Financial Reporting

SESSION 9

Group accounting
Equity accounting
Foreign currency translation
1

Objectives
The objectives of this session are to:

Introduce the concept of a group and group relationships

Understand that the accounting method used for acquisitions depends
on the extent to which the investors exerts influence over the investee

Learn about consolidation and preparation of consolidated financial

statements

Understand the concepts of goodwill and minority interests

Learn about the equity method of accounting
Understand the effects of dividends received and investees income on
the financial statements of the investor under the equity method

Understand about foreign currency activities

2

Introduction
So far we studied how to prepare financial statements of a single legal
entity

But many companies belong to a group of companies legally and

economically dependent

As the members of the group act together as though they were a single
economic entity it makes sense to prepare a single set of financial
statements for the entire group: consolidated financial statements.

Investors and other users can analyse a single set of financial reports to
assess the group business performance

The group
A group of companies is characterised by having:

Various legally independent companies (subsidiary companies) that

depend economically and legally of another company (holding or
parent company)

Various entities under a common control

The nature of the relationship between the parent company and group
entities determines the way group financial statements are presented

Percentage of control versus Percentage of interest

Percentage of control (percentage of voting rights)

Degree of dependency in which a parent company holds its subsidiaries or

associates

Percentage used to determine the consolidation method

Percentage of interest (percentage of ownership)

Claim held by the parent company over the shareholders equity of its subsidiaries
or associates

Percentage used in the consolidation calculations and to define majority and

minority interests

Percentage of control versus Percentage of interest

30%

S1

40%

S2

43%
% of control = 43% : P has no control over S1
% of interest = 55% (43% + 30% x 40%)

60%

S1

40%

S2

43%

% of control = 83% (40% + 43%): P has control over S1

% of interest = 67% (43% + 60% x 40%)

Investments in shares of other companies

The accounting method for share investments depends on the
degree of influence (control) the investing company has on the
decisions of the investee
Three method of accounting for such investments:

Control
Control over other entity exists when:

Parent company owns directly or indirectly more than half (> 50%) of voting rights

Parent company owns half or less (= < 50%) of voting rights and it obtains:
a)

Power to obtain the majority of votes at meetings of the board of directors or

equivalent governing body; or

b)

Power to govern the financial and operating activities of the company (large
influence over management) under a statute or 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 over more than half the voting shares by virtue of an agreement with
other investors.

Significant influence
Ownership >= 20% of the voting power of the investee
Evidence of significant influence:
Representation on the board of directors or equivalent governing body of
the investee;
Participation in policy-making processes;
Material transactions between the investor and the investee;
Interchange of managerial personnel; or
Provision of essential technical information

Group relationship and reporting methods

The method by which individual financial statements are combined
depends on the type of group relationship

Type of
relation
Control

Significant

Type of
company
Subsidiary

Reporting
method
Full consolidation
Global consolidation

Associate

Equity method

Joint

Joint

Proportional

Control

Venture

consolidation

Influence

10

Quick exercise

70%

C1

10%

C2

20%

In the situation described in the diagram above, what is

the percentage of:

Control?
Interest?
11

Quick exercise

70%

C1

10%

C2

20%

In the situation described in the diagram above, what is

the percentage of:

Control: 30%
Interest: 27%
12

Controlling influence consolidation method

When the investor controls the investee,
The investor company = parent
The investee company = subsidiary
The parent prepares consolidated financial statements that treat
the parent and the subsidiary as a single economic entity even
though they are separate legal entities

Consolidated financial reporting brings together multiple sets of

financial records at the time of reporting to outsiders

Each subsidiary maintains its own set of books that is independent

of who owns it, weather it is one person/company or one million

Parent has its set of books pre-consolidation

13

Controlling influence consolidation method

Basically, corresponding items of assets, liabilities, revenues and
expenses are added together on a line by line basis so as to show the
total amounts that are under control of a group as a single economic
entity owned by parent company shareholders

In the process of aggregation of individual companies accounts some

adjustments are necessary

Consolidation adjustments typically involve:

Goodwill recognition
Minority interests recognition
Elimination of inter-company balances

14

Consolidation process
The full consolidation process usually involves the following steps:
1.

2.

Perimeter (scope) of consolidation

Definition of the group

Identification of companies included and excluded in the group (% of control)

Alignment of accounting policies

3.

Conformity of accounting policies across companies in the group

Application of a consolidation method

Definition of the consolidation method to apply

Consolidation adjustments: goodwill recognition, minority interests recognition,

elimination of inter-company balances

15

Consolidation process (cont.)

The full consolidation process usually involves the following steps:
4.

Preparation of consolidated financial statements

Add group balance sheet and income statement items, plus consolidation
adjustments

Consolidation financial statements include:

Consolidated balance sheet

Consolidated income statement

Consolidated cash flow statement

Notes

16

Consolidated balance sheet

Suppose that on 31 December 2013, companies A and B have the
following summarised balance sheets:

17

Consolidated balance sheet: 100% acquisition

On this date, company A purchases 100% of the ordinary shares of B for
200. After this transaction, As balance sheet is:

18

Consolidated balance sheet

The consolidated balance sheet is prepared as follows:

19

Consolidated balance sheet

The consolidated balance sheet is prepared as follows:

Note that the elimination entries do not appear in either A or B accounts. The adjustments
are prepared in a working sheet in order to create the consolidated financial statements
20

Consolidated balance sheet

The consolidated balance sheet:

Investment in subsidiary of parent company is eliminated against % of equity

of subsidiary company at acquisition date

Consolidated share capital corresponds to the share capital of parent

company

Consolidated retained profits equal to the sum of parents and subsidiarys

retained earnings since acquisition (i.e. zero in this case)

21

Consolidated balance sheet

To illustrate this last point, suppose that during 2014, A and B make profits of
50 and 25 respectively so that the balance sheets at 31 December 2014
are:

22

Consolidated balance sheet

The consolidated balance sheet at 31 December 2014:

23

Goodwill
Assume that on 31 December 2013 company A purchases 100% of the ordinary
shares of B but for 320. After this transaction, company As balance sheet is :

24

Goodwill
The consolidated balance sheet at 31 December 2014 is prepared as follows:

Goodwill = excess of purchase price over fair value of assets acquired

25

Goodwill
Accounting treatment of goodwill

Under IASB standards

From 2005, goodwill should be recognised in the balance sheet at cost less
accumulated impairment losses (IFRS 3)

Goodwill should not be amortised (as was the treatment

under IAS 22)
Instead, it should be tested for impairment losses on an
annual basis (IAS 36)
The impairment loss cannot be reversed in subsequent
years

Similar accounting treatment under US GAAP (SFAS 142)

26

Goodwill impairment - revision

What is a goodwill impairment?
Reduction in value
When does the impairment occur?
When implied goodwill from fair value of business unit is below
book value of goodwill assigned to that unit
Requires accountants to value business units of the merged entity
What happens when goodwill is impaired?
Company writes down the value of goodwill and recognizes a
corresponding loss in I/S
In practices, what do you think will trigger goodwill impairment?
27

Minority interests: <100% acquisition

Assume now that company A acquires 80% of company Bs ordinary shares for
320. The consolidated balance sheet is prepared as follows:

28

Minority interests
When the parent company A divides ownership with other shareholders, company
B net assets should be divided between the majority shareholders and minority
shareholders:
Goodwill for the majority shareholders:
Purchase price

320

Fair value of net assets of subsidiary

160

(80% x 200)
Goodwill

160

Minority interests in the fair value of net assets of subsidiary:

(20% x 200)

40

29

Minority interests
Capital and reserves in the consolidated balance sheet will be:
Share capital

50

Retained profit

450

Shareholders funds

500

Minority interests
Total

40
540

30

Minority interests (economic concept)

Minority investors who own 20% of company B have a claim on the assets
and earnings of B.
But company A controls company B, so A has access to all of Bs assets (not
just 80%)
As consolidated reports shows 100% of Bs assets and liabilities, then
adjusts for the 20% of B not owned by A using an account called Minority
interests
Is Minority interest a liability of equity?
It has characteristics of both. It may be classified as either shareholders equity or
a liability claim of indeterminate amount and life.

31

Fair value adjustments and goodwill

Goodwill is the difference between:
(a) Price paid for the investment in subsidiary; and
(b) Fair value of the net assets acquired
In the previous examples we assumed fair value of net assets acquired to be
equal to its book value (200)

IFRS3 requires that, at acquisition date, the cost of acquisition should

be allocated to the assets and liabilities acquired at their fair value

32

Fair value adjustments and goodwill

Consider that, company A acquires 80% of company Bs ordinary shares for 320.
The fair value of the net assets acquired is 270 and book value is 200.
Goodwill:
Purchase price

320

Book value of net assets acquired

Fair value adjustment

200

70

Fair value of assets acquired (80% x 270)

Goodwill
Part of minority interests

216

104
(20% x 270)

54

33

Fair value adjustments and goodwill

The consolidated balance sheet is prepared as follows:

34

Overall idea behind consolidation adjustments

Consolidation combines the financial statements of a parent and
subsidiaries, resulting in one set of accounts

There are numerous items that appear twice

Adjustments correct for double counting that would result from simply
adding the financial statements together

Some adjustments we havent addressed:

Inter-company receivables and payables
Inter-company sales, costs and profits
Inter-company loans and interests charged
Dividends

35

Inter-company balances
In the consolidated balance sheet, eliminate assets and liabilities

Company A sold services on credit to company B

Eliminate accounts receivable in A against accounts payable in B

Inter-company loans
Eliminate asset (investment) in lender company and liability (loan payable) in
borrower company

36

Inter-company balances
In the consolidated income statement, eliminate revenues and expenses

Dividends paid by subsidiary to parent

Eliminate dividends in subsidiary and finance revenue in parent. Dividends
line in consolidated income statement should be just those paid by parent
company

Goods sold by one group company to another

Eliminate sales of one company and cost of sales of another company. Sales
and cost of sales in consolidated income statement should be just those with
external entities (if necessary eliminate unrealised profit in inventory)

Interests and fees charged by one group company to another

Eliminate interest expense in one company and interest revenue in another
company

37

Inter-company balances
Consider the balance sheets and income statements of company A (parent) and
company B (subsidiary):

38

Inter-company balances
Consider the balance sheets and income statements of company A (parent) and
company B (subsidiary):

39

Inter-company balances
Other information:
1. Company A acquired 100% of B when the claims on Bs net assets were:
Share Capital
Retained Profit

5,000
4,000

(Goodwill = 12,000 - 9,000 = 3,000)

2. Stock of A includes goods purchased from B for 200. The cost of these goods to B
was 100. (Unrealisable profit of 100, profit generated within the group)

Required:
Prepare the consolidated income statement and the consolidated balance sheet for
the group

40

Inter-company balances
Eliminations:
Goodwill
In the consolidated balance sheet
Investment

(12,000)

Goodwill

3,000

Share capital

(5,000)

Retained profit

(4,000)

Dividends
In the consolidated income statement (1)
Dividend income

(1,000)

Dividend expense

1,000

(1) If the parent company applies the equity method in its individual accounts, the investment account needs to
be adjusted as well

41

Inter-company balances
Eliminations:
Sales, cost of sales and unrealisable profit in inventory
In the consolidated balance sheet
Inventory (profit in closing inventory)
Profit

(100)

(100)

In the consolidated income statement

Sales

(200)

Cost of sales (purchases)

(200)

Cost of sales (profit in closing inventory)

Profit

100

(100)

42

Consolidated income statement

43

Consolidated balance sheet

44

Theories of consolidation
The way consolidation accounting deals with goodwill, minority interests
and inter-company balances varies with the concept of group used

Two widely accepted concepts:

Entity concept
Proprietary concept (parent entity) concept

45

Entity concept
Group is viewed as an economic unit rather than an aggregation of companies
dominated by the majority shareholders

Focus on the group resources controlled by the entity (group) and regards the
entity of the group owners as a secondary issue

There is no distinction between classes of shareholders thus minority interests

are reported under shareholders equity

Goodwill is recognised in the consolidated balance sheet by its full amount and
allocated to majority and minority interests

All transactions with shareholders, whether majority or minority, are treated as

intra-group transactions

46

Proprietary (parent entity) concept

Emphasis is given to the controlling shareholders interests
Consolidated financial statements are prepared principally to give information to
majority shareholders

Goodwill is recognised in the consolidated balance sheet by the amount

attributable to majority shareholders

Minority interests are reported outside shareholders equity

Several variants of this theory (e.g. parent entity extension concept)

47

Theories of consolidation
Currently, IFRS standards (IAS 27 and IFRS 3) are more inclined to the
parent company concept but includes elements of both approaches
hybrid model

The join project IASB-FASB on Business Combinations proposes to

require an approach more akin to the entity concept

48

Investments in non-controlled companies

Thus far we have dealt with investments that give rise to consolidation
Type of
relation
Control

Significant
Influence

Type of
company
Subsidiary

Associate

Reporting
method
Full consolidation
Global consolidation

Equity method

How do we account for investments that do not give control to the

investor company?
Proportional
consolidation

49

Investments in associate companies

When investor holds 20%-50% of investees shares
When investor does not control investee, but has significant influence
Investor should account the investment in the investee, in its individual
accounts, using the equity method

50

Significant influence equity method

Equity method accounting rationale:
For any company:
Ending retained earnings =
Beginning retained earnings + Net income - Dividends

At acquisition, the investment is recognised in the investors accounts, at

acquisition cost, as long-term non-current asset

Subsequently, following the rational above =>

Ending value of investment on investing companys books =
Beginning value of investment + investors share of investees net
income investors share of investees dividends

51

Equity method
Example
Company A buys 30% of company Bs shares for 400m on 1 Jan 2015,
of which 80m is goodwill.

During 2015 company B declares and pays 20m in cash dividends to all
of its shareholders.

During 2015, company B records a revaluation of a property resulting in a

revaluation reserve of 10m.

At the end of 2015, company B reports after-tax profit of 100m.

At the end of 2015, company A tests goodwill for impairment establishing

that goodwill should stand at 60m instead of 80m.

52

Equity method
Accounting entries:

Investment in B
Dividend received
(30% of 20m)
Share in asset revaluation
(30% of 10m)
Share in profit of B
(30% of 100m)
Impairment of goodwill

Cash

Investment

Goodwill

(400)

320

80

(6)
3

Reserve

Profit
(I/S)

30

30
(20)

(20)

Why is the dividend payment of B treated as a decrease in the investment value in A ?

53

Quick exercise
Assume following events
1. Investor acquires 48,000 shares amounting to 40% of CY
corporation for 10 euro per share

2. CY corp. pays a dividend of 60,000 euros or 50 cents per share

3. CY corp. earns 100,000 euros in Net Income
Record these events on investors accounts

54

Quick exercise
Assume following events
1. Investor acquires 48,000 shares amounting to 40% of CY
corporation for 10 euro per share

2. CY corp. pays a dividend of 60,000 euros or 50 cents per share

3. CY corp. earns 100,000 euros in Net Income
Record these events on investors accounts

55

Foreign currency activities

A company can engage in foreign currency activities in two ways:
(a) Entering in transactions denominated in foreign currencies (buying and selling
goods and services, borrowing and lending funds, acquiring or disposing
assets)
the results of transactions must be translated into the currency the
company reports its profit and financial position
(b) Conducting foreign operations through a foreign entity (subsidiary, associate,
etc.) which keeps its accounting records in its own operating currency
(functional currency)
The financial statements of the foreign entity must be translated to the
parents company reporting currency before being included in the
consolidated financial statements

56

Foreign currency transactions

Unhedged transactions in foreign currency have the following accounting treatment
at balance sheet date:
(a) Monetary items (currency held, payables and receivables) translated using the
closing rate at balance sheet date
(b) Non-monetary items translated at the exchange rate at the date of the
transaction (or fair value re-measurement)
(c) Foreign currency exchange differences are recognised in the income
statement

57

Foreign currency transactions

On 1 November X1, an English company imports, on credit, inventory from France.
The cost of the inventory is 1,000 (the exchange rate is 1 = 70p)
On 31 December X1, the balance sheet date, the debt remains unsettled. The
exchange rate is 1 = 65p
On 20 January X2 the company pays the French supplier. At that time the exchange
rate is 1 = 75p
Cash
1 Nov X1 Purchase of goods
31 Dec X1
20 Jan X2 Payment

(750)

Inventory

Acc
payable

700

700

Profit
(I/S)

(50)

50

(650)

(100)

Inventory account remains unchanged

58

Translation of foreign operations

Financial statements of a foreign operation (subsidiary, associated, branch, etc) in a
non-hyperinflationary economy are translated as follows:
(a) Assets and liabilities at the closing rate at balance sheet date
(b) Income and expenses at exchange rates at the dates of the transactions (or

average rate if more convenient)

(c) Exchange differences are recognised in equity (foreign currency translation

reserve)

59

Translation of foreign operations

Example
Swel Ltd. is a subsidiary of the British group Zell plc operating in Singapore
The group acquired the subsidiary on 1 January X1. The subsidiary
presents financial statements in Singapore dollar (SGD). Zell plc wants
to present consolidated statements in British pounds Functional currency
Reporting currency

The exchange rates to British pounds are:

1 January X1

1 GBP = 3 SGD

31 December X1

1 GBP = 4 SGD

Average rate in X1

1 GBP = 3.5 SGD

60

Translation of foreign operations

Swel Ltd. balance sheets at 1 January X1 and 31 December X1 (in SGDm):
(in SGDm)
31 Dec X1 1 Jan X1

Non-current assets
Current assets

1,600
2,400

4,000

1,100
1,500

31 Dec X1 1 Jan X1

Share capital
Retained profit

1,500
1,300
2,800

1,500
600
2,100

Liabilities

1,200

500

4,000

2,600

2,600

Swel Ltd. income statement at 31 December X1 (in SGDm):

(in SGDm)
Sales
Expenses
Profit for the year

4,900
4,200
700
61

Translation of foreign operations

Swel Ltd. balance sheet at 31 December X1

(in m)

31 Dec X1

Non-current assets
Current assets

1,600/4 =
2,400/4 =

400
600

31 Dec X1

Share capital
Retained profits

1,500/3 =
600/3 =
700/3.5 =

Foreign currency
translation reserve
Liabilities

(200)
700
1,200/4 =

Swel Ltd. income1,000

statement at 31 December X1

500
200
200

300
1,000

(in m)
Sales
Expenses
Profit for the year

4,900/3.5 =
4,200/3.5 =

1,400
1,200

700/3.5 =

200
62

Translation of foreign operations

The Foreign Currency Translation Reserve (200) allows for shareholders equity of
the subsidiary expressed in foreign currency (SGD 2,800m) to be expressed in
the reporting currency at the balance sheet exchange rate (700m)
Shareholders
equity (SGDm)

Closing
rate

Exchange
Foreign exchange
rate used in
currency difference
balance
sheet
3.0
1,500/4 1,500/3 = -125

Share capital

1,500

4.0

Retained profit

600

4.0

3.0

600/4 600/3 = -50

Profit for the

year

700

4.0

3.5

700/4 700/3.5 = -25

2,800

4.0

-200

63

Passive influence other investments

Investments in:
(a) bonds
(b) shares giving no control or influence over the investees operations (< than 20%)
(c) loans

Financial investments are measured at fair value or amortised cost except for equity
investments for which there is no quoted market price

Recognition and measurement of financial investments depends on the category of

investment (IAS 39):
Financial asset at fair value through profit or loss
Held-to-maturity investments
Loans and receivables
Available-for-sale financial assets

64

Summary
In this session we:

Discussed the definition of group and the different types of group

relationships

Presented the concepts of goodwill and minority interests in the

consolidation context

Learned about the consolidation process and how to prepare consolidated

financial statements

Learned about the accounting treatment of different categories of financial

investments that do not lead to consolidation

Studied the equity method of accounting

Understood how to deal with business activities in foreign currency

65