ACCA Paper F 7 Financial Reoirting F7FR Session20 d08

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OVERVIEW

Objective

¾

To explain the need for group accounts.

¾

To provide a theoretical background to acquisition consolidation.

¾

To explain and illustrate the technique.

CONCEPTUAL BACKGROUND

OVERVIEW OF THE TECHNIQUE

CONSOLIDATION

THE ISSUE ¾¾ Background Rule

¾ Basic principles ¾ Goodwill

¾ Post acquisition growth in reserves ¾ Non-controlling interest

¾ Consolidation ¾ Goodwill

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1.1

Background

¾

Many companies carry on part of their business through the ownership of other companies which they control – known as subsidiaries.

¾

Controlling interests in such companies would generally appear at cost in the statement of financial position of the investing company. Such interests may result in the control of assets of a very different value to the cost of investment. In other words the accounts will not provide the shareholders of the parent company with a true and fair view of what their investment actually represents.

Commentary

The substance of the relationship is not reflected in the accounts.

Illustration 1

Parent Subsidiary

$ $

Investment in 80% of Subsidiary 100

Net assets 900 1,800

_____ _____

1,000 1,800

_____ _____

¾

The investment of $100 in Parent’s accounts is, in substance, the cost of owning assets of 80% of $1,800 in Subsidiary i.e. $1,440.

¾

Parent’s shareholders cannot see this from looking at the accounts. The solution is to prepare group accounts to reflect this substance. The type of group accounts required by the regulatory framework are

called consolidated financial statements.

1.2

Rule

A company which has a subsidiary on the last day of its accounting period must prepare consolidated financial statements in addition to its own individual accounts.

¾

In practice a parent company usually will prepare (and publish): its own statement of financial position with relevant notes; and

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2

CONCEPTUAL BACKGROUND

2.1

Consolidation

¾

Consolidation involves the replacement of cost of investment in the parent’s accounts by what it actually represents i.e.:

Parent’s share of the net assets of the subsidiary as at the end of the reporting period;

AND

any remaining element of the goodwill which the parent paid for at the date of accquistion.

In addition to this, the reserves of the parent must be credited with the parent’s share of the subsidiary’s post acquisition reserves so that the accounts balance.

Commentary

This may not mean a great deal to you at the moment but the rest of this session will build to an understanding of the above.

2.2

Goodwill

¾

Goodwill is the difference between the value of the business taken as a whole and the fair value of its separate net assets.

Commentary

The idea is that when a company buys an interest in another it will pay a price that reflects both the net assets it buys and the goodwill. It can be calculated as:

COST X

less: SHARE OF NET ASSETS (X)

____

GOODWILL X

____

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Illustration 2

Parent’s own accounts

COST

Group accounts

SHARE OF NET ASSETS + GOODWILL At the date of

acquisition 1,000 800 + 200

The accounts will continue to balance after the consolidation. Cost 1,000 has been replaced with

800 + 200.

At the present

date 1,000 1,200 + 200

Now the accounts will not balance; 1,000 has been replaced with 1,200 + 200 = 1,400

The 400 increase in the subsidiary’s net assets is attributable to profitable trading since the acquisition. This must be reflected in the consolidated reserves for the group accounts to balance.

Any impairment of the goodwill over its life would reduce the 200.

3

OVERVIEW OF THE TECHNIQUE

¾

The approach may be broadly represented as follows:

INDIVIDUAL COMPANY ADJUSTMENTS

↓ ↓

Parent Subsidiary Consolidated

statement of

financial position

Net assets X X X

+ + CONSOLIDATION

Issued capital X X ADJUSTMENTS = X

Reserves X X X

X X X

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3.1

Individual company adjustments

¾

In exam questions the statements of financial position initially provided will be incorrect/deficient in some way. They must be corrected before the consolidation can proceed.

3.2

Consolidation adjustments

Major

adjustments adjustments “Cosmetic”

Two types

Those that “drive” the double entry:

*Goodwill

*Non-controlling interests *Consolidated reserves

*Inter company balances * Unrealised profit * Inventory

* Non-current asset transfers * Non-controlling interest

4

CONSOLIDATION

4.1

Basic principles

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Example 1

As at 31 December 2007

Non-current assets:

Tangibles 2,000 500

Cost of investment in Subsidiary 1,000

Net current assets 2,000 500

______ ______ 5,000 1,000 ______ ______

Issued capital 500 1,000

Retained earnings _{______}4,500

______ 5,000 1,000 ______ ______ Further information:

1. Parent bought 100% of Subsidiary on 31 December 2007. Features to note:

1. The issued capital of the group is the issued capital of Parent . This is always the case.

2. The cost of investment is to disappear. It is “replaced”.

3. The assets and liabilities of the group are simply a cross cast of those of Parent and Subsidiary. Parent’s share of Subsidiary’s net assets is 100% on a line by line basis.

Solution

Consolidated

statement of financial position $

Non-current assets: Tangibles

Net current assets _{_____}

_____

Issued capital Retained earnings

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WORKINGS

(1) Subsidiary net assets

Reporting date Acquisition

$ $

______ _{______}

______ ______

(2) Goodwill

$ Cost

Share of net assets

______ ______

(3) Retained earnings

$ Parent (as given)

Share of Subsidiary

______ ______

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This is the simplest of examples. Parent owns 100% of Subsidiary.

Consolidation is at the date of acquisition.

Cost = Share of net assets i.e. there is no goodwill

¾

The session will now proceed to relax these simplifications to build towards a realistic example.

4.2

Goodwill

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An asset that represents the future economic benefits that arise from other assets acquired in a business combination that are not individually identified and separately recognised

¾

Once recognised, goodwill must be tested annually for impairment and any fall in value will be recognised as an expense in the consolidated profit or loss.

Commentary

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Example 2

At 31 December 2007

$ $ Non-current assets

Tangibles 1,000 800

Net current assets _{______}400 _{______}200

2,600 1,000 ______ _{______}

Issued capital 100 900

Retained earnings 2,500 100

______ _{______} 2,600 1,000 ______ ______ Further information:

1. Parent bought 100% of Subsidiary on the 31 December 2007. 2. Subsidiary’s reserves are $100 at the date of acquisition. Features to note:

1. to 3. As before.

4. Part of the cost is goodwill. This must be separately identified as a debit (in this case) to help replace the cost of investment.

5. Parent’s share of the post acquisition profits of Subsidiary is included in the consolidated retained earnings. In this case it is zero.

Solution

Consolidated

Non-current assets: Goodwill (W2)

Tangibles

Net current assets

_____ _____

Issued capital

Retained earnings (W3) _{_____}

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WORKINGS

$ $

______ _{______}

______ ______

$ Cost

Share of net assets (W1)

______ ______

$ Parent (as given)

Share of Subsidiary (W1)

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Example 3

At 31 December 2007

Tangible assets 1,400 1,000

Net current assets 700 600

______ ______ 3,300 1,600 ______ ______

______ ______ 3,300 1,600 ______ ______ Further information:

1. Parent bought 100% of Subsidiary two years ago.

2. Subsidiary’s reserves were $100 at the date of acquisition.

3. Goodwill has been impaired by $80 since the date of acquisition. Features:

1. to 3. As before.

4 As before, part of the cost is goodwill. This must be separately identified as an asset to help replace the cost of investment.

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Solution

Consolidated

Tangibles

Net current assets _{_____}

_____

Issued capital

Retained earnings (W3)

_ _ WORKING

$ $

______ ______

$ Cost

Share of net assets

______

______ Impaired

As an asset (3) Retained earnings

$ Parent (as given)

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Example 4

Tangible assets 1,000 600

Cost of investment in Subsidiary 1,200 –

Net current assets 500 600

______ _{______} 2,700 1,200 ______ _{______}

Retained earnings _{______}2,600 1,150

______ 2,700 1,200 ______ ______ Further information:

1. Parent bought 80% of Subsidiary two years ago.

2. Subsidiary’s reserves were $150 at the date of acquisition. 3. Goodwill has been impaired by $208 since date of acquisition. Features:

1. and 2. As before.

3. As before, the assets and liabilities of the group are simply a cross cast of those of Parent and Subsidiary. Parent’s share of Subsidiary’s net assets is 100% on a line by line basis.

That part that does not belong to the parent is called “non-controlling interest”. It is shown as a credit balance, within equity, in the statement of financial position.

4. As before, only this time goodwill is impaired by $208.

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Solution

Consolidated

Tangibles

Net current assets

_____ _____ Issued capital

Retained earnings (W4) Non-controlling interest (W3)

_ _ WORKINGS

$ $

______ ______

$ Cost

Share of net assets

______

______ To retained earnings (impaired)

Goodwill recognised

(3) Non-controlling interests

$

Share of net assets _{______}

(4) Retained earnings $ Parent (as given)

Share of Subsidiary

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¾

It must consolidate 80% of 1,200 i.e. 960.

¾

This is achieved in two stages: 100% of Subsidiary’s net assets are consolidated on a line by line basis (as before) and a credit balance representing that part of Subsidiary’s net assets not owned is put into the accounts.

¾

Thus the balances included in the consolidated financial statements are:

Assets and liabilities 1,200

(600 in non-current assets/600 in net current assets.)

Bottom of statement of financial position

Non-controlling interest

(20% × 1,200) 240

_____

Overall effect 960

_____

¾

There are two other methods which would achieve a replacement more easily:

Equity Accounting

* Cost of $1,200 is replaced by $960 as a single figure.

Proportional Consolidation

* Cost of $1,200 is replaced by 80% of Subsidiary’s assets on a line by line basis.

* Thus the group accounts would include:

Non-current assets( 80% × 600) 480

Net current assets (80% × 600) 480

______

Total 960

______

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The reason the two-stage method is chosen for subsidiaries is that it is felt to provide the maximum informational content to the user.

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It gives information about CONTROL and OWNERSHIP.

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However, the other two methods are used in prescribed circumstances:

Equity accounting is used to account for associates;

Proportional consolidation is used to account for certain types of joint venture.

Commentary

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FOCUS

You should now be able to:

¾

explain the concept of a group and the purpose of preparing consolidated financial statement;

¾

explain the objective of consolidated financial statements;

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Solution 1

Consolidated

Non-current assets:

Tangibles (2,000 + 500) 2,500

←Cost of investment has disappeared Net current assets (2,000 + 500) 2,500

_____ 5,000 _____

Issued capital 500 ← Issued capital of Parent

Retained earnings 4,500

_ 5,000 _ WORKINGS

$ $

Issued capital 1,000 1,000

Retained earnings _{______}– –

______

1,000 1,000

______ ______

$

Cost 1,000

Share of net assets (1,000)

______ – ______

$

Parent (as given) 4,500

Share of Subsidiary –

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Solution 2

Consolidated

Non-current assets:

Goodwill (W2) 200

Tangibles 1,800

Net current assets 600

_____ 2,600 _____

Issued capital 100

Retained earnings (W3) 2,500 _____ 2,600 _____

WORKINGS

$ $

Retained earnings 100 100

______ _{______}

1,000 1,000

______ ______

$

Cost 1,200

Share of net assets (W1) (1,000)

______ 200 ______

$

100% × (100 – 100) –

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Consolidated

Non-current assets:

Goodwill (W2) 120

Tangibles 2,400

Net current assets 1,300

_____ 3,820 _____

Issued capital 100

Retained earnings (W3) 3,720 _____ 3,820 _____ WORKING

(1) Subsidiary net assets

$ $

Retained earnings 700 100

______ _{______}

1,600 1,000

______ ______

$

Cost 1,200

Share of net assets (100% × 1,000) (1,000) ______ 200 ______

Impaired 80

As an asset 120

$

100% (700 – 100) 600

Goodwill written off (W2) (80)

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Solution 4

Consolidated

Non-current assets:

Goodwill (W2) 832

Tangibles 1,600

Net current assets _{_____}1,100 3,532 _____

Issued capital 100

Retained earnings (W4) 3,192 Non-controlling interest (W3) 240 _____ 3,532 _____ WORKINGS

(1) Subsidiary net assets

$ $

______ _{______}

1,200 200

______ ______

$

Cost 1,200

Share of net assets (80% × 200) (160)

______ 1,040 ______

To retained earnings (impaired) 208

Asset recognised 832

(3) Non-controlling interests

$ Share of net assets (20% × 1,200 (W1)) 240

______ (4) Retained earnings $

Share of Subsidiary

80% × (1,150 – 150) (W1) 800

Goodwill impairment (208)

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ACCA Paper F 7 Financial Reoirting F7FR Session20 d08

OVERVIEW

CONCEPTUAL BACKGROUND

Background

CONCEPTUAL BACKGROUND

Commentary

COST X

Illustration 2

OVERVIEW OF THE TECHNIQUE

INDIVIDUAL COMPANY ADJUSTMENTS

Individual company adjustments

CONSOLIDATION

Solution

WORKINGS

Goodwill

Solution

WORKINGS

Example 3

Solution

_____ _____ WORKING

Example 4

Solution

_____ _____ WORKINGS

Bottom of statement of financial position

Commentary

_____ 5,000 _____ WORKINGS

Solution 2

WORKINGS

(1) Subsidiary net assets

Solution 4

(1) Subsidiary net assets

_ _ WORKING

_ _ WORKINGS

_ 5,000 _ WORKINGS