TOPIC 1:Consolidated statement of financial position- topic notes

Chapter learning objectives

Upon completion of this chapter you will be able to:

 prepare a consolidated statement of financial position for a simple group (parent

and one subsidiary)
 deal with pre- and post-acquisition profits
 deal with non-controlling interests (at fair value)
 describe the required accounting treatment of consolidated goodwill
 apply the required accounting treatment of consolidated goodwill
 explain the consolidation of other reserves (e.g. share premium and revaluation)
 account for the consolidation of other reserves
 account for the effects of intra-group trading in the statement of financial position
 explain why it is necessary to use fair values
 Acquisitions of subsidiaries part way through the financial year.

1 Principles of the consolidated statement of financial position

The concept of group accounts

What is a group?

If one company owns more than 50% of the ordinary shares of another company:

 this will usually give the first company 'control' of the second company

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  the first company (the parent company, P) has enough voting power to appoint
all the directors of the second company (the subsidiary company, S)
 P is, in effect, able to manage S as if it were merely a department of P, rather
than a separate entity
 in strict legal terms P and S remain distinct, but in economic substance they can
be regarded as a single unit (a 'group').

Definitions

IAS 27 Consolidated and Separate Financial Statements uses the following definitions:

 subsidiary “ an entity that is controlled by another entity (known as the parent)

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

Requirements for consolidated financial statements

IAS 27 outlines the circumstances in which a group is required to prepare consolidated

financial statements.

Consolidated financial statements should be prepared when the parent company has
control over the subsidiary. Control is usually established based on ownership of more
than 50% of voting power, but other forms of control are possible.

IAS 27 gives four other situations in which control exists i.e “ when the parent has
power:

 over more than half the voting rights by virtue of an agreement with other
investors
 to govern the financial and operating policies of the entity under a statute or an
agreement
 to appoint or remove the majority of the members of the board of directors
 to cast the majority of votes at a meeting of the board of directors.

Exclusion of individual companies from the group accounts

Subsidiary exclusion

An undertaking required to produce group accounts may have (or be required) to

exclude certain subsidiaries on the following basis:

Severe restrictions on control

Subsidiaries to be excluded if the holding company no longer has control. An example

of this is a foreign investment where the overseas government has imposed restrictions.

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Interest held exclusively for resale

IFRS 5 provides that an investment in a subsidiary which is held with an intention to

resell in the near future (approximately within one year) should not be consolidated.

Method of preparing a consolidated statement of financial position

(1) The investment in the subsidiary(S) shown in the parent (P) statement of financial
position is replaced by the net assets of S.

(2) The cost of the investment in S is effectively cancelled with the ordinary share
capital and reserves of the subsidiary.

This leaves a consolidated statement of financial position showing:

 the net assets of the whole group (P + S)

 the share capital of the group which always equals the share capital of P only
and
 the retained profits, comprising profits made by the group (i.e. all of P’s historical
profits + profits made by S post-acquisition).

Illustration 1 “ Simple CSFP

Statements of financial position at 31 December 20X4

P acquired all the shares in S on 31 December 20X4 for a cost of $50,000.

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Prepare the consolidated statement of financial position at 31 December 20X4.

Solution

Approach

(1) The balance on investment insubsidiary account’ in P’s accounts will be

replaced by theunderlying assets and liabilities which the investment represents, i.e.the
assets and liabilities of S.

(2) The cost of the investment in thesubsidiary is effectively cancelled with the ordinary
share capital andreserves of S. This is normally achieved in consolidation
workings(discussed in more detail below). However, in this simple case, it canbe seen
that the relevant figures are equal and opposite ($50,000), andtherefore cancel directly.

This leaves a consolidated statement of financial position showing:

 the net assets of the whole group (P + S)

 the share capital of the group, which equals the share capital of P only –
$100,000
 retained earnings comprising profits made by the group. Here this will only
include the $30,000 retained earnings of the parent company. S is purchased on
the reporting date, therefore there are no post-acquisition earnings to include in
the group amount.

By cross-casting the net assets of each company, and cancelling theinvestment in S

against the share capital and reserves of S, we arriveat the consolidated statement of
financial position given below.

P consolidated statement of financial position at 31 December 20X4

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Note: Under no circumstances will any share capital of any subsidiary company ever be
included in the figure of share capital in the consolidated statement of financial position.

The mechanics of consolidation

A standard group accounting question will provide the accounts of P and the
accounts of S and will require the preparation of consolidated accounts.

The best approach is to use a set of standard workings.

(W1) Establish the group structure

(W2) Net assets of subsidiary

(W3) Goodwill

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(W4) Non controlling interest

(W5) Group retained earnings

Goodwill

Goodwill on acquisition

In example 1 the cost of the shares in S was $50,000. Equally the net assets of S were
$50,000. This is not always the case.

The value of a company will normally exceed the value of its net assets. The difference
is goodwill.This goodwill represents assets not shown in the statement of
financialposition of the acquired company such as the reputation of thebusiness.

Goodwill on acquisition is calculated by comparing the value of the subsidiary acquired

to its net assets.

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Where 100% of the subsidiary is acquired, the calculation is therefore:

Where less than 100% of the subsidiary is acquired, the value of the subsidiary
comprises two elements:

 The value of the part acquired by the parent

 The value of the part not acquired by the parent, known as the non-controlling
interest

There are 2 methods in which Goodwill may be calculated:

(i) Proportion of net assets method (as seen in consolidation workings). Not examinable

(ii) Fair value method (as seen in consolidation workings). Examinable

The proportion of net assets method calculates the portion ofgoodwill attributable to the
parent only, while the fair value methodcalculates the goodwill attributable to the group
as a whole. This isknown as the gross goodwill i.e. goodwill is shown in full as this isthe
asset that the group controls.

Illustration 2 “ Goodwill

Daniel acquired 80% of the ordinary share capital of Craig on 31December 20X6 for
$78,000. At this date the net assets of Craig were $85,000. NCI is valued using the fair
value method and the fair value of the NCI on the acquisition date is $19,000

What goodwill arises on the acquisition?

Solution

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 IFRS 3 Business Combinations

IFRS 3 revised governs accounting for all business combinations other than joint
ventures and a number of other unusual arrangements notincluded in this syllabus. The
definition of goodwill is:

Goodwill is an asset representing the future economicbenefits arising from other assets
acquired in a business combinationthat are not individually identified and separately
recognised.

Goodwill is calculated as the excess of the considerationtransferred and amount of any

non-controlling interest over the net ofthe acquisition date identifiable assets acquired
and liabilitiesassumed.

Treatment of goodwill

Positive goodwill

 Capitalised as an intangible non-current asset.

 Tested annually for possible impairments.
 Amortisation of goodwill is not permitted by the standard.

Impairment of positive goodwill

If goodwill is considered to have been impaired during thepost-acquisition period it must

be reflected in the group financialstatements. Accounting for the impairment differs
according to thepolicy followed to value the non-controlling interests.

Proportion of net assets method:

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Dr Group reserves (W5)
Cr Goodwill (W3)

Fair value method:

Dr Group reserves (% of impairment attributable to the parent – W5)

Dr NCI (% of impairment attributable to NCI – W4)
Cr Goodwill (W3)

Negative goodwill

 Arises where the cost of the investment is less than the value of net assets
purchased.
 IFRS 3 does not refer to this as negative goodwill (instead it is referred to as a
bargain purchase), however this is the commonly used term.
 Most likely reason for this to arise is a misstatement of the fair values of assets
and liabilities and accordingly the standard requires that the calculation is
reviewed.
 After such a review, any negative goodwill remaining is credited directly to the
income statement.

Pre- and post-acquisition reserves

Pre and post-acquisition profits

Pre-acquisition profits are the reserves which exist in a subsidiary company at the
date when it is acquired.

They are capitalised at the date of acquisition by including them in the goodwill
calculation.

Post-acquisition profits are profits made and included in the retained earnings of the
subsidiary company following acquisition.

They are included in group retained earnings.

Group reserves

When looking at the reserves of S at the year end, e.g. revaluation reserve, a distinction
must be made between:

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  those reserves of S which existed at the date of acquisition by P (pre-acquisition
reserves) and
 the increase in the reserves of S which arose after acquisition by P (post-
acquisition reserves).

As with retained earnings, only the group share of post-acquisitionreserves of S is

included in the group statement of financial position.

Illustration 3 “Pre- and post-acquisition reserves

The following statements of financial position were extracted from the books of two
companies at 31 December 20X9.

Derek acquired all of the share capital of Clive one year ago. The retained earnings of
Clive stood at $2,000 on the day of acquisition.Goodwill is calculated using the fair
value method. There has been no impairment of goodwill since acquisition.

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Required:

Prepare the consolidated statement of financial position of Derek as at 31 December

20X9.

Solution

Derek consolidated statement of financial position at 31 December 20X9

(W1) Establish the group structure

(W2) Net assets of Clive

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(W3) Goodwill

(W4) NCI

Not applicable to this example as Clive is 100% owned.

(W5) Group retained earnings

Non-controlling interests

What is a non-controlling interest?

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In some situations a parent may not own all of the shares in the subsidiary, e.g. if P
owns only 80% of the ordinary shares of S, there is a non-controlling interest of 20%.

Note, however, that P still controls S.

Accounting treatment of a non-controlling interest

As P controls S:

 in the consolidated statement of financial position, include all of the net assets of
S (to show control).
 give back the net assets of S which belong to the non-controlling interest within
the equity section of the consolidated statement of financial position (calculated
in W4).

Test your understanding 1

The following SFPs have been prepared at 31 December 20X8.

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D acquired its 80% holding in J on 1 January 20X8, when J’s retained earnings stood at
$20,000. On this date, the fair value of the 20% non-controlling shareholding in J was
$12,500.

The D Group uses the fair value method to value the non-controlling interest.

Prepare the consolidated statement of financial position of D as at 31 December 20X8.

2 Fair values

Fair value of consideration and net assets

To ensure that an accurate figure is calculated for goodwill:

 the consideration paid for a subsidiary must be accounted for at fair value
 the subsidiary’s identifiable assets and liabilities acquired must be accounted for
at their fair values.

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 The fair value of assets and liabilities is defined in IFRS 3 (and several other
IFRSs) as the amount for which an asset could be exchanged or a liability settled
between knowledgeable, willing parties in an arm’s length transaction.

Fair values

In order to account for an acquisition, the acquiring company must measure the cost of
what it is accounting for, which will normally represent:

 the cost of the investment in its own statement of financial position

 the amount to be allocated between the identifiable net assets of the subsidiary,
the non-controlling interest and goodwill in the consolidated financial statements.

The subsidiary’s identifiable assets and liabilities are included in the consolidated
accounts at their fair values for the following reasons.

 Consolidated accounts are prepared from the perspective of the group, rather
than from the perspectives of the individual companies. The book values of the
subsidiary’s assets and liabilities are largely irrelevant, because the consolidated
accounts must reflect their cost to the group (i.e. to the parent), not their original
cost to the subsidiary. The cost to the group is their fair value at the date of
acquisition.
 Purchased goodwill is the difference between the value of an acquired entity and
the aggregate of the fair values of that entity’s identifiable assets and liabilities. If
fair values are not used, the value of goodwill will be meaningless.

Identifiable assets and liabilities recognized in the accounts are those of the acquired
entity that existed at the date of acquisition.

Assets and liabilities are measured at fair values reflecting conditions at the date of
acquisition.

The following do not affect fair values at the date of acquisition and are therefore dealt
with as post-acquisition items.

 Changes resulting from the acquirer’s intentions or future actions.

 Changes resulting from post-acquisition events.
 Provisions for future operating losses or reorganization costs incurred as a result
of the acquisition.

Fair value of net assets acquired

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IFRS 3 revised requires that the subsidiary’s assets and liabilities are recorded at their
fair value for the purposes of the calculation of goodwill and production of consolidated
accounts.

Adjustments will therefore be required where the subsidiary’s accounts themselves do

not reflect fair value.

How to include fair values in consolidation workings

(1) Adjust both columns of W2 to bring the net assets to fair value at acquisition and
reporting date.

This will ensure that the fair value of net assets is carried through to the goodwill and
non-controlling interest calculations.

(2) At the reporting date make the adjustment on the face of the SFP when adding
across assets and liabilities.

Test your understanding 2

Hazelnut acquired 80% of the share capital of Peppermint two years ago, when the
reserves of Peppermint stood at $125,000. Hazelnut paid initial cash consideration of $1
million.

Below are the statements of financial position of Hazelnut and Peppermint as at 31

December 20X4:

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At acquisition the fair values of Peppermints plant exceeded its book value by $200,000.
The fair value of the 20% non-controlling interest was $380,000

Prepare the consolidated statement of financial position as at 31 December 20X4.

Solution of test your understanding 2

Test your understanding 2

Hazelnut consolidated statement of financial position at 31 December 20X4

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Workings

(W1) Group structure

(W2) Net assets of Peppermint

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(W3) Goodwill

(W4) Non-controlling interest

(W5) Group retained earnings

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3 Intra-group trading

Types of intra-group trading

P and S may well trade with each other leading to the following potential problem areas:

 current accounts between P and S

 loans held by one company in the other
 dividends and loan interest.
 unrealised profits on sales of inventory
 unrealised profits on sales of non-current assets (not examinable)

Current accounts

If P and S trade with each other then this will probably be done on credit leading to:

 a receivables (current) account in one company’s SFP

 a payables (current) account in the other company’s SFP.

These are amounts owing within the group rather than outside thegroup and therefore
they must not appear in the consolidated statement of financial position.

They are therefore cancelled (contra) against each other on consolidation.

Cash/goods in transit

At the year end, current accounts may not agree, owing to the existence of in-transit
items such as goods or cash.

The usual rules are as follows:

 If the goods or cash are in transit between P and S, make the adjusting entry to
the statement of financial position of the recipient:
o cash in transit adjusting entry is:
Dr Cash in transit
Cr Receivables current account
o goods in transit adjusting entry is:
Dr Inventory
Cr Payables current account
this adjustment is for the purpose of consolidation only.
 Once in agreement, the current accounts may be contra and cancelled as part of
the process of cross casting the assets and liabilities.
 This means that reconciled current account balance amounts are removed from
both receivables and payables in the consolidated statement of financial position.

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 Test your understanding 3

Fair value adjustments/intercompany balance

Statements of Financial Position of P and S as at 30 June 20X8 are given below:

P acquired 75% of S on 1 July 20X5 when the balance on S’sretained earnings was
$1,150. P paid $3,500 for its investment in theshare capital of S.

At the reporting date P recorded a payable to S of $400. This agreed to the

corresponding amount in S's financial statements.

At the date of acquisition it was determined that S’s land,carried at cost of $2,500
had a fair value of $3,750. S’s plant wasdetermined to have a fair value of $500 in
excess of its carrying value.These values had not been recorded by S.

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The P group uses the fair value method to value the non-controlling interest which was
$1,100.

Required:

Prepare the consolidated statement of financial position of the P group as at 30 June

20X8.

Solution to test of understanding 3

Consolidated statement of financial position as at 30 June 20X8

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Workings

(W1) Group structure

(W2) Net assets

(W3) Goodwill

(W4) Non-controlling interest

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(W5) Group retained earnings

4 Unrealised profit (URP)

Profits made by members of a group on transactions with other group members are:

 recognised in the accounts of the individual companies concerned, but

 in terms of the group as a whole, such profits are unrealised and must be
eliminated from the consolidated accounts.

Unrealised profit may arise within a group scenario on:

 inventory where companies trade with each other

 non-current assets where one group company has transferred an asset to
another. (not examinable)

Intra-group trading and unrealised profit in inventory

When one group company sells goods to another a number of adjustments may be
needed.

 Current accounts must be cancelled (see earlier in this chapter).

 Where goods are still held by a group company, any unrealised profit must be
cancelled.
 Inventory must be included at original cost to the group (i.e. cost to the company
which then sold it).

PURP

Where goods have been sold by one group company to another at a profit and some of
these goods are still in the purchaser’s inventory at the year end, then the profit loading
on these goods is unrealised from the viewpoint of the group as a whole.

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This is because we are treating the group as if it is a single entity. No one can make a
profit by trading with himself. Until the goods are sold to an outside party there is
no realised profit from the group perspective.

For example, if Pineapple purchased goods for $400 and then sold these goods onto
Satsuma during the year for $500, Pineapple would record a profit of $100 in their own
individual financial statements.The statement of financial position of Satsuma will
include closing inventory at the cost to Satsuma i.e. $500.

This situation results in two problems within the group:

(1) The profit made by Pineapple is unrealised. The profit will only become realised
when sold on to a third party customer.

(2) The value in Satsuma’s inventory($500) is not the cost of the inventory to the group
(cost to the group was the purchase price of the goods from the external third
partysupplier i.e. $400).

An adjustment will need to be made so that the single entity concept can be upheld i.e.
The group should report external profits,external assets and external liabilities only.

Adjustments for unrealized profit in inventory

The process to adjust is:

(1) Determine the value of closing inventory included in an individual company’s

accounts which has been purchased from another company in the group.

(2) Use mark-up or margin to calculate how much of that value represents profit earned
by the selling company.

(3) Make the adjustments. These will depend on who the seller is.

If the seller is the parent company, the profit element is included in the holding
company’s accounts and relates entirely to the group.

Adjustment required:

Dr Group retained earnings (deduct the profit in W5)

Cr Group inventory

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If the seller is the subsidiary, the profit element is included in the subsidiary
company’s accounts and relates partly to the group, partly to non-controlling interests (if
any).

Adjustment required:

Dr Subsidiary retained earnings (deduct the profit in W2 – at reporting date)

Cr Group inventory

Test your understanding 4

H bought 90% of the equity share capital of S, two years ago on 1January 20X2 when
the retained earnings of S stood at $5,000.Statements of financial position at the year
end of 31 December 20X3 are as follows:

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S transferred goods to H at a transfer price of $18,000 at amark-up of 50%. Two-thirds
remained in inventory at the year end. Thecurrent account in H and S stood at $22,000
on that day.

The H group uses the fair value method to value the non-controllinginterest. The fair
value of the non-controlling interest at acquisitionwas $4,000

Prepare the consolidated statement of financial position at 31/12/X3.

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 Test your understanding 4

Solution

Consolidated SFP for H as at 31/12/X3

Workings

(W1) Group structure

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(W2) Net assets

(W3) Goodwill

(W4) Non-controlling interest

(W5) Group reserves

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(W6) PURP

5 Mid-year acquisitions

Calculation of reserves at date of acquisition

If a parent company acquires a subsidiary mid-year, the net assets at the date of
acquisition must be calculated based on the net assets at the start of the subsidiary's
financial year plus the profits of up to the date of acquisition.

To calculate this it is normally assumed that S’s profit after tax accrues evenly over
time.

Test your understanding 5

Consolidated Statement of Financial Position

On 1 May 2007 K bought 60% of S paying $76,000 cash. The summarisedStatements

of Financial Position for the two companies as at 30November 2007 are:

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The following information is relevant:

(1) The inventory of S includes $8,000 of goods purchased from Kat cost plus 25%.

(2) The K Group values thenon-controlling interest using the fair value method. At the
date ofacquisition the fair value of the 40% non-controlling interest was$50,000.

(3) S earned a profit of $9,000 in the year ended 30 November 2007.

Required:

Prepare the consolidated Statement of Financial Position as at 30 November 2007.

Test your understanding 5

Consolidated Statement of Financial Position as at 30 November 2007

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Workings

(W1) Group structure

(W2) Net assets

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(W3) Goodwill

(W4) Non-controlling interest

(W5) Group retained earnings

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(W6) PURP “ Inventory

Summary

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