62 student accountant June/July 2006

technical

consolidations This article is aimed primarily at candidates studying consolidations

for Paper 2.5, Financial Reporting. It will also benefit candidates studying for Paper 3.6, Advanced Corporate Reporting.

Recent examination performance on the Paper 2.5 consolidation question (always Question 1) has shown that most candidates have a sound understanding of basic consolidation techniques. This article looks at some of the more difficult areas, where candidates often experience problems, namely: fair values of consideration and adjustments to an acquired subsidiary’s identifiable assets, liabilities and contingent liabilities; elimination of intra-group trading and other transactions; and goodwill impairment. It is based on relevant International Financial Reporting Standards (IFRSs), but much of it is also relevant to other adapted papers, including those based on UK GAAP.

FAIR VALUE ADJUSTMENTSIn calculating goodwill, and the initial carrying amount of acquired assets and liabilities, IFRS 3, Business Combinations requires that both the consideration paid by the parent company (or ‘parent’) and the net assets of the acquired subsidiary are valued at their fair values. Fair value is defined (in several IFRSs) as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable and willing parties in an arm’s length transaction. Consideration paid may be in the form of assets given (normally cash), liabilities assumed, or shares or other financial instruments issued by the acquirer, plus any direct costs attributable to the business combination. The relevance of this requirement has previously been examined in the following ways:

Determining the number of shares a parent issues in an acquisition (usually on the basis of a specified share exchange), and applying the stock market price of the parent’s shares at the date of the acquisition. Often the question will say that the share issue has not yet been recorded in the parent’s financial statements. Candidates will therefore have to record both an increase in the nominal value of the parent’s share capital and any premium (determined by the stock market value) on the issue.

problem areas in group accountsrelevant to Professional Scheme Papers 2.5 and 3.6

Occasionally, cash consideration may be deferred (ie not paid at the date of acquisition) to a specified date after the acquisition. Where this period is significant (usually one or more years) the amount of the cash consideration will need to be discounted to a present value, at the rate for cost of capital given in the question. Candidates often manage to determine the present value of such consideration, but then fail to account for the ‘unwinding’ of the discounted amount, or fail to show the liability in the balance sheet. In the period after the acquisition, the parent should accrue a finance charge (at the rate of the cost of capital) in its income statement (which is consolidated), and add this to the carrying amount of the deferred consideration (a liability) in its balance sheet (which is also consolidated).

The most common form of fair value adjustment is that made to the assets of the acquired subsidiary. The amount of the required adjustment is normally given in the question. The simplest of these adjustments would be to a non-depreciating, non-current asset (normally land). The amount of the adjustment should be added to the carrying amount of the asset (as it appears in the subsidiary’s books), and the total included in the consolidated balance sheet (think of this as a debit entry). The amount of the adjustment should also be included in the calculation of goodwill (the equivalent of a credit entry, similar to creating a revaluation reserve). Note – sometimes in practice (but not in a Paper 2.5 examination question) a subsidiary will actually revalue its assets to fair values (in its entity financial statements) prior to consolidation, to assist the consolidation process. This is sometimes referred to as ‘push down’ accounting, whereby the fair values determined by the parent are ‘pushed down’ into the subsidiary’s books.

Where a fair value adjustment relates to a depreciating non-current asset, the above technique is also performed, but there is a further complication. In the post-acquisition period, the depreciation of acquired assets must be based on their fair values. In the subsidiary’s own (entity) financial statements, depreciation will have been based on the asset’s carrying amount. Thus the consolidated financial statements will require a fair value depreciation adjustment. The amount of this may be given in the question, or candidates may have to calculate it based on the remaining life (and depreciation policy) at the date of acquisition. The amount of this adjustment (assuming the fair value is greater than the carrying amount) reduces both the subsidiary’s post-acquisition profits (which will also affect any minority interests) and the carrying amount of the asset.

64 student accountant June/July 2006

technical

Inventories may also require fair value adjustments. Raw materials and bought-in components are normally valued at their replacement cost; finished goods should be valued at net selling price less a reasonable profit allowance. It is also possible (but not common in Paper 2.5 examination questions) that liabilities will require fair value adjustments. This may be as simple as recognising a liability that the subsidiary had not accounted for (eg an account payable inadvertently not recorded by the subsidiary), or the restatement of a loan to fair value due to a change in interest rates since it was taken out. A further complication is that IFRS 3 requires the recognition of any contingent liabilities of the subsidiary, provided they can be reliably measured. Such liabilities would not be recognised in the subsidiary’s financial statements, other than by way of a note. The IASB recognises that this requirement creates an inconsistency with IAS 37, Provisions, Contingent Liabilities and Contingent Assets.

EXAMPLE 1Holdrite purchased 80% of the issued share capital of Staybrite on 1 April 2005. Details of the purchase consideration given at the date of purchase are:

a share exchange of three shares in Holdrite for every five shares in Staybrite

the issue to the shareholders of Staybrite 8% loan notes, redeemable at par on 31 March 2008 on the basis of $100 loan note for every 125 shares held in Staybrite

a cash sum of $121 for every 100 shares in Staybrite, payable on 1 April 2007. Holdrite’s cost of capital is 10% per annum.

The market price of Holdrite’s shares at 1 April 2005 was $4.50 per share. In order to help fund the acquisition of new operating capacity for Staybrite, Holdrite also subscribed for a 10% $4m loan note (2008) issued by Staybrite immediately after the acquisition. A fair value exercise was carried out at the date of acquisition of Staybrite, with the following results: Carrying amount Fair value $000 $000Land 20,000 23,000Plant 25,000 30,000Inventory 5,000 6,000

The fair values have not been reflected in Staybrite’s financial statements.

In addition, a note to Staybrite’s financial statements gave details of a contingent liability in respect of outstanding litigation. The directors of Holdrite considered that $5m would be a reliable measurement of this contingent liability. The details of each company’s share capital and reserves at 1 April 2005 are: Holdrite Staybrite $000 $000 Equity shares of $1 each 20,000 10,000 Share premium 5,000 4,000 Retained earnings 18,000 8,000

RequiredCalculate the goodwill arising on the acquisition of Staybrite.

AnswerGoodwill in Staybrite: $000 $000 $000ConsiderationShares (10,000 x 80% x 3/5 x $4.50) 21,6008% loan notes (10,000 x 80% x $100/125) 6,400Deferred cash payment ($9,680/1.21 see below) 8,000 36,000Less Equity shares 10,000Share premium 4,000Pre-acquisition reserves 8,000Less contingent liability (5,000) 3,000Fair value adjustment (3,000 + 5,000 +1,000) 9,000 26,000 x 80% (20,800)Goodwill 15,200

The gross cash consideration will be $9,680 (10,000 x 80%/100 x $121). If $1 was invested for two years, carrying an interest rate of 10%, it would be worth $1.21.

Note: the 10% loan note issued after acquisition is not part of the consideration.

INTRA-GROUP ADJUSTMENTSThe objective of consolidated financial statements is to present the results of the parent – and all the entities over which it has control (ie a group) – as if they were a single entity.

It follows from this that an entity cannot trade with itself, nor make a profit from any transaction within the group. Thus any intra-group transactions need to be eliminated (cancelled) as part of the consolidation process. This article will consider the most common examples of such transactions: intra-group sales, the transfer of non-current assets, and the provision of loans.

Intra-group salesIf one member of a group sells goods to another, these sales are recorded by the seller in revenue, and by the purchaser in cost of sales at the same amount (the transfer price). Provided the purchaser has sold on the goods to an entity that is not a member of the group, it is a simple matter to eliminate the intra-group sale from revenue and cost of sales (at the same amount) when consolidating the income statements. This elimination would have no effect on the balance sheet. Occasionally,

candidates eliminate the selling price from revenue and the cost price from cost of sales – this is incorrect.

A problem arises when some of the goods from the intra-group sale are still in the inventory of the purchasing company at the year end. As these goods have not left the group, any profit added by the supplying company has not been realised and must therefore be eliminated. Once the amount of the unrealised profit has been determined, it is deducted from gross profit (by increasing cost of sales) and also deducted from the carrying amount of the consolidated inventory on the balance sheet. This deduction reduces the balance sheet value of the inventory to the cost of the group.

Occasionally, a non-current asset is transferred within the group (say from a parent to a subsidiary). The parent may have manufactured the asset as part of its normal production (and therefore included the sale in revenue), or it may have transferred an asset previously used as part of its own non-current assets. If the transfer is done at cost (which is probably unlikely in an examination question), then the first example would be equivalent to a company constructing its own non-current asset. The required elimination would therefore be to remove the cost of the asset from both revenue and cost of sales. In the second example, no elimination would be required.

The situation is also complicated if the transfer contains a profit element. In its entity financial statements, the parent would report this profit in its income statement. This would be either as a normal sale or as a profit on disposal if it represented the transfer of a non-current asset. The consequences in the subsidiary’s financial statements are that the carrying amount of the asset would be overstated (in terms of cost to the group), and future depreciation charges would also be overstated (when compared to depreciation based on cost to the group). At the date of sale/transfer, the profit is unrealised, and in financial statements prepared at this date, the profit would be eliminated from the (parent’s) income statement (and retained earnings) and from the carrying amount of the asset.

The adjustment required in subsequent years is more complex. Instinctively, one might eliminate the whole of the profit from the parent’s retained profits and the carrying amount of the asset (the same adjustment as on the date of the sale/transfer). A further adjustment might then be made to increase the subsidiary’s profit by the ‘excess’ depreciation, recorded in the income statement and retained earnings (this would also affect any minority interests), and also to increase the carrying amount of the asset by this amount. Some commentators and textbooks use this method and it will be marked as correct. However, it should be understood that depreciation is effectively a measure of the realisation of an asset. Thus, in subsequent accounting periods, it is only the unrealised profit left in the carrying amount of the asset that should be eliminated from the parent’s profit, and from the carrying amount of the asset. Both methods give the same carrying amount for the asset, but the ‘excess’ depreciation that was added back to the subsidiary’s profit in the first method is instead ‘netted’ off the initial amount of the unrealised profit, before being deducted from the parent’s profits. As well as being more conceptually correct, the second method is easier to apply.

Intra-group loansIt is quite common for a parent to provide a loan to a subsidiary on which

interest will usually be paid and received. The parent will normally show the loan as an investment, with any interest received included in its income statement. Conversely, the subsidiary will show the loan as a non-current liability (assuming repayment is due in more than one year’s time), and will show any interest paid as a financing cost in its income statement. It is a relatively simple matter to eliminate the asset (investment) against the liability (loan) in the consolidated balance sheet, and the interest received against the interest paid in the consolidated income statement. One point to watch out for is that a subsidiary may have issued, for example, $5m of loan notes of which the parent has purchased only $3m. In these circumstances, only the $3m (and the proportionate interest) should be eliminated. Thus, the consolidated financial statements would show a loan of only $2m together with proportionate interest paid (ie the amounts that relate to parties outside the group).

EXAMPLE 2Continuing the group situation in Example 1. In the post-acquisition period, Holdrite sold goods to Staybrite for $72,000. Holdrite achieved a mark-up on these goods of 20% on cost. At the year end, Staybrite still had $42,000 (at the transfer price) of these goods in its inventory.

On 1 April 2005, Holdrite sold an item of plant to Staybrite for $120,000. Holdrite had manufactured this plant at a cost of $100,000 and treated it as a normal sale. Staybrite is depreciating this plant on a straight-line basis over a five-year life with no estimated residual value.

On 1 October 2005, Staybrite issued a $2m 8% (actual and effective rate) loan note, redeemable in 2010. Holdrite had subscribed for $800,000 of this issue. All due interest had been paid by 31 March 2006.

RequiredUsing the journal format, show the adjustments required for the above transactions when preparing the consolidated financial statements for the year ended 31 March 2006.

Answer Dr Cr $ $

Revenue 72,000Cost of sales 72,000Elimination of intra-group sales:Profit (made by Holdrite) 7,000Inventory 7,000Elimination of URP from inventory (of Staybrite): A mark-up of 20% (ie 1/5th on cost) is equivalent to 1/6th on selling price, therefore unrealised profit (URP) is $42,000/6 = $7,000Revenue 120,000Cost of sales 100,000Depreciation charge 4,000Non-current assets – plant 16,000

June/July 2006 student accountant 65

technical

66 student accountant June/July 2006

technical

Elimination of the sale and cost of sale (effectively own costs have been capitalised as a non-current asset). Reduction of carrying amount of the plant by the URP over the remaining life of the plant (20,000/5 years x 4 years). Reduction of depreciation to be based on cost to group. Note: in the balance sheet, the effect of the first three entries relating to the plant in the income statement will reduce group retained earnings by $16,000.

Dr$ Cr$8% loan note (non-current liability) 800,000Investments 800,000Interest received 32,000Interest paid 32,000

Elimination of intra-group investment/loan and related interest (ie 8% on $800,000 for six months). Note: after these adjustments, the consolidated balance sheet will show 8% loan notes of $1.2m, and the income statement will include interest paid of $48,000.

Tutorial noteAlthough the above answers are framed as journal entries, it should be appreciated that they are not actual journal entries. Consolidated adjustments are merely workings – they do not exist in any company’s books.

GOODWILL IMPAIRMENTIFRS 3, Business Combinations changed the required subsequent accounting treatment for consolidated goodwill. Prior to its introduction, many companies amortised goodwill over its estimated useful life (a practice still continued in many jurisdictions, including the UK). IFRS 3 prohibited amortisation of goodwill in favour of an annual impairment test, which may be applied more frequently, if there are indications of impairment. The detailed procedures for impairment testing of goodwill are contained in IAS 36, Impairment of Assets. Many Paper 2.5 examination questions may simply say how much (if any) the goodwill impairment is, or possibly express it as a percentage of the goodwill (a rather contrived scenario). It is a simple matter to account for a given impairment loss; it is charged to the income statement (normally as an operating expense), and credited to the carrying amount of goodwill on the balance sheet.

It is useful to consider the process of testing for goodwill in a little more depth. Any asset is said to be impaired if its carrying amount is more than its recoverable amount. Goodwill generates cash flows in combination with other assets – these are known as cash generating units or CGUs. The impairment test must be done by comparing the carrying amount of the CGU containing the goodwill with its recoverable amount. For a consolidation question, the simplest form of CGU would be the assets of an acquired subsidiary (note: liabilities do not normally form part of a CGU). IFRS 3 has an interesting view of goodwill where there is a minority interest. It says that the traditional goodwill calculated on consolidation represents only the goodwill owned by the parent, and that there also exists (but is not recognised) a proportionate amount of

goodwill relating to the minority. Thus, when determining any impairment to a CGU, it is necessary to ‘gross up’ the recognised goodwill in respect of any minority interest. The grossed up goodwill is referred to as ‘notional goodwill’. Following this concept, IFRS 3 argues that the (determined) recoverable amount of a CGU is based on all its assets, and therefore should be compared to the carrying amount of all the CGU’s assets (which must include the unrecognised minority share of goodwill).

It is interesting to note that this thinking has been carried through in an exposure draft of amendments to IFRS 3, which proposes actual recognition of the minority interest (in future to be called ‘non-controlling interest’) share of goodwill when preparing a consolidated balance sheet.

Once determined, an impairment loss must first be allocated to goodwill (based on the notional amount), then any remaining loss allocated pro rata to the CGU’s other assets. If the amount of the impairment loss is less than the notional goodwill, the remaining goodwill balance is reduced by the minority interest percentage prior to it being reported in the consolidated balance sheet.

EXAMPLE 3At 31 March 2006, the following information is available for two CGUs:

CGU 1 CGU 2 $m $mGoodwill 90 60Other assets 140 120Minority interest 25% 40%Recoverable amount 180 90

RequiredShow the assets of the CGUs after impairment testing.

Answer CGU 1 CGU 2 $m $mGoodwill 30 nilOther assets 140 90

CGU 1The goodwill of $90m relates to a controlling interest of 75%: unrecorded goodwill relating to the minority interest would therefore be $30m (90/75% x 25%), giving notional goodwill of $120m, and notionally adjusted assets of $260m ($120m + $140m other assets). This gives an impairment loss of $80m ($260m - $180m recoverable amount). The whole of this loss would be allocated to goodwill, leaving a balance of $40m ($120m - $80m). When preparing the balance sheet after the impairment, the $40m is reduced to $30m reflecting only the parent’s share (75%) of the goodwill.

Note: the net assets are now shown at $170m ($30m goodwill + $140m other assets), which appears to be below the recoverable amount of $180m. However, there is $10m of unrecognised goodwill relating to the minority interest.

CGU 2A similar analysis to that applied to CGU 1 would give a notional goodwill figure of $100m ($60m/60%) and a notional carrying amount of all assets of $220m ($100m + $120m other assets). This means the impairment loss for CGU 2 is $130m ($220m - $90m recoverable amount). $100m of this amount would be allocated to goodwill (reducing it to zero) and the other assets would be written down to $90m ($120m - $30m remaining loss). This $30m would be applied pro rata to each of the asset groups (property, plant etc) that make up the other assets.

The issues discussed in this article are summarised in Example 3.

EXAMPLE 3Highveldt, a public listed company, acquired 75% of Samson’s ordinary shares on 1 April 2005. The purchase consideration consisted of:

a share exchange of one share in Highveldt for two shares in Samson. The market price of Highveldt shares at the date of acquisition was $4 each

an immediate $1.75 per share in cash a further amount of $81m payable on 1 April 2006. Highveldt’s cost

of capital is 8% per annum.

Highveldt has only recorded the consideration of $1.75 per share.

The summarised balance sheets of the two companies at 31 March 2006 are shown below:

Highveldt Samson $m $m $m $mTangible non-current assets 570 380Investments 150 nil 720 380Current assets 130 90Total assets 850 470

Share capital and reserves:Ordinary shares of $1 each 270 80Reserves:Share premium 80 40Revaluation reserve 40 nilRetained earnings – 1 April 2005 160 120– year to 31 March 2006 190 350 101 221 740 341 Non-current liabilities10% loan note nil 60

Current liabilities 110 69Total equity and liabilities 850 470

The following information is relevant:

i Highveldt has a policy of revaluing land and buildings to fair value. At the date of acquisition, Samson’s land and buildings had a fair value of $20m in excess of their carrying amounts, and at 31 March 2006 this had increased by a further $4m (ignore any additional depreciation).

ii Samson had established a line of products under the brand name of Titanware. Acting on behalf of Highveldt, a firm of specialists had valued the brand name at $40m with an estimated life of 10 years as at 1 April 2005. The brand is not included in Samson’s balance sheet.

iii Immediately after acquisition, Highveldt sold Samson an item of plant for $15m that it had manufactured at a cost of $10m. The plant had an estimated life of five years (straight-line depreciation) and no residual value.

iv On 1 October 2005 Samson issued $60m 10% (actual and effective rate) loan notes. Highveldt subscribed for $20m of this issue. Samson has not paid any interest on this loan, but it has recorded the amount due as a current liability. Highveldt has also accrued for its interest receivable on this loan.

v Post-acquisition, Samson sold goods at a price of $18m to Highveldt; $5m of these goods were still in the inventory of Highveldt at 31 March 2006. Samson applied a mark-up on cost of 25% to these goods.

vi A post-acquisition impairment test on the notionally-adjusted consolidated goodwill (ie the goodwill relating to the parent and the minority interest) concluded that it should be written down by $20m.

RequiredPrepare the consolidated balance sheet of Highveldt at 31 March 2006.

June/July 2006 student accountant 67

technical

68 student accountant June/July 2006

technical

AnswerConsolidated balance sheet of Highveldt at 31 March 2006 $m Tangible non-current assets (570 + 380 + 24 - 4 URP) (w (4)) 970

Intangible non-current assets:Brand (40 - 4) 36Consolidated goodwill (w (1)) 60

Investments (150 - 105 cash - 20 loan note) 25 1,091

Current assets (130 + 90 - 1 URP (w (2)) - 1 intra-group interest) 218Total assets 1,309 Share capital and reserves:Ordinary shares of $1 each (270 + 30 (w (1))) 300Reserves:Share premium (80 + 90 (w (1))) 170

Revaluation reserve (w (3)) 43

Retained earnings (w (4)) 396 909 Minority interest (w (2)) 101 1,010Non-current liabilities:10% loan note (60 - 20 intra-group) 40

Current liabilities (110 + 69 - 1 intra-group interest) 178Deferred consideration (75 + 6 (w (1))) 81Total equity and liabilities 1,309 Workings(1) Goodwill calculation $m $mInvestments at costShare exchange (80 x 75%/2 x $4) 120Immediate cash (80 x 75% x $1.75) 105 Deferred consideration (see below) 75 300LessOrdinary shares 80Share premium 40Pre-acquisition profit 120Fair value adjustments: brand (see below) 40 land and buildings 20 300 x 75% (225)Goodwill on acquisition 75Impairment (see below) (15) 60

The $120m share issue would be recorded as share capital of $30m (30m x $1), and share premium of $90m (30m x $3).

The deferred consideration of $81m must be discounted for one year, at the cost of capital of 8%, to $75m (81/1.08). The $6m difference is the accrued finance charge for the year to 31 March 2006.

Although the internally-generated brand cannot be recognised in Samson’s entity financial statements, it should be recognised in the consolidated balance sheet on the acquisition of Samson. This is because the valuation process, as described in the question, is an acceptable method of ‘reliable measurement’.

The fair value adjustment for Samson’s land and buildings on acquisition is $20m. The subsequent increase in value of $4m, in the year to 31 March 2006, is treated as a revaluation.

As Highveldt only acquired 75% of Samson, the goodwill of $75m would be grossed up to $100m. This is impaired by $20m, down to $80m, but only 75% of this (ie $60m) would be shown in the consolidated balance sheet. In effect, Highveldt’s goodwill is impaired by $15m.

(2) Minority interest $mOrdinary shares 80Share premium 40Retained earnings (221 - 1 URP see below) 220 Fair values at acquisition (40 + 20) 60Post-acquisition revaluation of land and buildings 4 404 x 25% = 101

There are $5m of goods in inventory at 31 March 2006. The URP on these goods is $1m (5 x 25%/125%).

(3) Revaluation reserve: (40 + (75% x 4)) 43

(4) Retained earningsHighveldt – from question 350Post acquisition – Samson (101 - 1 URP see above) x 75% 75Finance cost on deferred consideration (see below) (6)URP in sale of plant (4)Amortisation of brand (40/10 years) (4)Impairment of goodwill (15) (19)Retained earnings in consolidated balance sheet 396

At the date of sale, there is an unrealised profit of $5m ($15m - $10m) on the plant sold by Highveldt to Samson.

By 31 March 2006, the remaining life of the plant is four years out of an original five years. Thus 4/5ths of the URP (ie $4m) must be eliminated from the carrying amount of the asset, and from Highveldt’s profits.

Steve Scott is examiner for Paper 2.5