ADVANCED FINANCIAL

ACCOUNTING

Lecture 3
Group Reporting I&II

Angie Wang
School of Accountancy
Overview
-For the next topic
Group Reporting
-Introduction
Users of financial information may need more than one set of financial
statements to make investment decision.
Financial information may be reported at three levels

Financial information

Disaggregated reporting
Separate financial
Aggregated reporting for for business units
statements for the legal
the economic entity within a legal or
entity
economic entity
Group Reporting
-Introduction
Need for disaggregated Information
Corporate regulations may require separate financial statements to be prepared by each legal entity

Purpose of separate
Financial Statements

Prevent weakness of
Determine the financial individual companies to
Provide information for
solvency of individual be masked by strengths
legal and tax purposes
entities of other group
companies
Group Reporting
-Introduction
Need for aggregated Information
Group
Subsidiary

Parent
(Controlling Control
Subsidiary Consolidation:
entity) Process of preparing and presenting
financial statements of a group in
which the assets, liabilities, equity,
income, expense and cash flows of
the parent and its subsidiaries as if
Subsidiary they were one economic entity.
Group Reporting
-Introduction
The need for consolidated financial statements by the reporting entity:

❑If separate financial statements are the only source of information

-FS users may not be able to properly assess extent of the size, profitability,
cash flows and risks of the larger economic entity
-May not be able to obtain a clear picture of group performance as a whole
(i.e., not seeing the forest for the trees)

❑Consolidation allows investors to assess the risk-return profile of the combined

entity.

❑Value-enhancing VS. Value-destroying?

-Require aggregated (consolidated) and disaggregated (segment) information
 Economic Incentives for Entering into
Intercorporate Arrangements
Uncertainty
Three types of risks:
Risk mitigated by - Macro
M&A strategies - Industry
- Firm idiosyncratic

Value-enhancing Risk management strategies Value

VS. - Organic growth or acquisition - Combined risks
Value-destroying? - Risk diversification - Size effects
- Co-insurance effect
Information - Diversification effect
reporting

Control Joint-venture Significant Influence

(Acquisition method) (Equity method) (Equity method)
Economic Incentives for Entering into
Intercorporate Arrangements
Zero 20% 50% 100%
Ownership Ownership Ownership Ownership

Passive Active Active

Investment Investment Investment
- Trading securities - Associated company - Partially-owned subsidiary
- Available- for- - Joint-venture - Fully-owned subsidiary
sale securities

i. Earn dividend i. Exert significant i. Exert control over subsidiary’s operation

income influence over ii. Gain entry intro a new market
Purposes ii. Make capital gain investee’s iii. Achieve synergistic benefits from
operation or joint complementary strengths
control iv. Gain market dominance

Equity method Consolidation

(HKAS/IAS 28) (HKFRS/IFRS 10)
 Concepts of Control-Recap
Attributes of control under IFRS 10 (qualitative factors):
An investor controls an investee if and only if the investor has all of the following
elements: [IFRS 10:7]

Power

Control
Ability

Returns
Overview
Concepts of Control
Power: existing rights that give the investor the current ability to direct the activities that
significantly affect the investee’s returns (i.e., relevant activities).

❑Rights:
-Current voting rights
-Potential voting rights
-Rights to appoint or remove members of investee’s key management personnel or governing
body
-Other rights (such as decision-making rights specified in a management contract) that give the
holder the ability to direct the relevant activities

❑Relevant activities (activities that significantly affect the investee’s returns)

-Include operating and financial activities
-Decisions over those activities include operating and capital decisions of investee and
appointment etc.
Concepts of Control
Returns:

❑Variable returns that investors is exposed to could be:

(i) all positive
(ii) all negative
(iii) either positive or negative

❑Examples of returns:
-Dividends, interest from debt securities and changes in the value of investment
-Economies of scale, cost savings, synergies

❑Variable returns do not necessarily mean that the monetary amount is variable:
-Bonds with fixed interest payments is an evidence of exposure to variable returns
(Reason: exposed to credit risk)
Concepts of Control
Ability: Investor must have:

❑The ability to use the power must be current, but ‘current’ does not necessarily mean ‘instant’.

❑Little barriers that prevent the exercise of those rights.

❑substantive rights
(1) Exercisable when decisions about relevant activities need to be made
(2) Holder needs to have a practical ability to exercise those rights
Concepts of Control
Investor has power over an investee which is obtained directly and solely from the
VOTING RIGHTS that stem from holding voting interests (e.g., shares), when:
(i) Investor holds the majority of the voting rights; or

(ii) Investor holds less than majority of the voting rights BUT:
-Holds rights arising from other contractual arrangements;
-Holds potential voting rights that are exercisable when decisions about significant
activities of the investee will be made (an application of substantive rights);
-Holds voting rights sufficient to unilaterally direct the relevant activities of the
investee (de facto control)
Concepts of Control
De facto control:

❑ Applies to situation when investor holds less than a majority rights of the investee

❑ Holds significantly more voting rights than any other vote holder or organised group of vote
holders (relative voting rights)

❑ Still gives rise to sufficient evidence of power

Concepts of Control
More examples (Relative voting rights in the Determination of Control)
Investors A, B, and C collectively have more than 50% ownership interests.
The remaining 43% ownership interests are dispersed over 100 investors, each not
owning more than 0.5% interest.
Voting rights Voting at the Relative voting
annual general rights
meeting
Investor A 40% 40% 57%
Investor B 10% 10% 14%
Investor C 7% 7% 10%
Other investors 43% 13% 19%
100% 70% 100%
Concepts of Control
More examples (Potential Voting Rights in the Determination of Control)
Investor A: founding investor
Investor B: strategic investor who knows the company’s business (Issued options with 40,000
ordinary shares)
Investor C: related party of Investor A

Voting rights % Ownership Potential Combination % Ownership

voting rights
(if exercised)
Investor A 30,000 67% - 30,000 35%
Investor B 10,000 22% 40,000 50,000 59%
Investor C 5,000 10% - 5,000 6%
45,000 100% 40,000 85,000 100%
Concepts of Control
More examples (Potential Voting Rights in the Determination of Control)
Q1. The options are exercisable at the current date, who has control?
Conclusion: Investor B
Q2. The options are exercisable in Year 3, who has control?
Conclusion: Investor A
Voting rights % Ownership Potential Combination % Ownership
voting rights
(if exercised)
Investor A 30,000 67% - 30,000 35%
Investor B 10,000 22% 40,000 50,000 59%
Investor C 5,000 10% - 5,000 6%
45,000 100% 40,000 85,000 100%
Concepts of Control
Direct and Indirect control

❑IAS 27 requires consideration of the percentage of voting rights held “direct or indirectly
through subsidiaries.”

❑Control must be demonstrated at each intermediate level before the ultimate holding company
is said to have control over the lowest-level company

❑If an entity is able to control the intermediary, the first entity is deemed to have control over
all entities over which the intermediary has control.
Concepts of Control
Direct and Indirect control
If an entity is able to control the intermediary, the first entity is deemed to have control over all
entities over which the intermediary has control.

Affiliation structures
Situation 1: X Co. Situation 2:
X Co.
X Co. controls X Co. controls
Y Co. and A Co. Y Co., B Co. and Z Co.
100% 60%
Even though X.Co. Even though X Co.
indirectly owns 75% only indirectly owns
Y Co. Break in control at Y Co. 33% of B Co. and
B and hence no 49.2% of Z Co.
50% 50% 60% control over Z Co. 55% 60% 50%

B Co. Z Co. A Co. B Co. Z Co. A Co.

50% 40%

Situation 1 Situation 2
Concepts of Control
Link between Power, Ability, and Return

❑Consider whether the investor has the ability to use its power over the investee to affect its
returns
❑Investor has power and returns but misses the linkage element when the investor is an agent.
Concepts of Significant Influence
Zero 20% 50% 100%
Ownership Ownership Ownership Ownership

Passive Active Active

Investment Investment Investment
- Trading securities - Associated company - Partially-owned subsidiary
- Available- for- - Joint-venture - Fully-owned subsidiary
sale securities

i. Earn dividend i. Exert significant i. Exert control over subsidiary’s operation

income influence over ii. Gain entry intro a new market
Purposes ii. Make capital gain investee’s iii. Achieve synergistic benefits from
operation or joint complementary strengths
control iv. Gain market dominance

Equity method Consolidation

(HKAS/IAS 28) (HKFRS/IFRS 10)
Concepts of Significant Influence
Significant influence
Power to participate in the financial and operating policy decisions of the investee but
is less than control and is not equivalent to joint control over those policies (IAS 28:2)

Default assumption:
An investor has ownership of 20% or more of the voting power and equal to or less
than 50% of the voting power in an investee, including “potential voting rights.”

Other evidences (IAS 28:7)

Number of directors
Participation in Operational
representing investors on
policy-making processes interdependencies
board
Investors must disclose reasons for not complying with the default assumption.
Concepts of Significant Influence
❑An investor may participate in the policy-making processes of an investee, although they may
not have the power to govern the final outcome of decision-making process.

❑IAS 28 describes such an investor as having “significant influence”, and the investee is
deemed an “associate” of the investor.
❑ “An associate is an entity in which the investor has significant influence and which is neither a subsidiary nor
a joint-venture of the investor” (IAS 28:2)

❑Special accounting procedures described as the “equity method” are applied.

Concepts of Significant Influence
Direct and Indirect Significant Influence
Using the percentage criterion of >=20% and <=50% of the investee’s voting rights

Multi-level structures

P Situation 1: P Situation 2:
P has significant P has significant
influence over: influence over:
80% 50% i) Y (50% direct 40% 50% i) A (40% direct
interest) interest)
ii) Z (65% indirect ii) C (50% direct
X Y interest) – P has A C interest)
no control over Y iii) B (42% indirect
50% 50% 80% 20% interest)

Z B

Situation 1 Situation 2
Any questions?
Consolidation Theories
-Ownership of the Combined Entity
Ownership of the combined entity Joint-ownership of the combined entity
involving a wholly owned subsidiary involving a partially owned subsidiary

Parent company’s shareholders Parent company’s shareholders

30% ownership
Parent company Parent company
in subsidiary
100% Non-controlling 70%
ownership shareholders of a ownership
Subsidiary subsidiary Subsidiary

2 groups of shareholders
Wholly owned by the parent 1) The parent company’s shareholders; and
company’s shareholders 2) The non-controlling shareholders of the
subsidiary
Consolidation Theories
-Ownership of the Combined Entity
Parent company sells part of
its stake in a subsidiary to
external shareholders
“equity carve-outs”

Reasons why
non-controlling
Parent company interest Parent and non-controlling
buys a majority arise shareholders are the founding
stake in a subsidiary shareholders of a newly
from existing owners incorporated entity
(themselves become NCI)
Consolidation Process
Legal entities Economic entity

Parent’s Subsidiaries' Consolidation adjustments Consolidated

Financial + Financial +/- and eliminations
= financial
Statements Statements statements

❑Consolidation is the process of preparing and presenting the financial statements

of a group as an economic entity.
❑Consolidation worksheets are prepared to:
-Combine parent’s and subsidiaries financial statements
-Adjust or eliminate effects of intra-group transactions and balances
-Allocate profit to non-controlling interests
Consolidation Process
❑Consolidation involves adding together the financial statements of the parent
and subsidiaries and making a number of adjustments:

1. Business combination valuation entries: required to adjust the carrying amounts

of the subsidiary’s assets and liabilities to fair value

2. Pre-acquisitions entries: required to eliminate the carrying amount of the parent’s Combined:
investment in each subsidiary against the pre-acquisition equity of that subsidiary Consolidation
journal entries

3. Intragroup transactions: transactions between entities within the group

subsequent to acquisition date
 Consolidation Process
-Consolidation worksheets
❑Consolidation journals are posted into the consolidation worksheet in ‘adjustment’
columns as follows:
Add down for
Extract only Parent Subsidiary sub-totals

Purpose: to remove the parent’s investment in the subsidiary and the effect of all inter-entity
transactions so that the final column shows an ‘external view’
Consolidation Process
-Consolidation worksheets
❑Consolidation journal adjustments are ONLY prepared for the purpose of
consolidation.

❑They are posted onto the consolidation worksheet only ‒ they are NOT recorded in the
books of the parent or the subsidiary.

❑As a result, some consolidation adjustments are repeated (‘re-enact) every time
consolidated accounts are prepared.
Consolidation Process
-Business combination valuation entries
❑If the BV of subsidiary assets and liabilities differs from FV, or if a contingent liability exists,
it is necessary to make ‘business combination valuation’ adjustments. These adjustments:
-Increase or decrease subsidiary’s recorded assets and liabilities book values to fair value
-Recognise previously unrecognised assets
-Recognise subsidiary’s contingent liabilities as liabilities at fair values

❑Business Combination Valuation Reserve (BCVR) account is used to record these

adjustments.

❑The BCVR is similar to the Asset Revaluation Surplus (ARS) account

Consolidation Process
-Pre-acquisitions entries
❑Equity balances that existed in the subsidiary prior to acquisition date are referred to as
pre-acquisition equity. All movements after the date of acquisition are referred to as
post-acquisition.

❑You cannot have an investment in yourself, nor can you have equity in yourself. From a
consolidated viewpoint, these items should not exist, i.e., they must be eliminated to avoid
double counting.
Consolidation Process
-Pre-acquisitions entries
Elimination of Investment Account in a Subsidiary
Consideration Share of book value of Share of excess of fair
transferred = subsidiary’s net assets at + value over book value + Goodwill
acquisition date of identifiable net assets

Eliminated against Fair value differentials

subsidiary’s share capital
and pre-acquisition
retained earnings

Investment account is eliminated

-To ensure that the investment account must be zero
-Substituted with subsidiary’s identifiable net assets and goodwill (residual)
-Rationale: Avoid recognizing assets in two forms (investment in parent’s statement of financial
position and individual assets and liabilities of subsidiary)
Consolidation Process
-Pre-acquisitions entries
Elimination of Investment Account in a Subsidiary (Continued)

❑ Pre-acquisition retained earnings or pre-acquisition reserves of subsidiary are not included in

consolidated equity.
-Rationale: Pre-acquisition retained earnings arose prior to the exercise of control by the parent.

❑ The elimination process will result in residuals comprising of

-Goodwill; and
-Excess or deficit of fair value over book value of identifiable net assets

❑ Re-enactment of elimination of investment entry in the subsequent year (Re-enacted as long as the
investment exists)
-Rationale: The parent’s legal entity financial statements would always include investment in the
subsidiary balance as long as the investment exists.
Illustration: Elimination of Investment
Illustration
On 8 August 2010, Parent Co. bought 100% interest in subsidiary for $200,000. At the date of acquisition,
Subsidiary Co had the following:

Share capital: $50,000

Retained earnings: $30,000
Equity: $80,000

At the acquisition date, Subsidiary Co’s unrecognized intangible assets had a fair value of $50,000. Tax
rate was 20%.
Illustration: Elimination of Investment
Deferred Tax Relating to FV Differentials of Identifiable Assets and Liabilities
❑ The recognition of fair value differential may give rise to future tax payable or future tax deduction
– tax effects need to be accounted for because the basis for taxation does not change in a business combination
– i.e., The excess of fair value over book value of identifiable net assets will give rise to a taxable temporary
difference and vice versa.

FV > Book value of identifiable assets Deferred tax liabilities

FV < Book value of identifiable assets Deferred tax assets
FV < Book value of identifiable liabilities Deferred tax liabilities
FV > Book value of identifiable liabilities Deferred tax assets

❑ No deferred tax liability is recognized on goodwill as goodwill is a residual

Illustration: Elimination of Investment
Consolidation Consolidated Statement of financial
Parent Subsidiary
adjustments position
Dr Cr
Assets
Investment in
200,000 200,000 0
Subsidiary
Goodwill (Note 2) ? 80,000
Other net assets
300,000 80,000 ? ? 420,000
(Note 1)
500,000 80,000 130,000 210,000 500,000

Equity
Share capital 100,000 50,000 50,000 100,000
Retained earnings 400,000 30,000 30,000 400,000
500,000 80,000 80,000 0 500,000
210,000 210,000

Pre-acquisition
Illustration: Elimination of Investment
Note 1:
Increase in other net assets due to recognition of intangible assets 50,000

Decrease in other net assets due to recognition of deferred tax liability (10,000)

Net increase in other net assets 40,000

Note 2:
Goodwill is excess of the investment amount over the FV of identifiable net assets
Investment in Subsidiary 200,000
Book value of equity or net assets (80,000)
Fair value of intangible asset 50,000
Book value of intangible asset 0
Excess of fair value over book value 50,000
Deferred tax effects (10,000)
(40,000)
Goodwill 80,000
Illustration: Elimination of Investment
Consolidation Consolidated Statement of financial
Parent Subsidiary
adjustments position
Dr Cr
Assets
Investment in
200,000 200,000 0
Subsidiary
Goodwill (Note 2) 80,000 80,000
Other net assets
300,000 80,000 50,000 10,000 420,000
(Note 1)
500,000 80,000 130,000 210,000 500,000

Equity
Share capital 100,000 50,000 50,000 100,000
Retained earnings 400,000 30,000 30,000 400,000
500,000 80,000 80,000 0 500,000
210,000 210,000
Illustration: Elimination of Investment
Worksheet entries:
Business combination valuation entries
Dr Intangible asset 50,000
Cr Deferred tax liability 10,000
Cr Business combination valuation reserve 40,000

Dr Goodwill 80,000
Cr Business combination valuation reserve 80,000

Pre-acquisition entries
Dr Share capital 50,000
Dr Retained earnings 30,000
Dr Business combination valuation reserve 120,000
Cr Investment in Subsidiary 200,000
Illustration: Elimination of Investment
Worksheet entries (combined):
CJE1: Elimination of investment in subsidiary
Dr Share capital 50,000
Dr Retained earnings 30,000
Dr Goodwill 80,000
Dr Intangible asset 50,000
Cr Investment in Subsidiary 200,000
Cr Deferred tax liability 10,000
210,000 210,000

Re-enacting CJE

❑ Building blocks of consolidation worksheet are the legal entity financial statements
of parent and subsidiary.
❑ CJE 1 has to be re-enacted at each reporting date as long as Parent has control over
subsidiary.
❑ Each consolidation process is a fresh-start approach.
Any questions?
For next time…
• Read McGraw Hill Ch2&4, Wiley Ch21