consolidations

This article is aimed primarily at candidates studying consolidations for Paper F7, Financial Reporting. It will also benefit candidates studying for Paper P2, Corporate Reporting. Most candidates have a sound understanding of basic consolidation techniques. This article looks at some of the more difficult areas, where candidates often experience problems, namely: fair values of consideration and adjustments to an acquired subsidiarys identifiable assets, liabilities and contingent liabilities; elimination of intra-group trading and other transactions; and goodwill impairment. It is based on relevant International Financial Reporting Standards (IFRSs), but much of it is also relevant to other adapted papers, including those based on UK GAAP . FAIR VALUE ADJUSTMENTS In calculating goodwill, and the initial carrying amount of acquired assets and liabilities, IFRS 3, Business Combinations requires that both the consideration paid by the parent company (or parent) and the net assets of the acquired subsidiary are valued at their fair values. Fair value is defined (in several IFRSs) as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable and willing parties in an arms length transaction. Consideration paid may be in the form of assets given (normally cash), liabilities assumed, or shares or other financial instruments issued by the acquirer, plus any direct costs attributable to the business combination. The relevance of this requirement may be examined in the following ways: Determining the number of shares a parent issues in an acquisition (usually on the basis of a specified share exchange), and applying the stock market price of the parents shares at the date of the acquisition. The question may say that the share issue has not yet been recorded in the parents financial statements. Candidates will therefore have to record both an increase in the nominal value of the parents share capital and any premium (determined by the stock market value) on the issue. Occasionally, cash consideration may be deferred (ie not paid at the date of acquisition) to a specified date after the acquisition. Where this period is significant (usually one or more years) the amount of the cash consideration will need to be discounted to a present value, at the rate for cost of capital given in the question. Candidates must determine the present value of such consideration, and then account for the unwinding of the discounted amount, and show the liability in the balance sheet. In the period after the acquisition, the parent should accrue a finance charge (at the rate of the cost of capital) in its income statement (which is consolidated), and add this to the carrying amount of the deferred consideration (a liability) in its balance sheet (which is also consolidated). The most common form of fair value adjustment is that made to the assets of the acquired subsidiary. The amount of the required adjustment is normally given in the question. The simplest of these adjustments would be to a non-depreciating, non-current asset (normally land). The amount of the adjustment should be added to the carrying amount of the asset (as it appears in the subsidiarys books), and the total included in the consolidated balance sheet (think of this as a debit entry). The amount of the adjustment should also be included in the calculation of goodwill (the equivalent of a credit entry, similar to creating a revaluation reserve). Note sometimes in practice a subsidiary will actually revalue its assets to fair values (in its entity financial statements) prior to consolidation, to assist the consolidation process. This is sometimes referred to as push down accounting, whereby the fair values determined by the parent are pushed down into the subsidiarys books. Where a fair value adjustment relates to a depreciating non-current asset, the above technique is also performed, but there is a further complication. In the post-acquisition period, the depreciation of acquired assets must be based on their fair values. In the subsidiarys own (entity) financial statements, depreciation will have been based on the assets carrying amount. Thus the consolidated financial statements will require a fair value depreciation adjustment. The amount of this may be given in the question, or candidates may have to calculate it based on the remaining life (and depreciation policy) at the date of acquisition. The amount of this adjustment (assuming the fair value is greater than the carrying amount) reduces both the subsidiarys post-acquisition profits (which will also affect any minority interests) and the carrying amount of the asset. Inventories may also require fair value adjustments. Raw materials and bought-in components are normally valued at their replacement cost;

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problem areas in group accounts

relevant to ACCA Qualication Papers F7 and P2

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finished goods should be valued at net selling price less a reasonable profit allowance. It is also possible that liabilities will require fair value adjustments. This may be as simple as recognising a liability that the subsidiary had not accounted for (eg an account payable inadvertently not recorded by the subsidiary), or the restatement of a loan to fair value due to a change in interest rates since it was taken out. A further complication is that IFRS 3 requires the recognition of any contingent liabilities of the subsidiary, provided they can be reliably measured. Such liabilities would not be recognised in the subsidiarys financial statements, other than by way of a note. The IASB recognises that this requirement creates an inconsistency with IAS 37, Provisions, Contingent Liabilities and Contingent Assets. EXAMPLE 1 Holdrite purchased 80% of the issued share capital of Staybrite on 1 April 20X5. Details of the purchase consideration given at the date of purchase are: a share exchange of three shares in Holdrite for every five shares in Staybrite the issue to the shareholders of Staybrite 8% loan notes, redeemable at par on 31 March 20X8 on the basis of $100 loan note for every 125 shares held in Staybrite a cash sum of $121 for every 100 shares in Staybrite, payable on 1 April 20X7. Holdrites cost of capital is 10% per annum. The market price of Holdrites shares at 1 April 20X5 was $4.50 per share. In order to help fund the acquisition of new operating capacity for Staybrite, Holdrite also subscribed for a 10% $4m loan note (20X8) issued by Staybrite immediately after the acquisition. A fair value exercise was carried out at the date of acquisition of Staybrite, with the following results: Carrying amount Fair value $000 $000 Land 20,000 23,000 Plant 25,000 30,000 Inventory 5,000 6,000 The fair values have not been reflected in Staybrites financial statements. In addition, a note to Staybrites financial statements gave details of a contingent liability in respect of outstanding litigation. The directors of Holdrite considered that $5m would be a reliable measurement of this contingent liability. The details of each companys share capital and reserves at 1 April 20X5 are: Holdrite Staybrite $000 $000 Equity shares of $1 each 20,000 10,000 Share premium 5,000 4,000 Retained earnings 18,000 8,000 Required Calculate the goodwill arising on the acquisition of Staybrite. 64 student accountant June/July 2006

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Answer Goodwill in Staybrite: $000 Consideration Shares (10,000 x 80% x 3/5 x $4.50) 8% loan notes (10,000 x 80% x $100/125) Deferred cash payment ($9,680/1.21 see below) Less Equity shares Share premium Pre-acquisition reserves Less contingent liability Fair value adjustment (3,000 + 5,000 +1,000) $000 $000 21,600 6,400 8,000 36,000 10,000 4,000 8,000 (5,000) 3,000 9,000 26,000 x 80% (20,800) 15,200 Goodwill The gross cash consideration will be $9,680 (10,000 x 80%/100 x $121). If $1 was invested for two years, carrying an interest rate of 10%, it would be worth $1.21. Note: the 10% loan note issued after acquisition is not part of the consideration. INTRA-GROUP ADJUSTMENTS The objective of consolidated financial statements is to present the results of the parent and all the entities over which it has control (ie a group) as if they were a single entity. It follows from this that an entity cannot trade with itself, nor make a profit from any transaction within the group. Thus any intra-group transactions need to be eliminated (cancelled) as part of the consolidation process. This article will consider the most common examples of such transactions: intra-group sales, the transfer of non-current assets, and the provision of loans. Intra-group sales If one member of a group sells goods to another, these sales are recorded by the seller in revenue, and by the purchaser in cost of sales at the same amount (the transfer price). Provided the purchaser has sold on the goods to an entity that is not a member of the group, it is a simple matter to eliminate the intra-group sale from revenue and cost of sales (at the same amount) when consolidating the income statements. This elimination would have no effect on the balance sheet. Occasionally, candidates eliminate the selling price from revenue and the cost price from cost of sales this is incorrect.

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A problem arises when some of the goods from the intra-group sale are still in the inventory of the purchasing company at the year end. As these goods have not left the group, any profit added by the supplying company has not been realised and must therefore be eliminated. Once the amount of the unrealised profit has been determined, it is deducted from gross profit (by increasing cost of sales) and also deducted from the carrying amount of the consolidated inventory on the balance sheet. This deduction reduces the balance sheet value of the inventory to the cost of the group. Occasionally, a non-current asset is transferred within the group (say from a parent to a subsidiary). The parent may have manufactured the asset as part of its normal production (and therefore included the sale in revenue), or it may have transferred an asset previously used as part of its own non-current assets. If the transfer is done at cost, then the first example would be equivalent to a company constructing its own non-current asset. The required elimination would therefore be to remove the cost of the asset from both revenue and cost of sales. In the second example, no elimination would be required. The situation is also complicated if the transfer contains a profit element. In its entity financial statements, the parent would report this profit in its income statement. This would be either as a normal sale or as a profit on disposal if it represented the transfer of a non-current asset. The consequences in the subsidiarys financial statements are that the carrying amount of the asset would be overstated (in terms of cost to the group), and future depreciation charges would also be overstated (when compared to depreciation based on cost to the group). At the date of sale/transfer, the profit is unrealised, and in financial statements prepared at this date, the profit would be eliminated from the (parents) income statement (and retained earnings) and from the carrying amount of the asset. The adjustment required in subsequent years is more complex. Instinctively, one might eliminate the whole of the profit from the parents retained profits and the carrying amount of the asset (the same adjustment as on the date of the sale/transfer). A further adjustment might then be made to increase the subsidiarys profit by the excess depreciation, recorded in the income statement and retained earnings (this would also affect any minority interests), and also to increase the carrying amount of the asset by this amount. Some commentators and textbooks use this method and it will be marked as correct. However, it should be understood that depreciation is effectively a measure of the realisation of an asset. Thus, in subsequent accounting periods, it is only the unrealised profit left in the carrying amount of the asset that should be eliminated from the parents profit, and from the carrying amount of the asset. Both methods give the same carrying amount for the asset, but the excess depreciation that was added back to the subsidiarys profit in the first method is instead netted off the initial amount of the unrealised profit, before being deducted from the parents profits. As well as being more conceptually correct, the second method is easier to apply. Intra-group loans It is quite common for a parent to provide a loan to a subsidiary on which interest will usually be paid and received. The parent will normally show the loan as an investment, with any interest received included in its income

statement. Conversely, the subsidiary will show the loan as a non-current liability (assuming repayment is due in more than one years time), and will show any interest paid as a financing cost in its income statement. It is a relatively simple matter to eliminate the asset (investment) against the liability (loan) in the consolidated balance sheet, and the interest received against the interest paid in the consolidated income statement. One point to watch out for is that a subsidiary may have issued, for example, $5m of loan notes of which the parent has purchased only $3m. In these circumstances, only the $3m (and the proportionate interest) should be eliminated. Thus, the consolidated financial statements would show a loan of only $2m together with proportionate interest paid (ie the amounts that relate to parties outside the group). EXAMPLE 2 Continuing the group situation in Example 1. In the post-acquisition period, Holdrite sold goods to Staybrite for $72,000. Holdrite achieved a mark-up on these goods of 20% on cost. At the year end, Staybrite still had $42,000 (at the transfer price) of these goods in its inventory. On 1 April 20X5, Holdrite sold an item of plant to Staybrite for $120,000. Holdrite had manufactured this plant at a cost of $100,000 and treated it as a normal sale. Staybrite is depreciating this plant on a straight-line basis over a five-year life with no estimated residual value. On 1 October 20X5, Staybrite issued a $2m 8% (actual and effective rate) loan note, redeemable in 20Y0. Holdrite had subscribed for $800,000 of this issue. All due interest had been paid by 31 March 20X6. Required Using the journal format, show the adjustments required for the above transactions when preparing the consolidated financial statements for the year ended 31 March 20X6. Answer Dr $ Revenue 72,000 Cost of sales Elimination of intra-group sales: Profit (made by Holdrite) 7,000 Inventory Elimination of URP from inventory (of Staybrite): A mark-up of 20% (ie 1/5th on cost) is equivalent to 1/6th on selling price, therefore unrealised profit (URP) is $42,000/6 = $7,000 Revenue 120,000 Cost of sales Depreciation charge Non-current assets plant Cr $

72,000

7,000

100,000 4,000 16,000

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Elimination of the sale and cost of sale (effectively own costs have been capitalised as a non-current asset). Reduction of carrying amount of the plant by the URP over the remaining life of the plant (20,000/5 years x 4 years). Reduction of depreciation to be based on cost to group. Note: in the balance sheet, the effect of the first three entries relating to the plant in the income statement will reduce group retained earnings by $16,000. Dr$ 800,000 32,000 32,000 Cr$ 800,000

8% loan note (non-current liability) Investments Interest received Interest paid

Elimination of intra-group investment/loan and related interest (ie 8% on $800,000 for six months). Note: after these adjustments, the consolidated balance sheet will show 8% loan notes of $1.2m, and the income statement will include interest paid of $48,000. Tutorial note Although the above answers are framed as journal entries, it should be appreciated that they are not actual journal entries. Consolidated adjustments are merely workings they do not exist in any companys books. GOODWILL IMPAIRMENT IFRS 3, Business Combinations changed the required subsequent accounting treatment for consolidated goodwill. Prior to its introduction, many companies amortised goodwill over its estimated useful life (a practice still continued in many jurisdictions, including the UK). IFRS 3 prohibited amortisation of goodwill in favour of an annual impairment test, which may be applied more frequently, if there are indications of impairment. The detailed procedures for impairment testing of goodwill are contained in IAS 36, Impairment of Assets. It is a simple matter to account for a given impairment loss; it is charged to the income statement (normally as an operating expense), and credited to the carrying amount of goodwill on the balance sheet. It is useful to consider the process of testing for goodwill in a little more depth. Any asset is said to be impaired if its carrying amount is more than its recoverable amount. Goodwill generates cash flows in combination with other assets these are known as cash generating units or CGUs. The impairment test must be done by comparing the carrying amount of the CGU containing the goodwill with its recoverable amount. For a consolidation question, the simplest form of CGU would be the assets of an acquired subsidiary (note: liabilities do not normally form part of a CGU). IFRS 3 has an interesting view of goodwill where there is a minority interest. It says that the traditional goodwill calculated on consolidation represents only the goodwill owned by the parent, and that there also exists (but is not recognised) a proportionate amount of goodwill relating to the minority. Thus, when determining any impairment to a CGU, it is necessary to gross up the recognised goodwill in 66 student accountant June/July 2006

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respect of any minority interest. The grossed up goodwill is referred to as notional goodwill. Following this concept, IFRS 3 argues that the (determined) recoverable amount of a CGU is based on all its assets, and therefore should be compared to the carrying amount of all the CGUs assets (which must include the unrecognised minority share of goodwill). Once determined, an impairment loss must first be allocated to goodwill (based on the notional amount), then any remaining loss allocated pro rata to the CGUs other assets. If the amount of the impairment loss is less than the notional goodwill, the remaining goodwill balance is reduced by the minority interest percentage prior to it being reported in the consolidated balance sheet. EXAMPLE 3 At 31 March 20X6, the following information is available for two CGUs: CGU 1 $m 90 140 25% 180 CGU 2 $m 60 120 40% 90 Goodwill Other assets Minority interest Recoverable amount Required Show the assets of the CGUs after impairment testing. Answer CGU 1 $m 30 140 CGU 2 $m nil 90 Goodwill Other assets CGU 1 The goodwill of $90m relates to a controlling interest of 75%: unrecorded goodwill relating to the minority interest would therefore be $30m (90/75% x 25%), giving notional goodwill of $120m, and notionally adjusted assets of $260m ($120m + $140m other assets). This gives an impairment loss of $80m ($260m - $180m recoverable amount). The whole of this loss would be allocated to goodwill, leaving a balance of $40m ($120m - $80m). When preparing the balance sheet after the impairment, the $40m is reduced to $30m reflecting only the parents share (75%) of the goodwill. Note: the net assets are now shown at $170m ($30m goodwill + $140m other assets), which appears to be below the recoverable amount of $180m. However, there is $10m of unrecognised goodwill relating to the minority interest. CGU 2 A similar analysis to that applied to CGU 1 would give a notional goodwill figure of $100m ($60m/60%) and a notional carrying amount of all assets of $220m ($100m + $120m other assets). This means the impairment loss for CGU 2 is $130m ($220m - $90m recoverable

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amount). $100m of this amount would be allocated to goodwill (reducing it to zero) and the other assets would be written down to $90m ($120m - $30m remaining loss). This $30m would be applied pro rata to each of the asset groups (property, plant etc) that make up the other assets. The issues discussed in this article are summarised in Example 3. EXAMPLE 3 Highveldt, a public listed company, acquired 75% of Samsons ordinary shares on 1 April 20X5. The purchase consideration consisted of: a share exchange of one share in Highveldt for two shares in Samson. The market price of Highveldt shares at the date of acquisition was $4 each an immediate $1.75 per share in cash a further amount of $81m payable on 1 April 20X6. Highveldts cost of capital is 8% per annum. Highveldt has only recorded the consideration of $1.75 per share. The summarised balance sheets of the two companies at 31 March 20X6 are shown below: Highveldt $m $m 570 150 720 130 850 Samson $m 380 nil 380 90 470

ii

iii

iv

vi

Samson had established a line of products under the brand name of Titanware. Acting on behalf of Highveldt, a firm of specialists had valued the brand name at $40m with an estimated life of 10 years as at 1 April 20X5. The brand is not included in Samsons balance sheet. Immediately after acquisition, Highveldt sold Samson an item of plant for $15m that it had manufactured at a cost of $10m. The plant had an estimated life of five years (straight-line depreciation) and no residual value. On 1 October 20X5 Samson issued $60m 10% (actual and effective rate) loan notes. Highveldt subscribed for $20m of this issue. Samson has not paid any interest on this loan, but it has recorded the amount due as a current liability. Highveldt has also accrued for its interest receivable on this loan. Post-acquisition, Samson sold goods at a price of $18m to Highveldt; $5m of these goods were still in the inventory of Highveldt at 31 March 20X6. Samson applied a mark-up on cost of 25% to these goods. A post-acquisition impairment test on the notionally-adjusted consolidated goodwill (ie the goodwill relating to the parent and the minority interest) concluded that it should be written down by $20m.

Required Prepare the consolidated balance sheet of Highveldt at 31 March 20X6.

$m

Tangible non-current assets Investments Current assets Total assets Share capital and reserves: Ordinary shares of $1 each Reserves: Share premium Revaluation reserve Retained earnings 1 April 20X5 year to 31 March 20X6 Non-current liabilities 10% loan note Current liabilities Total equity and liabilities

270 80 40 160 190 120 101

80 40 nil

350 740 nil 110 850

221 341 60 69 470

The following information is relevant: i Highveldt has a policy of revaluing land and buildings to fair value. At the date of acquisition, Samsons land and buildings had a fair value of $20m in excess of their carrying amounts, and at 31 March 2006 this had increased by a further $4m (ignore any additional depreciation). June/July 2006 student accountant 67

Answer Consolidated balance sheet of Highveldt at 31 March 20X6 Tangible non-current assets (570 + 380 + 24 - 4 URP) (w (4)) Intangible non-current assets: Brand (40 - 4) Consolidated goodwill (w (1)) Investments (150 - 105 cash - 20 loan note) $m 970

Current assets (130 + 90 - 1 URP (w (2)) - 1 intra-group interest) 218 Total assets 1,309 Share capital and reserves: Ordinary shares of $1 each (270 + 30 (w (1))) Reserves: Share premium (80 + 90 (w (1))) Revaluation reserve (w (3)) Retained earnings (w (4))

Minority interest (w (2)) Non-current liabilities: 10% loan note (60 - 20 intra-group) Current liabilities (110 + 69 - 1 intra-group interest) Deferred consideration (75 + 6 (w (1))) Total equity and liabilities Workings (1) Goodwill calculation Investments at cost Share exchange (80 x 75%/2 x $4) Immediate cash (80 x 75% x $1.75) Deferred consideration (see below) Less Ordinary shares Share premium Pre-acquisition profit Fair value adjustments: brand (see below) land and buildings Goodwill on acquisition Impairment (see below)

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36 60 25 1,091 300 170 43 396 909 101 1,010 40 178 81 1,309 (2) Minority interest $m Ordinary shares 80 Share premium 40 Retained earnings (221 - 1 URP see below) 220 Fair values at acquisition (40 + 20) 60 Post-acquisition revaluation of land and buildings 4 404 x 25% = 101 There are $5m of goods in inventory at 31 March 20X6. The URP on these goods is $1m (5 x 25%/125%). (3) Revaluation reserve: (40 + (75% x 4)) 43 The $120m share issue would be recorded as share capital of $30m (30m x $1), and share premium of $90m (30m x $3). The deferred consideration of $81m must be discounted for one year, at the cost of capital of 8%, to $75m (81/1.08). The $6m difference is the accrued finance charge for the year to 31 March 20X6. Although the internally-generated brand cannot be recognised in Samsons entity financial statements, it should be recognised in the consolidated balance sheet on the acquisition of Samson. This is because the valuation process, as described in the question, is an acceptable method of reliable measurement. The fair value adjustment for Samsons land and buildings on acquisition is $20m. The subsequent increase in value of $4m, in the year to 31 March 20X6, is treated as a revaluation. As Highveldt only acquired 75% of Samson, the goodwill of $75m would be grossed up to $100m. This is impaired by $20m, down to $80m, but only 75% of this (ie $60m) would be shown in the consolidated balance sheet. In effect, Highveldts goodwill is impaired by $15m. $m $m 120 105 75 300 80 40 120 40 20 300 x 75% (4) Retained earnings Highveldt from question Post acquisition Samson (101 - 1 URP see above) x 75% Finance cost on deferred consideration (see below) URP in sale of plant Amortisation of brand (40/10 years) Impairment of goodwill Retained earnings in consolidated balance sheet 350 75 (6) (4) (4) (15) (19) 396 (225) 75 (15) 60 At the date of sale, there is an unrealised profit of $5m ($15m - $10m) on the plant sold by Highveldt to Samson. By 31 March 20X6, the remaining life of the plant is four years out of an original five years. Thus 4/5ths of the URP (ie $4m) must be eliminated from the carrying amount of the asset, and from Highveldts profits. Steve Scott is examiner for Paper F7 June/July 2006