UU-ACG-2100-MW Principles of Accounting and Finance

UU-ACG-2100-MW
PRINCIPLES OF ACCOUNTING & FINANCE
WEEK 1

Table of Contents Page #

Introduction .............................................................................................................................. 2
Business Combinations ............................................................................................................ 2
Business growth through acquisition, mergers and partnerships ........................................... 2
Important terms ...................................................................................................................... 4
Procedure for consolidating Financial Information ............................................................. 6
Conclusion .............................................................................................................................. 16
REFERENCES ....................................................................................................................... 17

Learning Objectives
1. Understand the current business environment and why we need to consolidate
accounts.
2. Learn what consolidation is, and the terms related to control.
3. Prepare all the steps regarding the simple consolidation of financial information
on acquisition day.

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Introduction
Where one company controls another, a group of companies is formed. The principle of
substance over form requires that in these circumstances group accounts are produced, which
reflect the performance and position of the group as a whole.
Basic groups were covered in earlier studies. In this module emphasis will be placed on more
complex aspects of consolidation. In cases where students find difficulties in the early stages
of their study they should revisit material from the previous module related to financial
reporting (Christensen et al 2016).

Business Combinations
According to BPP (2016), business combinations take place when an acquirer obtains control
of a business (e.g. an acquisition or merger). Below we discuss these concepts and how control
is acquired and accounted for.

Business growth through acquisition, mergers and partnerships

According to Hoyle & Doupnik (2009), as well as growing a business organically, one can also
expand by joining forces with another business. While this can create problems around
decision-making and possible management and staff issues, there can be clear advantages.

Benefits of business co-operation

 more resources
 sharing of the managerial load
 larger skills and talent base
 bigger pool of contacts
 increase in markets
 diversification and organic growth using increased resources
 reduced commercial risk

The right partner should complement a core brand and business development goals, so one
should consider carefully the type of partnership to be pursued to ensure the best chances of
success.

Partnerships and joint ventures

Joint ventures and partnerships can offer both partners significant benefits, including sharing
experience, skills, people, equipment and customer bases. Through a partnership or a joint

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venture arrangement with a complementary, non-competitive business, one may be able to

open new markets or improve offers to existing ones (Christensen et al 2016).

It's important to be very careful about choosing the right party. An agreement or contract
defining the terms of the partnership or joint venture is essential and further legal protection is
advisable.
Teaming up should be a win-win situation for both parties. Businesses involved with
complementary activities or skills are usually the most appropriate candidates. For example, a
group of sole traders - a carpenter, builder and gas installer/electrician - could form a company
to:
 increase their credibility in the construction trade
 allow them to bid for larger contracts
 appeal to customers looking for a 'one-stop-shop' service
(Christensen et al 2016).

Mergers and acquisitions

Growth through acquisition or merger is a common tactic used to achieve diversification and
market positioning. According to Hoyle & Doupnik (2009), it can help:
 increase market share
 expand the workforce
 widen the existing service or product offering
 grow revenues
 achieve economies of scale
 reduce costs through shared budgets and greater purchasing power

However Hoyle & Doupnik (2009) explain that combining two businesses can pose challenges
that did not exist before, such as:
 maintaining a presence in multiple markets
 managing a complex product and services portfolio
 retaining a larger and more diverse customer base
 managing more people and operational complexity

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Acquisition and merger may not be suitable business growth strategies for all businesses. They
are more suited to established enterprises, as transactions may involve commercial lawyers and
considerable legal work (Christensen et al 2016).

Important terms
BPP (2016) gives us the most important definitions needed for the understanding of control
over another entity:

Subsidiary
When a parent has control of another entity, then that entity is known as a subsidiary and is
consolidated using acquisition accounting.
This means the subsidiary’s assets and liabilities are added to those of the parent.
Control
An entity has control over an entity when it has the power to direct the activities, which is
assumed to be when the entity has > 50% of the voting rights.
The parent company must prepare consolidated financial statement if it has control over one or
more subsidiaries.
The underlying principles of consolidation are:
 Substance over legal form
 Control and ownership
Other situation where control exists are when the investor:
 Can exercise the majority of the voting rights in the investee
 Is in a contractual arrangement with others giving control
 Holds < 50% of the voting rights, but the remainder are widely distributed
 Holds potential voting rights which will give control
(BPP 2016)
Associate (& Joint Ventures)
When a parent has significant influence over another entity, then that entity is known as an
associate and is brought into the group FS using equity accounting.
This means the group FS include a share of the profit on the income statement and a share of
the net assets on the statement of financial.
Significant influence is the power to participate in the financial and operating policy decisions.
It is presumed that an investment of between 20% and 50% indicates the ability to significantly
influence the investee.
(BPP 2016)

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Other situations where significant influence exists are when the investor:
 Representation on the board
 Participation in policy making process
 Material transaction between the two entities
 Interchange of managerial personnel
 Provision of essential technical information
A joint venture is an entity over which the parent has joint control. Despite its name, joint
control is taken to mean very significant influence. So a JV is accounted for as a 50% associate
(BPP 2016).
Investment
When a parent has no relationship with another entity, then that entity is known as an
investment and brought into the FS using investment accounting (BPP 2016).
Goodwill impairment
Some groups questions require students to conduct an impairment review on the subsidiaries
at the year end. This results in a goodwill impairment.
An impairment occurs if the recoverable value of an asset falls below the carrying value.
 Recoverable value
This is the higher of VIU and FVLCTS (NRV).
● VIV = Value in use
● FVLCTS = fair value les costs to sell [this is almost identical to the more familiar NRV =
Net realisable value but more strictly this is actually phrased as “fair value less cost to sell”
which is essentially the same idea as NRV].
 Impairment of subsidiary
Goodwill impairment is identified by looking at the impairment of the whole subsidiary.
(BPP 2016)

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Procedure for consolidating Financial Information

According to Kaplan (2019) there are several steps/workings which need to be completed
before accounts across companies can be consolidated. All these workings and considerations
are explained below:
Workings

W1) Establish the Group Structure

P owns >50% in S
P owns 20-50% in A

W2) Net assets of subsidiary

At reporting date At acquisition Post- acquisition
Equity shares X X
Share Premium X X
Ret. earnings X X
PUP (W) – S seller (X)
FV adjustments X/(X) X/(X)
X X X

W3) Calculation of Goodwill

FV of consideration (shares/cash/loan stock) X
NCI at acquisition (FV) X
X
FV of net assets at acquisition (W2) (X)
Goodwill at acquisition (full) X
Less: impairments to date (X)
Goodwill (carrying value) X

W4) Non-controlling interest

NCI @ acqn (W3) X
Add: NCI% x S’s post-acqn profits (W2) X
Less: NCI% x impairment to date (W3) (X)
X

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W5) Group retained earnings

100% P X
Add: P’s % of S’s post acqn retained earnings (P’s% x (W2)) X
Add: P’s % of A’s post acqn retained earnings (P’s% x (W6)) X
Less: P’s% x impairment to date in subsidiary (W3) (X)
Less: Impairment to date (associate) (W6) (X)
Less: PUP (P seller) (X)
X

W6) Investment in associate

Cost X
Add: P% x A’s post-acqn profits X
Less: Impairment to date (100%) (X)
X

Adjustments – group and subsidiary

According to BPP (2016) the below need to be considered and eliminated:
 Intra-company balances
 Remove the payable
 Remove the receivable

 Cash in transit
Step 1 Take care of cash in transit first (adjust receiver’s books to assume they have recorded
the cash)
Step 2 Remove the intra-company trade receivable and payable

 Inventory in transit
Dr Inventory X
Cr Payables X

 Unrealised profits
 Inventory
Need to remove the intra-group profit included in inventory held at the year-end (cost
structures)

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Dr Retained earnings (of seller) X

Cr Inventory X
 If S is seller → Adjust (W2)
 If P is seller → Adjust (W5)

 Non-current asset PUP

Need to remove the intra group profit on intra -company transfers of non-current assets
Cr PPE (CSFP) X
Dr Retained earnings (of seller) X
 If S is seller → Adjust (W2)
 If P is seller → Adjust (W5)

 Fair value adjustments (IFRS 3)

 Bring in FV of identifiable assets and liabilities on a line by line basis into the group
SFP (PPE, inventory, contingent liabilities)
 Adjust S’s net assets (W2) @ SFP date and @ acquisition column.
 Adjust S’s net assets (W2) @ acquisition column (extra depreciation, sale of inventory)

 Other issues (Kaplan 2019)

 Cost of investment
o Cash
‣ now (at price paid/share)
‣ deferred (at PV)
‣ contingent (at FV)
o Shares
‣ number of S shares acquired
‣ number of P shares issued
‣ Value the P shares (at P’s share price)
‣ Record the share issue
o Mid-year acquisitions
Calculate the subsidiary’s retained earnings at acquisition, assuming subsidiary profits in the
year accrue evenly.

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o Uniform accounting policies

Subsidiary must adopt the parents accounting policies in the group accounts. Accounted for by
adjusting the value of assets/liabilities and (W2).
o Coterminous year-ends
Financial statements within three months of the parent’s year-end can be used and adjusted for
any significant events.
o Non-consolidation
Subsidiaries are not consolidated if it is:
‣ Held for sale in accordance with IFRS 5 and
‣ Operating under long-term restrictions such that the parent company cannot exercise control
 Adjustments - group and associate (BPP 2016)
Trading transactions – do not eliminate the balances
Unrealised profits – adjust for P’s% of any PUP
 Other components of equity
Other components of equity are an additional reserve that constitutes any reserve that does not
go into retained earnings. It could therefore include share premium, revaluation reserve,
gains/losses on fair value through other comprehensive income investments.
In the group accounts it is treated in exactly the same way as the group retained earnings, i.e.
100% P plus P’s% x S’s post acquisition movement (Kaplan 2019).

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Example-Other Components of equity (BPP 2016)

Luke, a public limited company, operates in the manufacturing sector. The draft statements of
financial position at 31 December 2015 are as follows:
Luke Han
$ $
Assets:
Non-current assets
Property, plant and equipment 3,650 2,480
Investment in Han 5,400
9,050 2,480
Current assets:
Inventory 1,950 1,480
Receivables 1,780 1,090
Cash 370 285
4,100 2,855
Total assets 13,150 5,335

Equity and liabilities:

Share capital 5,500 2,000
Retained earnings 3,200 1,000
Other components of equity 1,000 625
Total equity 9,700 3,625
Non-current liabilities 500 240

Current liabilities
Trade payable 1,900 1,020
Tax payable 1,050 450
2,950 1,470
Total liabilities 3,450 1,710
Total equity and liabilities 13,150 5,335

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The following information is relevant to the preparation of the group financial statements:
• On 1 January 2015, Luke acquired 80% of the equity interest of Han for a cash consideration
of $5,400 million. At 1 January 2015, the identifiable net assets of Han had a fair value of
$3,400 million, and retained earnings were $600 million and other components of equity were
$400 million. The excess in fair value is due to an item of non-depreciable land.
• The fair value of the non-controlling interest at the date of acquisition was $700m.
(a) Calculate the goodwill using (i) the proportionate share of net assets method, and (ii)
the fair value method.
(b) Calculate the group retained earnings and group other components of equity.

Solution (BPP 2016)

(a) (i) Goodwill – proportionate share method
FV of consideration 5,400
NCI at acquisition (20% x 3,400) 680
FV of net assets at acquisition (W) (3,400)
Goodwill at acquisition 2,680
(ii) Goodwill – fair value method
FV of consideration 5,400
NCI at acquisition 700
FV of net assets at acquisition (W) (3,400)
Goodwill at acquisition 2,700
(b) Group retained earnings
100% P 3,200
Add: P’s % of S’s post acqn retained earnings
(80% x 400(W)) 320
3,520
Group other components of equity
Cost 1,000
Add: P% x Ss post-acqn other comp. equity
(80% x 225 (W)) 180
1,180

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Workings (BPP 2016)

Net assets of subsidiary
At reporting date At acquisition Post-acquisition
Equity shares 2,000 2,000
Ret. earnings 1,000 600 400
Other comp. equity 625 400 225
FV – Land 400 400
4,025 3,400 625

Example-Consolidation (Kaplan 2019)

Rey, a public limited company, operates in the manufacturing sector.
The draft statements of financial position at 31 December 2015 are as follows:
Rey Finn
$m $m
Assets:
Non-current assets
Property, plant and equipment 1,560 1,250
Investments 1,540 -
3,100 1,250
Current assets:
Inventory 450 580
Receivables 380 390
Cash 190 230
1,020 1,200
Total assets 4,120 2,450
Equity and liabilities:
Share capital 1,700 1,000
Retained earnings 1,450 800
Total equity 3,150 1,800
Non-current liabilities 520 350
Current liabilities
Trade payable 300 190
Tax payable 150 110
450 300
Total liabilities 970 650
Total equity and liabilities 4,120 2,450

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The following information is relevant to the preparation of the group financial statements:
On 1 January 2014, Rey acquired 70% of the equity interest of Finn for a cash consideration
of $1,340 million.
At 1 January 2014, the identifiable net assets of Finn had a fair value of $1,850 million, and
retained earnings were $450 million. The excess in fair value is due to an item of property,
plant and equipment that has a remaining useful life of 10 years.
It is the group policy to measure the non-controlling interest at acquisition at is proportionate
share of the fair value of the subsidiary’s net assets.
On 1 July 2015, Rey acquired 25% of the equity interest of Ben for a cash consideration of
$200 million. Ben’s profits for the year were $80 million, out of which a dividend of $20
million was declared on 31 December 2015. The 25% holding gives Rey the power to
participate in the operating and financing decisions of Ben.
Prepare the group consolidated statement of financial position of Rey as at 31 December
2015.

Solution (Kaplan 2019)

Rey
$m
Assets:
Non-current assets
Property, plant and equipment (1,560 + 1,250 + (400 – 80) (W2)) 3,130
Goodwill (W3) 45
Investment in associate (W6) 205
3,380
Current assets:
Inventory
(450 + 580) 1,030
Receivables
(380 + 390) 770

Cash
(190 + 230) 420
2,220
Total assets 5,600

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Equity and liabilities:

Share capital 1,700
Retained earnings (W5) 1,644
3,344
Non-controlling interest (W4) 636
Total equity 3,980
Non-current liabilities
(520 + 350) 870
Current liabilities
Trade payable
(300 + 190) 490
Tax payable
(150 + 110) 260
750
Total liabilities 1,620
Total equity and liabilities 5,600

Workings
W1) Group Structure
P >50% in S
P 20-50% in A

W2) Net assets of subsidiary

At reporting date At acquisition Post -acquisition
Equity shares 1,000 1,000
Ret. earnings 800 450
FV – PPE 400 400
Depreciation (80) -
2,120 1,850 270

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W3) Goodwill
FV of consideration (shares/cash/loan stock) 1,340
NCI at acquisition
(30% x 1,850) 555
FV of net assets at acquisition (W2) (1,850)
Goodwill at acquisition 45
W4) Non-controlling interest
NCI @ acqn (W3) 555
Add: NCI% x S’s post-acqn profits (W2)
(30% x 270) 81
636
W5) Group retained earnings
100% P 1,450
Add: P’s % of S’s post acqn retained earnings (70% x 1,270(W2)) 189
Add: P’s % of A’s post acqn retained earnings (W6) 10
Less: Dividend (W6) (5)
1,644

W6) Investment in associate

Cost 200
Add: P% x A’s post-acqn profits (25% x 80 x 6/12) 10
Less: Dividend (25% x 20) (5)
205

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Conclusion
Nowadays, trends in mergers, takeovers, and other similar business strategic decisions, call for
reporting at Group level. An accountant should be able to understand the specifics of each
company in a group, and know the steps of consolidation, including all information that needs
to be collected in order to perform this exercise. Week 1 is a good start, although students are
urged to revisit and refresh International Financial Reporting Standards to be able to recognize
adjustments which are needed before consolidation and fair presentation of transactions.

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REFERENCES
BPP Learning Media (2016), Corporate Reporting Study Text, 9th Ed. London, UK: BPP
Learning Media Ltd

Christensen, T. & Cottrell, D. & Budd, C. (2016). Advanced Financial Accounting 11th
Edition. McGraw hill

Hoyle, J.B., Schaefer, T. F., and Doupnik, T.S, 2009 Advanced Acounting, McGraw Hill Irwin

Kaplan Publishing (2019), Financial Reporting, 2019 Ed. Berkshire, UK: Kaplan
Publishing UK

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