Session 9 - Group and Equity Accounting and Currency Translation_with Solutions

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Financial Reporting

SESSION 9Group accountingEquity accountingForeign currency translation##1ObjectivesThe objectives of this session are to:Introduce the concept of a group and group relationshipsUnderstand that the accounting method used for acquisitions depends on the extent to which the investors exerts influence over the investeeLearn about consolidation and preparation of consolidated financial statements Understand the concepts of goodwill and minority interestsLearn about the equity method of accountingUnderstand the effects of dividends received and investees income on the financial statements of the investor under the equity methodUnderstand about foreign currency activities##2IntroductionSo 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##3The groupA 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##4Percentage of control versus Percentage of interestPercentage 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##5Percentage of control versus Percentage of interestPS1S2% of control = 43% : P has no control over S1% of interest = 55% (43% + 30% x 40%) 30%40%43%% of control = 83% (40% + 43%): P has control over S1% of interest = 67% (43% + 60% x 40%)

##6ControlControl over other entity exists when:Parent company owns directly or indirectly more than half (> 50%) of voting rightsParent company owns half or less (= < 50%) of voting rights and it obtains:Power to obtain the majority of votes at meetings of the board of directors or equivalent governing body; orPower to govern the financial and operating activities of the company (large influence over management) under a statute or agreement; orPower to appoint or remove the majority of the members of the board of directors or equivalent governing body; orPower over more than half the voting shares by virtue of an agreement with other investors.##8Significant influenceOwnership >= 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; orProvision of essential technical information##9Group relationship and reporting methodsThe method by which individual financial statements are combined depends on the type of group relationshipType of relationType of companyReportingmethodControlSignificantInfluenceJointControlSubsidiaryAssociateJointVentureFull consolidationGlobal consolidationEquity methodProportionalconsolidation##10Quick exerciseIn the situation described in the diagram above, what is the percentage of:

Control?Interest?

PC1C270%10%20%##Quick exerciseIn the situation described in the diagram above, what is the percentage of:

Control: 30%Interest: 27%

PC1C270%10%20%##Controlling influence consolidation methodWhen the investor controls the investee,The investor company = parentThe investee company = subsidiaryThe parent prepares consolidated financial statements that treat the parent and the subsidiary as a single economic entity even though they are separate legal entitiesConsolidated financial reporting brings together multiple sets of financial records at the time of reporting to outsidersEach subsidiary maintains its own set of books that is independent of who owns it, weather it is one person/company or one millionParent has its set of books pre-consolidation

##13Basically, 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 necessaryConsolidation adjustments typically involve:

Goodwill recognitionMinority interests recognitionElimination of inter-company balances

Controlling influence consolidation method##14Consolidation processThe full consolidation process usually involves the following steps:

Perimeter (scope) of consolidationDefinition of the groupIdentification of companies included and excluded in the group (% of control)

Alignment of accounting policiesConformity of accounting policies across companies in the group

Application of a consolidation methodDefinition of the consolidation method to applyConsolidation adjustments: goodwill recognition, minority interests recognition, elimination of inter-company balances##15Consolidation process (cont.)The full consolidation process usually involves the following steps:

Preparation of consolidated financial statements Add group balance sheet and income statement items, plus consolidation adjustmentsConsolidation financial statements include:Consolidated balance sheetConsolidated income statement Consolidated cash flow statementNotes##16Consolidated balance sheetSuppose that on 31 December 2013, companies A and B have the following summarised balance sheets:

##17Consolidated balance sheet: 100% acquisitionOn this date, company A purchases 100% of the ordinary shares of B for 200. After this transaction, As balance sheet is:

##18The consolidated balance sheet is prepared as follows:

Consolidated balance sheet##19The consolidated balance sheet is prepared as follows:

Consolidated balance sheetNote 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##20The 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)Consolidated balance sheet##21To 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: Consolidated balance sheet

##22The consolidated balance sheet at 31 December 2014: Consolidated balance sheet

##23Assume 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 : Goodwill

##24The consolidated balance sheet at 31 December 2014 is prepared as follows:Goodwill

Goodwill = excess of purchase price over fair value of assets acquired##25IFRS3 allows only acquisition method. Pooling of interests not allowedAccounting treatment of goodwillUnder IASB standards From 2005, goodwill should be recognised in the balance sheet at cost less accumulated impairment losses (IFRS 3)

Similar accounting treatment under US GAAP (SFAS 142)

GoodwillGoodwill 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##26Goodwill impairment - revisionWhat 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 unitRequires 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/SIn practices, what do you think will trigger goodwill impairment?

##27Assume now that company A acquires 80% of company Bs ordinary shares for 320. The consolidated balance sheet is prepared as follows:Minority interests: Ending value of investment on investing companys books =Beginning value of investment + investors share of investees net income investors share of investees dividends

##51Equity methodExample

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.

##52Equity methodCashInvestmentGoodwillReserveProfit(I/S)Investment in B(400)32080Dividend received (30% of 20m)6(6)Share in asset revaluation (30% of 10m)33Share in profit of B (30% of 100m)3030Impairment of goodwill(20)(20)Why is the dividend payment of B treated as a decrease in the investment value in A ?Accounting entries:##53dividend distribution in B reduces B Equity

Quick exerciseAssume following eventsInvestor acquires 48,000 shares amounting to 40% of CY corporation for 10 euro per shareCY corp. pays a dividend of 60,000 euros or 50 cents per shareCY corp. earns 100,000 euros in Net IncomeRecord these events on investors accounts

##

Quick exerciseAssume following eventsInvestor acquires 48,000 shares amounting to 40% of CY corporation for 10 euro per shareCY corp. pays a dividend of 60,000 euros or 50 cents per shareCY corp. earns 100,000 euros in Net IncomeRecord these events on investors accounts

##Foreign currency activitiesA company can engage in foreign currency activities in two ways:

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

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##56Foreign currency transactionsUnhedged transactions in foreign currency have the following accounting treatment at balance sheet date:

Monetary items (currency held, payables and receivables) translated using the closing rate at balance sheet date

Non-monetary items translated at the exchange rate at the date of the transaction (or fair value re-measurement)

Foreign currency exchange differences are recognised in the income statement

##57Foreign currency transactionsOn 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 = 65pOn 20 January X2 the company pays the French supplier. At that time the exchange rate is 1 = 75pCashInventoryAcc payableProfit(I/S)1 Nov X1 Purchase of goods70070031 Dec X1 (50)5020 Jan X2 Payment (750)(650)(100) Inventory account remains unchanged ##58Translation of foreign operationsFinancial statements of a foreign operation (subsidiary, associated, branch, etc) in a non-hyperinflationary economy are translated as follows:

Assets and liabilities at the closing rate at balance sheet date

Income and expenses at exchange rates at the dates of the transactions (or average rate if more convenient)

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

##59Translation:1 Determine the functional currency of the entity (there is not a group functional currency, each individual entity has its functional currency)Functional currency = the currency of the primary economic environment in which the entity operates. It will normally be the currency in which primarily generates and expends cash

2 Foreign operation when the functional currency of subsidiary is the same as the presentation currency of the parent company is translated using the same rules as for individual transactions: a) monetary items (acc payable, acc receivable, cash, loans, pensions payable, dividends payable, provisions paid in cash) translated at closing rateb) non-monetary items (inventory, fixed assets, prepayments) translated at original rate. Non-monetary items at fair value are translated at rate of fair value measurement

Example: Parent company Ganbry functional and reporting currency is pounds. Subsidiary Berlin functional currency is also pounds but reports in Euros.Elliot&Elliot p.587

3 - Foreign operation when the functional currency of subsidiary is different from presentation currency as the parent company is translated using the following rules:

Example: Gramby parent company functional and reporting currency is pounds. Subsidiary Berlin functional currency is EurosElliot&Elliot p.595

A - When foreign operation has functional currency of a Non-Hyperinflationary economy (non-hyperinflationary functional currency)- Assets and Liabilities (closing rate at BS date)- Expenses and income (transaction/historical rate or average rate)- Other gains and Losses in Equity (transaction/historical rate or average rate)- Exchange differences are recognised in a separate component of Equity

Equity ?? Not specified in IAS 21 but: Share capital, Share premium, Treasury Shares, and other reserves at historical/transaction rate or at closing rate with difference between historical/transaction rate and closing rate taken to a reserve. This way it is indifferent which method to use because Total Shareholders Funds remains the same amount.Goodwill translated at closing date (treated as any other asset of the parent company)Comparative figures, follow the same rules, they are not adjusted for following year currency rates. They remain at their values of previous year.

B - When foreign operation has functional currency of a Hyperinflationary economy (hyperinflationary functional currency)- All items: assets, liabilities, equity, expenses and income are translated at closing rate at bs date- Comparative figures translation:if parent company (reporting currency) is in a non-hyperinflationary economy comparatives remain at previous year bs closing rateif parent company (reporting currency) is in a hyperinflationary economy comparatives are translated to current year closing rate at bs dateTranslation of foreign operationsExampleSwel 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

The exchange rates to British pounds are:1 January X11 GBP = 3 SGD31 December X11 GBP = 4 SGDAverage rate in X11 GBP = 3.5 SGDFunctional currencyReporting currency##60Translation of foreign operationsSwel Ltd. balance sheets at 1 January X1 and 31 December X1 (in SGDm):31 Dec X11 Jan X131 Dec X11 Jan X1 Non-current assets1,6001,100 Share capital1,5001,500 Current assets2,4001,500 Retained profit1,3006002,8002,100 Liabilities1,2005004,0002,6004,0002,600Swel Ltd. income statement at 31 December X1 (in SGDm): Sales4,900 Expenses4,200 Profit for the year700(in SGDm)(in SGDm)##61Translation of foreign operationsSwel Ltd. balance sheet at 31 December X1 Sales4,900/3.5 = 1,400 Expenses4,200/3.5 = 1,200 Profit for the year700/3.5 =20031 Dec X131 Dec X1 Non-current assets1,600/4 =400 Share capital1,500/3 =500 Current assets2,400/4 =600 Retained profits600/3 =200700/3.5 =200 Foreign currency translation reserve(200)700 Liabilities1,200/4 =3001,0001,000(in m)(in m)Swel Ltd. income statement at 31 December X1##62Translation of foreign operationsThe 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 rateExchange rate used in balance sheetForeign exchange currency differenceShare capital1,5004.03.01,500/4 1,500/3 = -125Retained profit6004.03.0600/4 600/3 = -50Profit for the year7004.03.5700/4 700/3.5 = -252,8004.0-200##63Passive 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 lossHeld-to-maturity investmentsLoans and receivablesAvailable-for-sale financial assets##64SummaryIn this session we:Discussed the definition of group and the different types of group relationshipsPresented the concepts of goodwill and minority interests in the consolidation contextLearned 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 consolidationStudied the equity method of accountingUnderstood how to deal with business activities in foreign currency ##65AB

Net assets500200

Share capital50175

Retained profit 45025

Equity500200

A

Investment200

Other assets300

Net assets500

Share capital50

Retained profit 450

Equity500

ABA+BAdjust.Consol

Investment in subsidiary200200(200)-

Other assets400300700700

Liabilities(100)(100)(200)(200)

Net assets500200700500

Share capital50175225(175)50

Retained profit 45025475(25)450

Equity500200700500

ABA+BAdjustConsol


Other assets400300700700

Liabilities(100)(100)(200)(200)




Equity500200700500

AB

Investment in

subsidiary200-

Other assets450325

Liabilities(100)(100)

Net assets550225

Share capital50175

Retained profit 50050

Equity550225

AB

A+BAdjust.Consol


Other net assets450325775775

Liabilities(100)(100)(200)(200)




Equity550225775575

A

Investment320

Other assets180

Net assets500

Share capital50

Retained profit 450

Equity500

AB

A+BAdjust.Consol



Goodwill120120




500200700500

AB

A+BAdjustConsol



Goodwill160160




Minority interests4040

500200700540

AB

A+BAdjustConsol



Goodwill104104




Minority interests5454

500200700554

AB

Investment in B12,000-

Inventory1,0002,000

Other net assets7,00010,000

Total assets20,00012,000

Share Capital12,0005,000

Retained Profits8,0007,000

20,00012,000

AB

Sales10,0004,000

Cost of Sales(4,000)(2,000)

Gross Profit6,0002,000

Administrative Expenses(2,000)(500)

Operating Profit4,0001,500

Dividend Income from Subsidiary B1,000 -

Profit before Tax5,0001,500

Tax(1,000)(500)

Profit after Tax4,0001,000

Dividend(2,000)(1,000)

Retained Profit2,000 0

A

BA+BAdjust.Consol.

Sales10,0004,00014,000(200)13,800

Cost of Sales(4,000)(2,000)(6,000)100(5,900)

Gross Profit6,0002,0008,000(100)7,900

Administrative Expenses(2,000)(500)(2,500)-(2,500)

Operating Profit4,0001,5005,500(100)5,400

Dividend Income

from Subsidiary1,000-1,000(1,000)-

Profit before Tax5,0001,5006,500(1,100)5,400

Tax(1,000)(500)(1,500)-(1,500)

Profit after Tax4,0001,0005,000(1,100)3,900

Dividend(2,000)(1,000)(3,000)1,000(2,000)

Retained Profit2,000-2,000(100)1,900

A

BA + BAdjust.Consol.

Investment in B12,000-12,000(12,000)-

Inventory1,0002,0003,000(100)2,900

Goodwill---3,0003,000

Other net assets7,00010,00017,000-17,000

Total assets20,00012,00032,000(9,100)22,900

Share Capital12,0005,00017,000(5,000)12,000

Retained Profits8,0007,00015,000(4,100)10,900

20,00012,00032,000(9,100)22,900

Sheet1

123

Sheet2

Sheet3

Sheet1CashL.T. InvestmentP/L1-480,000480,000224,000-24,000340,00040,000

Sheet2

Sheet3

Session 9 - Group and Equity Accounting and Currency Translation_with Solutions

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