Groups of companies

Question 1

What is the control concept?

Answer 1

Control concept

A group of companies is an economic entity made up of a set of companies where one entity (the parent) has control over another entity (the subsidiary).

When assessing whether an investor controls an investee, more than one factor needs to be considered.

In accordance with IFRS 10, ‘control‘ of an investor over an investee consists of the following three elements:

1. power,
2. variable returns and
3. the ability to use this power

Power

Power over the investee is typically existing rights, normally exercised through most of voting rights (owning more than 50% of the equity shares).

Variable returns

Exposure or rights to variable returns (a dividend) stems from the investor’s involvement with the investee.

Ability to use power

A crucial determinant of the control is the ability to use power over the investee to affect the amount of investor returns.

Question 2

What is the requirement to prepare consolidated accounts?

Answer 2

What is the requirement to prepare consolidated accounts?

IFRS 10 (Consolidated Financial Statements) defines the principle of control.

It outlines the requirements for the preparation and presentation of consolidated financial statements, requiring entities to consolidate the entities it controls.

If one company controls another, then IFRS 10 requires that a single set of consolidated financial statements be prepared to reflect the financial performance and position of the group as one combined economic entity.

These requirements are also set out by law CA 2006

Criteria:

Size criteria Gross Net

• Aggregate turnover £12.2m £10.2m
• Aggregate balance sheet total £6.1m £5.1m
• Aggregate number of employees 50 50

Question 3

What types of investment are there?

Answer 3

Investment Criteria Share holding Accounting method

Subsidiary Control >50% -Full consolidation (IFRS 10)
-Acquisition method (IFRS
3)

Associate or Single 20 - 50% -Equity method (ISA 28)
joint Influence

Joint Joint Equal -Depends on type (IFRS 11,
arrangement control IAS 28

Other Other Other -Disclosures
investment -Depends on type (IFRS 9
and 5

Question 4

How can control of a company be exercised?

Answer 4

Group structure

Control can be exercised in a variety of ways, most commonly by:

• control through direct and indirect voting rights
• via a contract
• through control of the board of directors
• through de facto control

Question 5

What is the basic method of consolidated accounts?

Answer 5

When a parent company controls a subsidiary company, the parent must produce consolidated financial statements which effectively add together the results of the parent and its subsidiary. The consolidated financial statements must present their assets, liabilities, equity, income, expenses and cash flows as those of a single economic entity.

A parent may control its subsidiaries through direct or indirect voting rights. If subsidiaries are controlled by the parent,
they must be consolidated irrespective of where subsidiaries are based (for example, they can be registered in another
country) or what legal form they take.

The first step is to establish whether there is a parent-subsidiary relationship and must consider NCI.

NCI I is the equity in the subsidiary not attributable, directly or indirectly, to the parent. It is also important to be aware of the date control was achieved or ceased.

When a parent has worked out which of its investments are subsidiaries, the parent’s and subsidiaries’ financial
statements are simply added up line-by-line to create total figures for the group. The consolidated financial statements include everything controlled by the parent on a 100% basis.

Question 6

What factors need to be avoided in consolidated accounts?

Answer 6

What factors need to be avoided in consolidated accounts?

Here are just a few:

1. To avoid double counting, intra-group items including all transactions, balances and unrealised profits and losses
   arising from intra-group trading must be eliminated. Intra-group items include purchase and sales of inventories and
   other assets between parent and subsidiary.

The consolidated totals should only consist of transactions, balances and profits and losses created through transactions with parties outside the group

2. The accounting policies of all group companies must be aligned, so that like items are treated in the same way for the group as a whole. Subsidiaries (such as those based overseas) that follow local accounting rules will need to be adjusted just for the consolidation process.
3. Any share of a subsidiary’s results or equity that belong to any NCI (previously known as the minority interest) must
   be disclosed at the foot of each consolidated financial statement
4. Consolidation will cease from the date the parent loses control of a subsidiary. If the control ceases or the subsidiary is acquired part way through the year, the financial results must be time-apportioned during the consolidation process

Question 7

What do consolidated financial accounts include?

Answer 7

What do consolidated financial accounts include?

1. a consolidated statement of financial position
2. a consolidated statement of profit or loss and other comprehensive income
3. a consolidated statement of changes in equity
4. a consolidated statement of cash flows
5. notes to the consolidated financial statements

Question 8

What are the two main methods for NCI valuation?

Answer 8

There are two main methods for NCI valuation:

• the fair value method
• the proportion of net assets method

Fair value method

Under the fair value method, the fair value of the controlling interest is usually the consideration paid by the parent
company for this interest.

the parent has to use other valuation methods, often using market share trading prices in the weeks before and after the purchase
to evidence a valuation.

Proportion of net method

The value of the controlling interest (and the NCI) is valued as the proportion of equity acquired (or retained), multiplied by the net assets of the acquired company at the date of the purchase.

Question 9

What is ‘Goodwill’?

Answer 9

Goodwill

The price paid for a company at acquisition (to gain control) will normally exceed the fair market value of its net assets or equity. The difference is purchased goodwill.

This represents the additional amount paid for factors such as the
reputation of the business, the experience of employees, the customer base and the brand of the business.

Question 10

What is ‘Negative goodwill’?

Answer 10

Negative goodwill

Goodwill can be negative when the aggregate of the fair values of the separable net assets acquired may exceed what
the parent company paid for them.

For negative goodwill, an entity should reassess by measuring both the cost of the combination and the acquiree’s identifiable net assets to identify any errors. Any excess remaining after such reassessment should be recognised (credited) immediately in the statement of profit or loss and OCI.

Question 11

What is ‘Impairment goodwill’?

Answer 11

The asset is impaired when an asset’s carrying value exceeds its recoverable amount (the higher of fair value less costs
of disposal and value in use).

Some triggering events that may cause the fair market value of a goodwill asset to drop below its carrying amount (impairment indicators) are:

• adverse economic conditions
• increased competition
• legal implications
• loss of key personnel
• declining revenue
• market value

An impairment is recognised as loss in the statement of profit or loss and OCI and as a reduction in the carrying amount
of goodwill in statement of financial position.

Question 12

What is ‘fair value’?

Answer 12

IFRS 13 defines fair value as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’. The fair value method is used when calculating goodwill (and NCIs).

Question 13

What is deferred consideration?

Answer 13

Deferred consideration is the amount payable at a future date by an acquirer to the acquiree in a business combination after a pre-defined time period, often linked to post-acquisition performance targets.

It tends to be driven primarily by tax and accounting considerations.

The present value of the amount payable is recorded as the part of the consideration at the date of acquisition. Interest normally accrues on the deferred consideration.

Question 14

What is contingent consideration?

Answer 14

Contingent consideration is an uncertain amount, that is payable at a future date by an acquirer to the acquiree in a business combination, which is linked to a specified future event or condition met within a pre-defined time period, such as financial performance of the acquiree.

For example, P plc acquired a 100% equity shareholding in S Ltd, with a fixed portion of the consideration of £1 million
and a promise to pay £200,000 if S Ltd meets both the revenue and the profit targets specified for the next two years.

The probability of meeting the targets is 50%.

Total consideration at the acquisition date is therefore calculated as:

Fixed portion of £1 million + expected value of £100,000 (£200,000 × 50%)

The contingent consideration payable at the end of the second year must be discounted back and recognised at its present value.

Question 15

Why are the subsidiary’s identifiable assets and liabilities included at their fair values in the consolidated financial statements?

Answer 15

Why are the subsidiary’s identifiable assets and liabilities included at their fair values in the consolidated financial statements?

Consolidated accounts are prepared from the perspective of the group and must reflect their cost to the group (to the parent), not the original cost to the subsidiary.

The book values of the subsidiary’s assets and liabilities are largely
irrelevant in the consolidated financial statements.

The cost to the group is the fair value of the acquired assets and
liabilities at the date of acquisition. Fair values are therefore used to calculate the value of goodwill

Question 16

Why are pre-acquisition profits of a subsidiary not included in the group accounts?

Answer 16

Pre-acquisition profits are the retained earnings of the subsidiary which exist at the date when it is acquired. They
are excluded from group retained earnings as they belong to the previous shareholders and were earned under their
ownership.

Question 17

Gorkha plc acquired Ye Ltd on 1 January 20X9. The retained earnings at 1 January 20X9 amounted to £500,000 and £800,000 respectively. Explain how the retained earnings of Ye ltd at 1 January 20X1 would be treated in the
consolidated financial statements

Answer 17

The retained earnings of Ye Ltd have accrued during the period prior to acquisition and were earned under the ownership of the previous shareholders. They form a part of the shareholders’ equity at acquisition in the subsidiary for the purpose of computing goodwill arising on consolidation

Question 18

What are non-controlling interests? How are they accounted for in consolidated financial statements?

Answer 18

In a situation where a parent has control but less than 100% of a shareholding, the portion of equity ownership in a subsidiary not attributable to the parent company is known as a non-controlling interest. This is also called a minority interest.

A non-controlling interest should be presented separately in the consolidated statement of financial position equity. Any share of a subsidiary’s results that belongs to the non-controlling interest or minority interest is disclosed at the foot of the balance sheet and income statement and in the statement of changes in equity.

Question 19

How is an investment of the parent in a subsidiary accounted for in the parent’s separate financial statements? How is it accounted for in the consolidated financial statements?

Answer 19

Parent company financial statements include ‘investments in subsidiary undertakings’ as an asset in the statement of financial position, as well as income from subsidiaries (dividends) in the statement of profit or loss. The parent entity’s investment in the subsidiaries, carried as an investment in its balance sheet, is also eliminated through the process of consolidation.

Question 20

During the year ended 31 December 20X1, the parent company (P Plc) sells goods to its subsidiary (S Ltd) at cost plus a mark-up of 15%. Explain the accounting treatment of the intra-group trading and the profit arising from the intercompany sales.

Answer 20

Intra-group items including all transactions, balances and profits and losses must be eliminated to avoid double counting.
The consolidated totals should consist of only transactions, balances and profits and losses created through transactions
with parties outside the group. For consolidated financial statements, it is therefore necessary to eliminate intra-group
balances and transactions.

Company P will make the following accounting adjustments for unrealised profits:

• Intra-group sales and purchases are eliminated. Reduce the retained earnings of Company P by 15% (the mark-up)
  or 15 ÷ 115 (13% of the selling price).
• Any unrealised profit relating to intercompany trading is eliminated. Reduce the inventory of Company B by 15%
  (the mark-up) or 13% of the price. The above adjustments only apply to unsold inventory.

Question 21

How does the difference between the equity method and the full consolidation method affect the decisions of investing
entities if the investee were a highly geared entity?

Answer 21

There are substantial differences between consolidation and equity accounting, thus influencing the behaviour of investing entities to structure transactions to achieve their desired accounting outcome. If an investee is highly geared with a lot of debt, the investor would bring 100% of the gross debt of the investee onto its consolidated balance sheet through consolidation.

It increases the gearing for the group as a whole. This is avoided if the investee is treated as a joint venture and accounted using the equity method.

A controlling interest in the investee is not desirable in this scenario. However, if the investee were very profitable, the
consolidated accounts would consolidate 100% of the investee’s profits in its accounts with any portion relating to NCI disclosed at the foot of the balance sheet.

Question 22

1. When is a parent exempted from preparing consolidated financial statements?

Answer 22

A parent is exempted from preparing consolidated financial statements when:

1. the parent is itself a wholly owned subsidiary, or a partially owned subsidiary and the non-controlling interests do not
   object;
2. its securities are not publicly traded or in the process of being traded; or
3. its ultimate or intermediate parent publishes IFRS-compliant financial statements.

Question 23

When does IFRS allow subsidiary undertakings to be excluded from consolidation? Can they be excluded on the
grounds of dissimilar activities?

Answer 23

Very rarely. The rules on exclusion of subsidiaries from consolidation are strict because entities use them to manipulate
their results. An exclusion originally allowed by IAS 27 (where control is intended to be temporary or where the subsidiary
operates under severe long-term restrictions) has been removed.

Instead, subsidiaries held for sale are accounted for in accordance with IFRS 5 (Non-Current Assets Held for Sale and Discontinued Operations) and the control must actually be lost for exclusion to occur.

Question 24

summarises the steps taken for preparing the consolidated statement of financial position (SoFP)

Answer 24

1. Combine line-by-line
2. Eliminate investment in the subsidiaries. Calculate and include goodwill.
3. Eliminate intra-group items (sales, purchases,
   unrealised profit and balances)
4. Eliminate share capital and share premium balances of subsidiaries. Group Share Capital = Parent only
5. Eliminate pre-acquisition profit of subsidiaries. Group retained earnings = Parent’s retained earnings (100%) + Parent’s % of Subsidiary’s post-acquisition earnings (after consolidation
   adjustments)
6. Disclose NCI at the foot of the SoFP NCI = FV of NCI at acquisition + NCI share of post acquisition earnings/reserve