ADVANCED FINANCIAL ACCOUNTING AND REPORTING

CONCEPT REVIEW NOTES PART 2

COVERAGE: Business Combination; Consolidation & Separate FS; Foreign Exchange Transactions &
Derivatives

KEY POINTERS ON BUSINESS COMBINATION & CONSOLIDATION

COST OF INVESTMENT
 The cost of investment is the consideration given to the owners of the acquired company for the
purchase of net assets (Merger) or stocks (Stock Acquisition) of the acquiree, this amount may
include a control premium in case of a stock acquisition. It may comprise of one or a combination
of the following:
o Price paid in cash;
o Noncash assets (At fair market value)
o Shares of stocks (at the fair market value of shares of the acquirer)
o Bonds (IFRS 9 will apply)
 If FVPL or FVOCI – at Fair Value of the bonds
 If AC – at Amortized Cost
o Contingent Consideration

NOTE: Contingent Consideration is different to a contingent liability but it can be in

a form of cash, noncash, stocks, bonds etc.

 When the cost of investment is determined, this shall be compared with the fair value of the net
assets of the acquiree. The acquiree’s assets and liabilities are acquired at its fair value and it
should be IDENTIFIABLE.

 The fair value of identifiable assets of the acquiree should include, assets that are not yet
recorded in the books but determined that it has a fair value at the date of acquisition and it
should NEVER include the Goodwill recorded in the books. This is because, goodwill unlike
intangible assets, lacks identifiability. Also, any contingent assets shall NOT be considered as
part of the fair value of identifiable net assets. The fair value of liabilities may, however, include
Contingent liabilities.

(Note: Net Identifiable assets is different from identifiable assets.)

MERGER
 Any difference of the Cost of Investment and the Fair value of the identifiable net assets of the
acquiree is attributable to Goodwill or Gain on Acquisition (Gain on Bargain Purchase). This
goodwill or gain on acquisition may be adjusted further during the measurement period.
 Note: In a merger, the goodwill from business combination is recorded in the books of the
surviving company and not in the working papers. The old books of the acquiree will be closed
and all the assets and liabilities (at fair value) of the dissolve entity will be recorded in the books
of the acquiring company.

ACQUISITION RELATED COSTS

 According to IFRS 3, Acquisition-related costs are costs the acquirer incurs to effect a business
combination. Generally, acquisition-related costs are expensed in the periods which the costs are
incurred and the services are received. But in exception, cost to issue debt and equity securities
share be recognized in accordance with IFRS 9.
 The following are examples of acquisition-related costs.
1. Directly attributable costs – these costs include professional fees paid to accountants,
legal consultations and other fees for services to effect the business combination such as
finder’s fee and brokerage fees. To be quickly reminded of the examples, these can be
costs for services that are attributable to persons who are not necessarily employees of the
company. These cost are treated as an EXPENSE.

2. Indirectly attributable costs – these costs includes general and administrative expenses
which are, from the term itself, not directly related to the business combination. These
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin

costs are normally salaries of employees, depreciation expenses and other normal
company expenses. The cost are also EXPENSED.
3. Cost to issue equity securities (Share Issuance Costs) – these costs includes costs that
are necessary for the issuance of securities which may include cost of registering stocks,
cost of printing, issuing stock certificates and other related transaction costs as
referred to IFRS 9.
 In the new interpretation of the Philippine Interpretations Committee (PIC), these
costs
are treated in the following order:
a. Debit to APIC from previous issuance
b. Debit to APIC from sources other than the previous issuance
c. Retained Earnings.
4. Cost of registering and issuing debt securities –these include adviser’s fee, underwriting
costs and brokerage fees. These costs are treated as bond issue costs.

MEASUREMENT PERIOD
 During the measurement period, the provisional amounts and the goodwill or gain on bargain
purchase recognized at the date of acquisition shall be retrospectively adjusted as long as the
following criteria are satisfied.
1. The measurement period shall not exceed one (1) year from the acquisition date.
2. The reasons for the changes in the provision are facts and information already existing
(also known as old or existing events) at the acquisition date.
 But once that the changes in the provisional amounts happened after one (1) year from acquisition
date or the reason of the changes are pertinent to facts and information that are inexistent (NEW
EVENTS) from the acquisition date, the treatment of these changes are reflected in the profit or
loss.
 Examples of new events are as follows:
1. Achievement of certain revenue or profit;
2. Achievement of a market share and other economic achievements;
3. Amortization of bonds if the contingent consideration are in the form of bonds or other
financial liabilities in amortized cost;
4. Changes in the fair value in cases of contingent consideration in form of stocks or bonds
measured at fair value.
 Mere changes due to errors of estimation of contingent consideration are NOT considered as
new events. However, such changes should be retroactively adjusted in the goodwill or gain on
acquisition arising from business combination. An example of this is when an entity measured a
contingent consideration in form of bonds at amortized cost. Normally an entity cannot initially
determine the exact rate to be used. In this case, the entity might estimate a temporary effective
rate and since it is just an estimation, this might change over a period of time. Such changes will
be considered as old events.
 The goodwill or gain on acquisition may change several times as long as it satisfies the criteria as
mentioned above.

STOCK ACQUISITION
 As far as the topic is concerned, the consideration given up to effect the business combination in a
stock acquisition is the same as the consideration given in a merger as previously discussed. But in
a stock acquisition, as the term itself, it is the purchase of the stocks to gain control over an entity.
Note that in a stock acquisition, the parent acquires stocks from the shareholders of the
subsidiary and not directly from the company. If the acquired company issued shares to the
acquirer resulting to a control of the purchaser, the effect is a reverse acquisition. As a result, the
purchaser gained control over the company.
 To start with a stock acquisition, the following must be determined:
1. The acquiring company and the company whose stock are being acquired;
2. The date of acquisition;
3. The control the acquirer gained as a result of the stock acquisition.
4. The fair value of the net identifiable assets.
5. The method of measuring goodwill and non-controlling interest.
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin

METHOD OF MEASURING GOODWILL AND NON-CONTROLLING INTEREST

1. Full-Goodwill Approach or Fair Value Option – in this method, goodwill will be recognized
and allocated in the part of the non-controlling interest.
2. Partial-Goodwill Approach or Proportionate Basis of Goodwill – the goodwill/(gain on
acquisition) will only allocated to the controlling interest.

If the problem is silent, the Full-Goodwill Approach is used whenever it is applicable. But there are
instances that the Full-Goodwill approach is inapplicable. According to IFRS 3, paragraph 32, the
acquirer shall recognize goodwill as of the acquisition date measured as the excess of the (a) over
(b):
a. The aggregate of:
1. Consideration transferred
2. Non-controlling interest
b. Fair value of the net assets

And if the amount of the Fair value of net assets is in excess of the aggregate amount of the consideration
transferred and the non-controlling interest, the business combination will result into a gain on
acquisition:

Note: In the separate allocation of goodwill, the amount of the fair value of the net assets attributable to
the controlling interest can be in excess of the consideration transferred, but, the fair value of the net
assets attributable to the non-controlling interest can NEVER be in excess of the FV of the non-
controlling interest.

If the company resulted into a gain on acquisition, no part of the gain shall be allocated to the non-
controlling interest.

Reason: The parent acquires the subsidiary because the acquired company has worth to the acquiring
company. Thus, we should never assess the fair value of the non-controlling interest lower than the fair
value of the net assets attributable to the non-controlling interest.

STEP ACQUISITION
 Business combination may be achieved in stages. When a transaction results into gaining of
control from no control, because of additional stocks purchased, the event is considered to be a
step acquisition. For example, an investment in equity securities or an investment in associate
becomes an investment in subsidiary by purchasing additional stocks of the subsidiary.
 According to IFRS 3, paragraph 42, in a business combination achieved in stages, the acquirer
shall remeasure its previously held equity interest in the acquiree at its acquisition-date fair value
and recognize the resulting gain or loss, if any, in profit or loss or other comprehensive income, as
appropriate.

INITIAL ELIMINATING ENTRIES PERTINENT TO A STOCK ACQUISITION

The purpose of eliminating entries in the working papers during a business combination by stock
acquisition is to consolidate the companies for the presentation of the consolidated financial statements.
The eliminating entries are as follows:

1. To eliminate the equity of the subsidiary

Share Capital xx
Share Premium xx
Retained Earnings xx
Investment in Subsidiary xx Based on Control Percentage
Non-controlling interest xx
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin

2. To adjust the book value of the net asset of the subsidiary to its fair value

Adjustment of an understated asset xx

Adjustment of an overstated liability xx
Adjustment of an understated liability xx
Adjustment of an overstated asset xx
Investment in subsidiary xx Based on Control Percentage
Non-controlling interest xx

3. To recognize a goodwill on business combination.

Goodwill xx
Investment in subsidiary xx Based on the
Non-controlling interest xx attributable goodwill
4. To recognize a gain on acquisition (gain on bargain purchase)

Investment in subsidiary xx
Gain on acquisition xx

ENTITIES REQUIRED TO PRESENT A SET OF CONSOLIDATED FINANCIAL

STATEMENTS
 The standards did not enumerate directly the entities that are required to present consolidated
financial statements, however they have enumerated the conditions when not to present a set of
consolidated financial statements.
 According to IFRS 10, (Business Combination), paragraph 4, an entity that is a parent shall
present consolidated financial statements. This IFRS applies to all entities, however, a parent
need not present consolidated financial statements if it meets all the following conditions:
1. The parent is a wholly-owned or partially-owned subsidiary of another entity and all its
other owners.
2. The debt or equity instruments are not traded in a public market.
3. The parent did not file, nor is it in the process of filing, its financial statements with a
securities commission or other regulatory organization for the purpose of issuing any class
of instruments in a public market; and
4. The entity has an ultimate parent or any intermediate parent that is produces financial
statements that are available for public use and comply with IFRSs, in which subsidiaries
are consolidated or are measured at fair value through profit or loss in accordance with
the IFRS.

Note: According to IFRS 10, paragraph 4B, a parent that is an investment entity (e.g. Dealer of
securities) shall not present consolidated financial statements if it is required, in accordance with
paragraph 31 of this IFRS, to measure all of its subsidiaries at fair value through profit or loss.

STOCK ACQUISITION – TRANSACTIONS SUBSEQUENT TO ACQUISITION

KEY POINTS TO CONSIDER:

 The preparation of consolidated financial statements at the date the acquirer company (parent)
acquires more than 50% of the stock of the acquired company (subsidiary) is not different when
preparing consolidated financial statements subsequent to acquisition, except for the fact that
there are transactions between the parent and the subsidiary occurred after the acquisition date,
which were already recorded in their books.
 Transactions between the two entities must be eliminated when preparing consolidated financial
statements because, although they are legally viewed as separate entities, they are economically
viewed as one entity.
 The transactions between the parent and subsidiary are eliminated only in the working papers
for consolidation purposes. Those transactions remain in their respective separate books.
 The parent’s control of the subsidiary due to the stock acquisition is the main reason why there
are items in the separate statement of comprehensive income, which will be shared by both the
controlling interest and the non-controlling interest.
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin

 If the result of the business combination is goodwill and the NCI has its share on the total
goodwill (full goodwill approach), the share of the controlling and non-controlling interest for
further impairment of goodwill may not be always based on the control percentage acquired
by the acquirer (parent).
 In intercompany profit transactions, there are two types of sale of assets, namely, upstream or
downstream sales. In upstream sale, the selling affiliate is the subsidiary, while in downstream
sale, the selling affiliate is the parent. It is very important to know what type of intercompany
profit transactions occur between the parent and the subsidiary because it will greatly affect the
consolidated net income attributable to the controlling and non-controlling interest.
o If the sale is upstream, the controlling interest will have to share in such adjustment to
the subsidiary’s net income equivalent to the control % of the parent because those
adjustments will affect the net income of the subsidiary, of which was already shared
between the controlling interest and non-controlling interest.
o If the sale is downstream, only the consolidated net income attributable to the
controlling interest will be affected because those items will only affect the net income
of the parent.
 For the preparation of the consolidated financial statements, in the working paper:
o The investment in subsidiary account of the parent is eliminated.
o The equity (ordinary shares, additional paid-in capital, retained earnings, etc.) of the
subsidiary is eliminated.
o Assets and liabilities of the subsidiary are updated to their fair values less any subsequent
amortization in excess of the fair value over the books, or plus the amortization of excess
of book value over the fair value, if any, and if applicable.
o Non-controlling interest in net assets (NCINAS) of the subsidiary is established
representing the percentage of ownership of subsidiary not acquired, if the not wholly-
owned by parent plus the consolidated net income attributable to subsidiary, less any
dividends declared to shareholders other than the parent.
o All the intercompany transactions between the parent and subsidiary are eliminated
because in their consolidated financial statements, they are viewed as one economic
entity.

THE CONSOLIDATED NET INCOME ATTRIBUTABLE TO PARENT AND NCI

 The consolidated net income of the parent includes the net income of the parent, the net income of
the subsidiary from the date of acquisition, any adjustments to their net income such as adjustment
for the depreciation expense previously recognized already in the books of subsidiary, all
intercompany transactions that resulted to a gain or loss, or declaration of dividends, profit arising
from the intercompany sale of inventories, and the impairment of goodwill that arose only from
the business combination, if any. In other words, it is basically the combination of their revenues,
expenses, gains, losses, and other income earned and incurred only from the unaffiliated
companies and individuals.

ITEMS IN THE INCOME STATEMENT PARENT NCI

Net income of the parent per books xx
Net income of the subsidiary per books xx xx
Amortization of excess of fair over book value of assets and liabilities of subsidiary (xx) (xx)
Amortization of excess of book over fair value of assets and liabilities of subsidiary xx xx
Intercompany dividends (xx) (xx)
Impairment of goodwill* (xx) (xx)
Gain on acquisition* xx
Unrealized (gain) / loss in the sale of plant assets (upstream) (xx) / xx (xx) / xx
Realized gain / (loss) in the sale of plant assets (upstream) xx / (xx) xx / (xx)
Unrealized (gain) / loss in the sale of plant assets (downstream) (xx) / xx
Realized gain / (loss) in the sale of plant assets (downstream) xx / (xx)
Unrealized profit in ending inventory (UPEI) – upstream (xx) / xx
Unrealized profit in ending inventory (UPEI) – downstream (xx)
Realized profit in the beginning inventory (RPBI) – upstream xx
Realized profit in the beginning inventory (RPBI) – downstream xx
Adjusted net income for consolidated income statement xxx xxx

* There can be only one result of the business combination. Gain on acquisition is included only in the
consolidated net income in the year of acquisition only.
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin

ITEMS IN THE CONSOLIDATED NET INCOME

a. Net income of the parent per books - it is the net income based on the separate financial
statements of the parent. Remember that this item is fully attributable to controlling interest only.

b. Net income of the subsidiary per books - it is the net income based on the separate financial
statements of the subsidiary. For consolidation purposes, the parent has a share of the of its net
income based on the percentage of ownership of stocks owned by the parent and what is
attributable to subsidiary is the percentage of ownership attributable to the non-controlling
interest.

c. Amortization of excess in fair over book value / book over fair value of assets and liabilities of
the subsidiary - these items pertain to the increases or decreases in assets and liabilities of the
subsidiary not recorded in the books of the subsidiary but recognized in the working paper for
consolidated financial statements at the date of acquisition. In the books of the subsidiary, some of
the expenses (CGS, depreciation, amortization, etc.) included in the net income of the subsidiary
are based on the book values of subsidiary’s assets and liabilities. Thus, these expenses are either
understated or overstated, because for consolidation purposes, these expenses must be based on
their fair values relevant to the reporting period. This is the reason why there is an additional
amortization for consolidation purposes. The following are the common items that are mostly
revalued at the date of acquisition and how are they being amortized for consolidation:

 Depreciable assets (PPE, intangibles, investment property accounted for at cost model,
leased assets) – the difference between the fair value and the book value shall be amortized
based on the remaining useful life from the date of acquisition because the excess pertains
to the overstatement (book over fair) or understatement (fair over book) of the depreciation
expense being included in the net income of the subsidiary.
 Working paper entries (depreciable assets)
I. Amortization of excess of depreciable assets (FAIR VALUE > BOOK VALUE)
1. YEAR OF ACQUISITION
Depreciation Expense xx
Accum. Depreciation xx

2. SUBSEQUENT YEARS
Retained Earnings xx
Depreciation expense xx
Accum. Depreciation xx

Reason for Adjustment: Depreciation is understated because depreciation in the

books is recorded based on the book value of depreciable asset

II. Amortization of excess of depreciable assets (FAIR VALUE < BOOK VALUE)
1. YEAR OF ACQUISITION
Accum. Depreciation xx
Depreciation expense xx

2. SUBSEQUENT YEARS
Accum. Depreciation xx
Retained Earnings xx
Depreciation expense xx

Reason for Adjustment: Depreciation is overstated because depreciation in the

books is recorded based on the book value of depreciable asset

d. Intercompany dividends - these arise because when the subsidiary declares a dividend, a major part of it
are received by the parent company, or when there are shares of stock of the parent owned by the
subsidiary, the latter as well received dividends from the parent. The controlling interest portion of the
dividends declared by subsidiary is deducted from the consolidated net income attributable to the
controlling interest because it was included as an income of the parent in the books. Also, retained
earnings of the subsidiary is credited in the amount of dividends received by the parent from the subsidiary
in the working paper because the balance of the retained earnings of the subsidiary was already
affected by the subsidiary’s dividend declaration. Dividends declared for subsidiary’s other shareholders
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin
(also represented by the non-controlling interest), will be accounted for as a deduction in the NCINAS in
the equity portion of the parent in the consolidated financial statements.
 Journal entry for dividends declared by subsidiary
Dividend income xx
NCI xx
RE – subsidiary xx

Reason for adjustment: Dividend income eliminated represents income recorded by

parent at the date of declaration of the subsidiary. The portion of NCI represents dividend
declared by subsidiary to other shareholders. The effect of dividend declaration to the
retained earnings because it must appear that the subsidiary only declares dividends to
other shareholders at the date of declaration.

e. Impairment of goodwill - goodwill is not amortized, but is tested for impairment annually. If the parent
company determined that the goodwill arising from the business combination is impaired, the impairment
shall be allocated proportionately on the basis on the share of the controlling interest and the NCI on the
goodwill at the date of acquisition, if the acquisition resulted in goodwill and the fair value of the NCI at
the date of acquisition is based only on fair value of the NCI (given or approximated based on the cost of
investment of parent), which is higher than proportionate share of NCI in the net assets of the subsidiary
(minimum amount of NCI). In short, the subsidiary will only share in the impairment of goodwill if there is
a part of goodwill allocated to the NCI at the date of acquisition (full goodwill approach). It must be noted,
however, that if the parent already has goodwill before the date of acquisition, then its impairment is
already reflected in the separate books in the parent, and is solely attributable to the controlling interest, as
it arose from a different transaction before the acquisition. The following table summarizes how the
goodwill will be allocated between the CI and NCI.

How NCI was measured at the Allocation of goodwill

date of acquisition
Estimated FV Controlling and non-controlling percentage or share of CI and NCI
in goodwill
Given fair value share of CI and NCI in goodwill
Proportionate FV Goodwill impairment is fully attributable to CI

f. Intercompany sale of plant assets. Any gain or loss on sale of those assets of the selling affiliate are
unrealized until those assets are either depreciated or sold to the outside parties, and must be eliminated in
the working paper in the net income of the selling affiliate, and recognized as realized on the consolidated
net income of the parent when depreciated or sold to outside parties. The realization of gains and losses
depends whether the plant assets are non-depreciable (land), or depreciable (e.g. machinery, equipment).
Also, the whether the parent will share in the adjustment to the net income of the subsidiary and such
adjustment is fully attributable to parent only will depend if the sale is upstream or downstream sale.
 In intercompany sale of land, because land is not depreciated over time, any unrealized gains or
losses from the intercompany sale of land remains unrealized until sold to outside parties.
 In intercompany sale of depreciable assets, the unrealized gains and losses are eliminated in the
working paper, and such gains or loss is realized in the net income periodically based on remaining
useful life from the date of sale in the form of adjusting depreciation expense and accumulated
depreciation in the working paper, in order to bring the depreciation expense and accumulated
depreciation to the amount based on the carrying amount of the equipment of the selling affiliate as
if no sale was occurred between the two parties, and as if the selling affiliate is still the owner of
the said depreciable asset. If the realized gain or losses is not adjusted, the resulting depreciation
expense in the consolidated income statement is either understated (loss on sale) or overstated (gain
on sale).
 Journal entries on GAIN on Intercompany sale of LAND
1. Year of acquisition
Unrealized gain xx
Land xx

2. Subsequent to the year of acquisition

Retained earnings xx
Land xx
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin

 Journal entries on LOSS on Intercompany sale of LAND

1. Year of acquisition
Land xx
Unrealized loss xx

2. Subsequent to the year of acquisition

Land xx
Retained earnings xx

Reason for adjustment: Unless sold to unaffiliated parties, there should

be no gain to be recognized and the working paper entry restores the
land to its carrying value before the sale.

 Journal entries on GAIN on Intercompany sale of DEPRECIABLE

ASSETS
1. Year of acquisition
Accum. Depreciation xx
Unrealized gain xx
Depreciable asset xx

Accum. Depreciation xx
Depreciation expense xx

2. Subsequent to the year of acquisition

Accum. Depreciation xx
Depreciation expense xx
Retained earnings xx

 Journal entries on LOSS on Intercompany sale of DEPRECIABLE

ASSETS
1. Year of acquisition
Depreciable asset xx
Accum. Depreciation xx
Unrealized gain xx

Depreciation expense xx
Accum. Depreciation xx

2. Subsequent to the year of acquisition

Depreciation expense xx
Retained earnings xx
Accum. Depreciation xx

Reason for adjustment: Either gain or loss, the first entry at the year of
acquisition restores the carrying amount of depreciable asset as if no
sale has occurred and as if the selling affiliate is the owner. The second
entry adjusts the depreciation expense and accumulated depreciation to
the amount as if no sale has occurred between the affiliates. However,
when that depreciable asset is already sold to unaffiliated companies,
the remaining unrealized gain or loss must be recognized in the working
paper in the year that sale occurred.

g. Intercompany sale of inventories - subsequent to acquisition date, there may be intercompany

sale of inventories between the affiliated parties (parent and subsidiary) of which the inventory of
the buying affiliate includes profit from sale of the selling affiliate. Those profits must be
eliminated for consolidation purposes until the inventory from the selling affiliate is sold to
unaffiliated companies and individuals. By eliminating these profits as well as intercompany sale
of inventory, in the consolidated financial statements: (1) the consolidated sales and cost of goods
sold will include only sales and cost of goods sold to unaffiliated parties; and (2) the inventory
balance to be included by the buying affiliate in the consolidated financial statements will include
only cost of inventory to the selling affiliate (either parent or subsidiary). Also, like in the
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin

intercompany sale of plant assets, any profit recorded in the books of the selling affiliate will only
be realized when the inventory coming from the selling affiliate has been sold to unaffiliated
parties.

Intercompany Sale of inventories between the affiliated parties may be upstream (subsidiary to
parent), downstream (parent to subsidiary), or horizontal sales (subsidiary to another subsidiary).
However, for consolidation purposes, only downstream or upstream sales are of concern by the
consolidating entity such that the determination of upstream or downstream sale may affect the
consolidated net income attributable to the controlling and non-controlling interest. If the sale is
upstream, two items are of concern of the consolidating parent in intercompany transactions:

 Unrealized profit in ending inventory (UPEI) – These are the profits of the selling
affiliate included in the unsold inventory of the buying affiliate which previously arose
from the intercompany sale. What is eliminated in the working paper is the profit from
the inventories coming from the selling affiliate such that those profits are reverted to
being unrealized. Because of higher inventory ending balance of the buying affiliate to the
unrealized profit, the cost of goods sold in its books is understated. It can be adjusted
by debiting CGS and crediting inventory in the working paper.
 Realized profit in the beginning inventory (RPBI) - These are the profits of the selling
affiliate included in the beginning inventory (overstating the total goods available for
sale) of the buying affiliate which was previously eliminated in the working paper,
because the related inventory was unsold in the year of intercompany sale. Those
profits are already recognized in the books of the selling affiliate in the year of
intercompany sale, but for consolidation purposes, those profits must be only
recognized in the consolidated net income in the year the inventories coming from the
selling affiliate are already sold to outside parties.

Below summarizes the intercompany sale of inventories, their adjustments to consolidated

financial statements, and rationale for the accounting treatment for those items. It must be noted
that when the sale is upstream sale, both the controlling and non-controlling interest will share
in such adjustment because it is the profit of the subsidiary. If such sale is downstream sale,
only the controlling interest’s share in the consolidated net income will be adjusted, because it is
the profit of the parent. However, whether downstream of upstream sale, there is no need to
allocate such adjustment of CNI-P and NCINIS to determine the consolidated net income.

a. Unrealized profit in ending inventory (UPEI)

 To eliminate the intercompany sale transactions:
Sales xx
CGS xx

 To eliminate the profit included in the ending inventory of the buying affiliate
coming from the selling affiliate:
CGS xx
Ending inventory xx

 Adjustments of selling affiliate’s profit to P/L or to B/S accounts in the working

paper
1.CGS – Add
2.CNI – Deduct
3.Ending Inventory – Deduct
4.Retained earnings – No Effect

 Reason for adjustment / explanation: If there is no 1st entry, it has still no effect in
the consolidated net income, but both the consolidated sales and CGS is overstated
for consolidation purposes because at the time of the intercompany sale, the selling
affiliate recorded sales and the buying affiliate recorded CGS in their respective
books. The amount of profit to be eliminated in the 2nd entry is the profit / markup
included by the selling affiliate to the buying affiliate its sale of inventories to the
latter.
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin

b. Realized profit in the beginning inventory (RPBI)

 To recognize the profit included in the sold inventory that was eliminated in the
year of intercompany transaction:
Consolidated RE xx
CGS xx

 Adjustments of selling affiliate’s profit to P/L or to B/S accounts in the working

paper
1.CGS – Deduct
2.CNI – Add
3.Ending Inventory – No Effect
4.Retained earnings – Deduct

 Reason for adjustment / explanation: The realized profit must be deducted from
CGS because in the books of the buying affiliate, when such inventory is sold to
unaffiliated / outside parties, the profit has been included in its inventory, making
the CGS overstated. Consolidated RE is debited to avoid double counting of such
realized profit as such profit (form of reduction to consolidated CGS) will
eventually be closed to consolidated RE.

THE CONSOLIDATED ITEMS IN THE CONSOLIDATED FINANCIAL STATEMENTS

I. CONSOLIDATED NET INCOME (CNI) ITEMS

The following items appear in consolidated net income are revenues, expenses, gains, and losses after the
necessary adjustments discussed earlier. In addition, accruals made

Consolidated Sales Consolidated operating expenses (OPEX)

Sales of the parent xxx OPEX - parent xxx
Sales of the subsidiary xxx OPEX - subsidiary xxx
Intercompany sale (xxx) Amortization of excess of fair value
Consolidated Sales xxx over the book value / (book value
over the fair value) of depreciable
Consolidated CGS assets xx/(xx)
CGS - parent xxx Realized loss on the sale of
CGS - subsidiary xxx depreciable assets xxx
Amortization of excess of fair value Realized gain on the sale
over the book value / (book value of depreciable assets (xxx)
over the fair value) of inventory xx/(xx) Consolidated OPEX xxx
UPEI xxx
RPBI (xxx) Consolidated Gain on sale
Consolidated CGS xxx Gain on sale of the parent xxx
Gain on sale of the subsidiary xxx
Consolidated Interest Income Unrealized gain (xxx)
Interest income of the parent xxx Consolidated gain on sale xxx
Interest income of the subsidiary xxx
Intercompany interest income (xxx) Consolidated Loss on sale
Consolidated Interest income xxx Loss on sale of the parent xxx
Loss on sale of the subsidiary xxx
Consolidated dividend income Unrealized loss (xxx)
Dividend income – parent xxx Consolidated loss on sale xxx
Dividend income - subsidiary xxx
Intercompany dividend (xxx) Consolidated Interest expense
Consolidated dividend income xxx Interest expense of the parent xxx
Interest expense of the subsidiary xxx
Intercompany interest expense (xxx)
Consolidated Interest expense xxx
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin
II. CONSOLIDATED BALANCE SHEET ITEMS
The items in the consolidated balance sheet of the consolidating entity comprise of the balance
sheet items in the books of both the parent and the subsidiary after all the adjustments
discussed above which may affect the consolidated asset and liability accounts. Note that the
investment in subsidiary account should be eliminated in the working papers, because, again,
they are economically viewed as one entity. Aside from the adjustments mentioned above, some
items below, if not eliminated in the working paper, may overstate or understate some items in the
balance sheet.

Intercompany receivables and payables. Intercompany receivables / payables arise when:

 the sales of the selling affiliate to the buying affiliate are on credit or on account in the
ordinary course of business (accounts receivable / accounts payable, notes receivable /
payable
– trade, advances to suppliers / advances from customers);
 when either of the affiliate grants a loan to the other affiliate not in the ordinary
course of business (notes receivable / payable – non-trade);
 when there are accrued interest arising from the notes (interest receivable / payable).

The intercompany receivable is the amount remained unpaid by the debtor affiliate to the
creditor affiliate as of the balance sheet date. It must be also eliminated because if not
eliminated, it will overstate both the total assets and liabilities in the consolidated balance
sheet. Generally, the entry to eliminate intercompany receivables and payables are as follows:

Payables xxx
Receivables xxx

Consolidated Cash
Cash of the parent xxx
Cash of the subsidiary xxx
Consolidated Cash xxx

Consolidated Receivables
Receivables of the parent xxx
Receivables of the subsidiary xxx
Intercompany receivables (xx)
Intercompany dividend receivables (xx)
Consolidated Receivables xxx

Consolidated Inventory
Inventory of the parent xxx
Inventory of the subsidiary xxx
Excess of the fair over book value /(book over fair value) of
inventory of subsidiary at the date of acquisition xx/(xx)
Amortization of excess of (fair over book value) / book over fair
value of inventory of subsidiary xx/(xx)
UPEI (xxx)
Consolidated Inventory xxx

Consolidated Land
Land of the parent xxx
Land of the subsidiary xxx
Excess of the fair over book value / (book over fair value) of
land of subsidiary at the date of acquisition xx/(xx)
Amortization of excess of (fair over book value) / book over
fair value of land of the subsidiary xx/(xx)
UPEI (xxx)
Consolidated Land xxx
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin
Consolidated Depreciable Assets*
Depreciable asset, net of the parent xxx
Depreciable asset, net of the subsidiary xxx
Excess of the fair over book value / (book over fair value) of depreciable
asset of subsidiary at the date of acquisition xx/(xx)
Amortization of excess of (fair over book value) / book over fair value of
depreciable assets of the subsidiary xx/(xx)
(Unrealized gain) /unrealized loss (xx)/xx
Realized gain / (realized loss)** xx/(xx)
Consolidated depreciable assets xxx

*applies to building, machinery, equipment, intangibles with definite useful life, investment
property accounted for at cost model, and other depreciable assets
**in the form of lower depreciation expense for realized gain, and higher depreciation expense for
the realized loss

Consolidated Goodwill
Goodwill of the parent before the business combination xxx
Goodwill arising from the business combination xxx
Impairment of goodwill arising from the business combination (xxx)
Consolidated goodwill xxx

Note: goodwill of the subsidiary should be eliminated in the working paper because it is not
identifiable unlike other intangible assets of the subsidiary and it does not have fair value.

Consolidated Liabilities
Liabilities of the parent xxx
Liabilities of the subsidiary xxx
Intercompany payables (xxx)
Dividend payable to the parent (xxx)
Consolidated Liabilities xxx

Consolidated Retained Earnings

RE, beginning* xxx
CNI – parent xxx
Dividends declared (xxx)
Consolidated RE, end xxx
*if it is the year of acquisition, the consolidated RE after the business combination at the date
of acquisition.

Non-controlling interest in the Net Assets of the subsidiary (NCINAS)

NCINAS, beginning* xxx
NCINIS xxx
Dividends declared (excluding dividends to be received by parent) (xxx)
NCINAS, end xxx
*if it is the year of acquisition, the NCINAS after the business combination at the date of
acquisition.

Consolidated SHE
Ordinary and preference shares of the parent xxx
APIC of the parent xxx
Consolidated RE, end xxx
NCINAS, end xxx
Items in OCI of the parent xxx
Consolidated SHE xxx
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin
Consolidated Assets
Total assets of the parent xxx
Total assets of the subsidiary xxx
Investment in subsidiary (xxx)
Goodwill of the subsidiary (xxx)
Goodwill arising from the business combination, net of accumulated
impairment loss, if the result is goodwill xxx
Unrealized (gain) / loss in the sale of plant assets (xx)/xx
Realized gain / (loss) in the sale of plant assets xx / (xx)
Unrealized profit in ending inventory (UPEI) (xxx)
Excess of fair over book value / (book over fair value of assets) xx/(xx)
Amortization of excess of fair over book value / (book over fair value)
of assets of subsidiary (xx)/xx
Intercompany receivables (xxx)
Consolidated Assets xxx

FOREX AND DERIVATIVES

Part I: Changes in Foreign Exchange Rates

 The objective of PAS 21 The Effects of Changes in Foreign Exchange Rates is to prescribe:
 How to include foreign currency transactions and foreign operations in the financial
statements of an entity.
 How to translate financial statements into a presentation currency.
 In other words, PAS 21 answers:
o What exchange rates to use.
o How to report gains or losses from foreign exchange rates in the financial statements.

Functional vs. Presentation Currency

 Functional currency is the currency of the primary economic environment in which the entity
operates. It is the own entity’s currency and all other currencies are “foreign currencies”.
 The most important factor in determining the functional currency is the entity’s primary
economic environment in which it operates.
 The primary economic environment is normally the one in which the entity primarily generates
and expends the cash. The following factors can be considered:
o What currency does mainly influence sales prices for goods and services?
o In what currency are the labor, material and other costs denominated and settled?
o In what currency are funds from financing activities generated (loans, issued equity
instruments)?
 Presentation currency is the currency in which the financial statements are presented.
 An entity can decide to present its financial statements in a currency different from its
functional currency – for example, when preparing consolidation reporting package for its parent
in a foreign country.
 While an entity has only 1 functional currency, it can have 1 or more presentation currencies,
if an entity decides to present its financial statements in more currencies.

How to report transactions in Functional Currency

 Initial recognition
o Initially, all foreign currency transactions shall be translated to functional currency by
applying the spot exchange rate between the functional currency and the foreign currency
at the date of the transaction.
o The date of transaction is the date when the conditions for the initial recognition of an
asset or liability are met in line with PFRS.
 Subsequent reporting
o Subsequently, at the end of each reporting period, you should translate:
 All monetary items in foreign currency using the closing rate.
 All non-monetary items measured in terms of historical cost using the exchange
rate at the date of transaction (historical rate).
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin
 All non-monetary items measured at fair value using the exchange rate at the
date when the fair value was measured.

How to report foreign exchange differences

 All exchange rate differences shall be recognized in profit or loss, with the following
exceptions:
o Exchange rate gains or losses on non-monetary items are recognized consistently with
the recognition of gains or losses on an item itself. For example, when an item is
revalued with the changes recognized in other comprehensive income, then also
exchange rate component of that gain or loss is recognized in OCI, too.
o Exchange rate gain or loss on a monetary item that forms a part of a reporting entity’s net
investment in a foreign operation shall be recognized:
 In the separate entity’s or foreign operation’s financial statements: in profit or
loss
 In the consolidated financial statements: initially in other comprehensive income
and subsequently, on disposal of net investment in the foreign operation, they shall
be reclassified to profit or loss.

 Change in functional currency

o When there is a change in a functional currency, then the entity applies the translation
procedures related to the new functional currency prospectively from the date of the
change.

How to translate financial statements into a Presentation Currency

 When an entity presents its financial in the presentation currency different from its functional
currency, then the rules depend on whether the entity operates in a non-hyperinflationary
economy or not.
 Non-hyperinflationary economy
o When an entity’s functional currency is NOT the currency of a hyperinflationary
economy, then an entity should translate:
 All assets and liabilities for each statement of financial position presented using
the closing rate at the date of that statement of financial position. This rule applies
for goodwill and fair value adjustments.
 All income and expenses and other comprehensive income items using the
exchange rates at the date of transactions. PAS 21 permits using some period
average rates for the practical reasons, but if the exchange rates fluctuate a lot
during the reporting period, then the use of averages is not appropriate.
 All resulting exchange differences shall be recognized in other comprehensive
income as a separate component of equity.
 However, when an entity disposes the foreign operation, then the cumulative
amount of exchange differences relating to that foreign operation shall be
reclassified from equity to profit or loss when the gain or loss on disposal is
recognized.

 Hyperinflationary economy
o When an entity’s functional currency IS the currency of a hyperinflationary economy,
then the approach slightly changes:
 The entity’s current year’s financial statements are restated first.
 Only then, the same procedures as described above are applied.

Part II: Derivatives

 A financial instrument that derives its value from the movement in commodity prices, foreign
exchange rate and interest rate of an underlying asset or financial instrument.
 It is an executory contract, not a transaction, because it is an exchange of promises about future
action.
 Derivatives are used for hedging. Derivatives are also called hedging instruments.
 It creates rights and obligations that have the effect of transferring between the parties to the
instrument the financial risks inherent in an underlying primary financial instrument.
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin
 Financial risks are of four (4) types:
o Price risk – uncertainty in future price of an asset.
o Credit risk – uncertainty over whether a counterparty or the party on the other side of the
contract will honor the terms of the contract.
o Interest rate risk – uncertainty about future interest rates and their impact on cash
flows and the fair value of the financial instruments.
o Foreign exchange risk – uncertainty about future Philippine peso cash flows stemming
from assets and liabilities denominated in foreign currency.

Characteristics
 Its value changes in response to the change in an “underlying” variable.
o An underlying is a specified interest rate, commodity price, foreign exchange rate,
index of prices or rates and other variables.
o An underlying may be a price or rate of an asset or a liability but not the asset or
liability itself.
o A derivative has a speculative amount of currency, number of shares, or number of
units or volume.
 It requires either no initial net investment or a little initial net investment that would be
required for other types of contracts that have similar response to changes in market conditions.
 It is readily settled at a future date by a net cash payment.

Basic Types of Derivatives

 Forward contract
o A contract to purchase or sell a particular commodity at a designated future date at a
predetermined price.
o A private or over-the-counter contract between two parties. Banks are the typical
counterparties.

 Futures contract
o A contract to purchase or sell a particular commodity at a designated future date at a
predetermined price.
o A standard contract traded in a future exchange market and one party will never know
who is on the other side of the contract.
o All cash settlements are made through the exchange market.

 Option
o A contract that gives the holder the right (not an obligation) to purchase or sell an
asset at a specified price within a given future time period.
o Can be a:
 Call option – gives the holder the right to purchase an asset (part of the buyer).
 Put option – gives the holder the right to sell an asset (part of the seller).
o A derivative that requires initial small payment for the protection against unfavorable
movement in price. Thus, an option must be paid for unlike an interest rate swap,
forward contract and futures contract.

 Interest rate swap (IRS)

o A contract whereby two parties agree to exchange cash flows for future interest
payments based on a contract of loan. Thus, a contract of loan is the primary financial
instrument while interest rate swap agreement is the derivative financial instrument.
AFAR CONCEPT REVIEW NOTES PART 2 by Vhin

Examples of Derivative Financial Instruments with the Underlying Variable

Type of Contract Underlying

Commodity Forward Commodity Price
Commodity Futures Commodity Price
Currency Forward Currency Rates
Currency Futures Currency Rates
Currency Swap Currency Rates
Equity Forward Equity Price
Interest Rate Swap Interest Rates
Interest Rate Forward Interest Rates
Purchased or Written Currency Option Currency Rates
Purchased or Written Commodity Option Commodity Price

Hedged Items
 Hedged items can be
o A single asset or liability
o Firm commitment
o Highly probable forecast transaction
o Net investment in a foreign operation

Hedging
 Means designating one or more hedging instruments so that their change in fair value is an
offset, in whole or in part, to the change in fair value or cash flows of a hedged item.
 A means of protecting a financing loss or the structuring of transactions to reduce risk.
 Categorized into three types of relationship:
o Fair value hedge – is a protection against the risk from changes in fair value caused by
fixed terms, rates or prices.
o Cash flow hedge – is a protection against the risk from changes in cash flows caused by
variable terms, rates or prices.
o Hedge of a net investment in a foreign operation – involves an underlying variable
which is the foreign currency.

Hedge Accounting
 All derivatives are recognized as either “investment” assets or liabilities being recognized by
either party, as market conditions change.
 They are measured at fair values. A change in fair values requires the recognition of a gain or
loss. A gain or loss on derivative financial instruments is accounted for depending on how the
derivative is used:
o No hedging designation
 Changes in fair value are recognized in earnings immediately.
o Fair value hedge
 Changes in fair value are recognized in earnings immediately.
 Gain or loss on the hedged item attributable to the hedged risk should adjust the
carrying amount of the hedged items and be recognized in earnings
immediately.
 Cash flow hedge
o The effective portion of the gain or loss on the hedging instrument is reported in equity
o The ineffective portion of the gain or loss on the hedging instrument is reported
immediately in earnings.
 Hedge of a net investment in foreign operation
o The effective portion of the gain or loss on the hedging instrument is reported in equity.

The ineffective portion of the gain or loss on the hedging instrument is reported immediately in
earnings.