CONSOLIDATIONS PART 1: CONTROL, ACCOUNTING FOR GROUPS AT

ACQUISITION DATE

TOPIC REVIEW PRACTICE QUESTIONS TO PREPARE AND CHECK PRIOR TO THE

WORKSHOP

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Leo et al chapter 18: Review questions 1, 2, 3 and 9
Case studies: 2, 4, 6 and 7
Leo text, chapter 19: Review questions 1, 4, and 8
Case study: 3
Questions 19.3 (part A only), 19.4 (only do entries at 1 July 2016 for each
part)

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CHAPTER 18:
1. What is a subsidiary?

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A subsidiary is an entity that is controlled by another entity, a parent.

2. What is meant by the term “control”?

An investor controls an investee when the investor is exposed, or has rights, to variable returns from
its involvement with the investee and has the ability to affect those returns through its power
over the investee.
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3. For what purposes are the consolidated financial statements prepared?
Possible objectives are:
- Supply of relevant information
- Supply of comparable information
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- Accountability of management
- Reporting of risks and benefits

9. Is the non-controlling interest classified as a liability or equity?

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It is classified as equity as the group does not have a present obligation to outflow funds to those
shareholders.

Case Study 2 Convertible debentures

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Peter Ltd establishes Pan Ltd for the sole purpose of developing a new product to be
manufactured and marketed by Peter Ltd. Peter Ltd engages Mr Hook to lead the team to
develop the new product. Mr Hook is named Managing Director of Pan Ltd at an annual salary
of $100 000, $10 000 of which is advanced to Mr Hook by Pan Ltd at the time Pan Ltd is
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established. Mr Hook invests $10 000 in the project and receives all of Pan Ltd’s initial issue of
10 shares of voting ordinary shares.
Peter Ltd transfers $500 000 to Pan Ltd in exchange for 7%, 10-year debentures convertible at any
time into 500 shares of Pan Ltd voting ordinary shares. Pan Ltd has enough shares authorised
to fulfil its obligation if Peter Ltd converts its debentures into voting ordinary shares.
The constitution of Pan Ltd provides certain powers for the holders of voting common shares and
the holders of securities convertible into voting ordinary shares that require a majority of each
class voting separately. These include:
(a) the power to amend the corporate purpose of Pan Ltd, and
 (b) the power to authorise and issue voting shares of securities convertible into voting shares.
At the time Pan Ltd is established, there are no known economic legal impediments to Peter Ltd
converting the debt.

Required
Discuss whether Pan Ltd is a subsidiary of Peter Ltd.

Source: Adapted from Case V issued by the Financial Accounting Standards Board (FASB) as a part

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of its Consolidations project.

Peter Ltd Pan Ltd

Convertible debentures Mr Hook owns 100% of shares

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The question is whether Peter Ltd is a parent of Pan Ltd.

This depends on whether Peter Ltd controls Pan Ltd.

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Consider the definition of control as per Appendix A of AASB 10.

Key question:
As Peter Ltd holds convertible debentures, does this give it control over Pan Ltd?

Mr Hook actually controls Pan Ltd but the AASB 10 concept of control is a capacity to control, a
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power to govern concept rather than an actual control concept.

Peter Ltd can be considered a passive controller. The holder of a presently exercisable instrument
has the capacity to control. It has the unilateral ability to exercise the instrument and thus obtain
the power to determine financial and operating policy.
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By not exercising the conversion option, Peter Ltd is implicitly accepting the policy determinations of
Pan Ltd. An analogy can be drawn with delegated authority. Mr Hook knows that if he fails to
gain the approval of Peter Ltd for his actions, then the latter can exercise control by converting
the debentures.
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The instrument must be currently exercisable.

An alternative position is that Mr Hook controls until Peter Ltd actually chooses to exercise the
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conversion option. Peter Ltd cannot actually make any policy decisions in relation to Pan Ltd. It
must first exercise the conversion option. It may never exercise that option. In that case, Mr
Hook determines all policies in relation to Pan Ltd. Mr Hook has current capacity to control; this
would change if Peter Ltd exercised its options. But until it takes that step, it does not have the
current capacity to control. Given that Peter Ltd has not exercised the option, do the
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shareholders in Peter Ltd want or need information about the combined entity of the two
companies?

A further point of discussion is whether the likelihood of exercise of the conversion option should
be part of the decision process. Under AASB 10, the rights must be substantive in order for
control to exist. For example, because of economic conditions, Peter Ltd may not want to
exercise the options. If it is detrimental to the holder of the options to exercise the options, the
holder does not have control over the other entity.
 Review illustrative examples 18.1 and 18.2 in the text.

Case Study 4 Voting interest widely held

Mickey Ltd is a production company that produces movies and television shows. It also owns cable
television systems that broadcast its movies and television shows. Mickey Ltd transferred to
Mouse Ltd its cable assets and the shares in its previously owned and recently acquired cable
television systems, which broadcast Mickey Ltd’s movies. Mouse Ltd assumed approximately

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$200 million in debt related to companies it acquired in the transaction. After the transfer
date, Mouse Ltd acquired additional cable television systems, incurring approximately $2
billion of debt, none of which was guaranteed by Mickey Ltd.
Mouse Ltd was initially established as a wholly-owned subsidiary of Mickey Ltd. Several months
after the transfer, Mouse Ltd issued ordinary shares in an initial public offering, raising nearly
$1 billion in cash and reducing Mickey Ltd’s interest in Mouse Ltd to 41%. The remaining 59%

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of Mouse Ltd’s voting interest is widely held.
The managing director of Mouse Ltd was formerly the manager of broadcast operations for
Mickey Ltd. Half the directors of Mouse Ltd are or were executive officers of Mickey Ltd.

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Mouse Ltd and its subsidiaries have entered individually into broadcast contracts with
Mickey Ltd, pursuant to which Mouse Ltd and its cable system subsidiaries must purchase 90% of
their television shows from Mickey Ltd at payment terms, and other terms and conditions of
supply as determined from time to time by Mickey Ltd. That agreement gives Mouse Ltd and
its cable television system subsidiaries the exclusive right to broadcast Mickey Ltd’s movies
and television shows in specific geographic areas containing approximately 45% of the
country’s population. Mouse Ltd and its cable television subsidiaries determine the advertising
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rates charged to their broadcast advertisers.
Under its agreement with Mickey Ltd, Mouse Ltd has limited rights to engage in businesses other
than the sale of Mickey Ltd’s movies and television shows. In its most recent financial year,
approximately 90% of Mouse Ltd’s sales were Mickey Ltd movies and television shows.
Mickey Ltd provides promotional and marketing services and consultation to the cable television
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systems that broadcast its movies and television shows. Mouse Ltd rents office space from
Mickey Ltd in its headquarters facility through a renewable lease agreement, which will expire
in 5 years’ time.

Required
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A. Should Mickey Ltd consolidate Mouse Ltd? Why?

B. If Mickey Ltd had not established Mouse Ltd but had instead purchased 41% of Mouse Ltd’s
voting shares on the open market, does this change your answer to requirement A? Why?
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Source: Adapted from Case III issued by the FASB as a part of its Consolidations project.

41%
Mickey Ltd Mouse Ltd
Mickey Ltd 41%
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NCI 59% - widely held

A)

If the NCI is widely held then it may be argued that Mickey Ltd has the capacity to control Mouse Ltd
based on the potential for the NCI to outvote Mickey Ltd in determining the directors of Mouse
Ltd.
 However, other factors should also be considered, such as:
- historical attendance at AGMs of Mouse Ltd
- interest groups such as Green groups within the NCI
- geographical distribution of NCI

If the NCI were tightly held would the decision be any different?

The other key factor in the definition is the returns criterion. A parent must have the rights to

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variable returns from the control exercised as well as the ability to use power to affect returns.

In this case, many of the key policy decisions seem to have been set by contract:
- must purchase 90% of TV shows from Mickey Ltd
- terms & conditions of supply determined by Mickey Ltd
- limited rights to engage in other businesses

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- provision of marketing services
- lease of rental space.

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Hence even if the NCI could dominate the Board of Mouse Ltd, there is not much they can change to
increase or modify their benefits. Mickey Ltd is therefore running the business. The NCI are
simply investors.

B)

Whether the ownership of Mouse Ltd’s shares comes from acquisition on the open market or
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acquisition at incorporation of the company is not of interest as it has no effect on the
determination of control.

Case Study 6 Options

Donald Ltd and Daisy Ltd own 80% and 20% respectively of the ordinary shares that carry voting
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rights at a general meeting of shareholders of Disneyland Ltd. Donald Ltd sells half of its
interest to Goofy Ltd and buys call options from Goofy Ltd that are exercisable at any time at a
premium to the market price when issued and, if exercised, would give Donald Ltd its original
80% ownership interest and voting rights. At 30 June 2015, the options are out of the money.
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Required
Discuss whether Donald Ltd is the parent of Disneyland Ltd.

Donald Ltd 40%

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40%
Disneyland Ltd Goofy Ltd

Daisy Ltd 20%

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As Donald Ltd holds options in Disneyland Ltd, it has the potential to control that entity. However,
including the options when determining control depends on whether the options are substantive
ie whether it is in the interest of Donald Ltd to exercise the options.

The options are currently out of the money. Hence the options should not be included in the
determination of control.
 However, if there are other reasons why Donald may be able to increase its returns from Disneyland
Ltd such as access to facilities/scarce resources then even if the options are out of the money,
Donald Ltd may still consider that it is worthwhile to exercise the options. In such cases, the
options would be included in the decision on who controls Disneyland Ltd.

Case Study 7 Relevant activities

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Caspar Ltd and Spooky Ltd decide to establish a new entity, Ghosts Ltd. The purpose of Ghosts Ltd
is to develop and market a new car seat designed for use by babies when travelling in a car.
Caspar Ltd and Spooky Ltd have specific roles in the new company and have unilateral ability
to make all decisions in relation to their specified roles. Caspar Ltd has agreed that it will be
responsible for developing the new car seat and obtaining all the approvals from the relevant
safety bodies in Australia. Once the seat has been designed and all safety approvals have been

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received, Spooky Ltd will manufacture and market the product.

Required

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Discuss the activities undertaken by the Caspar Ltd and Spooky Ltd in relation to the
determination of which entity controls Ghosts Ltd.

Power is defined as “existing rights that give the current ability to direct the relevant activities.
Relevant activities are “activities of the investee that significantly affect the investee’s returns”.
Discuss whether either or both activities affect the returns of Ghost Ltd.
If the activities of Caspar Ltd and Spooky Ltd both affect the investee’s returns then it is necessary to
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determine which activities – developing and obtaining regulatory approval or manufacturing and
marketing – MOST significantly affect the investee's returns.
In determining this, it would be necessary to consider:
 the purpose and design of the investee;
 the factors that determine the profit margin, revenue and value of the investee as well as the value of the car
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 the effect on the investee’s returns resulting from each investor’s decision-making authority with respect to
dot point above; and
 the investors’ exposure to variability of returns.

In this particular example, the investors would also consider:

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 the uncertainty of, and effort required in, obtaining regulatory approval (considering the investor’s recor
developing and obtaining regulatory approval of car seat products); and
 which investor controls the car seat product once the development phase is successful.
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CHAPTER 19
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1. Explain the purpose of the pre-acquisition entries in the preparation of consolidated financial
statements.

The purpose of the pre-acquisition entry is to:

- prevent double counting of the assets of the economic entity
- prevent double counting of the equity of the economic entity
- recognise any gain on bargain purchase
 A simple example such as that below could be used to illustrate these points:

A Ltd has acquired all the issued shares of B Ltd. The balance sheets of both companies
immediately after acquisition are as follows:

Share capital $200 Share capital $100

Reserves 100 Reserves 50
300 150

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Shares in B Ltd 150 --
Cash 150 Cash 150
300 150

The balance of the “Shares in B Ltd” account can be changed to introduce goodwill/

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gain on bargain purchase amounts.

4. If the subsidiary has recorded goodwill in its records at acquisition date, how does this affect

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the preparation of the pre-acquisition entries?

Discuss:
- the difference between internally generated and acquired goodwill, and how the goodwill
can be internally generated to the subsidiary but acquired by the parent
- the effects on the worksheet in relation to the goodwill eg if the subsidiary has recorded
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goodwill of $50 and the parent acquires all the shares in a subsidiary for $4,050 when the
equity of the subsidiary is $3 950

Parent Subsidiary Dr Cr Group

Goodwill 0 50 100 150
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In calculating the net fair value of the identifiable assets and liabilities acquired, there must be
an adjustment for the unidentifiable asset, goodwill, to calculate the goodwill acquired by the
group.
The goodwill acquired, but not recorded, is recognised in the business combination valuation
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entries. The pre-acquisition entries will eliminate the BCVR as pre-acquisition equity.
On consolidation, the adjustment columns in the worksheet contain the adjustment
necessary so that the group goodwill is shown in the consolidated balance sheet. This
amount is the total of the goodwill recognised by the subsidiary at acquisition date and
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the goodwill recognised on consolidation. This equals the total goodwill acquired by
the parent in its acquisition of the subsidiary.

8. What is the purpose of the business combination valuation entries?

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The purpose of these entries is to make consolidation adjustments so that in the consolidate balance
sheet the identifiable assets, liabilities and contingent liabilities of the subsidiary are reported at fair
value. This is to fulfil step 3 of the acquisition method required to account for business combinations
by AASB 3.

Case Study 3 Accounting for assets and liabilities

 Mensa Ltd has acquired all the shares of Cancer Ltd. The accountant for Mensa Ltd, having studied
the requirements of AASB 3 Business Combinations, realises that all the identifiable assets and
liabilities of Cancer Ltd must be recognised in the consolidated financial statements at fair value.
Although he is happy about the valuation of these items, he is unsure of a number of other
matters associated with accounting for these assets and liabilities. He has approached you and
asked for your advice.

Required

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Write a report for the accountant at Mensa Ltd advising on the following issues:
1. Should the adjustments to fair value be made in the consolidation worksheet or in the
accounts of Cancer Ltd?
2. What equity accounts should be used when revaluing the assets, and should different equity
accounts such as income (similar to recognition of an excess) be used in relation to
recognition of liabilities?

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3. Do these equity accounts remain in existence indefinitely, since they do not seem to be
related to the equity accounts recognised by Cancer Ltd itself?

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1. From the point of view of AASB 3 and AASB 127, there is no specification on where the
adjustments are made. However if the assets of the subsidiary are adjusted to fair value in the
accounts of the subsidiary itself then this amounts to adoption of the revaluation model by the
subsidiary and all the regulations in AASB 116 and AASB 138 apply. In particular, the assets must
be continuously adjusted to reflect current fair values. If, on the other hand, the adjustments are
made in the consolidation worksheet, this is a recognition on consolidation of the cost of the
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assets to the group entity rather than an adoption of the revaluation model. Hence the
recognition of the subsidiary’s assets at fair value is to measure cost to the acquirer. There is
then no need to make subsequent adjustments to the assets when the fair values change.
Because of the costs associated with using the revaluation model, it is expected that most
entities will make the adjustments in the consolidation worksheet rather than in the accounts of
the subsidiary itself.
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2. The accounting standards do not specify the name of the equity account raised on valuation of
the assets and liabilities of the subsidiary. Hence, an asset revaluation reserve account could be
used for the assets. Leo et al uses a BCVR because adjustments are made to both assets and
liabilities and the BCVR is then a generic account for all adjustments arising as a result of the
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business combination.

It is not appropriate to use income for liabilities as the recognition of equity for both assets and
liabilities does not affect current period profit or loss. There is no gain by the acquirer on
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recognition of assets or liabilities not recognised by the subsidiary.

3. The BCVR remains in existence while the underlying assets and liabilities remain unsold,
unconsumed or unsettled. With asset revaluation reserves under the revaluation model there is
no requirement that it ever be transferred to retained earnings, although this is normal practice
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and is allowed under AASB 116. Similarly, the BCV reserves could remain indefinitely. However,
the extra benefits/expenses resulting from using the assets or settling the liabilities will flow into
the subsidiary’s retained earnings account. Hence the group recognises the net benefits in the
BCVR while the subsidiary recognises them in retained earnings. This situation requires an
adjustment in the consolidation worksheet every year while such a difference in equity
classification occurs. If on consolidation as the assets are used up or sold and the liabilities
settled the BCVR is transferred to retained earnings, no subsequent consolidation adjustment is
required.
 QUESTION 19.3

On 1 January 2017, Graham Ltd acquired all the issued shares (cum div.) of Leslie Ltd for
$263 000. At that date the equity of Leslie Ltd was recorded at:

Share capital $150 000

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Reserves 40 000
Retained earnings 60 000

On 1 January 2017, the records of Leslie Ltd also showed that the company had recorded the
asset goodwill at cost of $5000. Further Leslie Ltd had a dividend payable liability of $10 000,
the dividend to be paid in March 2017. All other assets and liabilities were carried at amounts

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equal to their fair values.

Required

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A. Prepare the consolidation worksheet entries on 1 January 2017, immediately after
combination.

A: Consolidation worksheet entries at 1 January 2017

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At 1 January 2017:

Net fair value of identifiable assets

and liabilities of Leslie Ltd = ($150 000 + $40 000 + $60 000) (equity)
- $5 000 (goodwill)
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= $245 000
Consideration transferred = $263 000 - $10 000 (dividend receivable)
= $253 000
Goodwill acquired = $253 000 – 245 000
= $8 000
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Non-recorded goodwill = $8 000 - $5 000

= $3 000

Business combination valuation entries

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Goodwill Dr 3 000
Business combination valuation reserve Cr 3 000

Pre-acquisition entries
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Retained earnings (1/1/17) Dr 60 000

Share capital Dr 150 000
General reserve Dr 40 000
Business combination valuation reserve Dr 3 000
Shares in Leslie Ltd Cr 253 000

Dividend payable Dr 10 000

Dividend receivable Cr 10 000
 QUESTION 19.4

On 1 July 2016, John Ltd acquired all the issued shares of Robert Ltd for $153 000. At this date
the equity of Robert Ltd was recorded as follows:

Share capital $80 000

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General reserve 30 000
Retained earnings 40 000

All the identifiable assets and liabilities were recorded at amounts equal to their fair values.

Required

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A. Prepare the consolidation worksheet entries at 1 July 2016 assuming John Ltd paid $153 000 for
the shares in Robert Ltd.
B. Prepare the consolidation worksheet entries at 1 July 2016 assuming John Ltd paid $148 000 for

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the shares in Robert Ltd.
C. Prepare the consolidation worksheet entries at 1 July 2016 assuming John Ltd paid $145 000
for the shares in Robert Ltd and at that date Robert Ltd had recorded goodwill of $4000.

A: Consideration of $153 000

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Acquisition analysis:
At 1 July 2016:
Net fair value of identifiable assets
and liabilities of Robert Ltd = ($80 000 + $30 000 + $40 000) (equity)
= $150 000
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Consideration transferred = $153 000

Goodwill acquired = $153 000 – $150 000
= $3 000

Worksheet entries at 1 July 2016:

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Business combination valuation entries

Goodwill Dr 3 000
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Business combination valuation reserve Cr 3 000

Pre-acquisition entries

Retained earnings (1/7/16) Dr 40 000

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Share capital Dr 80 000

General reserve Dr 30 000
Business combination valuation reserve Dr 3 000
Shares in Robert Ltd Cr 153 000

B: Consideration of $148 000

 Acquisition analysis:
At 1 July 2016:
Net fair value of identifiable assets
and liabilities of Robert Ltd = ($80 000 + $30 000 + $40 000) (equity)
= $150 000
Consideration transferred = $148 000
Gain on bargain purchase = $148 000 – $150 000
= $2 000

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Worksheet entries at 1 July 2016:

Pre-acquisition entries

Retained earnings (1/7/16) Dr 40 000

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Share capital Dr 80 000
General reserve Dr 30 000
Gain on bargain purchase Cr 2 000

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Shares in Robert Ltd Cr 148 000

C: Consideration of $145 000 and recorded goodwill of $4000

Acquisition analysis:
At 1 July 2016:
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Net fair value of identifiable assets
and liabilities of Robert Ltd = ($80 000 + $30 000 + $40 000) (equity)
- $4 000 (goodwill)
= $146 000
Consideration transferred = $145 000
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Gain on bargain purchase = $145 000 – $146 000

= $1 000

Worksheet entries at 1 July 2016:

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1. Business combination valuation reserve entries

Business combination valuation reserve Dr 4 000

Goodwill Cr 4 000
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2. Pre-acquisition entries

Retained earnings (1/7/16) Dr 40 000

Share capital Dr 80 000
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General reserve Dr 30 000

Business combination valuation reserve Cr 4 000
Gain on bargain purchase Cr 1 000
Shares in Robert Ltd Cr 145 000