Advanced Financial
Accounting: Chapter 2
Group Reporting I: Concepts and
Context
Tan & Lee Chapter 2
© 2009
1
Learning Objectives
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 parentsubsidiary 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
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Introduction
• A primary issue that underpins financial reporting is the identification
of the reporting entity.
Components of Financial Reporting
Financial reporting
Separate financial
statements for the
legal entity
Tan & Lee Chapter 2
Aggregated reporting
for the economic
entity
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Disaggregated
reporting for business
units within a legal or
economic entity
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Introduction
Relationship of control within legal entities
•Shared ownership
•Contractual or statutory
arrangements
Legal Entity
Individual
financial
statement
Tan & Lee Chapter 2
Control
Effective relationship
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Legal entity
Individual
financial
statement
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Introduction
Incentive to extend economic boundaries
Capitalizing
on slack debt
or operating
capacity
Increased
market shares
Tapping on
growth
opportunities
Economies
of scale
and scope
Reduced
risk through
diversification
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Introduction
•
A group of companies better able to deal with economic risk like
–
–
–
Macro-economic risk
Industry risk
Firm-specific risk
• Corporate acquisition and diversification may be sub-optimal and
value-destroying if
– Motivate by managers’ self-interest to invest in size rather than value
(Jensen, 1986, Shelefier and Vishny, 1990)
– Costs and risks that arise from acquisition strategies, particularly in
unrelated diversification
• Synergistic benefits potentially reduced by direct and indirect costs
arising from these strategies
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Introduction
Disaggregated Information
Loss of information if only
aggregated information is provided
Source of
disaggregated
information
Separate financial
statements
Segment information
Determine risk profile of individual segments
Tan & Lee Chapter 2
Strength and weaknesses of specific
operation and geographical
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Introduction
Parent-Subsidiary Relationship
Group
Subsidiary
Parent
Control
Subsidiary
Subsidiary
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© 2009
Consolidation:
Process of
preparing and
presenting financial
statements of parent
and subsidiary as if
they were one
economic entity
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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
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Information Perspective
• Managers with a comparative advantage on information are
compensated for their ability to provide information on the future
cash flows of these firms (Holthausen and Leftwish, 1983)
Are consolidated financial
statements are more
informative than separate
financial statements?
Tan & Lee Chapter 2
No
Investors can duplicate “homemade”
consolidated financial statements
(Mian and Smith,1990)
Yes
The greater the interdependencies
among group companies, the more
informative combined earnings about
future cash flows of the combined
entity (Holthausen, 1990)
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Efficient Contracting
• Whittred (1987) suggests that consolidated information improves
wealth for firms
• Reduced information asymmetry between lenders and borrowers
– Lenders fear that borrowers will transfer assets to related companies
– Borrowers expropriate a considerable larger sum than what they stand
to lose because of limited liability
• Hence, lenders required cross-guarantees issued by parent
companies. Whittred suggests a set of consolidated financial
statements performs the same function as a “cross guarantee”
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Opportunism
• Consolidated financial statements lead to wealth transfers to
managers at the expense of other stakeholders if the acquisition is
motivated by managerial self-interest
– Managers enjoy higher compensation, perks and power through
managing a larger group
– Managers are more likely to over-invest in companies that are specific
and complementary to their skills
• Information asymmetry may arise by masking financial problems of
individual companies within the group
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© 2009
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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
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Economic Incentives for Entering into
Intercorporate Arrangement
Markets will not reward firm’s diversification if investors can replicate the
firm’s strategies
Corporate Diversification
Why Corporate Diversification?
Individuals not able to diversify as
efficiently because of indivisibility of
assets and high transaction costs
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© 2009
Firms involved in M&A have
stakeholders who are not able to
diversify their risks as well as
shareholders
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Economic Incentives for Entering into
Intercorporate Arrangement
Acquirer gains “control”
over the operating and
financial policies of the
acquiree
Two or more acquirers
gain “joint-control” over
the acquiree
Arrangements in M&A
Reciprocal investments
are held by each of the
two firms, as both are
deemed to be equally
dominant
Tan & Lee Chapter 2
Acquirer has “significant
influence” over the
operating and financial
policies of the acquiree
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Economic Incentives for Entering into
Intercorporate Arrangement
Risk mitigated by
M&A strategies
Uncertainty
Risk management strategies
•Organic growth or acquisition
•Risk diversification
Information
Control
Tan & Lee Chapter 2
Joint-control
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Value
•Risk
•Size effects
•Co-insurance effect
•Diversification
Significant Influence
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Investing Strategies, Ownership Levels and the
Impact on Financial Reporting
Continuum of intercorporate ownership
Zero
Ownership
20%
Ownership
Passive
Investment
ii.
Earn dividend
income
Make capital
gain
Tan & Lee Chapter 2
100%
Ownership
Active
Investment
Active
Investment
•Associated
company
•Jointventure
•Trading
securities
•Availablefor-sale
securities
i.
50%
Ownership
i.
Exert significant
influence or
control over
investee’s
operation
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•Partially-owned subsidiary
•Fully-owned subsidiary
i.
ii.
iii.
Gain entry intro a new market
Achieve synergistic benefits from
complementary strengths
Gain market dominance
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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
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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)
Power to decide on
the financial and operating
policies of an entity
Tan & Lee Chapter 2
Enjoy the benefits
from the exercise
of the power
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The Concept of Control
Determination of control
Ownership of more than 50% of voting power:
Control is presumed to exist when the parent owns
directly or indirectly through subsidiaries, more than
one-half of the voting power of an entity unless, in
exception circumstances, it can be clearly
demonstrated that such ownership does not constitute
control
Ownership of less than 50% of voting power but
there is :
a) Power over more than one-half of the voting rights
arising from an agreement with other investors; or
b) Power to govern the financial and operating
policies of an entity arising from a statute or an
agreement; or
c) Power to appoint or remove the majority of the
members of the board of directors or equivalent
governing body; or
d) Power to cast the majority of votes at meetings at
the board of directors or equivalent governing
Tan
& Lee
Chapter
2
© 2009
body
that
has control
over the entity
Control
Subsidiary
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Direct and Indirect Control
•
•
For the test of control, IAS 27 requires consideration of the percentage of
voting rights held “direct or indirectly through subsidiaries”
Control must be demonstrated at each intermediate level before the ultimate
holding company is said to have control over the lowest-level company
Affiliation structures
Situation 1:
X Co. controls
Y Co. and A Co.
Break in control
for Z Co. even
though X.Co.
indirectly owns
75%
X Co.
100%
Y Co.
50% 50%
B Co.
Z Co.
A Co.
Y Co.
B Co.
Z Co.
40%
50%
Situation
1
Tan & Lee Chapter
2
60%
55% 60%
60%
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Situation 2:
X Co. controls
Y Co., B Co.
and Z Co.
Does not own
A Co. (<51%)
X Co.
Situation 2
50%
A Co.
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Legal Ownership versus Effective Control
• IAS 27 is principles-based, and all evidence must be considered for
the existence of control
• IAS 27 requires potential voting rights, which are currently
exercisable or convertible, to be considered when determining the
existence of 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
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Potential Voting Rights in the
Determination of Control
• IAS 27:15: In determining whether potential voting rights contribute
to control, the investor examines all facts and circumstances, such
as terms of exercise of the potential voting rights and any other
contractual terms, but not the intention of management and the
financial ability to exercise or convert
• It is important that the potential voting rights must be currently
exercisable or convertible to be included in the test of control
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Potential Voting Rights in the
Determination of Control
Illustration of potential voting rights
Issued
ordinary
shares
Percentage
of ordinary
shares
Issued
share
warrants
Potential
shares from
warrants
Total shares
(issued and
potential)
Percentage
of total
shares
Company A
$10,000,000
50%
$5,000,000
$10,000,000
$20,000,000
62.50%
Other
investors
10,000,000
50%
1,000,000
2,000,000
12,000,000
37.50%
Total
$20,000,000
100%
$6,000,000
$12,000,000
$32,000,000
100.00%
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
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Potential Voting Rights in the
Determination of Control
Sources of Control
When one investor has the
right to increase its voting
power or reduce other
investors’ voting power
Currently exercisable share
options even though they are
currently “out of the money”
Not relevant
Management intention
Tan & Lee Chapter 2
Financial ability
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Impact of Potential Voting Rights
on the Allocation of Profits
• IAS 27:19: The proportion of profit or loss and changes in equity
allocated to the parent and non-controlling interests are determined
on the basis of present ownership interests and do not reflect the
possible exercise or conversion of potential voting rights”.
• However, if the potential voting rights, in substance, gives the holder
access at present to the economic benefits associated with an
ownership interest should be considered( IAS 27:IG 5-6)
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© 2009
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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
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The Concept of Significant Influence
• An investor may participate in the policy-making processes of an
investee, although they may not have the power to govern the final
outcome
• IAS 28 describes such an investor as having “significant influence”,
and the investee is deemed an “associate” of the investor
• Special accounting procedures described as the “equity method” are
applied
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What is 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
representing investors
on board
Participation in
policy-making
processes
Operational
interdependencies
Investor must disclose reasons for not complying with default assumption
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Direct and Indirect Significant Influence
Multi-level structures
P
80% 50%
X
50%
Y
50%
Situation 1:
P has significant
influence over:
i)
Y (50% direct
interest)
ii) Z (65% indirect
interest) – P has
no control over
Y
P
40% 50%
A
80%
Z
Situation 1
Tan & Lee Chapter 2
C
20%
Situation 2:
P has significant
influence over:
i)
A (40% direct
interest)
ii) C (50% direct
interest)
iii) B (42% indirect
interest)
B
Situation 2
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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
Accounting for
for Business
Business Combinations
Combinations
7. Consolidation Theories
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Accounting for Business Combinations
Standards relevant to the preparation and presentation of
consolidated financial statements
IFRS 3 Business Combination (deals with business
combination generally)
IAS 27 Consolidated and Separate Financial
Statements ( applies specifically to the preparation
and presentation of consolidated financial statements
for parent-subsidiary combinations)
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Overview of the Scope of the IFRS 3
• 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
the equity of
another entity
Purchasing
the net assets of
another entity
Business combinations result from
Assuming the
liabilities of
another entity
Tan & Lee Chapter 2
Purchasing some of the
net assets of another
entity that together form
one or more business
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Purchase of Net Assets versus
Purchase of Equity
•
•
•
Parent
Acquirer
Acquires controlling interest
Buys over net assets
Subsidiary
Acquiree
Parent – Subsidiary relationship
Separate legal entities
- separate FS
Single reporting entity
- Consolidated FS
Tan & Lee Chapter 2
•
•
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No Parent – Subsidiary relationship
One legal and economic entity
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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
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Consolidation Theories
• Theories relating to consolidation are critical when the percentage of
ownership in a subsidiary is less than 100%
• Termed “partially owned subsidiary”, where the remaining
percentage is owned by shareholders who are collectively referred
to as “non-controlling interest” (NCI)
Parent
Non-controlling interests
90%
10%
Subsidiary
Both parent and non-controlling interest have a proportionate share of
the subsidiary’s:
•
•
Net profit;
Dividend distribution;
Tan & Lee Chapter 2
•
•
Share capital
Retained profits and changes in equity
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Consolidation Theories
Parent company sells
part of its stake in a
subsidiary to external
shareholders
Parent company
buys a majority
stake in a subsidiary
from existing owners
Tan & Lee Chapter 2
Reasons why
non-controlling
interest
Parent and non-controlling
arise
shareholders are founding
shareholders of newly
incorporated entity
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Consolidation Theories
Ownership of the combined entity
involving a wholly owned subsidiary
Joint-ownership of the combined entity
involving a partially owned subsidiary
Parent company’s shareholders
Parent company’s shareholders
Parent company
100%
ownership
Non-controlling
shareholders of a
subsidiary
Subsidiary
Wholly owned by the
parent company’s
shareholders
Tan & Lee Chapter 2
30%
ownership in
subsidiary
Parent company
70%
ownership
Subsidiary
2 groups of shareholders
1) The parent company’s shareholders; and
2) The non-controlling shareholders of the
subsidiary
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Comparison of issues
Issues
Who are the primary
users of the consolidated
financial statements?
How should noncontrolling interests be
reported in the
consolidated balance
sheet?
Tan & Lee Chapter 2
Entity Theory
Both non-controlling
interest and majority
shareholders
Shown as equity
based on:
Consolidated equity
=
Consolidated assets
Consolidated liabilities
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Parent Theory
Benefit of parent
company shareholders
Shown as equity
based on:
Consolidated equity
NCI
=
Consolidated assets
Consolidated liabilities
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Comparison of issues
Issues
Entity Theory
Net assets of the
subsidiary acquired be
shown at full fair values
or at the parent’s share
of the fair value?
Net asset at date
of acquisition
reported in full
Do non-controlling
shareholders have a
share of goodwill?
Asset of economic
unit, and reflected
in full
How should net profit of
partially owned
subsidiary be reported?
Tan & Lee Chapter 2
Reported in full as
both majority and
non-controlling
shareholders
© 2009
Parent Theory
NCI net asset at date
of acquisition shown
at book value
Asset of parent
and restricted to
parent’s share
NCI’s share of current
profit is a deduction of
final profit
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Summary of differences
Attributes
Entity Theory
Parent Theory
Fair value differences in
relation to identifiable
assets and liabilities at
date of acquisition
Recognized in full,
reflecting both parent’s
and NCI’s share of fair
value adjustments
Recognized only in
respect of parent’s
share
Presentation of NCI
As part of equity
Neither as equity or
debt
Goodwill
Goodwill is an entity
asset and should be
recognized in full as at
date of acquisition
Goodwill is parent’s
asset
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Proprietary Theory
• Relevant to accounting for joint venture
• Parent seen as having a direct interest in a subsidiary’s assets and
liabilities
– resulting in proportional consolidation.
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The Implicit Consolidation Theory
Underlying IFRS 3
• Previously, IAS 22 allowed an acquirer to either recognize or ignore
non-controlling interests’ share of fair value adjustments of a
subsidiary’s identifiable assets and liabilities
• IFRS 3 (2008) permits the recognition of non-controlling interests’
share of goodwill
• Movement towards the full entity theory
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Illustration 1: Parent versus Entity Theory
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
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Illustration 1: Parent versus Entity Theory
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
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Illustration 1: Parent versus Entity Theory
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
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