Lecture 10: Issues in Consolidation: Debates about the

value of group accounting (Need to listen to lecture)

Lecture Aims:
- Explain CFS and equity accounting
- Articulate arguments FOR and AGAINST CFS
- Discuss alternatives to CFS

Readings:
Clarke, Dean and Egan. 2014. Group Accounting Shenanigans

The Debate about CFS: Background
As we know, ACCT3011 fundamentally looks at alternative methods of accounting
for investments.
We find that a number of qualitative and subjective principles based largely on ability
to direct and voting rights help us to decide between significantly different accounting
outcomes AASB10 and AASB 128 and AASB 139
The solutions developed overtime have varied according to the degree of the
investors involvement, distinguishing between
- (Sole) control W1-6 CFS
- Joint control and significant influence W7 EM
- Available for sale financial asset W11
- Joint operation W12
- Problem region (as we discovered in the equity lecture: 20-50% voting power
All the alternative methods reflect dissatisfaction with the cost method
Recall at the simplest level, in using the cost method the investor:
- Reports its investments in the investee at cost (Balance Sheet - BS)
- Reports dividends from investee as revenues (Income Statement IS)
In moving away from cost, all alternatives are trying to better address the relevance
principle trying to look for better words than accuracy

Our professional judgement is therefore critical
The difference between strong significant influence and weak control can be very
little
And yet, if we compare the accounting outcomes (consolidation versus equity), they
care very different:
- Elimination of the investment in CFS and replacement with the line by line
aggregation of R, E, A and L, versus the one line approach in the equity
- The 100% approach in CFS versus just our share in equity accounting
which requires a conception of NCI in the former but not the latter
- The approach to accounting for inter-company transactions and unrealised
profits in each

More differences in the accounting outcomes we can discuss:
- The approach to fair value adjustments in each
- The approach to accounting for goodwill in each; recognition in CFS (with a
choice of two methods) versus acknowledgement in equity
- What is disclosed?
o CFS statements highly aggregated however, NCI in NPAT and equity
presented. And disclosures of segment notes, notes detailing the names
of all subsidiaries etc.
o Equity accounting 2 line items within the statements and some
disclosure movements
- Lets look at a practical example to illustrate.

Sack Goldman Ltd assignment used in 2010
On 1 January 20X8 Sack Goldman Ltd acquired 45% of the voting shares of Wall St
Ltd for $3,000,000 and was able to appoint two directors to the Wall St Ltds eight
seat board of directors. On 1 January 20X8, all of the identifiable net assets and
contingent liabilities of Wall St Ltd were stated at fair value. Wall St Ltd reported the
following shareholders equity balances at:
1/1/20X8
$000
Share Capital 2000
General Reserve 400
Retained Earnings 1600
Total Equity 4000

Financial data for both entities (before the application of AASB 127 or AASB
128) for the year ended 31 December 20X8 are as follows (Sack Goldman Ltd is
referred to as SG Ltd and Wall St Ltd is referred to as WS Ltd):
Statement of Comprehensive Income for the year ending 31 December 20X8
SG Ltd WS Ltd
Sales 5,000,000 3,500,000
Other Revenue 2,000,000 500,000
Expenses (4,800,000) (2,000,000)
Profit before income tax 2,200,000 2,000,000
Income tax expense (1,200,000) (600,000)
Profit after continuing operations for
the year 1,000,000 1,400,000
Balance at the start of the year 4,000,000 1,600,000
Profit for the year 1,000,000 1,400,000
Total for the year 5,000,000 3,000,000
Dividend paid (1,000,000) (600,000)
Transfer to general reserve - (200,000)
Balance at the end of the year 4,000,000 2,200,000










Statement of Financial Position as at 31 December 20X8
SG Ltd WS Ltd
Share Capital 7,000,000 2,000,000
General Reserve 3,000,000 600,000
Retained Earnings 4,000,000 2,200,000
Total Equity 14,000,000 4,800,000

Assets 10,000,000 4,800,000
Other assets 6,500,000 20,000,000
Investments 3,500,000 -
Total assets 20,0000 24,800,000
Liabilities
Other Liabilities 6,000,000 20,000,000
Total Liabilities 6,000,000 20,000,000
Net Assets 14,000,000 4,500,000

Sack Goldman Ltd additional information
- Sack Goldman Ltd chooses to use the partial method for calculating goodwill
- Sack Goldman Ltd only recognises dividends from investments when received
(note that AASB 118.30 c) states that dividend shall be recognised when the
shareholders right to receive payment is established).
- On 15 June 20X8 Wall St Ltd sold equipment to Sack Goldman Ltd for
$1,000,000. The equipment had cost Wall St Ltd $900,000 and had an
accumulated depreciation at the date of sale of $400,000. At the date the
equipment had a remaining useful life of 2 years. Sack Goldman Ltd still owned
that equipment at 31 December 20X8.
- The transfer to general reserve made by Wall St Ltd was attributable to the
profit after acquisition.
- The company income tax rate is 30%
- The accounts on the preceding page are shown prior to the application of AASB
127 or AASB 128. They are also therefore shown prior to any impairment of
Sack Goldman Ltd.s investment in Wall St Ltd was $3,080,000.
- In your equity method calculations, you may credit any accumulated impairment
directly against the investment in Associate account. In your conclusion method
calculations, you must impair goodwill by the same impairment loss that you
will calculate using the equity method. In other words, you will need to fully
complete the equity method before you can then revise as the consolidation
method.
- In addition to its investment in Wall St Ltd, Sack Goldman Ltd also held shares in
Westpac Bank Limited which have already been marked to market value at 31
December 20X8. The investment in Wall St Ltd and the investment in Westpac
Bank Limited are the only 2 investments Sack Goldman Ltd held at 31 December
20X8.
- The remaining 55% shareholding of Wall St Ltd was made up of many small
investors, none of whom had either control or significant influence of Wall St
Ltd.
- It is Sack Goldman Ltd.s policy to record all entries required by the equity
method of accounting directly into Sack Goldman Ltd.s journals and ledgers.



Part 1 and 2 of the assignment:
1. Complete the Sack and Goldman Ltd accounts by applying the equity
method to account for the investment in Wall St Ltd.
2. You then reconsider the investment in Wall St Ltd and realised that your
conclusions in part 1, above were wrong. You now realise that Sack
Goldman Ltd does not have significant influence over Wall St, it actually
has control. Revise Sack Goldman Ltd.s accounts for 31 December 20X8.

Note: The journal entries required under both methods are provided
for you in a spreadsheet in the lecture 9 folder on Blackboard so
you can use this as a practice exercise
The Journal entry approach to allocating Direct Non-Controlling Interest
(DNCI) is utilised as illustrated in section 5.4.5 of your textbook but it
could also have been done as the memorandum approach as we did in
the tutes this semester.


























Extract from the Sack Goldman Ltd Group Accounts
Column 1
Using consolidation
method to account
for investment in
Wall St Ltd
Column 2
Using equity
method to
account for
investment in
Wall St Ltd
Statement of Comprehensive Income
Sales 8,200,000 5,000,000
Other revenue 1,730,000 1,730,000
Expenses (6,556,854) (5,952,687)
Share of profit of associate --------------- 502,687
Profit before income tax 3,373,146 2,280,000
Income tax expense (1,678,396) (1,224,000)
Profit from continuing operations
for the year 1,694,396 1,056,000
DNCI share of profit (614,396) -------------
Profit attributable to shareholders
of SG 1,080,000 1,056,000
Retained Earnings Note
Balance at start of the year 4,000,000 4,000,000
Profit for the year 1,080,000 1,056,000
Total for the year 5,080,000 5,056,000
Dividends (1,000,000) (1,000,000)
Transfer to general reserve (200,000) (90,000)
Balance at the end of the year 3,880,000 3,966,000
Statement of Financial Position
Share Capital 7,000,000 7,000,000
General Reserve 3,200,000 3,090,000
Retained Earnings 3,880,000 3,966,000
NCI 2,484,396 ------------
Total Equity 16,564,396 14,056,000

Assets
Equipment 14,445,833 10,000,000
Other assets 26,460,000 6,500,000
Investments - 3,080,000
Goodwill 1,047,313 -
DTA 121,250 -
Other financial 500,000 500,000
Total assets 42,564,396 20,080,000

Liabilities
DTL - 24,000
Other Liabilities 26,000,000 6,000,000
Total Liabilities 26,000,000 6,024,000
Net assets 16,564,396 14,056,000

Comparing the outcomes
Questions for you to consider:
How can slightly different circumstances justify two different accounting
outcomes?
Is all subjective-ness and professional judgement (and perhaps devious behaviour)
best serving our fundamental accounting goals?
Would it be better if AASB 10 and AASB 128 were more rules based and we simply
said that 45% was either control or significant influence? The answer must come
back to:
The purpose of accounting:
o Is to make the business look good? No! a couple of important
concepts you should appreciate earnings management and
balance sheet management
o Its about revealing truth (a true and fair view)
o And its about:
Accountability from managers to owners; and
Information useful for decision making (where do I get this
from? SAC2)
Reconsider Leibler reading from week 1
Users
- But useful to whom? Just investors? NO!
- AASB Framework:
o Para 9 the users of financial statements include present and
potential investors, employees, lenders, suppliers and other trade
creditors, customers, governments and their agencies and the
public
o Para 9 then goes on to explain many specific needs of each of these
distinct user groups
o See also SAC2 para 16ff
o So we have a difficult job! Our product should meet the diverse
needs of a diversity of users
Are we neglecting our second duty?
Part 2M.3 Corporations Act 2001. Annual financial reports must:
- comply with accounting standards (s 296) and
- give a true and fair view (s 297)
AASB 101:
- para 15 reporting entities must present fairly
- para 19 can depart from compliance if misleading but
- para Aus 19.1 little scope for departure
The TFV requirement is not overriding (it was prior to 2002 and still is in the
UK) and so detailed rules cannot be broken Chris Nobes this is the right
approach to dangerous otherwise
Nonetheless, we are called to consider whether compliance with AASB may not
align with a true and fair view if we feel there is more to say, we should be
providing complimentary disclosures to explain
(see interview with Chris Nobes on true and fair in lecture 10 folder)


True and Fair view the challenge
Leibler it is generally accepted that reporting entities do a good job at
complying with AASB and ASX listing rules where required. But how well do we
consider a true and fair view? Do accountants, directors, auditors, ASIC etc,
largely take it that the former sufficiently addresses the latter?
Certainly the true and fair view requirement is vague, and AASB compliance adds
certainty to our responsibilities and lends comparability. And so I agree that
True and Fair should not override AASB compliance.
But we must invest some thought in what true and fair means and consider
complementary disclosures:
- no explanation in the Act
- True? A true reflection of performance, position and cash flow. Leading
not misleading information. Facilitating informed and correct decisions.
Its not about making the reporting entity look good
- Fair? Equal utility to all users. Faithful representation.
4 Types of accountants
Which of the following perspectives do you think is a more appropriate decision?
3+1 types of accounts identified by Godfrey, Hodgson and Holmes (week 8
reading):
- rule-makers
- financial report preparers
- rule-enforcers
- (and lets add accounting academics to that list)
4 types of accountants identified by Macintosh:
- the truth-teller
- the liar
- the humbugger
- the bullshitter
Now lets pull apart CFS the case FOR CFS
Imagine a simple case, involving parent P and subsidiary S, where:
- Ps investment in S is one of its major assets, accounted for using the cost
method
- Ps users dont see Ss accounts (although Ss users can of course demand
accounts)
- Ps BS would otherwise show the investment in S at cost year after year
(ignoring AASB 128 and 139)
- Dividends received from S may not reflect its current year performance,
so Ps Income Statement (IS) will be misleading
- Consider also relevance versus reliability
- Both IS & BS (of P) may be distorted by controlled/fake transactions
between P & S (related parties)
- Example management fees
CFS seems to solve these problems. HOW?
- CFS provide an overview of financial position and income; a synoptic view
of how well the group is being managed (perhaps we can already see a
flaw maybe its not the group that our users want)
- Economic substance vs legal form look past the corporate veil
- Consider the concept of control; control implies that all of these entities
are acting as one; so our argument is that its meaningful to paint a
picture for that one group entity. By showing the parent and all
controlled entities as one, we see how well a collection of commonly
controlled assets and liabilities have been managed by that common
cohesive group of managers
- CFS are preferable to providing individual financial statements of all
members of the economic entity a lot to absorb and the point is that we
see value in aggregating them as one consider the number of
subsidiaries in Qantas (note 33)
- Lets also go back to the purpose of accounting how is consolidated data
useful for decision making? For addressing accountability?
- Cross guarantees provide support to all of this logic:
o What is cross guarantee?
o How does the existence of cross guarantee agreement add to the
meaningfulness of consolidated financial information?
o See for example, Qantas note 34
The case AGAINST CFS
Clarke, Dean and Egan:
CFS are based upon fiction, unrealistic assumptions, contain items and balances
not found in any of the group related companies said to form the economic
group, and fail to respect the separate legal entity principles fundamental to the
centuries-old corporate form (p. 122)
IFRS defence:
CFS are the statements of a group presented as those of a single economic entity
(AASB 10, Appendix A)
The fiction:
- P & S are separate legal entities which have real financial/commercial
implications. No group could own assets or incur liabilities, for both the
notion of asset and of liability entail the idea of property rights under
the British-based legal system
- if there is to be form, there must be legal substance
- unscrupulous operators will quickly use the accounting fiction or
alternatively the legal position when benefits accrue to them for doing so
directors schizophrenia
Unrealistic assumptions:
- CFS assume that P will take responsibility for Ss liabilities but P may
have no intention of doing so.
- CFS assume that Ps management can do as they want with Ss assets but
there are limited, e.g., where there are non-controlling interests in S.
Nonetheless, this assumption arguably has more validity now with new
definition of control under AASB 10.
More generally, P will also be limited in its control by virtue of the impact of
other managers delegated with control, diversity of directors on subsidiarys
boards, technical needs and limitations, distance, etc.
CFS are an amalgam of measurement methods:
o they include assets stated as past (sometimes amortised) and
present costs (money gone), some at estimated fair values (often
costs to acquire assets money wished for), cash balances (money
possessed), capitalised expenses (money often long gone), tax
effect debits and credits artifacts of the accounting system (not
money had in the past, guaranteed or committed in the future),
debts collectible (likely money in the future); and liabilities owing
(money committed).
CFS may be an amalgam of earnings management manipulations
undertaken by CFOs in cahoots with investment analysts. Opportunities
for earnings management include:
o Subjectivity -> Opportunism. E.g. accruals, impairment.
o Contradictions and ambiguities in GAAP e.g. between framework
and standards
o Structuring transactions particularly for tax
accounting/avoidance
o Altering timing of sales and expenses
o Negotiating with auditors
But appreciate
o CFS is not necessarily the culprit per se here
o None of this necessarily implies non compliance with accounting
standards but what about true and fair?
CFS are aggregated. As a consequence, detail is hidden. Disaggregation
can be valuable as we saw in the segment lecture. However,
i) the disaggregation provided in the notes to the accounts
may be poorly assessed
ii) both segment disclosures and related party disclosures
have limitations. E.g. Qantas and Woolworths
iii) segments are unlikely to also equate to separate
subsidiaries
iv) the whole situation becomes even more confused given the
possibility of existing flaws in Ps and Ss accounts
As a result of the elimination of transactions between group members, data is
lost. By virtue of highly contestable elimination assumptions, they [CFS] remove
the legally based financial impact of may of the most fundamental commercial
transactions of the individual (albeit related) entities of that group
Do related party disclosures overcome that?
- consolidation creates artifacts on consolidation including assets which
are not therefore owned by any legal entity.
- Consider goodwill
o Recognised only on consolidation
o Not separable
o Choice to adopt partial or full method
o Impairment is professional judgement a good thing here or not?
The capital boundary problem PATRICK STEVEDORES 1997
P 132-134, SEPT 97. Employees subsidiaries sold their valuable assets to other
group members.
Proceeds were used to pay debts owed to other group members and the
$60-70M was used to buy back equity held by other group members
Result: nothing left for employee debts
CFS did not reveal these transactions
Cross guarantees imperfect; closed group was only a part of the
economic entity
Note; we are considering here employees as a user group .. but this is a
framework asking too much; in truth, are the financial statements the
place that employees go to for related information?
The case AGAINST CFS other issues
CFS are dubious value to users who are more interested in Ss accounts.
For example creditors of S. Although cross-guarantees (c-gs) may help.
But we have seen that c-gs are of limited value if they dont cover ALL
group members. Consider Qantas note 34
CFS are of dubious value to NCI. Especially where there are more than 1
partly owned subsidiaries. Corporate groups are ungovernable
Other concerns
Off balance sheet items:
- keeping bad news items off the balance sheet, largely through special
purpose entities that might not be considered subsidiaries. Solved now
with AASB 10? More tinkering? Will a widen of ambit of control,
combined with a greater focus on disclosures just allow more hiding?
- shadow banking (controlled special purpose entities providing a finance
function to the group which are not subject to normal banking regulation)
Alternatives to CFS
1. Ban parents from investing in wholly owned subsidiaries? Thereby fore
all such operations to become divisional branches or branches within one
single legal entity
a. Pros? Better able to be regulated (our financial statements then
will reflect the A, L. R and E attributable to a single legal entity;
eliminate scope for opportunistic intra group transactions
b. Cons? What of partly owned subsidiaries? What of interests
overseas? Consider the entrepreneurial advantage of isolating
distinct elements of our business within separate legal entities
c. We do not oppose the provision of group accounts per se. As noted,
groups of related companies are unquestionably the common
business arrangement in modern, western-style commerce. Nor
should there be entertained any doubt that both management and
investors need reliable, orderly, aggregative financial information
about related companies, preferably arranged so that the input of
the separate companies to the group performance can be
sufficiently identified.
Clarke and Dean alternatives to CFS
2. Market price accounting for groups (MPAG)
a. Comprehensive asset reporting based on Current Cash Equivalents
(CCEs roughly fair value), marked to market market selling
prices for physical assets); with changes in CCEs included in
income.
i. Investments in listed entities are not eliminated by instead
are adjusted to CCE
ii. Investments in unlisted entities reported at investors share
of investees net assets calculated on a CCE basis (similar to
equity method)
iii. Non-vendible items reported at zero
Some features of MPAG:
Ps accounts are prepared on a CCE basis
Ps accounts are supplemented with a summary of Ps subsidiaries
accounts, also prepared on a CCE basis
A further statement of inter-entity indebtedness reveals details of
amounts owed within the group; while intra-group transactions could
also be disclosed in the notes to the accounts. Note strong emphasis in
this proposal on providing a lot of detail of related party transactions and
balances
Some advantages of MPAG
- assets are all reported on the same (contemporary) basis, CCEs can be
legitimately subtracted, added, underpin financial analysis (apples and
apples)
- Reporting at CCE counteracts fake transactions within the group.
Summarising the balances of all subsidiaries will also discourage
illegitimate movement of funds between group entities
- Transparency re (rather than elimination of) financial flows within the
group will be emphasised
Any disadvantages of MPAG?
- the group concept is retained to some degree, doesnt overcome all
problems
- unlisted investments remain problematic
- consider the understand-ability principle too much condensing all of
that commonly controlled data into one entity?
Some disadvantages or difficulties of MPAG:
- CCE-based accounting has been criticised because:
o It anticipates profits. Lacking sufficient conservatism
o Not reliable? (a bit like Nobes criticisms of equity accounting)
o There is no progress towards this alternative and so a reluctance
to change is evident. Why arent users calling for this apparently
better information is there anyone out there other than
investment analysts?
Summary
Potential exam essay questions
- contrasting equity method with CFS
- your perspective on the usefulness and limitations of CFS from the
perspective of specific users
- Basic explanation of possible alternatives
- Your perspective on professional judgement versus a more rules
based/quantitative approach to AASB 10 and AASB 128
Work on your writing skills develop a logical, clear structured narratives that
demonstrate your perspective. In essays, marks are always given for an
appropriate introduction and conclusion. Examples are often useful. Students
who simply provide bullet pints that do not demonstrate personal perspectives
and suggestions for improvement are not well rewarded.