An entity may expand by acquiring shares in other entities. Where one entity gains control over another entity, a parent-subsidiary relationship now exists between the two entities.
Each will prepare their own individual financial statements, using the IFRS’s in the normal way. However, in addition, the parent and subsidiary (collectively referred to as the group) are obliged by law to prepare a combined set of accounts, known as the consolidated accounts. These consolidated accounts are prepared and presented as if all the companies in the group are just one single entity. This means that it is necessary to exclude transactions between group companies, as failure to do so could result in the assets and profits being overstated for group purposes.
The accounting rules governing the preparation of consolidated accounts (also known as group accounts) are set out in a number of standards, namely:
- IFRS 3 (Revised) Business Combinations
- IAS 27 Consolidated and Separate Financial Statements
- IAS 28 Investments in Associates
- IAS 31 Interests in Joint Ventures
IFRS 3 has recently been revised and those revisions are now examinable. The main changes that have been introduced are as follows:
- Expenses that can be treated as part of acquisition costs have been restricted.
- The treatment of Contingent Consideration has been significantly altered.
- A new method of measuring Non-Controlling Interests (formerly known as Minority Interest) has been introduced. This new method (though not mandatory), if used, will have an effect on goodwill.
- The recognition and measurement of identifiable assets and liabilities of the acquired subsidiary has been refined. Guidance has now been provided on intangible assets such as market-related, customer-related, artistic-related and technology-related assets
IAS 27 covers some of the principles that must be applied in consolidating the accounts of group companies. It also sets out the circumstances when subsidiary companies must be excluded from consolidation.
In both IAS 27 and IFRS 3, the definitions of a subsidiary and control are the same.
A subsidiary is an entity, including an unincorporated entity such as a partnership that is controlled by another entity, known as the parent.
Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.
A group is a parent and all its subsidiaries.
Non-Controlling Interest is the equity in a subsidiary not attributable to a parent. Previously, this was referred to as the Minority Interest.
The extent to which an entity can control another is central to deciding the appropriate accounting treatment. Control is normally established when one company owns more than 50% of the shares carrying voting rights of another company.
IAS 27 however, outlines four other situations where control exists. Even though the parent might own half or less of the voting power of another company, control also exists 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.
A parent loses control when it loses the power to govern the financial and operating policies of the subsidiary. The loss of control can occur with or without a change in ownership levels; for example, if the subsidiary becomes subject to an administrator or liquidator.
EXEMPTIONS FROM THE REQUIREMENT TO PREPARE CONSOLIDATED
IAS 27 requires that, in general, all parent entities must prepare and present consolidated financial statements that include all of its subsidiaries.
However, there are exemptions from the requirement to prepare group accounts if, and only if, the following situations apply:
- The exemption only applies if the parents shares or debt is not traded in a public market or is about to issue shares in a public market; and
- The ultimate parent (or intermediate parent) of the parent produces consolidated financial statements that comply with IFRS’s.
- The parent did not file nor is it filing its financial statements with a securities commission or other regulator for the purpose of issuing shares.
All subsidiaries of the parent must be included in the consolidated accounts. Previously, it was argued that some subsidiaries should be excluded from the group accounts. But now, the standards are unequivocal. There are no exceptions to the requirement for a subsidiary under the control of the parent to be included in the group accounts.
However, if on acquisition a subsidiary meets the criteria to be classified as held for sale in accordance with IFRS 5, it must be accounted for in accordance with that standard. This requires that it will be shown separately on the face of the consolidated Statement of Financial Position. There should be evidence that the subsidiary has been acquired with the intention of disposing it within 12 months and management is actively seeking a buyer.
A subsidiary that has previously been excluded from consolidation and is not disposed of within the 12 month period must be consolidated from the date of acquisition.
However, if there are severe restrictions on the ability of the parent to manage a subsidiary, so that its ability to transfer funds to the parent is impaired, then such an entity must be excluded from the consolidation process, as control has effectively been lost. In this situation, the investment in the subsidiary will be treated under IAS 39, as a non-current asset investment.
IAS 27 requires that the financial statements of the individual companies in the group be prepared as of the same reporting date. If the reporting date of the parent and subsidiary differ, then the subsidiary should prepare additional financial statements as of the same date as the parent, unless it is impracticable to do so.
If it is considered impracticable, then the financial statements of the subsidiary should be adjusted for significant transactions or events that occur between the date of the subsidiary’s financial statements and the date of the parent financial statements. However, the difference between the reporting dates must not be more than three months.
All companies in the group should have the same accounting policies, without exception. If a member of the group uses different policies from those adopted in the financial statements, appropriate adjustments are made to its financial statements in preparing consolidated financial statements.
CESSATION OF CONTROl
If an entity ceases to be a subsidiary, then the investment in the entity will be accounted for in accordance with IAS 39 Financial Instruments from the date it ceases to be a subsidiary, provided that it does not become an associate company or a jointly controlled entity.
DISCLOSURE – IAS 27
IAS 27 requires the following disclosures:
- The nature of the relationship between the parent and subsidiary when the parent does not own more than half of the voting power.
- The reasons why the ownership of more than half of the voting rights by the investee does not constitute control.
- The reporting date of the subsidiary if different from the parent, and the reason for the difference.
- The nature and extent of any significant restrictions on the ability of the subsidiary to transfer funds to the parent in the form of dividends or to repay loans or advances.
In the previous IFRS 3, directly related costs such a professional fees (legal, accounting, valuation etc.) could be included as part of the cost of the acquisition. This is now no longer the case and such costs must now be expensed.
The costs of issuing debt or equity are to be accounted for under the rules of IAS 39 Financial Instruments: Recognition and Measurement.
The previous version of IFRS 3 required contingent consideration to be accounted for only if it was considered probable that it would become payable. This approach has now been amended.
The revised standard requires the acquirer to recognise the fair value of any contingent consideration at the date of acquisition to be included as part of the consideration for the acquiree. The “fair value” approach is consistent with the way in which other forms of consideration are valued. Fair value is defined as “the amount for which an asset could be exchanged, or liability settled between knowledgeable, willing parties in an arm’s length transaction”.
However, applying this definition to contingent consideration is not easy as the definition is largely hypothetical. It is most unlikely that the acquisition-date liability for contingent consideration could be (or would be) settled by “willing parties in an arm’s length transaction”. It is expected that in an examination context, the fair value of any contingent consideration at the date of acquisition will be given (or how to calculate it).
The payment of contingent consideration may be in the form of equity or a liability such as a debt instrument and should be recorded as such under the rules of IAS 32 Financial Instruments: Presentation (or other applicable standard).
The standard also addresses the problem of changes in the fair value of any contingent consideration after acquisition date. If the change is due to additional information obtained after acquisition date that affects the fact or circumstances as they existed at acquisition date, this is treated as a “measurement period adjustment” and the liability (and goodwill) are re-measured. In essence, this is a retrospective adjustment and is similar in nature to an adjusting event under IAS 10 Events After the Reporting Period.
However, changes due to events after the date of acquisition (for example, achieving a profit target which requires a higher payment than was provided for at acquisition) are treated as follows:
- Contingent consideration classified as equity shall not be re-measured and its subsequent settlement will be accounted for within equity, e.g.
Debit Retained Earnings
Credit Share Capital / Share Premium
- Contingent consideration classified as an asset* or a liability that
- Is a financial instrument and is within the scope of IAS 39 must be measured at fair value, with any resulting gain or loss recognised either in profit or loss, or in other comprehensive income in accordance with that IFRS
- Is not within the scope of IAS 39 shall be accounted for in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets (or other IFRSs as appropriate).
*Contingent consideration is normally a liability but may be an asset if the acquirer has the right to a return of some of the consideration transferred, if certain conditions are met.
An acquirer has a maximum period of 12 months to finalise the acquisition accounting. The adjustment period ends when the acquirer has gathered all the necessary information, subject to the one year maximum. There is no exemption from the 12-month rule for deferred tax assets or changes in the amount of contingent consideration. The revised standard will only allow adjustments against goodwill within this one-year period.
Deferred consideration should be measured at fair value at the date of acquisition. This means that future payment should be shown at its Present Value, by discounting the future amount at the company’s cost of capital. Each year, the discount will be then “unwound”. This will increase the deferred liability every year, with the discount treated as a finance cost in the Statement of Comprehensive Income.
MECHANICS AND TECHNIQUES
For the preparation of a consolidated statement of financial position, the following six steps should be followed:
Establish Group Structure.
Determine the % holding in the subsidiary and when the control was established
Carry out consolidation adjustments.
For example, inter company debts must be eliminated, revaluations of assets at acquisition must be accounted for, inter company profits must be adjusted for.
These adjustments will be dealt with in detail in a later chapter.
If goodwill on acquisition is positive, the following consequences should be observed:
- It is capitalised as an intangible asset in Non-Current Assets
- It should not be amortised
- It should be tested for impairment on an annual basis
If impairment arises, the accounting entries for the treatment of the impairment loss depends on the method used to value NCI.
Proportion of Net Assets Method:
Debit Group Retained Earning
Fair Value Method:
Debit Group Retained Earnings (group %)
Debit NCI (group %)
IFRS 3 refers to negative goodwill as “discount on acquisition”. It arises when the fair value of the consideration given to acquire the subsidiary is less than the fair value of the net assets purchased.
It is an unusual situation to arise, and the standard advises that should negative goodwill be calculated, the calculation should be reviewed, to ensure that the fair value of assets and liabilities are not inadvertently misstated.
Following the review, any negative goodwill remaining is credited to the Statement of Comprehensive Income immediately.
Calculate Non-Controlling Interest
The value at which NCI is shown in the Statement of Financial Position depends on the method used to value it:
Proportion of Net Assets Method
|NCI % of net assets of subsidiary at the reporting date
Fair Value Method
|NCI % of net assets of subsidiary at the reporting date||X|
|NCI share of goodwill||X|
|NCI share of goodwill impairment||(X)|
Calculate Consolidated Reserves
The Retained Earnings to be included in the consolidated statement of financial position are calculated as follows:
|Retained Earnings of parent (subject to adjustments in step 2) PLUS||X|
|Group share of post-acquisition earnings of subsidiary (subject to adjustments in step 2)
|Total Goodwill Impairments to date||(X)|
It is important to make a distinction between pre-acquisition and post-acquisition reserves.
Pre-Acquisition reserves are the reserves existing at the date the subsidiary company is acquired. They are included in the goodwill calculation.
Post-Acquisition reserves are reserves generated after the date of acquisition. They are included in group reserves.
Prepare Consolidated Statement of Financial Position
The assets and liabilities of the subsidiary and parent are combined in the final statement of financial position. The assets and liabilities will include any adjustments arising in Step 2.
In addition, the Goodwill, NCI and Consolidated reserves as calculated in Steps 3, 4 and 5 are included.
Note that the Share Capital and Share Premium to be included will be those of the parent company only.