Chapter 2

Group
Reporting I:
Concepts
and Context

Copyright © 2019 by McGraw-Hill Education (Asia). All rights reserved. 1

Learning Objectives

Understand:
1. The rationale for group reporting and the complementarity of
reporting by legal and economic entities, and business units;
2. The economic incentives for the provision of consolidated financial
information;
3. The economic context of group reporting – merger and acquisition
as risk management strategy and the impact on financial reporting;
4. The concept of “control” and the determination of the parent-
subsidiary relationship;
5. The concept of “significant influence” and the notion of “associate”
6. The concept of a “business combination” and the scope of IFRS 3;
7. The theories relating to consolidation; and
8. The effects of parent versus entity theories of consolidation

2
Content

1. Introduction
2. Economic Incentives for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangements
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation Theories
3
Introduction

• A primary issue that underpins financial reporting is the identification

of the reporting entity.

Financial information may be reported at three levels

Reporting of financial
information

Consolidated financial Segment reporting

Separate financial statements (Disaggregated
statements for the (Aggregated reporting reporting for business
legal entity for the economic units within a legal or
entity) economic entity)

4
Introduction
Relationship between legal entities on the basis of control

• Ownership
• Contractual or statutory
arrangements
• De facto control

Legal Entity Control

Legal entity
(Subsidiary)
(Parent)
Effective relationship

Group
5
Introduction
Incentives to extend economic boundaries

Capitalizing
on slack debt Increased
or operating market shares
capacity

Tapping on Economies
growth of scale
opportunities and scope
Reduced
risk through
diversification

6
Introduction

• A group of companies may be better able to deal with economic risk

than a single company. Examples of risks:
– Macro-economic risk (e.g. changes in government policies)
– Industry risk (e.g. technological risks)
– Firm-specific risk (e.g. over-reliance on specific human capital)

• However, corporate acquisition and diversification may be sub-optimal

and value-destroying if
– Motivated by managers’ self-interest to invest in size rather than value
(Jensen, 1986; Shleifer and Vishny, 1990)
– Costs and risks that arise from acquisition strategies, particularly in
unrelated diversification exceed benefits

• Synergistic benefits potentially reduced by direct and indirect costs

arising from these strategies
7
Introduction

• Principle of substance over form:

– Notion of a reporting entity extends beyond the legal entity to that of an
economic group of related companies

• The need for consolidated financial statements of the reporting

entity
– If separate financial statements (FS) are the only source of information,
FS users
• Will 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 the group performance
as a whole (i.e. not seeing the forest for the trees)
• May not be able to assess the outcome of an investor’s acquisitions
– Consolidated FS allows investors to assess the risk-return profile of the
combined entity
8
Introduction

• Corporate regulations may require separate financial statements to

be prepared by each legal entity

Purpose of separate
financial statements

Prevent weaknesses 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

9
Introduction
Need for disaggregated Information

Loss of information if only

aggregated information is provided

Source of
disaggregated
information

Separate financial
Segment information
statements

Determine risk profile of individual segments

Strength and weaknesses of specific

operation and geographical 10
Introduction
Parent-Subsidiary Relationship
Group
Subsidiary
nt rol
Co

Consolidation:
Parent Process of preparing
Control and presenting
(Controlling Subsidiary
financial statements of
entity) parent and subsidiary
as if they were one
Co economic entity
nt rol

Subsidiary
Consolidated FS:
Economic entity
11
Content

1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangement
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation Theories
12
Information Perspective

• Managers with a comparative advantage on information about their

firms are compensated for their ability to provide information on the
future cash flows of these firms (Holthausen and Leftwich, 1983)

No (Mian and Smith, 1990)

Are consolidated financial
statements more
informative than separate
financial statements?
Investors can duplicate “homemade”
consolidated financial statements
[Assumption: intragroup transactions
are small]
Yes (Holthausen, 1990)
The greater the interdependencies
among group companies, the more
informative combined earnings are
about future cash flows of the
combined entity
13
Information Perspective

• According to Mian and Smith’s views, a firm is more likely to choose

consolidated reporting when:
– There are greater interdependencies between parent and subsidiaries
– Foreign rather than domestic subsidiaries
– Parent provides direct guarantee of the subsidiary’s debt
– Parent is in the financial services industry

• Under Holthausen’s view:

– The greater the interdependencies among the group companies, the
higher the likelihood of intragroup transactions
– More difficult for external users to replicate the consolidation process
– Managers have incentives to voluntarily provide consolidated FS that
will enable investors to better predict group’s future cash flows

14
Efficient Contracting
• Whittred (1987) suggests that consolidated information improves wealth for firms

• Reason: reduced information asymmetry between lenders and borrowers

– Lenders fear that borrowers will transfer assets to related companies
– Borrowers expropriate a considerable larger sum than what they stand to lose because
of limited liability

• Hence, lenders require cross-guarantees issued by parent companies. Whittred

suggests a set of consolidated financial statements performs the same function as
a “cross-guarantee”

• Hence, a set of consolidated FS performs the same function as a “cross-guarantee

issued by a parent company
– Undo the effects of separately incorporated companies within the group (e.g. if Sub A is
not able to pay its debt as legal entity, its shortfall is compensated by net assets of other
entities within the group [“Co-insurance” effect])
– Implicit assurance to lenders that debt is financially backed by assets of combined entity
15
Opportunism

• Consolidated financial statements lead to wealth transfers to

managers at the expense of other stakeholders if the acquisition is
motivated by managerial self-interest
– Managers enjoy higher compensation, perks and power through
managing a larger group of companies  sheer increase in size will
result in higher pay out for managers notwithstanding their competency.
– Managers are more likely to over-invest in companies that are specific
and complementary to their skills (Shleifer and Vishny, 1990)

• Information asymmetry may arise by masking financial problems of

individual companies within the group

• Conclusion: Both aggregated (consolidated) and disaggregated

(segment) information are required

16
Content

1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangement
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation Theories
17
Economic Motives for Entering into
Intercorporate Arrangement
Markets will not reward firm’s diversification with a higher price for its shares if investors
can replicate the firm’s strategies

Sub-optimal consequence

Corporate Diversification
Other reasons

Why Corporate Diversification?

• Firms involved in M&A have
stakeholders (i.e. managers and
• Individuals not able to diversify as
employees) who are not able to diversify
efficiently because of indivisibility of
their risks as well as shareholders
assets and high transaction costs
(i.e. to achieve economies of scale)
• Corporate diversification may mitigate
the problem of under-investment by risk-
averse managers
18
Economic Motives for Entering into
Intercorporate Arrangement

Acquirer gains “control”

over the operating and Two or more acquirers
financial policies of the gain “joint control” over the
acquiree acquiree
(“Consolidation”) (“Joint arrangement”)

Arrangements in M&A
Reciprocal investments
Investor has “significant
held by each of the two
influence” over the
firms, both are deemed to
operating and financial
be equally dominant
policies of the investee
(“Pooling of interests” no
(“Associate”)
longer permitted)

19
Economic Motives for Entering into
Intercorporate Arrangement

Risk mitigated by Uncertainty

M&A strategies

Risk management strategies

• Organic growth or acquisition Value
• Risk diversification • Combined risks
• Size effects
• Co-insurance effect
Information • Diversification effect

Control Joint-venture Significant Influence

(Acquisition method) (Equity accounting) (Equity accounting)

20
Investing Strategies, Ownership Levels and the
Impact on Financial Reporting
Continuum of intercorporate ownership (under previous accounting standards such
as IAS 27, IFRS 12, IAS 28, IFRS 13 and IAS 31)

Zero 20% 50% 100%

Ownership Ownership Ownership Ownership
Significant
Passive Control
Influence
Quantitative
Active thresholds do
Passive Active NOT apply in
Investment Investment Investment
IFRS 10, but they
are often used as
• FVTPL Instruments • Associated a rule of thumb
• FVOCI Instruments • Partially-owned subsidiary
company measure in
• Fully-owned subsidiary straight forward
• Joint-
p arrangements situations
u
r 1. Exert significant 1. Gain entry intro a new market
1. Earn dividend
p influence or control 2. Achieve synergistic benefits
2. Make capital
o over investee’s from complementary strengths
gain
s operation 3. Gain market dominance
e

21
Investing Strategies, Ownership Levels
and the Impact on Financial Reporting
• Current accounting standards
– IFRS 10: Consolidated Financial statements
– Revised IAS 27: Separate Financial statements
– IAS 28 Investments in Associates and Joint Ventures
– IFRS 11: Joint Arrangements

• Definition of control
Under previous IAS 27
Control is determined by the following:
1. Power to govern financial and
operating policies
2. Benefits derived therein, or risk and
rewards
IFRS 10
Investor controls an investee when:
1. It has power over the investee
2. It is exposed, or has rights to the
variable returns from its
involvement with the investee
3. Has ability to affect those returns
through its power over the investee

22
Content

1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangement
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation Theories
23
The Attributes of Control under IFRS 10

• An investor controls an
investee if and only if Power
the investor has all of
the following:
– Power over the
investee
– Exposure, or rights to
variable returns from Ability Control
its involvement with
the investee, and
– The ability to use its
power over the
investee to affect the Returns
amount of the
investor’s returns

24
Step-by-step Process of Assessing
Control
01What is the purpose and
design of the investee?
04How are decisions
about those
activities made?
05
Do rights of the investor
give it a current ability to
direct relevant activities?
02 Is control by voting
03 What are the
rights only?
relevant activities
of the investee?
The process of determining
control considers all three
06 attributes of control:
Power, Ability and Returns.
Is the investor exposed
to or have rights to
variable returns from its
involvement with the
investee?
25
Step-by-step Process of Assessing
Control
• The process considers how decision making over the relevant
activities is empowered and which party has the power to make
those decisions.
– Decision making (power): e.g. voting rights, contracts, relationships
– Relevant activities: those have the most significant effect on the returns
e.g. selling, purchasing, acquisition of assets, R&D

• The process considers if the rights enables an investor to have a

current ability to direct the most relevant activities of the investee.
– Practically able to make decisions without any restriction

• The process evaluates if the investor is exposed to or have rights to

variable returns from its involvement with the investee

26
The Attributes of Control: Power

P +A+R
• Sources of power: voting rights
– The most common and the most persuasive source of power
– Consider evidence beyond absolute voting rights, e.g. relative voting rights,
dispersion of voting rights, the number and likelihood of parties that may act
together to outvote the investor, potential voting rights and voting patterns

Illustration 2.1 relative voting rights

Three investors (A, B, C) collectively have each more than 50% ownership interests. The remaining
43% are dispersed over 100 investors, each not owning more than 0.5% interest. The AGM is attended
by investors A, B and C and about a third of other investors.
Voting rights Voting at AGM Relative voting rights
Investor A 40% 40% 57%
Investor B 10% 10% 14%
Investor C 7% 7% 10%
Other investors 43% 13% 19%
100% 70% 100%
27
The Attributes of Control: Power

P +A+R
• Sources of power: potential voting rights
– Rights to obtain voting rights from potential ordinary shares, e.g. options,
convertible instruments and forward or future contracts
– Consider the purpose and design, the terms and conditions, the motives for the
issue and the intent to vest control of these instruments

Illustration 2.2 potential voting rights

Investor A, the founding investor, invited Investor B and Investor C to purchase shares in Entity X. B
is a strategic investor who has knowledge of Entity X’s business. A is a financial investor. C is a
related party of A. B was issued options that would allow B to be issued with 40,000 ordinary shares.
Consider: (a) The options are exercisable at current date? (b) exercisable in Year 3?

28
The Attributes of Control: Power

P +A+R
• Sources of power: power over key management personnel
– Control arises when an entity is able to make decisions on the activities
that are most significantly impact returns, and these decisions are made
by key management personnel
– The entity that is able to appoint, remove and remunerate these
personnel effectively has the power over these personnel.
– Key management personnel: persons having authority and responsibility
for planning, directing and controlling the activities of the entity, directly
or indirectly, including any director (whether executive or otherwise) of
that entity. (IAS 24)
– Key management personnel may include “shadow directors” or people
who control key management personnel of that entity.

29
The Attributes of Control: Power

P +A+R
• Sources of power: control over another entity that directs relevant activities
– Control may be direct (e.g. voting right) or indirect (e.g. management contracts
and other arrangements)
– E.g. Investor A controls Entity X. Entity X has 20% interest in Entity Y, but it is
able to direct the relevant activities of Y because Y is dependent on X for its
technical know-how. Through X, Investor A has control of Y.

• Sources of power: Statutory and contractual provisions, rights to veto or

enter into transactions
– Rights: must be “substantive rights” and not “protective rights”
– E.g. if a franchising contract allows the franchisor to intervene to protect the
franchise brand name, the power is protective and is not a sufficient basis to give
rise to power to direct most relevant activities of the entity.

30
The Attributes of Control: Power

P +A+R
• Sources of power: special relationship
– Consider all sources of power including interpersonal and operational
links between an investor and the investee
– May arise from the following situations:
• The key management personnel of the investee are current or
previous employees of the investor;
• The investee’s operations are dependent on the investor (for
example, provision of critical services or specialized knowledge);
• A significant portion of the investee’s activities are conducted on
behalf or may significantly involve the investor; or
• The investor’s exposure or rights to returns is proportionately higher
than its ownership interests in the investee.

31
The Attributes of Control: Ability

P+A+R
• In IFRS 10, an investor must demonstrate the ability to use the
power to affect the returns to the investor from its involvement with
the investee.

• Substantive rights
– Substantive rights relate to rights to make decisions on the most
significant activity (activities) that affect an entity’s returns.
– Consider whether there are barriers that prevent the use of the right,
e.g. financial barriers, operational barriers or legal and regulatory
barriers

Look again at the previous Illustration 2.2…

32
The Attributes of Control: Ability

P+A+R
Illustration 2.2 potential voting rights (modified)
Investor A, the founding investor, invited Investor B and Investor C to purchase shares in
Entity X. B is a strategic investor who has knowledge of Entity X’s business. A is a
financial investor. C is a related party of A. B was issued options that would allow B to be
issued with 40,000 ordinary shares.

Assuming the options are immediately exercisable, consider

a) The options are profitable (in the money).
b) The options are clearly not profitable (deeply out of the money).
c) The options are out of the money but not deeply so.

33
The Attributes of Control: Ability

P+A+R
• Protective rights
– Rights must be substantive and not merely protective
– Protective rights are decision making rights on fundamental changes to
an investee’s activities and are often relating to exceptional events, e.g.
the right of a lender to restrict the payment of dividends by the borrower
when lending covenants are breached

• Unilateral ability
– When an investor is able to exercise power on another entity without
restrictions from other parties
– Control is therefore different from joint control which requires unanimous
consent from parties.

34
The Attributes of Control: Ability

P+A+R
• Currently exercisable
– In the situations with potential ordinary shares, the rights must be
exercisable in a timely manner to enable the holder to direct relevant
activities to make returns.

Illustration 2.3 Decision making rights over different activities

Investor A and Investor B own 50% interest each in Entity X. Through contractual
agreement, Investor A has power to make decisions on strategic policies relating to
research and development while Investor B has power to make decisions on strategic
policies relating to marketing.
Discuss different scenarios.

35
The Attributes of Control: Ability

P+A+R
• Delegated Power
– The “decision maker” may act on delegated power and is an agent
– To control an investee, the decision maker must act for own interests
and must be a principal and not an agent for other investors.
– Example: Is the decision maker an agent or principal?

Property Unrelated Under a management agreement

Owner 20% 80% Investors between the property owner and
the REIT, a wholly owned
Real Estate subsidiary of the property owner
100% Investment Trust manages the transferred property .
(REIT) the property owner is both an
Provides services investor and a manager and is
Fees based on 3% exposed to returns from dividends
Property
Manager pre-tax profit of the REIT and management fees.

36
The Attributes of Control: Ability

P+A+R
• Delegated Power: the decision maker is an agent or a principle?
– The scope of the decision-making authority
• Is the decision maker significantly involved in the design of the investee?
– Rights held by other parties
• The relative power of the investor who controls the decision maker and the
other investors?
– Remuneration
• Is the remuneration commensurate with the services provided?
• Are the terms, conditions or amounts in line with those customarily provided
for in a similar contract negotiated on an arms-length basis?
– Exposure to variability in returns from other interests
• What is the magnitude and variability of the aggregate returns, e.g. from
ownership interests, guarantees and other arrangements?

37
The Attributes of Control: Returns

P +A+R
• An investor has to consider total variable returns that it is exposed or have a
right to as a result of its involvement with an investee.
– Variable returns: not fixed any may be only positive (e.g. option holder), only
negative (option writer) or both positive and negative (e.g. holding ordinary
shares)

• Return includes: dividends, changes in fair value, remuneration, synergies,

operational advantages to the investor and etc.

******************************************************************************
IFRS 10 is dynamic. Continually re-assess control when facts and
circumstances change with respect to power, ability and returns.
Power may be gained or lost through events that do not involve the investor.

38
Direct and Indirect Control
• For the test of control, IFRS 10 requires consideration of control from rihts
held directly 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
Affiliation structures
X Co. Situation 1: X Co. Situation 2:
X Co. controls X Co. controls
Y Co. and A Co. Y Co., B Co.
100% Even though 60% and Z Co.
X.Co. indirectly Does not own
owns 75% Break A Co. (<51%)
Y Co. in control at B and Y Co.
hence no control
50% 50% 60% over Z Co. 55% 60% 50%

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

50% 40%

Situation 1 Situation 2 39
Content

1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangement
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation Theories
40
The Concept of Significant Influence

• In this relationship, the investor does not have control over the
investee but has power to participate in the financial and operating
policy decisions of the investee.

• IAS 28 describes such an investor as having “significant influence”,

and the investee is deemed an “associate” of the investor

• Special accounting procedures described as the “equity method”

are applied

41
What is 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 presumption:
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 policy-making
interdependencies
on board processes
Investor must disclose reasons for not complying with default presumption
42
Definition of associate

• “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)

• If investee is an associate, the investor is not referred to as the

“parent”
– “parent” applies only to relationships where investor has control over
investee

43
Direct and Indirect Significant
Influence

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 iii) B (42% indirect
50% 50% Y 80% 20% interest)

Z B

Situation 1 Situation 2

44
Content

1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangement
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting
6. Accounting for
for Business
Business Combinations
Combinations
7. Consolidation Theories
45
Accounting for Business Combinations

Standards relevant to the preparation and presentation of

consolidated financial statements

IFRS 3 Business Combination (deals with business

combination generally)

IAS 27 Consolidated and Separate Financial

Statements ( applies specifically to the preparation
and presentation of consolidated financial statements
for parent-subsidiary combinations)

46
Overview of the Scope of the IFRS 3
• Objective of IFRS 3
– Specify the requirements governing the method of accounting,
disclosure and presentation of the financial statements of a reporting
entity comprising one or more separate entities that are brought
together in a business combination

Purchasing Purchasing
the equity of the net assets of
another entity another entity
Business combinations result from
Transferring its net assets, Purchasing some of the net
together with the net assets assets of another entity that
of other combining entities to together form one or more
a newly formed entity business

47
Purchase of Net Assets versus
Purchase of Equity

Parent Acquirer If the net assets

do not constitute
a business, the
transaction is
Acquires controlling interest in Buys over net assets
NOT a business
equity of (which are “business”)
combination and
the acquisition
method does
not apply. The
Subsidiary Acquiree assets acquired
are subsumed
with the
Parent – Subsidiary No Parent – Subsidiary standalone FS
Separate legal entities One legal and economic of the
(separate FS) entity purchaser.
One economic entity Do not require consolidated
(consolidated FS) financial statements

48
Content

1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangement
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation
7. Consolidation Theories
Theories
49
Consolidation Theories

• Theories relating to consolidation are critical when the percentage of

ownership in a subsidiary is less than 100%

• Described as “partially owned subsidiary”, where the remaining

percentage is owned by shareholders who are collectively referred to
as “non-controlling interest” (NCI)
Parent Non-controlling interests

90% 10%

Subsidiary
Both parent and non-controlling interest have a proportionate share of
the subsidiary’s:
• Net profit; • Share capital
• Dividend distribution; • Retained profits and changes in equity
50
Consolidation Theories

Parent company sells part

of its stake in a subsidiary
to external shareholders

Reasons why
non-controlling
interest
Parent company arise Parent and non-controlling
buys a majority shareholders are founding
stake in a subsidiary shareholders of newly
from existing owners incorporated entity

51
 Consolidation Theories
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%
Parent company ownership in Parent company
Non-controlling subsidiary
100% 70%
ownership shareholders of a ownership
subsidiary
Subsidiary Subsidiary

2 groups of shareholders
Wholly-owned by the
1) The parent company’s shareholders; and
parent company’s
2) The non-controlling shareholders of the
shareholders
subsidiary
52
 Comparison of issues
Issues Entity Theory Parent Theory
Who are the primary Both non-controlling Benefit of parent
users of the consolidated interest and majority company shareholders
financial statements? shareholders

Shown as equity in Shown as equity in

How should non- BS based on: BS based on:
controlling interests be Consolidated equity
reported in the Consolidated equity +
consolidated balance = NCI
sheet? Consolidated assets =
- Consolidated assets
Consolidated liabilities -
Consolidated liabilities

53
Comparison of issues
Issues Entity Theory Parent Theory
Should net assets of
the subsidiary acquired Fair value of net NCI net assets of
be shown at full fair assets of subsidiary subsidiary at date of
values or at the at date of acquisition acquisition shown at
parent’s share of the reported in full book value
fair value?

Do non-controlling Goodwill = asset of Asset of parent

shareholders have a economic unit, and and restricted to
share of goodwill? reflected in full parent’s share

How should net profit of Reported in full as NCI’s share of current

partially-owned accruing to both profit is a deduction of
subsidiary be reported? majority and NCI final profit

54
Summary of differences

Attributes Entity Theory Parent Theory

Fair value differences in Recognized in full,

Recognized only in
relation to identifiable reflecting both parent’s
respect of parent’s
assets and liabilities at and NCI’s share of fair
share
date of acquisition value adjustments

Neither as equity or
Presentation of NCI As part of equity
debt

Goodwill is an entity
asset and should be Goodwill is parent’s
Goodwill
recognized in full as at asset
date of acquisition

55
Proprietary Theory

• Relevant to accounting for joint ventures

• Parent seen as having a direct interest in a subsidiary’s assets and

liabilities
– Resulting in proportional or pro-rata consolidation (parent’s interest
is directly multiplied to each individual asset or liability of subsidiary and
combined with parent’s assets and liabilities).

56
The Implicit Consolidation Theory
Underlying IFRS 3
• Previously, IAS 22 allowed an acquirer to either recognize or ignore non-
controlling interests’ share of fair value adjustments of a subsidiary’s identifiable
assets and liabilities (mix of parent and entity theories)

• IFRS 10 requires NCI to be presented in equity separately from the equity of the
owners of the parent.
• By showing in equity: consistent with entity theory.
• By presenting separately in equity: more consonant with parent theory.

• IFRS 3 (2008) permits the acquirer to choose to recognize or not recognize non-
controlling interests’ share of goodwill.

• Movement towards the full entity theory

– IFRS 3 (2008) permits the inclusion of NCI’s share of goodwill as at date of acquisition
– FASB through SFAS 141, now known as Codification Topic No. 805 Business
Combinations, requires the recognition of the NCI’s share of goodwill

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Illustration 1: Parent versus Entity Theory

Scenario
• P Co purchased 80% interest in S Co on 1/1/20x1
• Consideration transferred: $1,200,000
• NCI: 20%
• BV of equity of S Co at acquisition date (1/1/20x1): $1,200,000
• (FV – BV) of property: $100,000
(Ignore tax effect and depreciation)
• FV of NCI: $300,000
• BV of equity of S Co at 31/12/20x1: $1,270,000
• Net profit after tax (NPAT) of S Co: $ 70
• Net profit after tax (NPAT) of P Co: $350

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Illustration 1: Parent versus Entity
Theory
Net profit after tax and NCI
Parent theory
NCI’s share of net profit is after tax completed as follows:
= 20% x S’s net profit after tax
= 20% x $70
= $14

Entity Theory
NCI are not shown as a deduction but included in entity-wide NPAT.
Disclosure is made of the amount of NPAT that relates to NCI
= (100% x P’s NPAT) + (80% x S’s NPAT)
= (100% x $350) + (80% x $70)
= $406

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Illustration 1: Parent versus Entity
Theory
Goodwill
Parent Theory
Goodwill = Investment in S – P’s ownership %
X (FV of S’s identifiable net assets at date of acquisition)
= $1,200 – (80% x $1,300)
= $160

Entity theory
Parent’s share of goodwill = $160
NCI’s share of goodwill = Fair value of NCI – share of FV of identifiable
net assets
= $300 – (20% x $1,300)
= $40

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Illustration 1: Parent versus Entity Theory

Presentation of NCI
Parent Theory
Non-controlling interests are shown separately from equity
Non-controlling interests = Non-controlling interest % x BV of S’s equity
= 20% x $1,270
= $254
Entity Theory
Non-controlling interests (NCI) are deemed to have an equity interest and are thus
presented as a component in equity.
NCI = NCI % x (BV of S’s equity + FV adjustments)
+ NCI’s share of goodwill
= 20% x ($1,270 + $100) +$40
= $314
This is a purist representation of the entity theory. However, the pure form of
presenting NCI as part of the combined equity component is not done in practice.

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