28-1 copyright 2007 mcgraw-hill australia pty ltd ppts t/a australian financial accounting 5e by...

28-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig DeeganSlides prepared by Craig Deegan

Chapter 28

Accounting for group structures: An

introduction to consolidation accounting


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

• 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


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


Introduction

• Common for groups of companies to combine in pursuit of common goals

• Where a reporting entity controls another entity, AASB 127 ‘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 Australian consolidated accounting

requirements– the importance of control in 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


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 intragroup 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 with external parties

• 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


History of Australian Accounting Standards that govern the preparation of consolidated financial statements

• AAS 24, issued June 1990 (following ED 40)• AASB 1024, effective from 31 December 1991• 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


History of Australian Accounting Standards that govern the preparation of consolidated financial statements (cont.)

• Before amendments to the Corporations Law in 1991, 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 Figure 28.2 on page 938)—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



• Amendments to the Corporations Law deleted previous definitions of ‘group’ and ‘group accounts’

• Corporations Act 2001 now adopts requirements embodied within AASB 127 (replacing AASB 1024)– Section 295(2)(d) states that, if required by the accounting

standards, a consolidated profit and loss statement, balance sheet and statement of cash flows are to be provided

– Section 297 requires that the financial statements and notes for a financial year must give a true and fair view of the

(a) financial position and performance of the company, registered scheme or disclosing entity; and

(b) if consolidated financial statements are required, the financial position and performance of the consolidated entity



Consolidated entity defined in Corporations Act

• A company-registered management investment scheme or disclosing entity, together with all the entities it is required by accounting standards to include in consolidated financial statements

Result

• Electing to present consolidated accounts in different formats no longer an option

• AASB 127 provides (as AASB 1024) that group accounts must be presented as one set of accounts, which eliminates availability of alternatives previously available under The Corporations Law

Consolidated financial report (AASB 127, par. 4)

• The financial report of a group presented as those of a single economic entity



AASB 127 (par. 12)• The consolidated financial report is to include all subsidiaries of the

parent

Note per AASB 127• Even where control is only temporary, the consolidated statements

should incorporate the results of a subsidiary (entity controlled by a parent entity) during the time for which control existed, even if this was only for a small part of the year

If control lost during a period (AASB 127, par. 30)• Income and expenses of a subsidiary are to be included in the

consolidated financial report until the date on which the parent ceases to control the subsidiary


Alternative consolidation concepts

Generally speaking, there are three major consolidation concepts1. The entity concept (adopted by AASB 1024 and

also AASB 127) 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 AASB 127 (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


Alternative consolidation concepts (cont.)

Example of minority interest:

– company A owned 80 per cent of Company B—remaining 20 per cent owned by unrelated entity, from perspective of Company A, minority interest is 20 per cent

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


Alternative consolidation concepts (cont.)

3. The parent entity concept– all assets and liabilities of the parent and subsidiaries are

included Minority interest typically treated as a liability

• AASB 127 requires adoption of the entity concept


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 (AASB 127, 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


Concept of control (cont.)Factors that might indicate the existence of control (AASB 127, 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.


Concept of control (cont.)Factors that might indicate the existence of control (AASB 127, par. 13) (cont.)

Control also exists when the parent owns half or less of the voting

power of an entity when there is

(a) power over more than half of the voting rights by virtue of an

agreement with other investors;

(b) power to govern the financial and operating policies of the entity

under a statute or an agreement;

(c) 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

(d) 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.


Concept of control (cont.)

Subsequent loss of control (AASB 127, par. 21)• A parent looses control when it losoes 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.



Existence of potential voting rights• These are instruments which have the potential, if

exercised or converted, to give the entity voting power– would include share options, convertible notes

• In considering ‘capacity to control’ we must consider potential voting rights

• Paragraph 14 of AASB 127 statesThe existence and effect of potential voting rights that are currently exercisable or convertible, including potential voting rights held by another entity, are considered when assessing whether an entity has the power to govern the financial and operating policies of another entity.



Control is defined as

the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities

• Hence, must govern another entity in a way that provides benefits to the parent entity

• Parties such as receivers and managers would not be required to consolidate the entities over which they have control in their capacity as receiver or manager as they are governing for the benefit of others


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


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


Direct and indirect control

• Consider the following diagram and consider:– does Entity A control Entity C?– which control would be considered to be direct and which

control would be considered to be indirect?– what does minority interest represent?– we need to remember that the ‘economic entity’ is comprised

of the parent entity and all of its subsidiaries, regardless of whether the subsidiary is directly controlled by the parent entity, or indirectly controlled by virtue of an indirect equity interest


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


Accounting for the consolidation of separate legal entities (cont.)

Goodwill defined (AASB 3 ‘Business Combinations’)• Future economic benefits arising from assets that are not capable of

being individually identified and separately recognised

AASB 3 (par. 51) requires the following

The acquirer shall, at the acquisition date:

(a) recognise goodwill acquired in a business combination as an asset; and

(b) 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.



Goodwill (cont.)AASB 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



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


Goodwill calculation

Let us assume that Entity A acquired Entity B, and that• Entity A provided the following consideration

– cash $2 million– land (cost: 1 million; fair value: $1.5 million)– there were also associated legal fees of $50,000

• The assets and liabilities of Entity B at the date of acquisition were– property, plant and equipment: carrying value $1.8 million; fair

value $2 million– land: Cost $700,000; fair value $800,000– liabilities: $300,000

• What was the amount of purchased goodwill?


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



Goodwill impairment testingAASB 3, par. 54• After initial recognition, the acquirer is to measure goodwill

acquired in a business combination at cost less any accumulated impairment losses

AASB 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’



Goodwill impairment testing (cont.)

AASB 136 ‘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 AASB 116). 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

• AASB 136 (pars 80–99) offer additional guidance in relation to impairment testing of goodwill



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



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 AASB 127, pars 22–25

Refer to Worked Example 28.1 on pp. 948 and 952-54—A simple consolidation– consolidation worksheet used to facilitate consolidation process



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


Recognition of discount on acquisition

• Possible (though not common) 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 AASB 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(a) 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

(b) recognise immediately in profit and loss any excess remaining after that reassessment.


Recognition of discount on acquisition (cont.)

• Current treatment pursuant to AASB 127 is to treat the discount on acquisition as a gain

Eliminate investment in subsidiary acquired at discount• Journal entry to eliminate

Dr Share capitalDr Retained earnings

Cr Gain on acquisition of subsidiaryCr Investment in Subsidiary Ltd

Refer to Worked Example 28.2 on pp. 955 -57—Acquisition of subsidiary at a discount


Subsidiary’s assets not recorded at fair values

• If subsidiary’s assets not recorded at fair value then adjustments will be required so that a reliable figure for goodwill (or discount) can be calculated

• AASB 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. We would firstly recognise a revaluation of the non-current assets in the consolidation worksheet (Dr Asset; Cr Revaluation reserve), and then we would eliminate the investment in the subsidiary against the pre-acquisition shareholders’ funds of the subsidiary (which would include the amount recognised on revaluation).


Subsidiary’s assets not recorded at fair values (cont.)

Adjustment on consolidation– to revalue assets to fair value

Dr Non-current assetsCr Revaluation reserve

– to eliminate the investment in the subsidiary, as well as the revaluation reserve created in the previous entryDr Share capitalDr Retained earningsDr Revaluation reserveDr Goodwill

Cr Investment in subsidiarySee Worked Examples 28.3 and 28.4 (pp. 957 & 959)


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


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 28.5 on pp. 962–4—Consolidation in a period subsequent to the acquisition of the subsidiary


SummaryConsolidated 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. We MUST clearly understand what ‘control’ means.

• 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


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 AASB 136 ‘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)


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 and NOT in the accounts of the separate legal entities

28-1 copyright 2007 mcgraw-hill australia pty ltd ppts t/a australian financial accounting 5e by...

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