goodwill + 60 60 Current assets 420 480 Totals 1620 180 -90 1710 Share capital 300 80 -80 Reserves 10 -10 720 90 Payables 40 340 Debt 600 50 650

IAS 28 Investments in Associates IAS 28 Investments in Associates assumes significant influence if the investor holds at least 20 per cent of the voting rights of the investee IAS 28 requires the equity method to account for associated companies The part of the investor in the profit and loss of the associated company is introduced as a separate caption in the group income statement (“income from associates”)

Joint ventures A joint venture is a contractual arrangement whereby two or more parties undertake an economic activity that is subject to jount control (IAS 31 Investments in Joint Ventures) IFRS recognizes three kinds of arrangement: Jointly controlled operations Jointly controlled assets Jointly controlled entities IFRS recommends use of proportionate consolidation for jointly controlled entities