International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Part three Consolidated accounts and the multinational

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Structure of part three Chapter 25: Introduction to consolidated financial statements Chapter 26: IFRSs and preparation of consolidated financial statements Chapter 27: Alternative methods of preparing consolidated financial statements Chapter 28: Accounting for associates, joint ventures, special purpose entities and related party transactions Chapter 29: Foreign currency translation

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Chapter 25 Introduction to consolidated financial statements

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Contents Control in groups Need for group accounts Goodwill in group accounts Preparation of simple consolidated statements of financial position Preparation of more complex consolidated statements of financial position Preparation of consolidated statement of income

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Learning objectives Outline the need for consolidated financial statements Explain a business combination Consider the mechanics of preparing consolidated financial statements Prepare consolidated statements of income for combinations of more than one subsidiary Prepare consolidated statements of financial position for more than one subsidiary

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Different types of business combinations A new company may be formed in order to absorb one or more existing companies. The essential feature here is that the new company would physically take over the assets and liabilities of the companies absorbed and the latter would then cease to exist. A company may be taken over by another company, but in this case the company being taken over would continue to exist (and would still, of course, keep its own assets and liabilities).

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity 25.1 Company A, an engineering firm, owns buildings and plant and machinery with NBV of $ Company B buys these assets on 1 January 200X from A at a cost of $ and leases them back to A on an operating lease. Company C, on the 1 January 200X purchases 55% of the ordinary voting shares of Company A on the open market. Which company, B or C, has control of A?

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Control Control is the power to govern the financial and operating policies of an entity or business so as to obtain benefits from its activities A parent is an entity that has one or more subsidiaries A subsidiary is an entity controlled by another entity

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Group structure examples B subsidiary of AS1 is not a subsidiary of H S, S1 and S2 all subsidiaries of H S1 is not a subsidiary of H

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Minority interest or non- controlling interest Minority interest is that part of the subsidiary that the holding (parent) entity does not own. Or ; is that portion of the profit or loss and the net assets of a subsidiary attributable to equity interests that are not owned, directly or indirectly through subsidiaries, by the parent

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Need for group accounts To provide useful information to shareholders and other users of the holding enterprise’s financial statements about the group as a whole

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Goodwill Goodwill is the difference between the revalued net assets and the investment (price paid at acquisition) of the parent Goodwill can be considered as a premium on acquisition

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Negative goodwill Negative goodwill occurs when the investment (price paid at acquisition) of the parent is higher than the revalued net assets of the company Might occur when companies with e.g. recent history of losses are bought Discount on acquisition

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Preparation of simple consolidated statements of financial position Statement of financial position at date of acquisition Consolidated statement of financial position later than date of acquisition Subsequent adjustments to purchase price Inter-company trading and the elimination of unrealised profits Reconciliation of inter-company balances Consistency of reporting dates and accounting policies within the group

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Example 25.1 the statements of financial position of H and S as at 31 December 200X H in €S in € Tangible non-current assets Investment in S Net current assets Total Share capital Reserves Total

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Example 25.1 (cont’d) H acquired the whole of the share capital of S for cash on 31 December 200X. The fair value of S’s net assets at this date were € Prepare the consolidated statement of financial position of H group as at 31 December 200X. To do this consolidation there are several steps: 1. calculate goodwill 2. revaluate the net assets of the subsidiary S to fair value 3. Consolidate H and S

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA GOODWILL Fair value of purchase price Fair value of 100% net assets acquired Goodwill 8 000

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Revalued Statement of financial position Net assets Share capital Reserves Revaluation reserve 7 000

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Group consolidated statement of financial position Net assets ( ) Goodwill on acquisition Share capital Reserves

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Example 25.2: A bought 75% of S at 31 December 200X at (=equal to the fair value of the net assets A in € at XB in € at X Net assets Investment in B Share capital reserves

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Goodwill calculation Cost of controlNon-controlled interest Fair value of purchase price Purchased 75% of shares % x Plus 75% reserves at acquisition % x goodwill 6 750

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Consolidated statement of financial psoition for A group as at 31 December 200X Net assets goodwill Share capital (only A even though ownership not 100%) Reserves (only A) Non-controlling interest 25% x

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Consolidated statement of financial position later than the date of acquisition All reserves prior to acquisition belonging to the subsidiary are taken to the cost of control or belong to the non-controlling interest. We can only include the parent share of the reserves post acquisition in the consolidation

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity 25.5 The statements of financial position of H and S at the date H acquired 1 million 10p shares of S at a fair value of £ for cash (the transaction has not yet been entered in H’s accounts). The fair value of S’s net assets at the date of acquisition were £ (£ land and buildings, £ plant and equipment, £ net current assets). Prepare the consolidated statement of financial position of H group as at X at acquisition

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Statements of financial position at the date S acquired H H £000sS £000s Land and buildings Plant and equipment Net current assets Share capital £1 shares800 Share capital 10p shares 125 reserves

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity feedback 25.5 Cost of controlNon controlled interest Purchase price FV120 80% shares10020% shares25 80% reserves9.620% reserves % revaluation420% revaluation goodwill6.4

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Consolidated statement of financial position of H group as at 31 December 200X £ 000s Land and buildings ( )758 Plant and equipment ( )132 goodwill6.4 Net current assets ( ) Share capital £1 shares (only H)800 Reserves (only H, S either cost of control or non-controlled interest) Non-controlled interest

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Acquisition accounting later than the date of acquisition (Activity 25.6) H Ltd purchased 80% of the equity share capital of S Ltd for cash at 31 December year 1 at a price of €1.50 per share, when the balance on S Ltd’s reserves stood at € The consolidation is required to be made at 31 December year 2, at which point the individual statements of financial position of the two companies are as follows:

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Acquisition accounting later than the date of acquisition (Activity 25.6) H Ltd €S Ltd € Sundry current assets Investment in S Ltd9 600– Plant and machinery Represented by shares of € Reserves

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity 25.6 feedback Sundry current assets Plant and machinery Goodwill Share capital Reserves Minority interests

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Subsequent adjustments to purchase price Acquisition agreements often provide for adjustment to the cost of an acquisition depending on future events. These can be: –The results of acquiree’s operations exceeding or falling short of an agreed level –The market price of securities issued as part of the purchase consideration being made

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Inter-company trading and the elimination of unrealized profits In order for a group to realize profit, the sale must be made to a customer outside of the group In the underlying individual accounts intra-group profit is included in the profit figure of the individual income statement and result of the individual company

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Fig 25.2 Inter-company trading and elimination of unrealized profits

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity 25.9 AssetsA €000sB €000s Land and plant Stock Debtors20040 Investment in B275– Liabilities Creditors Represented by Shares of € Reserves

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity 25.9 feedback Consolidated statement of financial position as at 30 June 200X Assets€000s Goodwill (note 1) 50 Land and plant1 200 Stock (1000 – 10) 990 Debtors (240 – 2) Liabilities Creditors (46 – 2) Represented by: Shares of € Reserves Minority interest (note 3)

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity 25.9 feedback (cont’d) Note 1 Cost of investment in B 275 Less ordinary shares acquired75 Reserves acquired 75% x Note 2 Reserves A1 045 Reserves post-acquired B 75% (524 – 10 – 200) Note 3 Minority interest 25 25% ordinary shares % reserves = 25% x

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity The financial year-end of two entities A and B within the same group is 31 December. On 29 December A despatched goods to B to the invoice value of € and charges B’s ledger account accordingly. B does not receive either goods or invoice until 4 January. Prepare the consolidation adjustment on B’s books and not any other adjustment that may be required on consolidation.

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity feedback B’s books as at 31 December B ledger books Dr Cr Goods in transit € A Current account € On consolidation the respective inner-company balances in the current accounts, which are now in agreement, will cancel out Remember this stock in transit contains unrealised profit

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Reconciliation of inter- company balances In relation to the group’s position as regards the outside world, these balances are internal balances and will, therefore, not require to be shown in the group statement of financial position. They are, in fact, cancelled on consolidation across the individual statements of financial position of group members. These adjustments only affect the consolidated accounts

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Preparation of more complex consolidated statements of financial position Acquisition by stages Reverse acquisitions Adjustments to identifiable assets or liabilities Disposal of part interest Preparation of consolidated accounts involving more than one subsidiary

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Acquisition by stages With staged acquisitions one needs to determine the date when a subsidiary relationship exists, what the cost was and what the fair value of the assets and liabilities acquired was. The date of acquisition = the date when control was transferred

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity Acquisition by stages H acquired an interest in S as follows: –10% of the voting shares for $ on –30% of the shares for $ on – 40% of the voting shares for $ on – the remaining 20% for $ on –The fair values of the recognized assets and liabilities of S at these dates were $1m, $1.5m, $1.75m and $2m respectively. Accounts are drawn up as at 31 March.

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity feedback $ FV at first stage Acquired 10% Cost Goodwill Stage FV at second stage Acquired 30% Cost Goodwill stage

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity feedback (cont’d) $ FV at third stage Acquired 40% Cost Goodwill stage Total goodwill after third purchase FV at fourth stage Acquired 20% Cost Negative goodwill stage

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity feedback (cont’d) StageFV

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Reverse Acquisition When an enterprise obtains ownership of the shares of another enterprise but as part of the exchange transaction issues enough voting shares as consideration such that control of the combined enterprises passes to the owners of the enterprise whose shares have been acquired, then we have what has become known as a reverse acquisition. Although legally the enterprise issuing the shares may be regarded as the parent or continuing enterprise, the enterprise whose shareholders now control the combined enterprise is the acquirer.

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Reverse acquisition: illustration Enterprise A with a share capital of €100 shares issues a further 50 shares to acquire the complete shareholding of enterprise B consisting of 200 €1 shares, a one A share for four B shares exchange. In this case A now owns all B shares, 200,and A’s shareholders hold 100 A shares. B shareholders hold 50 A shares. Thus A shareholders retain control of A. If, however, A had issued 200 A shares to acquire the 200 B shares then B shareholders would now hold two-thirds of the shareholding of A and in ‘substance’ the acquiree, B, becomes the acquirer.

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Adjustments to identifiable assets or liabilities These can occur because: –the acquirer was unaware of certain assets or liabilities of the acquiree –the assets or liabilities did not satisfy recognition criteria –or further information comes to light which enables more accurate estimation of fair values

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Adjustments to identifiable assets or liabilities (cont’d) How these adjustments are dealt with depends on whether they occur before or after the first complete annual accounting period subsequent to acquisition: –before and the adjustment is reflected in goodwill providing the amount will be recovered from expected future economic benefits, otherwise it would be recognized as an expense –after and the adjustment is reflected in income or expense not goodwill

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Disposal of part of an interest When a group disposes of part of an interest in a subsidiary undertaking a profit or loss on disposal will arise. Gain or loss= the difference between the carrying amount of the net assets of that subsidiary undertaking attributable to the group’s interest before the reduction and the carrying amount attributable to the group’s interest after the reduction together with any proceeds received

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity The value of a subsidiary’s net assets at 31 March 200X is € At this date the parent, which held a 100% share in the subsidiary, disposes of 40% for € On the original acquisition of the subsidiary, goodwill of € arose. This goodwill has not subsequently been impaired and is in addition to the net assets of € Calculate the profit or loss on disposal.

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity feedback € Group share of net assets before disposal including goodwill (100% x ( )) Group share of net assets after disposal including goodwill (60% x( )) Disposal proceeds Profit on disposal 8 000

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Preparation of consolidated accounts involving more than one subsidiary – Activity A plc acquired 5m €1 shares of B Ltd five years ago when the reserves of B stood at € 6m. B Ltd acquired 2.25m € 1 shares in C Ltd four years ago when the accumulated reserves of C were € 0.5m. A plc also acquired 3 m € 1 share of D Ltd two years ago when D’s reserves were € 0.3m. At the date of acquisition the net book value of all assets equated to fair value. There has been no issue of shares in any of these companies throughout the five-year period. The statements of financial position relate to the group companies as at X

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity A €mB €mC €mD €m Fixed assets Investment in B16 Investment in C4.5 Investment in D4 Net current assets Share capital reserves79201(1)

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Activity – consolidated statement of financial position A group € m Goodwill Fixed assets 53.5 Net current assets Share capital 18 Reserves [79 +(20-6)2/3+(1- 0.5)1/2+(-1-0.3)3/4] Minority interest

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Consolidated statement of income The total revenues and expenditures of the parent and the subsidiary are included in the consolidated statement of income Intra-group balances and results need to be eliminated

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Consolidated statement of income: Example 25.4 High €Low € Turnover Cost of sales Gross profit Distribution expenses Administration expenses Investment income: Dividends received Taxation Earnings Retained earnings

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Consolidated statement of income: example 25.4 (cont’d) HighLow Cost of High’s control of Low Bought 75% of Low’s shares Bought 75% of Low’s retained profits Goodwill12 000

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Consolidated statement of income: example 25.4 (cont’d) Inter-company trading Reduce High’s sales by Reduce High’s profits by1 000 Reduce Low’s stock by1 000

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Consolidated statement of income: example 25.4 (cont’d) Consolidated statement of income for the year ended X €€ Turnover ( – ) Cost of sales ( – ) Distribution expenses7 000 Administration expenses Taxation Consolidated earnings on ordinary activities after tax less Minority interest (25% x – Low’s profit after tax)1 500 Consolidated earnings for the financial year Retained earnings

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Questions to be solved by regulators Definition of control Method of accounting to be used for subsidiaries How to account for other business relationships Is merger accounting/pooling of interest a suitable method? Are there any other suitable methods available e.g. fresh start method?

International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN © 2011 Cengage Learning EMEA Questions to be solved by regulators (cont’d) Use of fair value for purchase consideration How to deal with the goodwill within a business combination How and where should minority interests be shown within the financial statements? What other disclosure regulations are required?