1. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-1 Chapter 27 Accounting for group structures

2. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-2 Objectives of this lecture Understand what it means to ‘consolidate’ financial statements 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

3. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-3 Objectives (cont.) Understand the meaning of ‘goodwill’, and how to measure it Understand what a ‘gain on bargain purchase’ represents Be able to provide the journal entries necessary to account for any goodwill or gain on bargain purchase that arises on consolidation Be aware of some of the history behind the development of the accounting standards pertaining to consolidated financial statements

4. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-4 Introduction Common for groups of companies to combine in pursuit of common goals Where a reporting entity controls another entity, AASB 10 Consolidated 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 gain on bargain purchased that might arise on consolidation

5. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-5 Rationale for consolidating the accounts of different legal entities Purpose of providing consolidated financial statements is to show the results and financial position of a group as if it were operating as a single economic entity Effects of all intragroup transactions are eliminated The consolidated statement of comprehensive income will show the financial results derived from operations with parties external to the group of entities The consolidated statement of financial position will show the total assets controlled by the economic entity and the total liabilities owed to parties outside the economic entity

6. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-6 Figure 27.1—A simple parent and subsidiary relationship

7. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-7 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 From 2005 we had AASB 127 Consolidated and Separate Financial Standards which replaced AASB 1024 AASB 127 was then superseded by the release of AASB 10 Consolidated Financial Statements (effective from 1 January 2013) and AASB 127 was re-released as Separate Financial Statements

8. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-8 History of Australian Accounting Standards that govern the preparation of consolidated financial statements (cont.) Before amendments to the Corporations Law in 1991, group consolidated financial statements 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 27.2 on p. 872)—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

9. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-9 History of Australian Accounting Standards that govern the preparation of consolidated financial statements (cont.) Amendments to the Corporations Law deleted previous definitions of ‘group’ and ‘group accounts’. Corporations Act 2001 adopts requirements embodied within AASB 10. S. 295(2)(d) states that: The financial statements for the year are: (a)the financial statements in relation to the entity reported on that are required by the accounting standards, and (b)if required by the accounting standards—the financial statements in relation to the consolidated entity that are required by the accounting standards

10. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-10 History of Australian Accounting Standards that govern the preparation of consolidated financial statements (cont.) AASB 10 The consolidated financial statements are to include all subsidiaries of the parent Note per AASB 10 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 is lost during a period (AASB 10) Income and expenses of a subsidiary are to be included in the consolidated financial statements until the date on which the parent ceases to control the subsidiary

11. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-11 Alternative consolidation concepts Generally speaking, there are three major consolidation concepts: 1. The entity concept (adopted by AASB 10) 2. The proprietary concept 3. The parent entity concept AASB 10 requires adoption of the entity concept

12. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-12 Concept of control The definitions of ‘control’ and ‘subsidiary’ are central to determining the entities to be consolidated and the nature of the group The definition of a subsidiary directly relies upon the concept of ‘control’. A subsidiary is defined in AASB 127 as: an entity that is controlled by another entity Requirement to consolidate is based upon the existence of control, which is defined in AASB 10 as: –Existing rights that give the current ability to direct the relevant activities

13. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-13 Concept of control (cont.) This in turn requires a definition of ‘relevant activities’ which is defined in AASB 10 as: –activities of the investee that significantly affect the investee’s returns In deciding whether an entity is a subsidiary it is necessary that the investor has the capacity to ‘exercise’ power

14. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-14 Central concept of control—the requirement of ‘variable returns’ Where control is considered to exist, the amount of returns to be derived from the interest in the investee would be expected to vary depending upon the efforts and performance of both the investee and the investor. According to paragraph 17 of AASB 10: –An investor controls an investee if the investor not only has power over the investee and exposure or rights to variable returns from its involvement with the investee, but also has the ability to use its power to affect the investor’s returns from its involvement with the investee.

15. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-15 Joint control Only one party can be in ‘control’ of an entity before that controlling entity can be considered to be the parent entity. If an entity ‘jointly controls’ another entity then that entity cannot be considered to be a subsidiary, and rather than applying AASB 10, another standard–– AASB 11 Joint Arrangements (released in August 2011)––needs to be applied (and this standard does not allow consolidation for jointly controlled entities).

16. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-16 Situations in which control might exist A number of situations could lead to control, including: where a majority of voting rights are held by the investor where less than a majority of the voting rights are held by the investor (but perhaps where the balance of the voting rights are widely dispersed among many different owners) where the investor holds some potential voting rights in the investee

17. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-17 Concept of control (cont.) 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

18. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-18 Concept of control (cont.) As paragraphs BC120 and BC 121 of the Basis for Conclusions to IFRS 10 state: –Potential voting rights can give the holder the current ability to direct the relevant activities. This will be the case if those rights are substantive and on exercise or conversion (when considered together with any other existing rights the holder has) they give the holder the current ability to direct the relevant activities. The holder of such potential voting rights has the contractual right to ‘step in’, obtain voting rights and subsequently exercise its voting power to direct the relevant activities—thus the holder has the current ability to direct the activities of an investee at the time that decisions need to be taken if those rights are substantive.

19. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-19 Delegated power Another factor to consider in determining whether to consolidate an entity is whether any power to be exerted over the entity is being used in the context of an agency relationship, or whether the power is being exercised to benefit the investor directly. In defining an ‘agency relationship’, paragraph BC129 of the Basis for Conclusions to IFRS 10 states: –The Board decided to base its principal/agent guidance on the thinking developed in agency theory. Jensen and Meckling (1976) define an agency relationship as ‘a contractual relationship in which one or more persons (the principal) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent.

20. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-20 Delegated power (cont.) If an entity has power, but is acting under the direction of another entity––perhaps as an ‘agent’ of that other entity–– then control would not be deemed to exist and the entity would not be required to consolidate the entity over which it had power.

21. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-21 Exposure to variable returns As we have noted, another necessary attribute of control is that there is an expectation that the investor will be exposed to variable returns from its involvement with the investee. Specifically, paragraph 15 states: –An investor is exposed, or has rights, to variable returns from its involvement with the investee when the investor’s returns from its involvement have the potential to vary as a result of the investee’s performance. The investor’s returns can be only positive, only negative or both positive and negative.

22. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-22 Exposure to variable returns (cont.) This requirement means that parties such as receivers and managers of financially troubled organisations, as well as trustees, would not be required to consolidate a controlled entity’s financial statements with their own statements because, apart from the professional fees being received, those concerned would not be managing such organisations for their own benefit but on behalf of owners and creditors.

23. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-23 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

24. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-24 Entity A Entity B Entity C Non-controlling interest A directly controls B A indirectly controls C

25. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-25 Accounting for business combinations According to AASB 3, a ‘business combination’ is defined as: A transaction or other event in which an acquirer obtains control of one or more businesses If the assets acquired do not fit the description of business considered above, the transaction shall represent the acquisition of a group of assets and the appropriate accounting treatment would be covered by AASB 116 Property, Plant and Equipment, and AASB 138 Intangible Assets rather than AASB 3 Business Combinations

26. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-26 Accounting for business combinations (cont.) At the acquisition date, the acquirer is required to recognise: –goodwill separately from the identifiable assets acquired –the liabilities assumed –any non-controlling interest in the acquiree

27. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-27 Accounting for the consolidation of separate legal entities 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 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

28. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-28 Accounting for the consolidation of separate legal entities (cont.) AASB 3 notes that there are four steps to be considered when accounting for business combinations, these being: 1 Identifying the acquirer 2 Determining the acquisition date 3 Recognising and measuring the identifiable assets acquired, the liabilities assumed and any non- controlling interest in the acquiree, and 4 Recognising and measuring goodwill or a gain from a bargain purchase

29. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-29 Recognising and measuring goodwill Calculation of Goodwill/Bargain on purchase FAIR VALUE OF CONSIDERATION TRANSFERRED XXX plus Amount of non-controlling interest XXX plus Fair value of any previously held equity interest in the acquiree XXX XXX less Fair value of identifiable assets acquired and liabilities assumed XXX GOODWILL ON ACQUISITION DATE XXX Calculated in the manner shown above, the net figure for goodwill will be a positive number. If the number is negative, then rather than it being considered as goodwill, the amount would be considered as a gain on bargain purchase

30. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-30 Consideration transferred In a business combination the consideration transferred is measured at fair value. AASB 3 states that the fair value of consideration transferred is calculated as: the sum of the acquisition-date fair values of the assets transferred by the acquirer, the liabilities incurred by the acquirer to former owners of the acquiree and the equity interests issued by the acquirer

31. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-31 Recognising and measuring goodwill (cont.) Consistent with the requirements of paragraph 48 of AASB 138 Intangible Assets that internally generated goodwill not be recognised as an asset, no goodwill would be brought to account by Yang Ltd (the acquiree) in Worked Example 27.2 as only purchased goodwill, and not internally generated goodwill, is recognised for accounting purposes The purchased goodwill will be brought to account by Ying Ltd as part of the consolidation process and will appear in the consolidated financial statements

32. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-32 Amortisation of goodwill 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

33. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-33 Goodwill impairment testing After initial recognition, the acquirer is to measure goodwill acquired in a business combination at cost less any accumulated impairment losses 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

34. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-34 Accounting for the consolidation of separate legal entities (cont.) 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 offers additional guidance in relation to impairment testing of goodwill

35. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-35 Accounting for the consolidation of separate legal entities (cont.) 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, for example, the goodwill acquired

36. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-36 Accounting for the consolidation of separate legal entities (cont.) 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 10, pars B86 to B89 Refer to Worked Example 27.3—A simple consolidation—on pp. 890–893 –Consolidation worksheet used to facilitate consolidation process

37. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-37 Recognition of gain on bargain purchase 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. 36) requires the acquirer to: (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

38. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-38 Recognition of gain on bargain purchase (cont.) Pursuant to AASB 3 we are to treat the gain on bargain purchase as part of profit or loss Eliminate investment in subsidiary acquired at discount Journal entry to eliminate DrShare capital DrRetained earnings CrGain on bargain purchase CrInvestment in Subsidiary Ltd Refer to Worked Example 27.4 on pp. 894-5—Acquisition of subsidiary at a discount

39. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-39 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 ‘gain on bargain purchase’) 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 first recognise a revaluation of the non-current assets in the consolidation worksheet (Dr Asset; Cr Revaluation surplus), 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) See Worked Examples 27.5 and 27.6 (pp. 896 and 897)

40. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-40 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 and be included within the consolidated equity Refer to Worked Example 27.8 on pp. 902–4—Consolidation in a period subsequent to the acquisition of the subsidiary

41. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-41 Summary Consolidated 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 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

42. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-42 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 gain on bargain purchase 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 on bargain purchase (part of income) in the consolidated financial statements 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)

43. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 16-43 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 This means—and this is IMPORTANT—that the effects of all prior period consolidation adjustments and eliminations are not found in any ledger accounts when we start a new financial period