GROUP FINANCIAL STATEMENTS (CONSOLIDATION) Definitions • A parent is an entity that controls another entity • A subsidiary is an entity that is controlled by another entity • Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. • A group - Parent Company & Subsidiaries Why consolidated group accounts? • To show a clearer picture of the position and profitability of a parent company and its subsidiaries after properly making the necessary adjustments for inter-company dealing and transactions. • To show how the management of the parent company was able to utilize the assets at its disposal to generate profit. Why consolidated group accounts cont….. • Attempt to show the financial position and earnings of a company – as if the parent company. bought assets of the subsidiary instead of buying the share capital. Problems of consolidated accounts • The loss of one company in the group might be masked by the profits in others • The group as a whole is not liable for the debts of any individual group company • The group appears to be highly geared than their constituent companies Control • Is presumed when one entity acquires more than one-half of another entity's voting rights, unless it can be demonstrated that such ownership does not constitute control Control cont….. Even if one of the entity does not acquire more than one-half of the voting rights of another entity, it might have obtained control of that other entity if, as a result of the combination, it obtains: power over more than one-half of the voting rights of the other entity by virtue of an agreement with other investors; or Control cont….. power to govern the financial and operating policies of the other entity under a statute or an agreement; or power to appoint or remove the majority of the members of the board of directors or equivalent governing body of the other entity; or Power to cast the majority of votes at meetings of the board of directors or equivalent governing body of the other entity. Exemption from presenting Consolidated financial the parent is itself a wholly-owned subsidiary, or is a partially owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements; the parent's debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets); Exemption from presenting Consolidated financial cont… the parent did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organization for the purpose of issuing any class of instruments in a public market; and the ultimate or any intermediate parent of the parent produces consolidated financial statements available for public use that comply with International Financial Reporting Standards Group Structure • Direct Subsidiary H 70% S S is a subsidiary of H since 70% of its shares are owned by H. The effective interest of H is also 70% Group Structure cont…. • Indirect Subsidiary a) Case A H 80% S1 70% S2 Group Structure cont…. • S1 = Direct subsidiary of H • S2 = Indirect subsidiary of H S2 Controlling % = 80% of 70% Effective Interest% = 56% (70% x 80%) Group Structure cont…. b)Case B H 60% S1 70% S2 Group Structure cont…. • H controls 70% of S2 • Effective interest is 60% x 70% = 42% • Note that even though in Case B, the effective interest % is only 42%, S2 is still a subsidiary of H. Group Structure cont…. • Mixed Group • • H 20% 70% S1 S2 40% Group Structure cont…. S1 is a subsidiary of H Question: Is S2 a subsidiary of H? Group Structure cont…. • Answer S2 is a subsidiary of H, because H & S1 together owns 60% of S2 (H can order S1 to vote in a certain way, therefore they control the 40% shares in S2 through S1. 40% + 20% of direct ownership comes to 60%). However, Effective interest is • Direct – 20% • Indirect 70% x 40% - 28% 48% Group Structure cont…. • Note that unless otherwise stated, H will be required to consolidate the accounts of S2 even though its effective interest is less than 50%. H in collaboration with S1 (controlled by H) have a majority voting on how S2 should be run. BASIC CONSOLIDATION TECHNIQUES • The principle of commercial substance over legal form is applied(substance over form) i.e individual assets and liabilities are combined because they are under the control of the parent company Consolidated Statement of Financial Position • Control is reflected by all of the assets and liabilities of the subsidiary • The actual ownership of the shares in the subsidiary are reflected in an adjustment for Non Controlling Interest in the equity section of consolidated statement of financial position Consolidated Statement of Financial Position • Step 1: Establish group structure • Step 2:Determine net assets of subsidiary(at the date of acquisition) • Step 3: Determine goodwill on acquisition • Step 4: Calculate Non Controlling Interest • Step 5: Compute consolidated retained earnings Step 1: Establish group structure • Is determined by considering ordinary shares acquired by the parent company ONLY • Preference shares, bonds and debentures are not considered to determine group structure Step 2:Determine net assets of subsidiary(at the date of acquisition) Recall the accounting equation: • A = L + C + Reserves • A - L = C + Reserves Net assets = C + Reserves Step 2:Determine net assets of subsidiary(at the date of acquisition) cont… • Reserves should be split between preacqusition reserves and post acquisition reserves Pre-acquisition profits/reserve represents the net assets at the time of acquisition. To Parent Company, this is not profit, but it is capital Post-acquisition profits are included in the Consolidated Profit & Loss account Step 2:Determine net assets of subsidiary(at the date of acquisition) cont… Dividends declared by subsidiary out of the preacquisition profits represent a return of capital (not income) to parent company Dividends declared by subsidiary out of the post-acquisition profits represent income to parent company Step 3: Determine goodwill on acquisition Goodwill is computed by comparing • Cost of Investment (Purchase price), and • Net assets(at the time of acquisition) Goodwill= Cost of Investment – Net Assets N.B If Cost of Investment is LESS than Net Assets of subsidiary acquired at the date of acquisition = Negative goodwill Example 1 Statement of Financial Positions H Ltd • • • • • • • • S Ltd Assets Investments in S Ltd 51,000 49,000 100,000 52,000 - 52,000 Ord Share Capital Reserves 70,000 30,000 100,000 40,000 12,000 52,000 Example 1 cont… H acquired ALL shares in S Ltd at a cost of 49,000 when S Ltd reserves were 4,000. Determine goodwill on acquisition Example 1 cont… Since Net assets at time of acquisition, OSC + pre- acquisition reserves = 44,000 • Goodwill is 49,000 – (40,000 + 4000) = 5,000 • Consolidated reserves now include those of the H Ltd and profits made in the subsidiary after acquisition (post-acquisition profits) = 30,000 + 8,000. Step 4: Calculate Non Controlling Interest • Non controlling Interest account is credited with their share of net assets at the date of the Statement of Financial Position. That is, no attempt is made to distinguish pre and post acquisition reserves for the Non controlling interest. Step 5: Compute consolidated retained earnings • Only parent share of subsidiary’s postacquisition reserves goes to the Consolidated reserves account to be combined with parent company’s reserves to get total reserves to appear in the Consolidated Statement of Financial Position. Intra-group transactions a) Dividends from subsidiaries Post-Acquisition Dividends When dividend is declared/paid by subsidiary, the subsidiary will Dr. Reserves Cr. Proposed dividends/Cash if paid Intra-group transactions cont… Entry in the Parent Company books. Dr. Dividend receivable/Cash if received Cr. Reserves Intra-group transactions cont… Treatment in preparing group accounts The treatment depends on whether the dividends have already been paid or not If Paid No action is required. Intra-group transactions cont… • If NOT PAID , We need to ask ourselves a question “has the Parent Company taken credit of (i.e, recognized or recorded) the proposed dividends in its books”? If the answer is YES, then offset the intercompany indebtedness arising out of the dividends payable by the subsidiary to the Parent Company. Intra-group transactions cont… If the answer is NO, then the Parent Company will need to first recognize the dividends as follows: Dr. Dividends receivable Cr. Reserves Intra-group transactions cont… • For consolidation purposes, the intercompany indebtedness will need to be eliminated. That means, in the consolidated accounts, dividends payable (i.e., proposed dividends) should only include the amount payable to outside parties, that is, the amount payable to Non controlling shareholders ONLY. Intra-group transactions cont… Pre-Acquisition Dividends Dividends declared by subsidiary out of the preacquisition profits represent a return of capital (not income) to parent company Accounting entry required in parent company Dr Cash/Dividend receivable(if not paid) Cr Cost of investment Intra-group transactions cont… In Subsidiary, Dr Pre-acquisition reserves Cr Dividends payable For consolidation purposes, “New” preacquisition profits will now be: pre-acquisition profits at the time of acquisition minus dividends out of those profits. Intra-group transactions cont… Note that Goodwill will not change. Why? Because on one hand the cost of investment has gone down by H’s share of the pre-acquisition dividend, and on the other hand the net assets acquired (or pre-acquisition reserves) will have gone down by the same amount. Inter company trading of stock Adjustment entry for goods in transit should be made as follows. • If it involves the Parent Company, goods in transit should be included in the Parent Company books. • If it involves two subsidiaries, the subsidiary to which goods are headed should record the goods in transit in its books. The resulting equal balances in the trade debtors and trade creditors will then be cancelled Unrealized profit • For consolidated accounts purposes, a provision for unrealized stocks should be made as follows: Dr. Consolidated Reserve xx Cr. Consolidated Stocks xx This is for wholly owned subsidiary Unrealized profit • For partly owned subsidiary • Dr Consolidated retained earnings(Share of parent) -say 90% • Dr Non controlling interest -say 10% Cr Consolidated inventory Example • P owns 90% of S. During the year S sells goods to P at cost plus 25%.At the year end the closing stock of P includes 8,000,000 of goods at invoice value acquired from S. What are consolidation adjustments needed? INTER-COMPANY SALE OF NON CURRENT ASSETS • The selling company will record any gain or loss and delete the asset (cost and applicable accumulated depreciation) from its books • The price paid will normally be the cost at which the buying company will record the asset in its book and depreciation will be based on this figure INTER-COMPANY SALE OF NON CURRENT ASSETS Important things to note: • The cost of the asset in the consolidated Statement of Financial Position should be that incurred by the first owner in the group • The depreciation expense and accumulated depreciation should be based on the cost in (i) above as if the sale had not taken place. INTER-COMPANY SALE OF NON CURRENT ASSETS • Sale by parent Dr Consolidated R/E XX Cr Non current assets xx • Sale by subsidiary Dr Consolidated R/E(Group’s share of S) XX Dr Non Controlling Interest(NCI’s share of S) XX Cr Non current assets xx Example • Suppose that during the year the parent (P ltd) sold a machine to subsidiary B (B Ltd) for shs 570,000. Suppose further that the machine was bought by A Ltd for shs 700,000 and had an accumulated depreciation of shs 252,000. Depreciation in the group is 20% on book value. What consolidation adjustment would be required? Solution • The gain on sale of shs 122,000 should be cancelled since this is not considered a sale from the point of view of the group. The shs 122,000 should be deducted from the group profits. Dr Consolidated Reserve 122,000 Cr Non current assets 122,000 Solution • The overcharge in depreciation should be added back to the group profits. It is found by taking a difference between – The depreciation recorded in B Ltd of shs 114,000, and – Depreciation recomputed taking shs 448,000 as the book value, i.e., 448,000 x 20% = 89,600 – Group profit should be revised upward by shs 24,400. Solution • The consolidated Statement of Financial Position should report the asset at the book value as would have been reported if the sale had not taken place, i.e., 448,000 – 89,600 = 358,400. Example 3 Patel Ltd acquired 80% of the ordinary shares of Shamo Ltd on 31st December 2004 for Tshs 20 million. On that date, Shamo Ltd financial statements showed a share premium of TZS 4,000,000, share capital of TZS 10,000,000 and Revenue Reserves of TZS 15,000,000. On 1st February 2005,Shamo Ltd declared dividend of Tshs 5,000,000 out of pre-acquisition profit. Example 2 cont…. Required: a. Compute goodwill or negative goodwill on acquisition b. Determine Non-Controlling interest and consolidated reserve on 31 December 2005 if on that date retained earnings for Shamo Ltd and Patel Ltd were Tshs 18,000,000 and Tshs 31,000,000 respectively.