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Advanced Financial Accounting: Chapter 2: Group Reporting I: Concepts and Context
Advanced Financial Accounting: Chapter 2: Group Reporting I: Concepts and Context
Accounting: Chapter 2
Group Reporting I: Concepts and
Context
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 “associates”
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
Tan & Lee Chapter 2 © 2009 2
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
Tan & Lee Chapter 2 © 2009 3
Introduction
Financial reporting
Disaggregated
Separate financial Aggregated reporting
reporting for business
statements for the for the economic
units within a legal or
legal entity entity
economic entity
•Shared ownership
•Contractual or statutory
arrangements
Capitalizing
on slack debt Increased
or operating market shares
capacity
Tapping on Economies
growth of scale
opportunities and scope
Reduced
risk through
diversification
Source of
disaggregated
information
Separate financial
Segment information
statements
Parent Control
Subsidiary Consolidation:
Process of
preparing and
presenting financial
statements of parent
and subsidiary as if
Subsidiary they were one
economic entity
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
Tan & Lee Chapter 2 © 2009 10
Information Perspective
No
Investors can duplicate “homemade”
consolidated financial statements
Are consolidated financial (Mian and Smith,1990)
statements are more
informative than separate Yes
financial statements? The greater the interdependencies
among group companies, the more
informative combined earnings about
future cash flows of the combined
entity (Holthausen, 1990)
Tan & Lee Chapter 2 © 2009 11
Efficient Contracting
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
Tan & Lee Chapter 2 © 2009 14
Economic Incentives for Entering into
Intercorporate Arrangement
Markets will not reward firm’s diversification if investors can replicate the
firm’s strategies
Corporate Diversification
Arrangements in M&A
Reciprocal investments
Acquirer has “significant
are held by each of the
influence” over the
two firms, as both are
operating and financial
deemed to be equally
policies of the acquiree
dominant
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
Tan & Lee Chapter 2 © 2009 19
The Concept of Control
Control
Power to govern the financial and operating
policies of an entity so as to obtain benefits from its activities
(IAS 27:4)
Situation
Tan & Lee Chapter 2 1 © 2009 Situation 2 22
Legal Ownership versus Effective Control
• IAS 27:14: Potential voting rights arise from “share warrants, share
call options, debt or equity instruments that are convertible into
ordinary shares, or other similar instruments that have the potential,
if exercised or converted, to give the entity voting power or reduce
another party’s voting power over the financial and operating
policies of another entity
Other
10,000,000 50% 1,000,000 2,000,000 12,000,000 37.50%
investors
Although Company A owns only 50% of the total issued ordinary shares, its
holding of the share warrants gives it de facto control over Company B
Sources of Control
Not relevant
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
Tan & Lee Chapter 2 © 2009 28
The Concept of Significant Influence
Significant influence
Power to participate in the financial and operating policy decisions of the
investee but is less than control and is not equivalent to joint control over
those policies (IAS 28:2)
Default assumption:
An investor has ownership of 20% or more of the voting power and equal to
or less than 50% of the voting power in an investee, including “potential
voting rights”
Other evidences
Number of directors Participation in
Operational
representing investors policy-making
interdependencies
on board processes
Investor must disclose reasons for not complying with default assumption
Tan & Lee Chapter 2 © 2009 30
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
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
Accounting for
for Business
Business Combinations
Combinations
7. Consolidation Theories
Tan & Lee Chapter 2 © 2009 32
Accounting for Business Combinations
• 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
Parent Acquirer
Subsidiary Acquiree
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
Tan & Lee Chapter 2 © 2009 36
Consolidation Theories
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
Tan & Lee Chapter 2 © 2009 37
Consolidation Theories
Reasons why
non-controlling
Parent company interest Parent and non-controlling
buys a majority arise shareholders are founding
stake in a subsidiary shareholders of newly
from existing owners incorporated entity
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
Tan & Lee Chapter 2 © 2009 39
Comparison of issues
Issues Entity Theory Parent Theory
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
Scenario
• Consideration transferred: $1,200,000
• NCI: 20%
• BV of equity 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 at 31/12/20x1: $1,270,000
Goodwill
Parent Theory
Goodwill = Investment in S – P’s ownership %
X (Fair value 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
Non-controlling interests’ share of goodwill = Fair value of NCI – Share of FV
of identifiable net assets
= $300 – (20% x $1,300)
= $300 – $260
= $40
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 are deemed to have an equity interest and are thus
presented as a component in equity
Non-controlling interests = Non-controlling interest %
x (BV of S’s equity + FV adjustments)
+ NCI’s share of goodwill
= 20% x ($1,270 + $100) +$40
= $314