FAC2602

Open Rubric
 LEARNING OUTCOME
You should be able to identify and define a business combination, a parent and
subsidiary company as well as simple groups in relation to International Financial
Reporting Standards (IFRS).

OVERVIEW

1.1 INTRODUCTION ................................................................................................... 2

1.2 BUSINESS COMBINATION, PARENT AND SUBSIDIARIES .............................. 2
1.3 ACCOUNTING FOR GROUPS ............................................................................. 7
1.4 GENERAL PRINCIPLES....................................................................................... 8
1.5 EXERCISES .......................................................................................................... 9
SELF-ASSESSMENT.................................................................................................... 10

KEY CONCEPTS
• Business combination
• Acquisition and control
• Parent and subsidiaries
• Share capital
• Simple group
• Complex group

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 ASSESSMENT CRITERIA

After studying this learning unit, you should be able to

• define a business combination

• define a parent
• define a subsidiary
• explain the difference between simple and complex groups
• discuss the principle of control and how it is applied in business
combinations
• discuss the general principles applicable to group accounting

1.1 INTRODUCTION

The first learning unit, which deals with group financial statements, is mainly background
knowledge. As you progress through the course, you will come to understand the purpose
that this background knowledge serves. We refer back to certain concepts and principles
discussed here in subsequent learning units, so they should become clearer to you later
on in the module.

1.2 BUSINESS COMBINATION, PARENT AND SUBSIDIARIES

Over the years, the tendency in the business world has been to form bigger and bigger
enterprises. Sole proprietors combined to form partnerships, which in turn amalgamated
to form yet bigger partnerships. However, these bigger partnerships posed one problem:
not all the partners were equally involved. Some partners merely contributed capital,
whereas others were more actively involved in managing the enterprise on a daily basis.
The result was the formation of companies to limit the liability of the inactive partners.

Companies also began to combine with other companies to form larger companies and
groups of companies.

IFRS 3 Business Combinations regulates business combinations. We can define a

business combination as a transaction or other event in which an acquirer obtains control
of one or more businesses.

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 EXAMPLE 1

The following is an example of such a group:

P Ltd

75% of the control by

means of 75% of the
share capital

S Ltd

a) P Ltd is the parent. (P Ltd holds more than half of the issued share capital and it
is assumed also more than half the voting rights in S Ltd.)
b) S Ltd is the subsidiary.

Where a parent is linked with a subsidiary to form a larger economic unit, it is customary
to refer to the entity as a group.

IFRS 10 Consolidated Financial Statements (issued May 2011) defines a group as a

parent and all its subsidiaries. In such a group, the management of the different
independent parent and subsidiary entities would coordinate their efforts on a central and
unified basis to serve the interests of the group as a whole. It is possible for management
to operate on a unified basis because of the control that the parent exercises over its
subsidiaries.

IFRS 10 determines that an investor (in this case the parent) controls an investee (the
subsidiary) when the investor is exposed or has rights to variable returns from its
involvement with the investee and has the ability to affect those returns through its power
over the investee.

The above is an example of a simple group. Although you will only have to deal with
accounting and disclosure for simple groups in this course, we would like to introduce you
to the concept of complex groups so that it will not be an entirely new or foreign concept
to you in future.

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 EXAMPLE 2

The following are two examples of complex groups:

1.
P Ltd

80% of the control 60% of the control

through 80% of the through 60% of the
share capital share capital

S1 Ltd S2 Ltd

a) P Ltd is the parent.

b) S1 Ltd and S2 Ltd are the subsidiaries.
c) P Ltd, S1 Ltd and S2 Ltd collectively form a complex group (horizontally).

2.
P Ltd

75% of the control through 75% of the share capital

S1 Ltd

80% of the control through 80% of the share capital

S2 Ltd
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 a) P Ltd is the parent.
b) S1 Ltd is the subsidiary, and S2 Ltd is the sub-subsidiary.
c) P Ltd, S1 Ltd and S2 Ltd collectively form a complex group (vertically).

It should be clear to you from the above that simple groups have only one subsidiary,
whereas complex groups have more than one subsidiary.

The following definitions are important in the light of the above explanation:

• Business combination

A business combination is defined as a transaction or another event in which an

acquirer obtains control of one or more businesses.

• Parent

A parent is an entity that controls one or more other entities (subsidiaries).

• Subsidiary

A subsidiary is an entity that is controlled by another entity (the parent).

• Sub-subsidiary

A sub-subsidiary is a subsidiary of another subsidiary.

• Control

An investor (parent) controls an investee (subsidiary) when the investor (parent) is

exposed or has rights to variable returns from its involvement with the investee
(subsidiary) and has the ability to affect those returns through its power over the
investee (subsidiary).

All facts and circumstances need to be considered when determining whether an

investor controls an investee. If two or more investors need to work together to
direct business activities, neither investor individually controls the investee.
Instead, each investor needs to evaluate and account for its interest in the investee
as a subsidiary, associate or joint venture depending on the extent of control over
the investee. Interests in subsidiaries are covered in detail in learning units 1-9,
while associates and joint ventures and dealt with in learning unit 11.

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An investor (parent) controls an investee (subsidiary) only if all of the following are
true for the investor:

• It has power over the investee (subsidiary).

• It has exposure or rights to variable returns from its involvement with the
investee.
• It has the ability to use its power over the investee (subsidiary) to affect the
amount of the investor's returns.

These criteria are explained in further detail below:

Power

An investor has power over an investee when the investor has the right to direct
the activities of the investee. Rights could arise from contractual arrangements or
may include voting rights attached to shares or other equity instruments. The
power of the investor results from having these rights as these rights enable the
investor to significantly affect the investee’s returns.

If an investor has the ability to direct the relevant activities of the investee, it
possesses power over the investee even if the necessary rights to direct the
investee’s activities have not yet been exercised. The potential to direct activities
of the investee is in itself insufficient in determining whether the investor possesses
power over the investee. If, however, two or more investors each have existing
rights that enable them to direct the activities of the investee, the investor that can
significantly affect the returns of the investee at present has power over the
investee. An investor can have power over an investee even if other entities have
rights that enable them to exert significant influence over the investee.

Returns

An investor has the rights to variable returns from the investee when the investor’s
returns vary as a result of the investee’s performance. Although only one investor
can control an investee, more than one party can share in the returns of an
investee (i.e., non-controlling interests obtain a share of the profits of the
subsidiary).

Link between power and returns

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 activities
with the investee. The ability of the investor to make decisions regarding activities
of the investee therefore needs to be considered.

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Please note that in FAC2602 we will assume that an investor obtains control by
possessing 50% or more of the shares and voting rights of a company.

The issued share capital of a company may consist of both ordinary and preference
shares.

Shares do not have a nominal or par value in terms of the Companies Act 71 of 2008.
All shares of the same class have the same rights, and each share has one voting right,
except when the company's memorandum of incorporation provides otherwise (e.g. the
voting rights of preference shares may be excluded).

It should now be clear to you that a parent can obtain control over a subsidiary when the
parent holds the majority of the shares in the subsidiary.

In the examples we use, the percentages of shareholding and voting rights usually
correspond, since each share normally carries one vote. However, it is important to know
that this is not always the case in practice and that the percentage of voting rights would
determine the percentage of equity if there are no other factors influencing control.

In learning unit 3, we will explain the calculation of the percentage interest in more detail.

1.3 ACCOUNTING FOR GROUPS

The essence of consolidations is that the parent is able to control the policy and
management of the subsidiary. Therefore, the group should be seen as an economic unit.

Although the parent shows investments in its subsidiaries on its statement of financial
position, it is highly probable that the value of the investments have changed considerably
since the investments were made. The statements may therefore not be an accurate
reflection of the activities of the group.

For this reason, it is in the interest of the shareholders of the parent to have a single set of
annual financial statements drawn up for the group to give the shareholders an idea of
the earnings per share and the assets and liabilities of the group. We also call this set of
statements the consolidated statements, group annual financial statements or group
statements. Briefly, these are a combination of all the statements of the companies in the
group. They indicate that the investment represented in the parent's statements has been
replaced by the assets and liabilities of the subsidiary which represent this investment.
However, we need to make certain adjustments to represent these combined values
realistically as a single economic unit, which we will explain to you in the next learning
unit.

IFRS 10 requires parent companies to consolidate their investments in subsidiaries and

to include all their subsidiaries in the consolidated financial statements. This implies that

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consolidated financial statements are compulsory when a parent-subsidiary relationship
exists.

Group annual financial statements may include the following consolidated financial
statements: statement of profit or loss and other comprehensive income, statement of
changes in equity, statement of financial position, statement of cash flows and notes to
the consolidated financial statements.

When are group statements not required?

IFRS 10, however, allows a parent not to present consolidated financial statements only if
it meets all of the following conditions:

• The parent itself is a wholly owned subsidiary, or the parent is a partly owned
subsidiary of another entity and has informed its owners, including those not otherwise
entitled to vote, that it will not present consolidated financial statements, and its
owners do not object to this.
• The parent's debt or equity instruments are not traded in a public market.
• The parent did not file its financial statements with a securities commission or other
regulatory organisation for the purpose of issuing any class of instruments in a public
market, nor is it in the process of doing so.
• The ultimate or any intermediate parent of the parent produces consolidated financial
statements available for public use that comply with International Financial Reporting
Standards (IFRS).

A parent that elects in terms of the above not to present consolidated financial statements
may present separate financial statements as its only financial statements.

1.4 GENERAL PRINCIPLES

• Group statements should be a fair reflection of the state of affairs of the parent and its
subsidiaries as at the accounting date.
• Eliminate profits or losses that have arisen as a result of transactions within the group
and that have not been realised outside the group.
• Eliminate all intragroup balances when determining the total assets and liabilities of
the group.
• Eliminate the carrying amount of the parent's investment in the subsidiary.

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1.5 EXERCISES

We end the learning unit with a few revision questions. Your e-tutor can guide you in
answering these questions. For your own sake, try to answer them by referring to the
notes before you look at the proposed solutions.

QUESTION 1

Explain the following concepts:

a) Parent
b) Subsidiary
c) Wholly owned subsidiary

QUESTION 2

Distinguish between simple and complex groups and give a schematic representation of
each.

QUESTION 3

When are consolidated annual financial statements not required?

SOLUTIONS

Refer to the following sections of this learning unit for the answers to the questions:

QUESTION 1

a) Section 1.2
b) Section 1.2
c) Section 1.2

QUESTION 2

Section 1.2

QUESTION 3

Section 1.3

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SELF-ASSESSMENT

After studying this learning unit, are you able to:

• define a business combination?

• define a parent?
• define a subsidiary?
• explain the difference between simple and complex groups?
• discuss the principle of control and how it is applied in business
combinations?
• discuss the general principles applicable to group accounting?

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