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Chapter 27

Accounting for
group structures

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Objectives of this lecture
• Understand what it means to ‘consolidate’ financial
statements
• Understand the reasons for preparing consolidated financial
statements
• Understand the basics involved in preparing consolidated
financial statements
• Be able to use a consolidation worksheet to perform
relatively simple consolidations
• Understand that control, and not legal form, is the criterion
for determining whether or not to consolidate an entity
• Be able to explain what control means, and be able to
explain what factors should be considered in determining
the existence of control

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Objectives (cont.)

• Understand the meaning of ‘goodwill’, and how to


measure it
• Understand what a ‘gain on bargain purchase’
represents
• Be able to provide the journal entries necessary to
account for any goodwill or gain on bargain purchase
that arises on consolidation
• Be aware of some of the history behind
the development of the accounting standards pertaining
to consolidated financial statements

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Introduction
• Common for groups of companies to combine in pursuit of
common goals
• Where a reporting entity controls another entity, AASB 10
Consolidated Financial Statements requires that consolidated
financial statements be prepared
• Key issues addressed in this topic
– Rationale for presenting consolidated financial statements
– Brief review of history of Australian consolidated accounting
requirements
– The importance of control in the decision to consolidate an
entity
– The basic mechanics of the consolidation process, together
with consideration of how to account for any goodwill or gain
on bargain purchased that might arise on consolidation
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Rationale for consolidating the accounts
of different legal entities
• Purpose of providing consolidated financial statements is
to show the results and financial position of a group as if
it were operating as a single economic entity
• Effects of all intragroup transactions are eliminated
• The consolidated statement of comprehensive income
will show the financial results derived from operations
with parties external to the group of entities
• The consolidated statement of financial position will show
the total assets controlled by the economic entity and the
total liabilities owed to parties outside the economic
entity

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Figure 27.1—A simple parent and
subsidiary relationship

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History of Australian Accounting Standards
that govern the preparation of consolidated
financial statements
• AAS 24, issued June 1990 (following ED 40)
• AASB 1024, effective from 31 December 1991
• Issued to eliminate practice of using partnerships and trusts to
keep debt off consolidated balance sheet
• From 2005 we had AASB 127 Consolidated and Separate
Financial Standards which replaced AASB 1024
• AASB 127 was then superseded by the release of AASB 10
Consolidated Financial Statements (effective from 1 January
2013) and AASB 127 was re-released as Separate Financial
Statements

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History of Australian Accounting Standards
that govern the preparation of consolidated
financial statements (cont.)
• Before amendments to the Corporations Law in 1991,
group consolidated financial statements could only
include entities that were companies
• Results in a ‘partition effect’ caused by, for example,
interposing a unit trust within a group structure (refer to
Figure 27.2 on p. 872)—everything from the trust down
was partitioned off and excluded from the consolidation
process
• Often had the effect of providing a consolidated balance
sheet with lower debt ratios than would otherwise have
been the case—not a ‘true and fair’ view of the financial
position of the group

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History of Australian Accounting Standards
that govern the preparation of consolidated
financial statements (cont.)
Amendments to the Corporations Law deleted previous
definitions of ‘group’ and ‘group accounts’. Corporations
Act 2001 adopts requirements embodied within AASB 10.
S. 295(2)(d) states that:
The financial statements for the year are:
(a) the financial statements in relation to the entity
reported on that are required by the accounting
standards, and

(b) if required by the accounting standards—the


financial statements in relation to the consolidated
entity that are required by the accounting
standards

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History of Australian Accounting Standards
that govern the preparation of consolidated
financial statements (cont.)
AASB 10
• The consolidated financial statements are to include all
subsidiaries of the parent
Note per AASB 10
• Even where control is only temporary, the consolidated
statements should incorporate the results of a subsidiary
(entity controlled by a parent entity) during the time for
which control existed, even if this was only for a small
part of the year
If control is lost during a period (AASB 10)
• Income and expenses of a subsidiary are to be included
in the consolidated financial statements until the date on
which the parent ceases to control the subsidiary

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Alternative consolidation
concepts
Generally speaking, there are three major
consolidation concepts:

1. The entity concept (adopted by AASB 10)


2. The proprietary concept
3. The parent entity concept

AASB 10 requires adoption of the entity concept

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Concept of control
• The definitions of ‘control’ and ‘subsidiary’ are
central to determining the entities to be consolidated
and the nature of the group
• The definition of a subsidiary directly relies upon the
concept of ‘control’. A subsidiary is defined in AASB
127 as:
an entity that is controlled by another entity
• Requirement to consolidate is based upon the
existence of control, which is defined in AASB 10 as:
– Existing rights that give the current ability to direct
the relevant activities

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Concept of control (cont.)

• This in turn requires a definition of ‘relevant activities’


which is defined in AASB 10 as:
– activities of the investee that significantly affect the
investee’s returns

• In deciding whether an entity is a subsidiary it is


necessary that the investor has the capacity to
‘exercise’ power

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Central concept of control—the
requirement of ‘variable returns’
• Where control is considered to exist, the amount of
returns to be derived from the interest in the investee
would be expected to vary depending upon the efforts
and performance of both the investee and the investor.
According to paragraph 17 of AASB 10:
– An investor controls an investee if the investor not
only has power over the investee and exposure or
rights to variable returns from its involvement with the
investee, but also has the ability to use its power to
affect the investor’s returns from its involvement with
the investee.

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Joint control
• Only one party can be in ‘control’ of an entity before
that controlling entity can be considered to be the
parent entity.

• If an entity ‘jointly controls’ another entity then that


entity cannot be considered to be a subsidiary, and
rather than applying AASB 10, another standard––
AASB 11 Joint Arrangements (released in August
2011)––needs to be applied (and this standard does
not allow consolidation for jointly controlled entities).

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Situations in which control might exist
A number of situations could lead to control,
including:
• where a majority of voting rights are held by the
investor
• where less than a majority of the voting rights are held
by the investor (but perhaps where the balance of the
voting rights are widely dispersed among many
different owners)
• where the investor holds some potential voting rights
in the investee

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Concept of control (cont.)

Existence of potential voting rights


• These are instruments which have the potential, if
exercised or converted, to give the entity voting
power
– Would include share options, convertible notes

• In considering ‘capacity to control’ we must consider


potential voting rights

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Concept of control (cont.)
• As paragraphs BC120 and BC 121 of the Basis for
Conclusions to IFRS 10 state:
– Potential voting rights can give the holder the
current ability to direct the relevant activities. This
will be the case if those rights are substantive and
on exercise or conversion (when considered
together with any other existing rights the holder
has) they give the holder the current ability to direct
the relevant activities. The holder of such potential
voting rights has the contractual right to ‘step in’,
obtain voting rights and subsequently exercise its
voting power to direct the relevant activities—thus
the holder has the current ability to direct the
activities of an investee at the time that decisions
need to be taken if those rights are substantive.
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Delegated power
• Another factor to consider in determining whether to
consolidate an entity is whether any power to be exerted
over the entity is being used in the context of an agency
relationship, or whether the power is being exercised to
benefit the investor directly. In defining an ‘agency
relationship’, paragraph BC129 of the Basis for
Conclusions to IFRS 10 states:
– The Board decided to base its principal/agent guidance on
the thinking developed in agency theory. Jensen and
Meckling (1976) define an agency relationship as ‘a
contractual relationship in which one or more persons (the
principal) engage another person (the agent) to perform
some service on their behalf which involves delegating
some decision-making authority to the agent.

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Delegated power (cont.)

• If an entity has power, but is acting under the


direction of another entity––perhaps as an
‘agent’ of that other entity–– then control would
not be deemed to exist and the entity would not
be required to consolidate the entity over which it
had power.

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Exposure to variable returns
• As we have noted, another necessary attribute of
control is that there is an expectation that the investor
will be exposed to variable returns from its
involvement with the investee. Specifically,
paragraph 15 states:
– An investor is exposed, or has rights, to variable
returns from its involvement with the investee
when the investor’s returns from its involvement
have the potential to vary as a result of the
investee’s performance. The investor’s returns
can be only positive, only negative or both positive
and negative.

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Exposure to variable returns (cont.)

• This requirement means that parties such as receivers


and managers of financially troubled organisations, as
well as trustees, would not be required to consolidate a
controlled entity’s financial statements with their own
statements because, apart from the professional fees
being received, those concerned would not be
managing such organisations for their own benefit but
on behalf of owners and creditors.

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Concept of control (cont.)
Summary
• Subsidiaries are considered to be entities that are
under the control of a parent entity—theoretically,
control can exist in the absence of any equity-
ownership interest

• Holding of an ownership interest usually entitles the


investor to an equivalent percentage interest in the
voting rights of the investee, and consequently a
majority ownership interest would normally, though
not necessarily, be accompanied by the existence of
control

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Entity A

A directly controls B

Non-controlling
Entity B interest

A indirectly controls C

Entity C

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Accounting for business
combinations
• According to AASB 3, a ‘business combination’ is
defined as:
A transaction or other event in which an acquirer
obtains control of one or more businesses
• If the assets acquired do not fit the description of
business considered above, the transaction shall
represent the acquisition of a group of assets and the
appropriate accounting treatment would be covered by
AASB 116 Property, Plant and Equipment, and AASB
138 Intangible Assets rather than AASB 3 Business
Combinations

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Accounting for business combinations
(cont.)

• At the acquisition date, the acquirer is required to


recognise:
– goodwill separately from the identifiable assets
acquired
– the liabilities assumed
– any non-controlling interest in the acquiree

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Accounting for the consolidation
of separate legal entities
Goodwill defined (AASB 3 Business Combinations)
• Future economic benefits arising from assets that are not
capable of being individually identified and separately
recognised

AASB 3 requires the following:


The acquirer shall, at the acquisition date:
(a) recognise goodwill acquired in a business combination as
an asset, and
(b) initially measure that goodwill at its cost, being the excess
of the cost of the business combination over the acquirer’s
interest in the net fair value of the identifiable assets,
liabilities and contingent liabilities recognised
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Accounting for the consolidation of
separate legal entities (cont.)

AASB 3 notes that there are four steps to be considered


when accounting for business combinations, these
being:
1 Identifying the acquirer
2 Determining the acquisition date
3 Recognising and measuring the identifiable assets
acquired, the liabilities assumed and any non-
controlling interest in the acquiree, and
4 Recognising and measuring goodwill or a gain from a
bargain purchase

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Recognising and measuring goodwill
Calculation of Goodwill/Bargain on purchase

FAIR VALUE OF CONSIDERATION TRANSFERRED XXX


plus Amount of non-controlling interest XXX
plus Fair value of any previously held equity
interest in the acquiree XXX
XXX
less Fair value of identifiable assets acquired
and liabilities assumed XXX
GOODWILL ON ACQUISITION DATE XXX

Calculated in the manner shown above, the net figure for


goodwill will be a positive number. If the number is negative,
then rather than it being considered as goodwill, the amount
would be considered as a gain on bargain purchase

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Consideration transferred
In a business combination the consideration transferred
is measured at fair value. AASB 3 states that the fair
value of consideration transferred is calculated as:

the sum of the acquisition-date fair values of the assets


transferred by the acquirer, the liabilities incurred by the
acquirer to former owners of the acquiree and the
equity interests issued by the acquirer

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Recognising and measuring goodwill
(cont.)
• Consistent with the requirements of paragraph 48
of AASB 138 Intangible Assets that internally
generated goodwill not be recognised as an asset,
no goodwill would be brought to account by Yang
Ltd (the acquiree) in Worked Example 27.2 as only
purchased goodwill, and not internally generated
goodwill, is recognised for accounting purposes

• The purchased goodwill will be brought to account


by Ying Ltd as part of the consolidation process
and will appear in the consolidated financial
statements
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Amortisation of goodwill

• Prior to 2005, goodwill acquired also had to be


amortised systematically over the periods in which the
benefits were expected to be provided (maximum of 20
years)
• Goodwill amortisation now prohibited and goodwill is
now required to be subject to impairment testing

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Goodwill impairment testing
Goodwill impairment testing
• After initial recognition, the acquirer is to measure goodwill
acquired in a business combination at cost less any
accumulated impairment losses

• Goodwill acquired in a business combination is not to be


amortised. Instead, the acquirer is to test it for impairment
annually, or more frequently if events or changes in
circumstances indicate that it might be impaired, in
accordance with AASB 136 Impairment of Assets

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Accounting for the consolidation of
separate legal entities (cont.)
Goodwill impairment testing (cont.)
AASB 136 Impairment of Assets (par. 60) states:
An impairment loss shall be recognised immediately in the
profit and loss, unless the asset is carried at revalued amount
in accordance with another Standard (e.g. in accordance with
the revaluation model in AASB 116). Any impairment loss of a
revalued asset shall be treated as a revaluation decrease in
accordance with that other Standard.
Note
• As goodwill cannot be revalued, an impairment loss pertaining
to goodwill is to be recognised in the profit and loss
• AASB 136 offers additional guidance in relation to impairment
testing of goodwill

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Accounting for the consolidation of
separate legal entities (cont.)
First step in consolidation process
• Substitute the assets and liabilities of the
subsidiary for the investment account, which
currently exists in the parent company

• Where the net assets do not equal the value of the


investment, this will lead to a difference on
consolidation, for example, the goodwill acquired

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Accounting for the consolidation of
separate legal entities (cont.)
Elimination of pre-acquisition shareholders’ equity
• The investment account in the subsidiary will be eliminated in
full against the pre-acquisition shareholders’ funds of the
subsidiary
• This will avoid the double counting of assets, liabilities and
shareholders’ funds of the subsidiary
• Procedural details contained in AASB 10, pars B86 to B89

Refer to Worked Example 27.3—A simple consolidation—on pp.


890–893
– Consolidation worksheet used to facilitate consolidation
process

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Recognition of gain on bargain
purchase
• Possible (though not common) for a company to gain
control of an entity for an amount less than the fair
value of the proportional share of the net assets
acquired (acquired at a discount)

• Where an entity is acquired at a discount AASB 3 (par. 36)


requires the acquirer to:
(a) reassess the identification and measurement of the
acquiree’s identifiable assets, liabilities and
contingent liabilities and the measurement of the cost
of the combination, and
(b) recognise immediately in profit and loss any excess
remaining after that reassessment

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Recognition of gain on bargain
purchase (cont.)
• Pursuant to AASB 3 we are to treat the gain on bargain
purchase as part of profit or loss

Eliminate investment in subsidiary acquired at discount


• Journal entry to eliminate
Dr Share capital
Dr Retained earnings
Cr Gain on bargain purchase
Cr Investment in Subsidiary Ltd

Refer to Worked Example 27.4 on pp. 894-5—Acquisition


of subsidiary at a discount

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Subsidiary’s assets not recorded at
fair values
• If subsidiary’s assets not recorded at fair value then
adjustments will be required so that a reliable figure for
goodwill (or ‘gain on bargain purchase’) can be calculated
• AASB 3 stipulates either:
– revalue the identifiable assets in the accounting records of
the subsidiary before consolidation—all the non-current
assets of the subsidiary are revalued to their fair values in
the accounting records of the subsidiary, or
– recognise the necessary adjustments on consolidation. We
would first recognise a revaluation of the non-current assets
in the consolidation worksheet (Dr Asset; Cr Revaluation
surplus), and then we would eliminate the investment in the
subsidiary against the pre-acquisition shareholders’ funds of
the subsidiary (which would include the amount recognised
on revaluation)
See Worked Examples 27.5 and 27.6 (pp. 896 and 897)

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Consolidation after the date
of acquisition
• Pre-acquisition shareholders’ funds of the subsidiary are
eliminated on consolidation
• Typically provides for goodwill on consolidation
• In period following acquisition, subsidiary will generate
profits or losses—to the extent that these results have
been generated in the period after acquisition, they
should be reflected in the results of the economic entity
and be included within the consolidated equity

Refer to Worked Example 27.8 on pp. 902–4—Consolidation in a


period subsequent to the acquisition of the subsidiary

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Summary
Consolidated financial statements
– Present aggregated information about the financial
performance and financial positions of various separate legal
entities
– Provide a single set of financial statements that represent
the financial position and performance of the group as if it
were operating as a single economic entity
• ‘Control’ is the determining factor in deciding which
organisations should be included in the consolidation process.
We MUST clearly understand what ‘control’ means
• All controlled entities to be included in the consolidation process
regardless of legal form and field of activities
• Investment in subsidiary must be offset on consolidation against
the pre-acquisition capital and reserves of the subsidiary

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Summary (cont.)
• An adjustment may be required to reflect the fair value
of the subsidiary’s assets as at the date of acquisition,
and any difference will be either goodwill or gain on
bargain purchase
• If balance represents goodwill, goodwill must be
periodically reviewed for any impairment losses in
accordance with AASB 136 Impairment of Assets
• If a discount arises on consolidation, the discount is to
be treated as a gain on bargain purchase (part of
income) in the consolidated financial statements
• Following consolidation, the consolidated retained
earnings balance represents the parent entity’s retained
earnings plus the economic entity’s share of the post-
acquisition earnings of the controlled entities
(subsidiaries)

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Summary (cont.)
• The balance in the various consolidated reserve
accounts will represent the balance of the parent entity’s
reserve accounts plus the parent entity’s share of the
post-acquisition movements of the subsidiaries’
reserve accounts
• Consolidation entries are to be performed in a separate
consolidation worksheet/journal and NOT in the
accounts of the separate legal entities
• This means—and this is IMPORTANT—that the effects
of all prior period consolidation adjustments and
eliminations are not found in any ledger accounts when
we start a new financial period

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