Model answer F2: changes in group structure

Before attempting the following question, please read the Study Notes article by Sally
Baker in the January/February edition of Financial Management.

Question

Below are the summarised financial statements of three entities, P, S and R for the year
ended 31 December 2009.

INCOME STATEMENTS
P S R
$ $ $
Revenue 85,000 60,000 50,000
Operating expenses (60,000) (45,000) (40,000)
Operating profit 25,000 15,000 10,000
Tax (5,000) (5,000) (2,000)
Profit for the year 20,000 10,000 8,000

STATEMENTS OF FINANCIAL POSITION

P S R
ASSETS $ $ $
Non-current assets 300,000 200,000 100,000
Investment in S 150,000 - -
Investment in R 70,000 - -
520,000 200,000 100,000

Current assets 80,000 50,000 25,000

Total assets 600,000 250,000 125,000

EQUITY AND LIABILITIES

Equity
Share capital $1 shares 100,000 80,000 50,000
Retained earnings 380,000 110,000 50,000
480,000 190,000 100,000

Non-current liabilities 50,000 20,000 10,000

Current liabilities 70,000 40,000 15,000
Total liabilities 120,000 60,000 25,000

Total equity and liabilities 600,000 250,000 125,000

1. On 1 January 2006, P acquired 80% of the equity share capital of S for $140,000. At the
same date it acquired 75% of the equity share capital of R at a cost of $70,000. At this
time the balances on the retained earnings of S and R and the fair value of non-
controlling interests were as follows:
S R
$ $
Retained earnings 75,000 30,000
Fair value of non-controlling interests 35,000 22,000

2. It is P’s policy to measure goodwill gross and so to record NCIs at fair value at
acquisition. Neither the goodwill of S or R have suffered any impairment since acquisition.
3. On 1 July 2009 P acquired a further 5% of the equity shares of S for $10,000. This
additional investment is recorded in P’s books at its cost.

4. On 1 October 2009, P disposed of 50% of R’s equity shares for cash proceeds of
$90,000. At this time, it was determined that the fair value of the remaining interest was
$25,000. P has not yet recorded this disposal in its individual financial statements.

5. It may be assumed that profits accrue evenly over the year and that no dividends were
paid during the year.

Requirement
Prepare the consolidated income statement and consolidated statement of financial
position of the P group for the year ended 31 December 2009.

Answer

Consolidated income statement

$
Revenue (85,000+60,000+(9/12x50,000)) 182,500
Operating expenses (60,000+45,000+(9/12x40,000)) (135,000)
Operating profit 47,500
Gain on disposal of subsidiary W7 31,500
Share of profit of associate (25% x 3/12 x 8,000) (W8) 500
Profit before tax 79,500
Income tax expense (5,000+5,000+(9/12 x 2,000)) (11,500)
Profit for the year 68,000

Attributable to:
Parent shareholders Balance 64,750
NCI shareholders W4 3,250
68,000

Consolidated statement of financial position

Assets $
Non-current assets (300,000+200,000) 500,000
Goodwill W3 20,000
Investment in associate W8 25,500

Current assets (80,000+50,000+90,000) (W7) 220,000

Total assets
765,500

Equity
Share capital $1 shares 100,000
Retained earnings W5 454,000
554,000
Non-controlling interests W4 31,500

Total 585,500

Non-current liabilities (50,000+20,000) 70,000

Current liabilities (70,000+40,000) 110,000
Total equity & liabilities
765,500

Workings

W1 Group Structure
P

S R
80% 1 Jan 06 75% 1 Jan 06
+5% 1 July 09 -50% 1 Oct 09
85% 25%

Step acquisition Disposal

Reduces NCI Control is lost

Sub all year Sub for 9 months

20% NCI for 6 months Associate for 3 months
15% NCI for 6 months

W2 Net Assets
S
Acquisition Step Reporting
acquisition date
$ $ $
Share capital 80,000 80,000 80,000
Retained earnings 75,000 105,000 110,000
155,000 185,000 190,000

The net assets of S are also calculated at the date of the step acquisition in order to
calculate the NCI balance at this date. In turn, this is used to calculate the difference
between the cash paid and the reduction in NCI which is taken to equity (W6).

S made a profit of $10,000 during the year of which 6/12 x $10,000 = $5,000 relates
to the period after the step acquisition. Therefore the balance on retained earnings at
the date of the step acquisition is the closing balance of $110,000 less $5,000 =
$105,000.

S’s post acquisition profits are $185,000 - $155,000 = $30,000 while it is an 80% sub
and $190,000 - $185,000 = $5,000 while it is an 85% sub.

R
Acquisition Disposal Rep Date
$ $ $
Share capital 50,000 50,000 50,000
Retained earnings 30,000 48,000 50,000
80,000 98,000 100,000

The net assets of R are calculated at the date of disposal as this will be required for
calculating the gain arising on disposal (W7).
 R made a profit of $8,000 during the year of which 3/12 x $8,000 = $2,000 relates to
the period after the disposal. Therefore the balance on retained earnings at the date
of disposal is the closing balance of $50,000 less $2,000 = $48,000.

R’s post acquisition profits are $98,000 - $80,000 = $18,000 while it is a subsidiary
and $100,000 - $98,000 = $2,000 while it is an associate.

W3 Goodwill

Goodwill is calculated at the date that control is achieved which is 1 January 2006 for
both S and R. The goodwill of S will be recognised in the CSFP as S is still a
subsidiary at the year end. The goodwill of R will be taken to the gain on disposal
calculation (W7).

S R
$ $
Cost of investment 140,000 70,000
Fair value of NCI’s 35,000 22,000
100% of sub’s net assets at acquisition (155,000) (80,000)
Gross goodwill 20,000 12,000

An alternative goodwill calculation would be:

S R
$ $
Cost of investment 140,000 70,000
Parent’s % of net assets at acquisition
(80% x 155,000) (124,000)
(75% x 80,000) (60,000)
Parent’s goodwill 16,000 10,000
Fair value of NCIs 35,000 22,000
NCI% of net assets at acquisition
(20% x 155,000) (31,000)
(25% x 80,000) (20,000)
NCI’s goodwill 4,000 2,000
Gross goodwill 20,000 12,000

W4 Non-controlling interests

Non controlling interests are only relevant at the year end for S since R is no longer a
subsidiary. When calculating this figure, it is important that the NCIs owned 20% of S
up to the date of the step acquisition and only 15% thereafter.

For consolidated statement of financial position

$
Fair value at acquisition 35,000
Share of post acquisition profits
(20% x $30,000) (W2) 6,000
(15% x $5,000) (W2) 750
Reduction in NCI on step acquisition (W6) (10,250)
31,500

An alternative calculation would be:

$ $
Share of net assets at reporting date
(15% x 190,000) 28,500
NCI’s share of goodwill
At acquisition per W3 4,000
 Reduction on step acquisition
(5/20 x 4,000) (1,000)
3,000
31,500

Remember for the consolidated income statement that R was a subsidiary for the first
nine months of the year. It is therefore necessary to include its share of profits for this
period.

For consolidated income statement

$
NCI’s share of S’s profits for year
20% x $10,000 x 6/12 1,000
15% x $10,000 x 6/12 750
NCI’s share of R’s profits for year
25% x $8,000 x 9/12 1,500
3,250

W5 Retained earnings
$
P 380,000
S (80% x $30,000) (W2) 24,000
(85% x $5,000) 4,250
Increase to equity on step acquisition W6 250
R (75% x $18,000) (W2) 13,500
(25% x $2,000) (W2) 500
Gain on disposal W7 31,500
454,000

W6 Step acquisition
The step acquisition represents a transaction between shareholders and so a
difference between the cash paid by P and the reduction in the NCI’s is recorded in
equity:

$
Consideration paid by P 10,000
Transfer to reduce the NCI (5/20 x $41,000) 10,250
Increase to equity 250

$250 is recorded as an increase in equity since effectively P has acquired the NCI
shareholding at a discount and so gained.

NCIs immediately before the step acquisition were:

$
Fair value of NCIs at acquisition 35,000
NCI% of post acquisition profits (20% x $30,000) (W2) 6,000
41,000

Or alternatively:
$
NCI% of net assets at date of step acquisition (20% x $185,000) (W2) 37,000
NCI’s goodwill W3 alternative 4,000
41,000
W7 Gain on disposal
Since by disposing of shares on 1 October 2009, P loses control of R, it is necessary
to calculate the gain arising on disposal for inclusion in the consolidated income
statement so also in consolidated retained earnings:

$ $
Proceeds 90,000
Fair value of residual 25% interest 25,000
Less carrying value of subsidiary
Net assets at disposal (W2) 98,000
Goodwill at disposal (W3) 12,000
NCI’s at disposal (below) (26,500)
(83,500)
Gain on disposal 31,500

Since P has not recorded the disposal in its individual financial statements, the cash
proceeds have not yet been recorded. It will therefore need to be recorded in current
assets on the consolidation process.

NCIs at the date of disposal would be:

$
Fair value of NCIs at acquisition 22,000
NCI% of post acquisition profits (25% x $18,000) (W2) 4,500
26,500

Or alternatively:
$
NCI% of net assets at date of disposal (25% x $98,000) (W2) 24,500
NCI’s goodwill W3 alternative 2,000
26,500

W8 Investment in associate
At the reporting date, the 25% investment in R would be assumed to give P
significant influence and so R must be equity accounted. The cost of the investment
is the fair value of $25,000 as at 1 October 2009. This will be increased by the year
end by 25% of R’s post acquisition profits:
$
Cost of investment 25,000
Share of post acquisition profits (25% x $2,000) (W2) 500
25,500

The share of post acquisition profits are also recognised in the consolidated income
statement as 'Share of profit of associate'.