IFRS 9 Financial Instruments

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                                                          CONSOLIDATION PART 3

                                                                                           2011
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                                                                                                                                   CONSOLIDATION PART 3

                                                                 IFRS WORKBOOKS
                                                                (1 million downloaded)
Welcome to IFRS Workbooks! These are the latest versions of the legendary workbooks in Russian and English produced by 3 TACIS projects, sponsored by the
European Union (2003-2009) and led by PricewaterhouseCoopers. They have also appeared on the website of the Ministry of Finance of the Russian Federation.

The workbooks cover various concepts of IFRS based accounting. They are intended to be practical self-instruction aids that professional accountants can use to upgrade
their knowledge, understanding and skills.

Each workbook is a self-standing short course designed for approximately of three hours of study. Although the workbooks are part of a series, each one is independent of
the others. Each workbook is a combination of Information, Examples, Self-Test Questions and Answers. A basic knowledge of accounting is assumed, but if any
additional knowledge is required this is mentioned at the beginning of the section.

Having written the first three editions, we want to update them and provide them to you to download. Please tell your friends and colleagues. Relating to the first
three editions and updated texts, the copyright of the material contained in each workbook belongs to the European Union and according to its policy may be used free of
charge for any non-commercial purpose. The copyright and responsibility of later books and the updates are ours. Our copyright policy is the same as that of the
European Union.

We wish to especially thank Elizabeth Appraxine (European Union) who administered these TACIS projects, Richard J. Gregson (Partner, PricewaterhouseCoopers)
who led the projects and all friends at Bankir.Ru for hosting the books.

TACIS project partners included Rosexpertiza (Russia), ACCA (UK), Agriconsulting (Italy), FBK (Russia), and European Savings Bank Group (Brussels). The help of
Philip W. Smith (editor of the third edition) and Allan Gamborg, project managers and Ekaterina Nekrasova, Director of PricewaterhouseCoopers, who managed the
production of the Russian version (2008-9) is gratefully acknowledged. Glyn R. Phillips, manager of the first two projects conceived the idea, designed the workbooks and
edited the first two versions. We are proud to realise his vision.

Robin Joyce
Professor of the Chair of
International Banking and Finance
Financial University
under the Government of the Russian Federation

Visiting Professor of the Siberian Academy of Finance and Banking                                  Moscow, Russia         2011 Updated




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                                                                                                                                                            CONSOLIDATION PART 3
CONTENTS
                                                                                                                         1.     Consolidation Introduction
1.       Consolidation Introduction .................................................................... 3
                                                                                                                         Aim
2.       Definitions................................................................................................ 4
                                                                                                                         The aim of this workbook is to assist the individual in
3.       Fair Value Accounting ............................................................................ 5
                                                                                                                         understanding consolidation methodology for IFRS.
4.       Disposal of a Subsidiary ...................................................................... 18
5.       The Equity Method of Accounting....................................................... 32                       Consolidation Approach
6.       Associates ............................................................................................. 33
                                                                                                                         To consolidate a business combination requires:
7.       Cost Method .......................................................................................... 41
8.       Joint Ventures ....................................................................................... 41       (i) identifying the acquirer;
9 Special Purpose Entities / Special Purpose Vehicles ................................. 45
                                                                                                                         (ii) determining the acquisition date;
10. Outsourcing contracts: an accidental business combination? .............. 50
11. Carve-out / combined financial statements .............................................. 53                          (iii) recognising and measuring the identifiable assets acquired,
12.      Multiple Choice Questions ................................................................... 59                liabilities assumed and any non-controlling interest in the
                                                                                                                         acquiree; and
13.      Self Test Questions .............................................................................. 60
14.      Suggested Solutions ............................................................................ 64             (iv) recognising and measuring goodwill or a gain from a bargain
                                                                                                                         purchase.

                                                                                                                         Before commencing a consolidation, the accountant should have
                                                                                                                         the full financial statements of the parent and subsidiaries
Other Workbooks
                                                                                                                         prepared using the same accounting policies. This includes
                                                                                                                         statements for companies bought or sold.
Consolidation 1 and 2 concentrate on practical consolidation.
                                                                                                                         Ideally all subsidiary year-ends should be the same as the parent
The IFRS 3 workbook concentrates on that standard which                                                                  undertaking. But IFRS 10 permits a maximum difference of 3
provides guidance on specific points, such as the purchase of                                                            months.
companies in stages, loss of control but retention of an associate,
and reverse takeovers.                                                                                                   Adjustment should be made for any significant differences
                                                                                                                         created by any subsidiary having a different accounting date.


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                                                                                                          CONSOLIDATION PART 3
The length of reporting periods, and any difference in the             Control
reporting dates, should be consistent from period to period.           Control is the power to govern the financial and operating policies
                                                                       of an undertaking to obtain benefits.
Transactions between group undertakings should be listed, and
intercompany balances reconciled.                                      Indications of control are:

Spreadsheets are ideal for producing consolidated balance                    Ownership of more than 50% of the voting rights.

sheets and income statements, although bespoke consolidated                  Effective control over more than 50% of the voting rights.

software is also available.                                        For example, a husband owns 30% and a wife owns 40%. As they
                                                                        are connected parties, they can exercise control over the
                                                                        subsidiary.
2.     Definitions
                                                                             Controlling the composition of the board of directors.
Undertaking
An undertaking is any business, either incorporated or                 Minority Interest (now called non-controlling interests)
unincorporated.                                                        Minority interest is the part of the results and net assets of a
                                                                       subsidiary attributable to others outside the group.
Parent (now called controlling interests)
A parent is an undertaking that controls another undertaking.
                                                                         Fair value The price that would be received to sell an asset, or
Subsidiary
                                                                                    paid to transfer a liability, in an orderly transaction
A subsidiary is an undertaking that is controlled by another.                       between market participants at the measurement
                                                                                    date. (IFRS 13)
Group, or business combination
Two or more companies where one company controls the                   Monetary assets
other(s).                                                              Monetary assets are money held, assets receivable, and
                                                                       liabilities payable, in cash.
Consolidated accounts will be required if one business controls
another, whatever are the means of control.                            Uniting of Interests
                                                                       Uniting (or pooling) of interests is an alternative method of
Dissimilar business activities must be consolidated, if they
                                                                       consolidation.
controlled by the parent undertaking.

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                                                                                                          CONSOLIDATION PART 3
It reflects the merger of two, or more, interests, where no             Consolidated financial statements should reflect these under and
undertaking can be identified as the acquirer.                          overvaluations by revaluing assets and liabilities.

IFRS 3 eliminated this method as an option for acquisitions.            This process of revaluing to contemporary market prices is Fair
                                                                        Value Accounting.
Associate
An undertaking in which the parent has significant influence, but       The basic principles of using Fair Value Accounting in
is neither its subsidiary, nor part of a joint venture of the parent.   consolidated financial statements are:

Indications of significant influence are:                                     All assets and liabilities acquired are brought into the
                                                                               consolidated balance sheet (SFP) at fair value on
        Ownership of 20-50% of the voting shares.                             acquisition (exceptions are listed in IFRS 5, being assets
                                                                               held for sale);
        Representation on the Board of Directors.
                                                                              All changes in the values of acquired assets after
Joint Venture                                                                  acquisition are included in the consolidated income
A joint venture is an undertaking subject to the joint control of two          statement.
or more enterprises. The joint control is usually governed by a
contract between the parties.                                           Establishing market prices for all assets and liabilities can have
                                                                        many problems in practice and estimates may have to be made.

3.       Fair Value Accounting                                          One problem that can arise is that any assets / liabilities
                                                                        recognised on acquisition are capitalised, and included in the
When making an acquisition, you pay the market price (or an             balance sheet, whereas any changes in asset value post-
                                                                        acquisition are included in the income statement.
amount close to the market price) for the undertaking being
                                                                        This could provide scope for manipulation of profits.
purchased.
                                                                        For example, provisions may be set up in the balance sheet on
                                                                        acquisition, and used against items that would normally be
You take into account any undervaluation of fixed assets,               charged in the income statement, thus inflating profit.
overvaluation of inventory or accounts receivable, and future           Example (no longer possible):
liabilities that have not been booked in the accounts.

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                                                                                                           CONSOLIDATION PART 3
You buy a firm for its net asset value of $1 million. You plan to       The vendor of a firm wants $25million for it. You only have $22
merge its business with your own and to make its staff redundant,       million now.
which will cost you $0,2million.
                                                                        You agree to pay the additional $3million, if the first year‘s
You record a provision, in the balance sheet, for the $0,2million       audited profits exceed $4million. There is therefore a liability
by creating goodwill of the same amount.                                created in the consolidated balance sheet for $3m, discounted to
                                                                        a net present value to reflect that payment will be made in the
                                                                        future.
There is no impact on the income statement.
                                                                        from IFRS 3 (Revised): Impact on earnings − the crucial Q&A
                                                                        for decision makers _PwC
When the redundancies occur, they are charged to the provision,
again avoiding any impact on the income statement.                      Consideration

IAS 37 Provisions, Contingent Liabilities and Contingent Assets         Consideration is the amount paid for the acquired business.
                                                                        Some of the most significant changes are found in this section of
details when a provision should be recognised. In the above             the revised standard. Individual changes may increase or
                                                                        decrease the amount accounted for as consideration. These
example a provision is no longer allowed to be made and                 affect the amount of goodwill recognised and impact the post-
                                                                        acquisition income statement.
such costs have to be expensed when incurred.
                                                                        Transaction costs no longer form a part of the acquisition
IFRS 3 Business Combinations forbids creating liabilities for           price; they are expensed as incurred. Consideration now
                                                                        includes the fair value of all interests that the acquirer may have
future losses, or costs anticipated to be incurred as a result of the   held previously in the acquired business. This includes any
                                                                        interest in an associate or joint venture or other equity interests of
acquisition, unless:                                                    the acquired business. If the interests in the target were not held
                                                                        at fair value, they are re-measured to fair value through the
                                                                        income statement.
     -the acquiree had developed plans prior to the
      acquisition, or                                                   The requirements for recognition of contingent consideration
   - an obligation comes into existence as a direct                     have also been amended. Contingent consideration is now
      consequence of the acquisition.                                   required to be recognised at fair value, even if it is not deemed to
Example:                                                                be probable of payment at the date of the acquisition. All
                                                                        subsequent changes in debt contingent consideration are
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                                                                                                         CONSOLIDATION PART 3
recognised in the income statement, rather than against goodwill
as today.                                                             Some of the payments for the business are earn-outs. How
                                                                      are these accounted for?
The selling-shareholders will receive some share options.
What effect will this have?                                           It is common for some of the consideration in a business
                                                                      combination to be contingent on future events. Uncertainty might
An acquirer may wish selling-shareholders to remain in the            exist about the value of the acquired business or some of its
business as employees. Their knowledge and contacts can help          significant assets. The buyer may want to make payments only if
to ensure that the acquired business performs well.                   the business is successful. Conversely, the seller wants to
                                                                      receive full value for the business. Earn-outs are often payable
The terms of the options and employment conditions could              based on post-acquisition earnings or on the success of a
impact the amount of purchase consideration and also the              significant uncertain project.
income statement after the business combination. Share options
have a value.                                                         The acquirer should fair value all of the consideration at the date
                                                                      of acquisition including the earn-out. If the earn-out is a liability
The relevant accounting question is whether this value is             (cash or shares to the value of a specific amount), any
recorded as part of the purchase consideration, or as                 subsequent re-measurement of the liability is recognised in the
compensation for post-acquisition services provided by                income statement. There is no requirement for payments to be
employees, or some combination of the two. Is the acquirer            probable, which was the case under IFRS 3.
paying shareholders in their capacity as shareholders or in their
capacity as employees for services subsequent to the business         An increase in the liability for strong performance results in an
combination?                                                          expense in the income statement. Conversely, if the liability is
                                                                      decreased, perhaps due to under-performance against targets,
How share options are accounted for depends on the conditions         the reduction in the expected payment will be recorded as a gain
attached to the award and also whether or not the options are         in the income statement.
replacing existing options held by the employee in the acquired
business.                                                             These changes were previously recorded against goodwill.
                                                                      Acquirers will have to explain this component of performance: the
Options are likely to be consideration for post-acquisition service   acquired business has performed well but earnings are lower
where some of the payment is conditional on the shareholders          because of additional payments due to the seller.
remaining in employment after the transaction. In such
circumstances, a charge is recorded in post-acquisition earnings      Does it make a difference whether contingent consideration
for employee services. These awards are made to secure and            (an earn-out) is payable in shares or in cash?
reward future services of employees rather than to acquire the
existing business.                                                    Yes, it does make a difference. An earn-out payable in cash
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                                                                                                                  CONSOLIDATION PART 3
meets the definition of a financial liability. It is re-measured at fair       shares used to buy the business. Do these also have to be
value at every balance sheet date, with any changes recognised                 expensed?
in the income statement.
                                                                               No, these costs are not expensed. They are accounted for in the
Earn-outs payable in ordinary shares may not require re-                       same way as they were under the previous standard.
measurement through the income statement. This is dependent
on the features of the earn-out and how the number of shares to                Transaction costs directly related to the issue of debt instruments
be issued is determined.                                                       are deducted from the fair value of the debt on initial recognition
                                                                               and are amortised over the life of the debt as part of the effective
An earn-out payable in shares where the number of shares varies                interest rate.
to give the recipient of the shares a fixed value would meet the
definition of a financial liability. As a result, the liability will need to   Directly attributable transaction costs incurred issuing equity
be fair valued through income.                                                 instruments are deducted from equity.

Conversely, where a fixed number of shares either will, or will                Asset and liability recognition
not, be issued depending on performance, regardless of the fair
value of those shares, the earn-out probably meets the definition              The revised IFRS 3 has limited changes to the assets and
of equity and so is not re-measured through the income                         liabilities recognised in the acquisition balance sheet. The
statement.                                                                     existing requirement to recognise all of the identifiable assets and
                                                                               liabilities of the acquiree is retained. Most assets are recognised
A business combination involves fees payable to banks,                         at fair value, with exceptions for certain items such as deferred
lawyers and accountants. Can these still be capitalised?                       tax and pension obligations.

No, they cannot. The standard says that transaction costs are not
part of what is paid to the seller of a business. They are also not            Have the recognition criteria changed for intangible assets?
assets of the purchased business that are recognised on
acquisition.                                                                   No, there is no change in substance. Acquirers are required to
                                                                               recognise brands, licences and customer relationships, amongst
Transaction costs should be expensed as they are incurred and                  other intangible assets. The IASB has provided additional clarity
the related services are received.                                             that may well result in more intangible assets being recognised,
                                                                               including leases that are not at market rates and rights (such as
The standard requires entities to disclose the amount of                       franchise rights) that were granted from the acquirer to the
transaction costs that have been incurred.                                     acquiree.

What about costs incurred to borrow money or issue the                         What happens to the contingent liabilities of the acquired
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                                                                                                          CONSOLIDATION PART 3
business?                                                             those customers, which is likely to be high, will be amortised over
                                                                      that three-year period.
Many acquired businesses will contain contingent liabilities − for
example, pending lawsuits, warranty liabilities or future             There may be more charges in the post-combination income
environmental liabilities. These are liabilities where there is an    statement due to increased guidance in IFRS 3 (Revised) on
element of uncertainty; the need for payment will only be             separating payments made for the combination from those made
confirmed by the occurrence, or non-occurrence,                       for something else. For example, guidance has been included on
 of a specific event or outcome. The amount of any outflow and        identifying payments made for post-combination employee
the timing of an outflow may also be uncertain.                       services and on identifying payments made to settle pre-existing
                                                                      relationships between the buyer and the acquiree.
There is very little change to current guidance under IFRS.
Contingent assets are not recognised, and contingent liabilities      With contingent consideration that is a financial liability, fair value
are measured at fair value. After the date of the business            changes will be recognised in the income statement. This means
combination contingent liabilities are re-measured at the higher of   that the better the acquired business performs, the greater the
the original amount and the amount under the relevant standard,       likely expense in profit or loss.
IAS 37. US GAAP has different requirements in this area.
                                                                      Can a provision be made for restructuring the target
Measurement of contingent liabilities after the date of the           company in the acquisition accounting?
business combination is an area that may be subject to change in
the future.                                                           The acquirer will often have plans to streamline the acquired
                                                                      business. Many synergies are achieved through restructurings
If consideration paid and most assets and liabilities are at          such as reductions in head-office staff, or consolidation of
fair value, what does this mean for the post-combination              production facilities.
income statement?
                                                                      An estimate of the cost savings will have been included in the
Fair valuation of most things that are bought in a business           buyer‘s assessment of how much it is willing to pay for the
combination already existed under IFRS 3. The post-combination        acquiree.
income statement is affected because part of the ‗expected
profits‘ is included in the valuation of identifiable assets at the   The acquirer can seldom recognise a reorganisation provision at
acquisition date and subsequently recognised as an expense in         the date of the business combination. There is no change from
the income statement, through amortisation, depreciation or           the previous guidance in the new standard: the ability of an
increased costs of goods sold.                                        acquirer to recognise a liability for terminating, or reducing, the
                                                                      activities of the acquiree in the accounting for a business
A mobile phone company may have a churn rate of three years           combination is severely restricted.
for its customers. The value of its contractual relationships with
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                                                                                                            CONSOLIDATION PART 3
A restructuring provision can be recognised in a business               (i) a guaranteed minimum payment of 20m with no performance
combination only when the acquiree has, at the acquisition date,        conditions; and
an existing liability, for which there are detailed conditions in IAS
37, the provisions standard.                                            (ii) a further payment of 30m if actual profits for the four-year
                                                                        period exceed the cumulative forecast profit.
Those conditions are unlikely to exist at the acquisition date in
most business combinations. A restructuring plan that is                The forecast cumulative profit over the four-year period is 80m.
conditional on the completion of the business combination is not
recognised in the accounting for the acquisition. It is recognised      Entity A‘s management concludes at the acquisition date that it is
post-acquisition, and the expense flows through post-acquisition        not probable that the forecast levels will be reached.
earnings.
                                                                        Actual profits are 15m in the first year following the acquisition.
EXAMPLE - Deferred and contingent considerations                        However, cumulative actual profits are 60m by the end of the
                                                                        second year.
Entity A produces and sells sporting goods and clothes. It
acquired 100% of entity B from Mr Jones in 20X4.                        Management conclude at the end of the second year that
                                                                        payment of the additional 50m is probable. Actual profits exceed
Entity B sells badminton clothing, shoes, equipment and                 forecast profits for the final two years.
accessories and has grown rapidly since incorporation. Mr
Jones‘s asking price was based on aggressive profit forecasts,          How should the deferred and contingent amounts affect the
which assume continuing rapid growth and estimated the fair             accounting for the purchase consideration?
value of entity B to be 200m.
                                                                        The purchase consideration is 150m plus the present value of the
Fashions in the sporting goods and clothing sector change               guaranteed minimum payment of 20m (16.5m) at the acquisition
rapidly.                                                                date (IFRS 3).

Entity A has taken a more conservative view and estimated the           The 20m represents deferred purchase consideration and is a
fair value to be 166.5m.Entity A is only prepared to pay Mr             financing transaction. Entity A records 166.5m as its cost of
Jones‘s price if profits reach his forecast levels.                     investment, together with a
                                                                        provision for the deferred consideration of 16.5m.The discount of
Entity A agreed to acquire entity B for 150m plus a further             3.5m is a finance cost and is recorded as interest expense over
payment of 50m in four years.                                           the four-year period.

This payment will comprise:                                             An additional amount is payable if entity B achieves a certain
                                                                        level of performance. The 30m represents contingent
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                                                                                                           CONSOLIDATION PART 3
consideration.                                                         only.

Management concludes at the date of acquisition that payment is        Should the fair value of the identifiable assets and liabilities of F
not probable as the forecast profit levels are too aggressive. It      include any synergy values arising from the business
considers the fair value to be zero and does not increase the          combination or should the synergy value be subsumed within
purchase consideration. It reaches the same conclusion at the          goodwill?
end of year one as actual results are below forecast.
                                                                       Fair value is measured for each identifiable asset and liability and
IFRS 3 allows a maximum of 1 year to change the purchase               is therefore an asset-specific, rather than an entity-specific
consideration.                                                         concept.

(Had it believed by the end of year 1 that the payment would           It follows that the fair value of an asset is determined based on
have to be made,                                                       the separate purchase of that asset. The purchaser is assumed
an adjustment would be made to the purchase consideration to           to be a hypothetical market participant, and the market of
record the discounted present value of the 30m (IFRS3.32).The          potential purchasers is made up of all potential purchasers – both
revision to purchase consideration results in the recognition of       industry and financial buyers.
additional goodwill and a liability.
                                                                       Synergies available to more than one market participant should
Management revises its estimate at the end of the second year          be included in the fair value of the identifiable assets. The
and concludes that payment of the contingent consideration is          definition of fair value under IFRS encompasses the synergies
probable.                                                              that could be obtained by any market participant that might buy
                                                                       the asset.
It is now too late to change the purchase consideration, and
any payment will be expensed in the income statement.                  As such, those synergies are reflected in the purchase price of
                                                                       the individual asset. All acquirer-specific synergies would not
EXAMPLE - Fair values in a business combination                        affect the fair value of the individual asset and should be included
                                                                       in goodwill.
Entity E operates two lines of business: luxury leather goods and
perfumes. It acquires entity F, which operates in leather goods        Synergies that result from the use of E‘s retail network to sell
and has its own brand. E plans to sell F‘s products through E‘s        products under F‘s brand are market synergies of the luxury
existing retail network. It also plans to develop the acquired brand   industry, as other potential acquirers of this business also have a
in its perfume business.                                               retail network. These should be reflected in the fair value of the
                                                                       identifiable assets.
Many entities in the luxury business have their own retail network
but the fact that E also has the perfume business is specific to E     Synergies relating to the development of the acquired brand
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                                                                                                           CONSOLIDATION PART 3
through one of E‘s existing activities are synergies specific to E     assets (including intangibles) and liabilities at their fair values
and should be included in goodwill.                                    where they meet the recognition criteria of IFRS 3.

Intangible Assets (see IAS 38 workbook)                                Subsequent to the acquisition, I plc has incurred costs from
                                                                       external organisations in having valuations performed to
Intangible assets should be created as a result of business            determine the fair value of the assets (particularly intangible
combinations if they meet the IAS 38 criteria. Some of the             assets) acquired.
intangible assets, such as client lists, would not meet the criteria
if internally-generated, but meet the criteria if purchased in a       I plc‘s management argue that the costs would not have been
business combination.                                                  incurred if the business combination had not occurred and that
                                                                       they are therefore directly attributable to the combination.
IAS 38 specifies the accounting treatment of significant classes of
intangible assets, eg in business combinations acquired                Can I plc capitalise these valuation costs as part of the cost of
trademarks, trade names, internet domain names, non-                   acquisition?
competition agreements, customer lists and databases, customer
contracts and the related contractual and non-contractual              IFRS 3 excludes within the cost of the business combination any
customer relationships, banking or other licenses, favourable          costs that
lease agreements, construction permits, patented technology,           are directly-attributable to the combination such as professional
etc.                                                                   fees paid to accountants, legal advisers, valuers and other
                                                                       consultants to effect the combination. These must be expensed
Servicing contracts such as mortgage servicing contracts               and reported as transaction costs.
acquired in business combinations may be intangible assets
except if mortgage loans, credit card receivables or other             In our view, directly attributable means that the costs have to
financial assets are acquired in a business combination with           have been incurred to effect the combination.
servicing retained, then the inherent servicing rights are not a
separate intangible asset because the fair value of those              Valuation costs incurred prior to the acquisition date must be
servicing rights is included in the measurement of the fair value of   expensed and reported as transaction costs as part of the cost of
the acquired financial asset                                           the combination.

                                                                       However, costs incurred post-acquisition to determine the fair
EXAMPLE - Business combinations: valuation of assets –                 value of the assets acquired have not been incurred to effect the
transaction costs                                                      combination and must be expensed and not considered to be
                                                                       transaction costs of the combination..
I plc acquired J Ltd during the year. IFRS 3 requires that I plc
must allocate the cost of the business to J Ltd‘s identifiable         This would also apply to other types of valuation costs (eg, for
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                                                                                                          CONSOLIDATION PART 3
tangible fixed assets and pension liabilities).                        IAS 27 requires that uniform accounting policies are applied
                                                                       when preparing consolidated financial statements.
Consistent accounting policies
Consistent accounting policies must be applied and in preparing        Accounting for entity B‘s financial assets as available for sale is
consolidated financial statements, the accounting statements of        therefore appropriate.
the acquired company may have to be adjusted to reflect the
same policies of the parent.                                           EXAMPLE - Fair values calculation

EXAMPLE - Different accounting policies for parent and                 Entity B operates a national chain of fashion clothing retail stores.
subsidiary                                                             During 2006 it acquired entity C, which operates a rival fashion
                                                                       clothing retail chain. The majority of C‘s stores are in locations
Entity A is preparing its first IFRS financial statements in           where entity B does not have stores.
accordance with IFRS 1, First-time Adoption of IFRS. One of its
subsidiaries, entity B, already publishes IFRS financial               Entity B‘s management have decided to replace C‘s brand name
statements.                                                            over a two-year period and during this time it will replace the
                                                                       storefront signs with its own brand name.
Entity A must therefore include B‘s assets and liabilities in its
consolidated IFRS financial statements at the same values at           The fair values of C‘s brand name and the signage to be replaced
which they are included in B‘s financial statements after              have been determined by independent valuations specialists at
consolidation adjustments and the effects of any business              €40m and €10m respectively.
combination in which entity A acquired entity B (IFRS 1).
                                                                       The fair value of the brand name represents the value that a third
Entity B holds fixed interest medium-term debt securities. Entities    party would be willing to pay in an arm‘s length transaction. The
A and B both intend for these investments to be held until             fair value of the signage to be replaced has been calculated
maturity. Entity A has adopted a policy of classifying all financial   based on depreciated replacement cost in accordance with IFRS
assets of this type as available for                                   3.
sale. However, entity B classifies all these financial assets as
held to maturity.                                                      Entity B‘s management propose to recognise C‘s brand name
                                                                       and signage at only E4m and E1m respectively in its purchase
Does IFRS 1 prevent entity A from accounting for the fixed             accounting under IFRS 3 as it plans to phase out the brand name
interest medium-term debt securities held by entity B as available     and replace the signage over the next two years.
for sale?
                                                                       It plans to include the remaining value within goodwill because
No. IFRS 1 requires entity A to apply its accounting policy of         the benefits that B will receive from the acquisition will be derived
available for sale to the financial assets held by entity B because    largely from synergy benefits of the complementary geographical
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                                                                                                          CONSOLIDATION PART 3
spread of C‘s stores.                                                   c) derivatives to which DCG has applied hedge accounting.

Is the proposed accounting treatment acceptable?                        Easter Bunny has early adopted IFRS 3 (Revised). How should
                                                                        Easter Bunny account for these financial instruments in its
No. IFRS 3 requires that the acquired assets and liabilities are        consolidated financial statements?
recognised by the acquirer at fair value. The fair value should not
reflect the acquirer‘s intentions for the use of the assets acquired.   IFRS 3 (Revised) provides more guidance on the classification or
                                                                        designation of financial instruments than the current standard. It
Accordingly B should recognise C‘s brand name as an intangible          requires Easter Bunny to treat the financial instruments in the
asset at E40m and the signage as property, plant and equipment          same way as if it had acquired them individually (rather than in a
at E10m. The assets should be amortised and depreciated to              business combination).
their residual value over their expected useful lives in accordance
with IAS 38 Intangible Assets, and IAS 16. Property, Plant and          Accordingly, on the acquisition date:
Equipment, respectively.
                                                                        a) Easter Bunny needs to reassess the classifications of the non-
The replacement of the signs will be phased over the two years.         derivative investments held by DCG to reflect Easter Bunny‘s
As each sign is replaced the cost of the new sign should be             intentions and practices.
capitalised and any undepreciated book value of the replaced            This means that some items may be measured on a different
sign should be written off.                                             basis in the consolidated accounts of Easter Bunny, than
                                                                        previously by DCG.
EXAMPLE - Fair values calculation – financial instruments,
insurance contracts, leases                                             b) Easter Bunny needs to reassess whether any embedded
                                                                        derivatives need to be separated, based on the relevant
Easter Bunny acquires Dark Chocolate Group (DCG) on the 24              conditions at acquisition date. As a result, embedded derivatives
March 2008. DCG holds a range of financial instruments                  that were not previously separated by DCG may need to be
accounted for in accordance with IAS 39 + IFRS 9 including:             separated and vice versa.

a) non-derivative investments classified by DCG as held to              c) Easter Bunny needs to reassess the designation of derivative
maturity, available for same and at fair value through profit or        instruments as hedging instruments to reflect its own risk
loss,                                                                   management policies and practices.

b) hybrid (combined) instruments containing embedded                    Furthermore, hedge accounting should be restarted as from the
derivatives that have been separated under the requirements in          acquisition date. This means that some hedges in particular
IAS 39,and                                                              cashflow hedges that previously qualified for hedge accounting
                                                                        may fail the effectiveness test
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                                                                                                          CONSOLIDATION PART 3
required by IAS 39, in which case hedge accounting cannot be           The determination of fair value should not, therefore, reflect the
continued in the group accounts.                                       acquirer‘s discount rate because this would provide a value
                                                                       specific to the acquirer rather than a general, nonentity-specific,
However, under IFRS 3 (Revised), Easter Bunny does not                 fair value.
reassess whether contracts are classified as insurance contracts
in accordance with IFRS 4, Insurance Contracts, nor the                EXAMPLE - Indemnities under IFRS 3 (Revised)
classification of lease contracts as financial or
operating leases in accordance with IAS 17, Leases.                    Daffodil plc buys 61% of Folly Limited from Bluebell. Per the
                                                                       agreement Bluebell will indemnify Daffodil for any warranty
EXAMPLE - Business combinations - lease valuation                      claims post the transaction. The warranty relates to inventory
                                                                       sold by Folly before the acquisition.
Entity C acquired 100% of entity D in March 2005. C‘s
management is in the process of determining the fair value of the      Assuming that Daffodil early adopts IFRS 3 (Revised), Business
identifiable assets and liabilities acquired in that business          Combinations, how should Daffodil account for the indemnity on
combination.                                                           acquisition?

A significant liability of D is a finance lease payable. A condition   IFRS 3 (Revised) clarifies that the indemnity is recognised as an
of the acquisition of D by C was that C had to provide the lessor      asset of the acquiring business and therefore does not affect
with a guarantee for the lease payable.                                goodwill.

Entity C‘s management will determine the fair value of the finance     The indemnity is measured on the same basis as the indemnified
lease payable based on the present value of the estimate future        liability according to the terms of the contract, subject to the need
cashflows.                                                             for a valuation allowance for uncollectability of the asset.

Should C‘s management use a discount rate that reflects only           Where the indemnified liability is not measured at fair value then
entity D‘s credit                                                      the indemnification asset is measured using assumptions
rating or should it use one that reflects the combined credit rating   consistent with those used in measuring the indemnified item.
of both entities C and D to determine the fair value?
                                                                       This should result in a matched treatment for the recognition and
Entity C‘s management should use a discount rate that reflects         measurement of the liability and the related indemnity asset. The
the credit rating only of entity D.                                    resulting
                                                                       income statement gains on the one will offset losses on the other.
IFRS 3 requires that the acquirer recognises the acquiree‘s
liabilities at their fair values at acquisition date.                  EXAMPLE - Subsidiary transitioning

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                                                                                                        CONSOLIDATION PART 3
Entity A has reported under IFRS since 1990. Entity A acquired        -B Transitions to IFRS in 2005
entity B in 2003. B will transition from its national GAAP to IFRS    -B acquired C in 2000
in 2005, with a transition date of 1 January 2004, and will prepare   -C Continuing national GAAP preparer
consolidated financial statements for its sub-group.
                                                                      B should de-recognise the market share intangible at 1 January
Entity B acquired a subsidiary, entity C, in 2000 and applied its     2004 and the related deferred tax liability. B will therefore
previous GAAP business combinations accounting to that                increase the goodwill to 9,900 (6,400 + 5,000 -1,500) at 1
acquisition.                                                          January 2004.

When B acquired C it recognised goodwill of 8,000 and an              The subsidiary transition exemption is applied as:
intangible asset of 5,000 under its previous GAAP for C‘s market
share. It also recognised a deferred tax liability of 1,500 in                  -   the results for entity B.s sub-group at 1 January
respect of the market share intangible.                                             2004, as reported to A,
                                                                                -   less consolidation adjustments,
B amortises goodwill over 20 years under previous GAAP but                      -   less the IAS 22 adjustments made by A on
does not amortise the market share intangible.                                      acquisition of B.

The intangible asset does not qualify for recognition under IFRS      The result of applying only these adjustments would be the
and would have been subsumed within goodwill under IAS                inclusion in B‘s transition balance sheet of the previous GAAP
22(now IFRS 3), or IFRS 3.                                            market share intangible asset at 5,000, and goodwill of 6,400
                                                                      (8,000 less four years‘ amortisation).
Entity A derecognised the market share intangible when it applied
IAS 22 to the business combination in which it acquired B.            Application of the subsidiary transition exemption does not
                                                                      override the requirement to apply the business combinations
Entity B intends to use the subsidiary transition exemption in        exemption in Appendix B of IFRS 1.
IFRS 1which allows a subsidiary to transition to IFRS using the
IFRS results that it already reports to its parent (entity A).        B‘s management must therefore apply the business combinations
                                                                      exemption to the market share intangible. It will therefore de-
How does this affect the market share intangible?                     recognise the market share intangible at 1 January 2004 and the
                                                                      related deferred tax liability.
The corporate structure and key information is summarised as
follows:                                                              The adjusted goodwill balance of 9,900 is tested for impairment
                                                                      at transition date. It will also be tested annually thereafter and
-A Existing IFRS reporter                                             whenever indicators of impairment are identified.
-A acquired B in 2003
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                                                                                                       CONSOLIDATION PART 3
EXAMPLE - Group reconstruction                                        This would be the same value as the carrying amount of the net
                                                                      assets of Louise Ltd at that date.
During the year, Louise Ltd reorganises the structure of its group
by establishing a new parent. The shareholders of Louise Ltd
exchange their interests in Louise for shares issued by
Newparentco.
                                                                      EXAMPLE - Use of a Newco in business combinations
There have been no changes to the assets and liabilities of the
new group when compared with the original group. Furthermore,         (a) Newco used by a venture capitalist in an acquisition
the owners of Louise Ltd have the same absolute and relative
interests in the net assets of the original group and the new group   A Holdco holds its businesses through a wholly-owned subsidiary
immediately before and after the reorganisation.                      Opco. A Holdco is intending to sell Opco. Several potential
                                                                      purchasers have been identified.
The IASB recently issued an amendment to IAS 27, Consolidated
and Separate Financial Statements.                                    Management of A Holdco are conducting negotiations and
                                                                      preparing Opco for sale. Venture Capital Partners (VCP) is the
Assuming Newparentco can early adopt the amendment, how               winning bidder and negotiations are concluded. VCP establishes
would it account                                                      a new company, VCP Newco.
for the acquisition of Louise in its separate accounts under IFRS?
                                                                      VCP Newco raises substantial amounts of debt conditional on the
In the separate accounts of Newparentco, it has the choice to         acquisition of Opco. VCP Newco buys 75% of the shares of Opco
account for investments in subsidiaries at cost or fair value in      from A Holdco for cash.
accordance with IFRS 10.
                                                                      Pre-transaction Post-transaction
Newparentco would previously have accounted for this                  If VCP Newco has to prepare consolidated accounts, can VCP
transaction at the fair value of the consideration paid for the       Newco be identified as the acquirer of Opco in the transaction in
investment in Louise − at the fair value of the equity instruments    terms of IFRS 3?
issued.
                                                                      VCP Newco also uses IFRS. IFRS 3 indicates that where a new
However, the amendment specifies that if Newparentco accounts         company (.newco.) is formed and issues shares to effect a
for its investment in Louise Ltd at cost, Newparentco measures        business combination, it cannot be regarded as the acquirer in
the investment in Louise Ltd at its share (in this case, 100%) of     the transaction.
the equity items shown in the separate financial statements of
Louise Ltd on the date of reorganisation.                             However, in certain cases, where a newco pays cash, it will be
                                                                      the acquirer. This will be the case where the newco is in
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                                                                                                             CONSOLIDATION PART 3
substance an extension of a substantive acquirer.                       financial statements. As a result, B‘s assets and liabilities are
                                                                        included in New Co‘s consolidated financial statements at their
Therefore, in this scenario, VCP Newco has acquired Opco from           pre-combination carrying amounts without fair value uplift.
A Holdco. It records the assets and liabilities of the acquired
businesses in its consolidated financial statements at fair value. It   Therefore, a new company that pays cash is not necessarily the
also records the 25% minority interest in Opco held by A Holdco.        acquirer and the substance of the transaction needs to be
                                                                        evaluated to conclude on the accounting treatment.
(b) Newco with third party debt
                                                                        Impact of Minority Interests (now called non-controlling
Entity A arranges loan funding from a financial institution in a new    interests) on Fair Values.
wholly-owned subsidiary, New Co. The loan is used to fund the           Where the parent co-owns the subsidiary with minority interests,
acquisition of A‘s                                                      the impact of the fair value accounting will increase (or decrease)
100% shareholding in entity B, for cash consideration. A applies        the value of the minority interest.
IFRS 3 to account for common control transactions.
                                                                        For example if the minority owns 20% of the subsidiary, then 20%
Pre-transaction structure Post-transaction structure                    of the net asset revaluation will be attributable to the minority
                                                                        interests.
On the assumption that New Co has to prepare consolidated
accounts, can New Co be identified as the acquirer in a business        4.       Disposal of a Subsidiary
combination and apply purchase accounting in its consolidated
financial statements?                                                   Principles
                                                                        On disposal of a subsidiary, include in the consolidated financial
New Co cannot be the acquirer as A has created New Co and is            statements:
the vendor.
                                                                                Profits / losses to date of disposal
Therefore, substance is that New Co has been set up to issue                    Gains or losses on disposal
shares, acquire B and then to effect a return of capital from B
through the payment of cash to A for the shares in B that were          The gain /loss is calculated from:
acquired by the New Co (leaving A with more cash but an                       Group share of subsidiary net assets before disposal
investment with more debt in it when compared with the previous               Less
structure).                                                                   Group share of subsidiary net assets after disposal, plus
                                                                              the proceeds received
B is identified as the acquirer of New Co, as it is the combining
entity that existed before the combination. The transaction is          Net assets may include goodwill.
accounted for as a reverse acquisition in New Co.s consolidated
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                                                                                                      CONSOLIDATION PART 3
Proceeds may include a performance-related element (for
example, if future profits are x then payment will be y). This will   Note:
be treated as a contingent asset (gain), and only recognised as
profit when it becomes receivable.                                    Cost of the investment= Net assets (90)+ goodwill (8)-
                                                                           minority interests (18) =80
It would also be disclosed in the notes to the accounts.
                                                                       Subsidiary 1 Balance Sheet (before consolidation)
A deferred payment may need to be discounted to present value.
                                                                      Assets                       Liabilities
IAS 37 has more details on accounting for contingent assets.          Cash                     20 Accounts            480
                                                                                                  payable
Example 1 Sale of Subsidiary                                          Accounts                400
                                                                      receivable
80% of a subsidiary cost 80 in January 2XX6, when 100% of the         Investments             100
                                                                      Fixed Assets             50 Shareholders‘        90
net assets of the subsidiary were valued at 90.                                                   Funds
                                                                                              570                     570
In 2XX9, goodwill of 8 had a net value of 2, after an impairment
charge of 6.
                                                                                     P & S1 Group Balance Sheet
         Parent Balance Sheet (after acquisition)                     Assets                       Liabilities
                                                                      Cash                     240 Accounts           1280
Assets                                                                                            payable
                                 Liabilities                          Accounts                1400 Accruals           300
Cash                        220 Accounts                      800     receivable
                                payable                               Investments             300 Minority Interest    18
Accounts                   1000                                       Fixed Assets            150 Shareholders‘       500
receivable                                                            Goodwill                  8 Funds
Investments                 200 Accruals                      300                            2098                     2098
S1 Investment                80
Fixed Assets                100 Shareholders‘                 500
                                Funds                                 Notes:
                           1600                             1600      Cash= 220+20=240
                                                                      Accounts Receivable= 1000+400=1400
                                                                      Investments= (280-80)+100=300
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                                                                                                           CONSOLIDATION PART 3
Fixed Assets= 100+50=150                                                          Parent Balance Sheet (after disposal)
Accounts Payable= 800+480=1280
                                                                         Assets                        Liabilities
The investment in the subsidiary was sold in December 2XX9 for           Cash                     320 Accounts                800
100 and, at that time, the net assets were valued at 115.                                             payable
                                                                         Accounts                1000
                  P 2XX9 Income Statement                                receivable
Proceeds                                                           100   Investments              200 Accruals                300
Cost                                                                80   S1 Investment              0
                                                                         Fixed Assets             100 Shareholders‘           500
Parent company’s Gain on sale                                       20                                Funds                    20
                                                                                                      Profit on sale
                                                                                                 1620                        1620
      Group 2XX9 Income Statement
Proceeds                                                           100
                                                                         Notes:
Share of assets 80% of 115                                 92            Cash= 220+100=320
Net goodwill                                                             The parent’s profit on sale =20 (100-80).
                   8-(6)                                     2
                                                                    94   Example 2 Share Exchange
Group Gain on Sale                                                   6
                                                                         P owns 100% of S1. This cost 100.
                                                                         When S1 was acquired the net assets were 90. Today the net
There is a difference between the gain made by the group and             assets of S1 are 130.

the gain made by the parent company.                                     S1 retained earnings comprise 30 pre-acquisition profits and 40
                                                                         post acquisition profits.
The group has been recognising the profits made by the
subsidiary in each period since its purchase.                            At the date of the exchange, following an impairment charge,
                                                                         goodwill of 4 remains.
The parent company has not been recognising any profit of the
subsidiary since its purchase, so is recognising any gain, or loss,      P exchanges the shares of S1 for 75% of S2.
only on disposal of the subsidiary.
                                                                         Goodwill arising on acquisition of S1 is:

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                                                                                                      CONSOLIDATION PART 3
                                                                    Assets                       Liabilities
     (Cost less net              =
                assets                                              Cash                     30 Accounts                 450
                                                                                                payable
     100                90       =10                                Accounts                400
                                                                    receivable
         Parent Balance Sheet (after acquisition)                   Investments             100
                                                                    Fixed Assets             50 Share Capital             60
Assets                           Liabilities
                                                                                                   Retained               30
Cash                        150 Accounts                      800
                                                                                                  Earnings                40
                                payable
Accounts                   1000                                                                    Pre-acquisition
receivable                                                                                         Post-acquisition
Investments                 250 Accruals                      300                           580                          580
S1 Investment               100
Fixed Assets                100 Shareholders‘                 500
                                Funds
                           1600                             1600


                                                                              P/ S1 Consolidated Balance Sheet

                                                                    Assets                       Liabilities
                                                                    Cash                    180 Accounts                1250
                                                                                                payable
                                                                    Accounts               1400
                                                                    receivable
                                                                    Investments             350 Accruals                 300
                                                                    Fixed Assets            150 Shareholders‘            534
                                                                    Goodwill                  4 Funds
                                                                                           2084                         2084

                                                                    The derivation of these figures appears on the next page.

         S1 Balance Sheet (at date of exchange)

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                                                                                                                 CONSOLIDATION PART 3
          Derivation of Group Figures (for example
          on previous page)                                        Parent Parent   S1    S1 Adjustments Adjustments    P/S1       P/S1
                                                                    DR      CR     DR    CR      DR         CR         DR         CR
          Assets
          Cash                                                        150           30                                   180
          Accounts Receivable                                        1000          400                                  1400
          Investments                                                 250          100                                   350
          Investment in S1                                            100                                        100
          Investment in S2
          Fixed assets                                                100           50                                   150
          Goodwill                                                                                     4                      4
          Liabilities
          Accounts payable                                                   800         450                                       1250
          Accruals                                                           300                                                    300
          Minority Interests
          Shareholders' funds                                                500         130           96                           534


                                                                     1600   1600   580   580          100        100    2084       2084




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                                                                                                 CONSOLIDATION PART 3
      Parent Balance Sheet (at date of exchange)                    75% of the net assets of S2 are worth 75% of (120+80)=150

Assets                           Liabilities                        75% of the net assets of S2 have cost 100% net assets of S1
Cash                        150 Accounts                      800   (60+70)=130
                                payable
Accounts                   1000                                     The goodwill of 4 relating to S1 is credited in the consolidated
receivable                                                          balance sheet, with the net assets of S1, reducing
Investments                 250 Accruals                      300   consolidated reserves by 4.
S2 Investment               130
Fixed Assets                100 Shareholders‘                 530              P/ S2 Consolidated Balance Sheet
                                Funds
                           1630                             1630    Assets                        Liabilities
                                                             Sh     Cash                     230 Accounts                 1480
                                                             are                                 payable
holders‘ funds increase by 30, reflecting the gain on disposal of   Accounts                1500
S1 (130-100 purchase price).                                        receivable
                                                                    Investments              450 Accruals                   300
         S2 Balance Sheet (at date of exchange)                                                   Minority Interests         50
                                                                    Fixed Assets             200 Shareholders‘              530
Assets                               Liabilities                    Negative Goodwill        -20 Funds
Cash                          80     Accounts                 680                           2360                          2360
                                   payable
Accounts                    500
receivable                                                          Notes:
Investments                 200 Share Capital                 120   Cash=150+80=230
Fixed Assets                100 Retained                       80   Accounts Receivable= 1000+500=1500
                                Earnings                            Investments= 250+200=450
                            880                               880   Fixed Assets= 100+100=200
                                                                    Accounts Payable= 800+680=1480
                                                                    Negative goodwill arising on consolidation is: Purchase
The net assets of S2 are worth 200.                                 price-net assets 130-150=-20
                                                                    Minority Interests= 25% of 200=50

                                                                    Since IFRS 3, negative goodwill is immediately eliminated by
The effect of the exchange is:
                                                                    writing it off to profit.

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                                                                                                   CONSOLIDATION PART 3
Loss of Control                                                      Net assets (including goodwill) attributable to the parent after
The parent may lose control of a subsidiary by disposing of          disposal plus any sale proceeds.
part, or all, of its holding.
                                                                     Goodwill, relating to the subsidiary, is written off against
This loss of control may either be deliberate, or as a result of a
confiscation by a government. An apparent loss of control may        consolidated reserves on disposal.
occur during a group reorganisation.

Loss of control should be treated as a complete disposal,            Loss of Control – Retention of part of the undertaking

although it is possible that no disposal proceeds will have been     A new aspect of consolidation, introduced into IFRS in 2008, is
                                                                     the accounting when part of the undertaking is retained,
received. Any remaining share that is held is treated as a new       though control is lost.

asset obtained at fair value.                                        A partial disposal of an interest in a subsidiary in which the
                                                                     parent company retains control does not result in a gain or
                                                                     loss, but an increase or decrease in equity. (Purchase of some
Where the disposal is a sale, a gain or loss will arise. If the      or all of the non-controlling interest is treated as a treasury
subsidiary has been confiscated, a loss will probably be             share-type transaction and accounted for in equity.)
suffered.
                                                                     A partial disposal of an interest in a subsidiary in which the
From a reorganisation, there will be no gain (nor loss), in group    parent company loses control, but retains an interest (say an
terms, unless cash changes hands. In economic terms,                 associate) triggers recognition of gain or loss on the entire
nothing has changed.                                                 interest.
On cessation, the consolidated financial statements should           A realised gain or loss is recognised on the portion that has
show:                                                                been disposed of; a holding gain is recognised on the interest
    The subsidiary results up to the date of cessation
                                                                     retained, calculated as the difference between the fair value
    The gain / loss on cessation.
                                                                     and the book value of the retained interest.
Any gain / loss is calculated from:                                  The accounting is to account for a complete disposal of the
Net assets (including goodwill) attributable to the parent           undertaking and then recognise the retained part at fair value.
before disposal
Less:                                                                The impact is to eliminate the subsidiary and all goodwill from
                                                                     the balance sheet, and to match it with cash received and the
                                                                     fair value of the associate.
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                                                                                                 CONSOLIDATION PART 3
                                                                    the parent-company shareholders.
IAS 27 (Revised) – new proposals on minority interests
and disposals from IFRS 3 (Revised): Impact on earnings             What happens if a non-controlling interest is bought or
− the crucial Q&A for decision makers _PwC                          sold?

A partial disposal of an interest in a subsidiary in which the      Any transaction with a non-controlling interest that does not
parent company retains control does not result in a gain or         result in a change of control is recorded directly in equity; the
loss, but in an increase or decrease in equity under the            difference between the amount paid or received and the non-
economic entity approach.                                           controlling interest is a debit or credit to equity.

Purchase of some or all of the non-controlling interest is          This means that an entity will not record any additional
treated as a treasury transaction and accounted for in equity. A    goodwill upon purchase of a non-controlling interest nor
partial disposal of an interest in a subsidiary in which the        recognise a gain or loss upon disposal of a non-controlling
parent company loses control, but retains an interest (say an       interest.
associate), triggers recognition of gain or loss on the entire
interest.                                                           How is the partial sale of a subsidiary with a change in
                                                                    control accounted for?
A gain or loss is recognised on the portion that has been
disposed of; a further holding gain is recognised on the interest   A group may decide to sell its controlling interest in a
retained, being the difference between the fair value of the        subsidiary but retain significant influence in the form of an
interest and the book value of the interest. Both are recognised    associate, or retain only a financial asset.
in the income statement.
                                                                    If it does so, the retained interest is remeasured to fair value,
What happened to minority interest?                                 and any gain or loss compared to book value is recognised as
                                                                    part of the gain or loss on disposal of the subsidiary.
All shareholders of a group − whether they are shareholders of
the parent or of a part of the group (minority interest) − are      Consistent with a ‗gain‘ on a business combination, the
providers of equity capital to that group.                          standards take the approach that loss of control involves
                                                                    exchanging a subsidiary for something else rather than
All transactions with shareholders are treated in the same way.     continuing to hold an interest.
What was previously the minority interest in a subsidiary is
now the non-controlling interest in a reporting entity.             How does the new standard affect transactions with
                                                                    previously recognised non-controlling interests?
There is no change in presentation of non-controlling interest
under the new standard. Additional disclosures are required to      An entity might purchase a non-controlling interest recognised
show the effect of transactions with non-controlling interest on    as part of a business combination under the previous version
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                                                                                                  CONSOLIDATION PART 3
of IFRS 3 − that is, where only partial goodwill was recognised.
                                                                    In the above example, the absence of trading means that the
Alternatively, an entity might recognise partial goodwill under     accounting in the parent company and consolidated financial
the new IFRS 3 (Revised) and might purchase a non-                  statements are identical. The rise in the fair value is purely as
controlling interest at a later date.                               illustration, as it is unlikely to have changed between the time
                                                                    of purchase and resale.
In both cases, no further goodwill can be recognised when the
non-controlling interest is purchased. If the purchase price is     If the above example is changed (see below), so that the stake
greater than the book value of the non-controlling interest, this   is sold after a year, and S made a profit of 50, 40 (= 50*80%)
will result in a reduction in net assets and equity. This           accruing to P, other numbers unchanged, P‘s profit and
reduction may be significant.                                       bookkeeping entries will be the same, as the subsidiary is held
                                                                    at cost. It therefore does not reflect the increased value of P.
In the following examples, I/B refers to Income Statement
and Balance Sheet (SFP).                                            However, the consolidated financial statements will differ, as
                                                                    they will revalue S to its fair value and include its contribution
                                                                    of 40 in the consolidated income statement:
EXAMPLE - Loss of Control – Retention of part of the
undertaking- 1

P holds 80% of S. It was bought as part of a group of companies     EXAMPLE - Loss of Control – Retention of part of the
and 50% is immediately resold to its management. The remaining      undertaking - 2
30% will be treated as an associate.
The cost was 880 including 80 goodwill.                             P holds 80% of S. It was bought as part of a group of companies
The 50% stake is resold for 600.                                    and 50% is resold to its management after 1 year. The remaining
The fair value of the remaining stake is 360.                       30% will be treated as an associate.
                                          I/B   DR        CR        The cost was 880 including 80 goodwill. A profit of 50 was made
Loss on disposal of subsidiary              I      280              during the year, 40 attributable to P‘s 80% share in the company.
Investment in subsidiary (including B                        880
goodwill)                                                           The 50% stake is resold for 600.
Cash                                       B       600              The fair value of the remaining stake is 360.
Sale of subsidiary and elimination of                                Consolidated financial statements I/B              DR          CR
goodwill                                                            Loss on disposal of subsidiary            I           320
Investment in associate (30%)              B       360              Investment in subsidiary (including B                                920
Profit on disposal of subsidiary            I                360    goodwill)
Recognition of associate at fair value                              Cash                                      B            600

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                                                                                                        CONSOLIDATION PART 3
Sale of subsidiary and elimination of                                     Investment in subsidiary (including        B                       936
goodwill                                                                  goodwill)
Investment in associate (30%)                  B          360             Cash                                       B          600
Profit on disposal of subsidiary               I                    360   Sale of subsidiary and elimination of
Recognition of associate at fair value                                    goodwill
                                                                          Investment in associate (30%)              B          360
The consolidated financial statements will show a different gain          Profit on disposal of subsidiary           I                       360
(or loss) on disposal from the parent financial statements, as            Recognition of associate at fair value
the parent balance sheet shows the investment of a subsidiary
at cost, and does not reflect subsequent trading.                         Again, the parent financial statements will be as in the first
                                                                          example, recording a profit of 80.
In the above case, the net impact on the income statement is
the same.                                                                 The consolidated financial statements will show a profit of 24
The smaller gain on sale (-40) will be offset by the income               (360-336), plus the trading profit of 20 for year 2. The
(+40).                                                                    difference between the 2 sets of financial statements is the 40
                                                                          profit recorded in the consolidated financial statements in year
In the following case (see below), extending the example for              1, but not reflected in the parent financial statements.
another year before the sale, the impact will be different:
                                                                          If a subsidiary or non-current assets are available (or intended)
EXAMPLE - Loss of Control – Retention of part of the                      for sale, the rules of IFRS 5 apply.
undertaking - 3
                                                                          EXAMPLE - IFRS 5 and partial disposals
P holds 80% of S. It was bought as part of a group of companies
and 50% is resold to its management after 2 years. The                    Entity A has a 70% ownership stake in a subsidiary, entity B,
remaining 30% will be treated as an associate.                            which represents a separate major line of business within the
The cost was 880 including 80 goodwill. A profit of 50 was made           group.
during the first year, 40 attributable to P‘s 80% share in the
company. A profit of 20 was made during the second year, 16               During the year A enters into a binding sale agreement
attributable to P‘s 80% share in the company                              whereby it will dispose of 40% of its investment in the
                                                                          subsidiary in the next financial year.
The 50% stake is resold for 600.
The fair value of the remaining stake is 360.                             How should A disclose the results of B in its consolidated
 Consolidated financial statements I/B                 DR          CR     financial statements at year end? In particular, should it
Loss on disposal of subsidiary            I              336              classify entity B as a discontinued operation under IFRS 5,
                                                                          Non-current Assets Held for Sale and Discontinued
                                                                          Operations?
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                                                                                                  CONSOLIDATION PART 3

The principle for applying IFRS 5 depends on the manner in           Entity D, a subsidiary of entity E, meets the definition of a held-
which an entity will recover a non-current asset or disposal         for-sale asset in accordance with IFRS 5. Financial assets within
group.                                                               the scope of IFRS 9, comprise the majority of the value of D.
                                                                     Such assets are outside the scope of IFRS 5 for measurement
If an entity will recover the carrying amount of a disposal group    purposes (IFRS 5).
principally through sale rather than through use, IFRS 5 is
applicable.                                                          On initial classification as held for sale, E measured D at the
                                                                     lower of carrying amount and fair value less costs to sell (IFRS
The 40% disposal will result in the assets and liabilities being     5).
principally recovered through sale and a single new asset
(associate) being recognised.                                        If the value of the financial assets within D increase above the
                                                                     initial value of the disposal group, can E record the increase?
Entity A should therefore disclose all of the results and assets
of entity B in its consolidated statements as a discontinued         IFRS 5 notes that on subsequent remeasurement of a disposal
operation in accordance with IFRS 5 at the year end.                 group, the carrying amount of any assets and liabilities that are
                                                                     not within the scope of the measurement requirements of IFRS 5.
Once the disposal is completed, entity A accounts for the
resultant associate using the equity method in IAS 28,               They are included in a disposal group classified as held for sale,
Investments in Associates.                                           shall be re-measured in accordance with applicable IFRSs before
                                                                     the fair value less costs-to-sell of the disposal group is re-
Classification under IFRS 5 for a subsidiary will be based only      measured.
on the loss of control of that subsidiary.
                                                                     Therefore, on subsequent re-measurement, the financial assets
For example, if an entity with a 51% holding in a subsidiary         within the scope of IFRS 9 should be remeasured first in
entered into a contract to dispose of only 2% of its holding and     accordance with IFRS 9.
this would result in a loss of control in the future, IFRS 5 would
apply.                                                               The value of the E disposal group as a whole should then be
                                                                     determined and recorded at the lower of carrying value (ie the
The amendment also clarifies that all of the subsidiary‘s assets     current IFRS 9 value plus the carrying amount of other out-of-
and results                                                          scope assets and liabilities plus carrying value of IFRS 5 assets
would be accounted for as held for sale prior to the disposal        and liabilities) and fair value less costs-to-sell of the disposal
under IFRS 5 and not just the effective interest to be disposed      group as a whole.
of.
                                                                     Group restructuring and treatment of currency translation
Held for sale subsidiary with financial assets                       reserve
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                                                                                                CONSOLIDATION PART 3
                                                                    EXAMPLE - Actuarial gains and losses on disposal of a
IAS 21, The Effects of Changes in Foreign Exchange Rates,           business
requires exchange differences on net investments in a foreign
operation to be recognised as a separate component of equity        Company E has disposed of its main subsidiary F in the year
in the consolidated financial statements.                           to 31 December 20X6. E has a defined benefit pension
                                                                    scheme and any actuarial gains and losses arising have been
This separate component of equity is commonly referred to as        recognised in line with IAS 19, Employee Benefits.
the currency translation account (CTA). Such exchange
differences are recognised in profit or loss (‗recycled‘) on the    Other standards, such as IFRS 9, require recycling of gains
disposal or partial disposal of the net investment.                 and losses that have previously been taken to equity. As such,
                                                                    on disposal of E, should the cumulative actuarial gains and
In a group restructuring, a foreign operation is transferred from   losses previously taken to capital be recycled to the income
one intermediate holding company to another.                        statement?

The group continues to hold a 100% interest in that foreign         Actuarial gains and losses should not be recycled through the
operation. No third parties are involved with the group             income statement. The IASB considered the possibility of
restructuring. Should the CTA be recycled in the group‘s            recycling, given that most gains and losses under IFRS that
consolidated financial statements?                                  are recognised outside profit and loss are recycled.

No. The question is whether the restructuring results in an         However, on balance, the IASB concluded that actuarial gains
economic change from the group‘s perspective that constitutes       and losses should not be recycled and IAS 19 confirms this.
a partial or full disposal.
                                                                    EXAMPLE - Separate financial statements
In this case, the foreign operation continues to be part of the
consolidated group and the restructuring is not a disposal          Parent entity C has decided to sell one of its subsidiaries,
event from the group‘s perspective under IAS 21.                    entity D. The criteria in IFRS 5 have been met which means
                                                                    that entity D will be classified as held for sale.
No recycling occurs for the exchange differences recognised in
equity.                                                             Entity C is preparing its separate parent company financial
                                                                    statements in accordance with IFRS. IAS 27 provides a choice
However, if the intermediate holding company that disposes of       of either using cost or fair value in accordance with IFRS 9,
the foreign operation prepares consolidated financial               when accounting for an investment in a subsidiary in the
statements under IFRS, the CTA (if any) that arises at that         parent‘s separate financial statements.
intermediate reporting level would be recycled on the group
restructuring.                                                      Entity C has chosen to account for investments in subsidiaries
                                                                    at fair value in its separate financial statements.
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                                                                                                  CONSOLIDATION PART 3

How does entity C‘s policy choice to use fair value for its         EXAMPLE - Paying to sell a subsidiary
investment in entity D affect the application of IFRS 5?
                                                                    Entity A has a subsidiary that management has committed to
The policy choice provided in IAS 27 on measuring an                sell. The criteria in IFRS 5 for this subsidiary to be classified as
investment in a subsidiary at cost or at fair value in accordance   held for sale have been met.
with IFRS 9 is available for subsidiaries that are not classified   The subsidiary is loss-making and entity A has written off the
as held for sale in accordance with                                 subsidiary‘s property, plant and equipment (PPE) under IAS
IFRS 5.                                                             36, Impairment of Assets.

IFRS 5 requires that immediately before an asset is classified      The subsidiary also has some sundry working capital. Entity
as held for sale its carrying amount is measured in accordance      A‘s management considered closing the subsidiary, but this
with applicable IFRSs.                                              would result in making all the staff redundant.

Consequently, the investment in a subsidiary that is accounted      Management identified that a third party might be willing to
for at fair value in accordance with IFRS 9 will be revalued to     take over the subsidiary if it was able to utilise some of the
current fair value at the date that the IFRS 5 criteria are met.    assets and workforce, thereby saving some of the jobs.

Subsequent measurement under IFRS 5 is at the lower of              However, entity A will need to pay such a third party
carrying amount and fair value less costs to sell. Parent entity    approximately e20m to achieve the sale. The subsidiary
C will therefore freeze the carrying amount of its investment in    (disposal group) therefore has a negative fair value of e20m.
the subsidiary held for sale at current fair value and only re-
measure it if fair value less costs to sell falls below this        Entity A is committed to its plan to sell the subsidiary but it
amount.                                                             does not yet have a binding sales agreement for the disposal.

The scope restriction set out in IFRS 5, which requires that        Should entity A record a liability for the expected payment to a
financial assets within the scope of IFRS 9 continue to be          third party on disposal of the subsidiary as the disposal is
measured in accordance with IFRS 9, does not apply to the           considered highly probable in accordance with IFRS 5?
investment in the subsidiary.
                                                                    Entity A should not record a liability for the payment to a third
This is because IAS 27 only permits the use of fair value           party in respect of the highly probable disposal.
measurement in accordance with IFRS 9 for those subsidiaries
that are not held for sale.                                         IFRS 5 requires that a disposal group is measured at the lower
                                                                    of its carrying amount and its fair value less costs to sell (IFRS
IAS 27 also makes clear that subsidiaries classified as held for    5.15). However, IFRS 5 applies only to the measurement of
sale should be accounted for in accordance with IFRS 5.             the non-current assets in the disposal group.
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                                                                                                 CONSOLIDATION PART 3

It does not affect the measurement of current assets and             The decision was taken in April 2005 and the transaction was
current and noncurrent liabilities within the disposal group.        completed in July 2005.The disposed business segment meets
This is made clear in the basis                                      the definition of a discontinued operation under IFRS 5.
for conclusion, BC 22, which states:
                                                                     Management is considering the balance sheet presentation of
The board also noted that the requirements of IAS 37establish        the assets and liabilities for the 31 May 2005 financial
when a liability is incurred, whereas the requirements of the        statements and whether this should change when presented
IFRS relate to the measurement and presentation of assets            as comparatives in the 31 May 2006 financial statements.
that are already recognised.                                         IFRS 5 does not permit the assets and liabilities of the
                                                                     business segment to be presented on two lines. The two-line
A liability would only be recognised if there was a binding sale     presentation is restricted to disposal groups that are held for
agreement as required by IAS 37. IFRS 5 and IAS 37 both              sale and cannot be extended to disposal by way of a
require that the entity is committed in order to qualify for their   distribution.
respective accounting treatments.
                                                                     The assets and liabilities of the segment should therefore be
However, the standards require commitment to different things.       presented within their normal classifications in the balance
IFRS 5 requires commitment to a plan to sell for the subsidiary      sheet in the 31 May 2005 financial statements.
to be classified as a disposal group held for sale. IAS 37
requires that the entity is committed to the sale, which it          Management should not change this presentation in the 31
specifies can only be met if there is a binding sale agreement.      May 2006 financial statements. Although the segment was
                                                                     distributed to shareholders in August 2005 and therefore
EXAMPLE - Presentation of assets and liabilities of spun-            qualified as a discontinued operation from that date, IFRS 5
off segment                                                          does not permit the comparative balance sheet to be
                                                                     amended.
Entity D has a 31 May year-end and has adopted IFRS
5,Noncurrent Assets Held for Sale and Discontinued                   The segment‘s assets and liabilities must therefore continue to
Operations. It has spun-off one of its major business segments       be presented in their normal classifications in the 2005
to its existing shareholders as part of management‘s decision        comparative balance sheet in the 31 May 2006 financial
to focus on the remaining businesses within D‘s consolidated         statements.
group.
                                                                     However, the results of the discontinued operations for the
It carried out the transaction by creating a new holding             year ending 31 May 2005, and the three months ending 31
company and distributing the shares in the new holding               August 2005 should be presented on a single line in the
company to D‘s existing shareholders in proportion to their          income statement in the 31 May 2006 financial statements.
ownership interests in D.
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                                                                                                    CONSOLIDATION PART 3
5.     The Equity Method of Accounting                               At the time of acquisition, the net assets of S had a value of

The equity method of accounting values the investment at             200 (100 Share Capital and 100 Pre-Acquisition Profits).
cost, and is adjusted for the investor‘s share of post-acquisition
profits.
                                                                     Post-acquisition profits are 70 and the parent‘s balance sheet
Likewise, the investor's income statement includes its share of      has not changed since the acquisition.
post-acquisition profits. The equity method is usually applied to
associates and joint ventures.
                                                                          Subsidiary Balance Sheet (after acquisition)
The equity method can be applied in both parent and
consolidated financial statements.                                   Assets                         Liabilities
                                                                     Cash                      10   Current Liabilities      300
Equity Method of Accounting                                          Accounts                 200          Share             100
                                                                     receivable                           Capital
       Parent Balance Sheet (before acquisition)                     Fixed Assets             360 Pre-acquisition            100
                                                                                                  profits
Assets                           Liabilities                                                         Post-acquisition         70
Cash                        300 Accounts                      800                                 profits
                                payable                                                       570                            570
Accounts                   1000
receivable
Investments                 200 Accruals                      300      Parent Balance Sheet including S (equity method)
Fixed Assets                100 Shareholders‘                 500
                                Funds                                Assets                        Liabilities
                           1600                             1600     Cash                      50 Accounts                   800
                                                                                                  payable
                                                                     Accounts                1000
P bought 80% of S for 250.                                           receivable
                                                                     Investments              200 Accruals                   300
It was bought with other undertakings, and P had determined          S (250+56)               306
that S should be sold as quickly as possible, and immediately        Fixed Assets             100 Shareholders‘              500
sought a buyer.                                                                                   Funds                       56
                                                                                                   Profits of S
                                                                                             1656                          1656
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                                                                                                   CONSOLIDATION PART 3

                                                                     Other assets and liabilities are not consolidated.
Notes:
Post-Acquisition Profits attributable to are 80% of 70 = 56.         Dividends received from the investee reduce the carrying
Investment in S comprises purchase price +post-
acquisition profits 250+56=306                                       amount of the investment.

This method shows the profits of the investment only in the
lines of the investment in the subsidiary and the shareholders‘      6.       Associates
funds.
                                                                     An associate is an undertaking in which the investor has
Goodwill is not shown separately, as there is no breakdown of        significant influence, and which is neither a subsidiary, nor a
                                                                     joint venture.
net assets.
                                                                     The investor in an associate has the opportunity to influence
As goodwill that forms part of the carrying amount of an             the financial and operating decisions of the associate, but
investment in an associate (see next section) is not separately      without control over them.
recorded, it is not tested for impairment separately by applying
the requirements for impairment testing goodwill in IAS 36           An indication of significant influence would be the ownership of
Impairment of Assets.                                                20%-50% of the voting shares.

Instead, the entire carrying amount of the investment is tested      Owning more than 50% would give control, and would normally
for impairment in accordance with IAS 36 as a single asset, by       require full consolidation.
comparing its recoverable amount (higher of value in use and
fair value less costs to sell) with its carrying amount, whenever    If the holding is less than 20% of voting shares, it is presumed
application of the IFRS 9 indicates that the investment may be       that the investor does not have significant influence, unless
impaired.                                                            this can be demonstrated.

An impairment loss recorded in those circumstances is not            Further indications of significant influence are:
allocated to any asset, including goodwill, that forms part of the
carrying amount of the investment in the associate.                          representation on the board of directors or governing
                                                                              body;
So, any reversal of that impairment loss is recorded in                      participation in policy-making processes;
accordance with IAS 36 to the extent that the recoverable                    material transactions between the investor and
amount of the investment subsequently increases.                              investee;
                                                                             interchange of managerial personnel;
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                                                                                                  CONSOLIDATION PART 3
      provision of vital technical information.                     certain implied requirements explicit and removing some
                                                                     impracticability exceptions.
Associates are accounted for using the Equity Method (see 5.
above).                                                              However, problems and inconsistencies are arising in application
                                                                     as more companies move to IFRS. This article examines some of
If a loss has been incurred the associate, the investor must         the practical issues that have arisen and some areas of
recognise its share of that loss, both in the income statement       inconsistency in the accounting literature.
and as a reduction of the investment in associate,
                                                                     Notional purchase price allocation
It is important to understand that the investor includes its share
                                                                     What accounting is required when an associate is first
of profit, even if it has not received the money in the form of      purchased? IAS 28 states that ‗the investment in an associate is
                                                                     initially recognised at cost‘. This is straightforward.
dividends. This becomes a serious issue if the investor is
                                                                     The standard goes on to say that, ‗on acquisition of the
                                                                     investment any difference between the cost of the investment
expected to pay dividends based on its earnings within the
                                                                     and the investor‘s share of the net fair value of the associate‘s
                                                                     identifiable assets, liabilities and contingent liabilities is
associate.
                                                                     accounted for in accordance with IFRS 3.

Equity accounting: practical difficulties                            The equity investment continues to be recognised on one line in
                                                                     the balance sheet as the IFRS 3-type purchase price allocation
IFRS News - December 2005 and February 2006                          and calculation of goodwill is notional. The notional purchase
                                                                     price allocation (PPA) should include the investor's portion of
Entities applying the IAS 28 equity method to their                  the fair value of any intangible assets and contingent liabilities
associates and joint ventures are finding some difficult             (whether or not recognised by the associate) and the investor's
areas. The equity method of accounting has been around for           share of any fair value step ups or adjustments to recorded
many years. It is thought to be straightforward and well             assets and liabilities.
understood.
                                                                     The practical challenge is that the investor will seldom have
Equity accounting has received little attention from standard-       access to proprietary information about the company.
setters in recent years, despite criticism of it by some as a
concept.                                                             Most public companies are prohibited from making information
                                                                     available to shareholders on a selective basis - what one
IAS 28 was part of the improvements project when various             shareholder knows usually needs to be made available to all
changes pushed equity accounting closer to accounting for            shareholders. Thus, the investor needs to calculate the notional
business combinations and subsidiary accounting by making            PPA with publicly available information and a substantial degree
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                                                                                                     CONSOLIDATION PART 3
of estimation.                                                         associate as represented by the patent intangible asset should
                                                                       have been reduced to nil, through periodic amortisation and not
Is this notional PPA really required? The answer is yes and part       an impairment charge.
of the answer is that is explicitly required by the standard.
However it can also be crucial so that the correct share of the        Negative goodwill arising on the acquisition of an associate
associate‘s results is recorded post-acquisition.
                                                                       The notional PPA might also result in negative goodwill
The share of results will not include the correct amortisation if      (technically - excess of the investor‘s share of the net fair value of
tangible and intangible assets are not recorded at their fair value.   the associate‘s identifiable assets, liabilities and contingent
                                                                       liabilities - as IFRS describes negative goodwill).
Two other potential problems make the notional PPA important.
Purchase of an associate may be the first step in a step               Negative goodwill might exist if the associate has a significant
acquisition. Goodwill and revised fair values are needed at each       unrecorded contingent liability, or the investor managed to secure
step, so the contemporaneous information that supports the             shares at a discount price because of the vendor's need for cash.
amount of goodwill present at the date of each transaction is
crucial.                                                               The negative goodwill should be credited to the investor‘s income
                                                                       statement in the period that the associate is required. This seems
If an associate is impaired, any notional goodwill written off         inconsistent with the principle that the associate is recorded
cannot be reversed, thus, where the associate is a public              initially at cost.
company, the amount of notional goodwill is crucial.
                                                                       The associate will be recorded at an amount greater than cost
Example                                                                where negative goodwill exists. The standard is explicit on the
                                                                       requirement to recognize negative goodwill where it exists and
Company A, a large pharmaceutical company, buys 30% of                 this is the natural extension of the notional PPA concept
Company B, a small company. B owns a valuable patent that              discussed above.
covers a specific prescription drug. The patent will expire in
seven years. Assume that there are no other fair value                  However, an associate with a carrying value in excess of market
adjustments to be recorded.                                            value is a trigger for impairment testing. For any associate
                                                                       acquired in a public market, cost was presumably market value.
B earns revenue by licensing the patent to other companies in
each major market. Company A, the investor, must perform a fair        The recognition of negative goodwill may trigger an impairment
value exercise, allocate value to the patent and amortise it over      test, and the adjustment may well be written off to the income
the remaining life. The charge reduces the income from the             statement. The recognition of negative goodwill is expected to be
associate and the carrying value of the associate. Therefore, as       rare and any negative goodwill recognised on acquisition of an
the patent expires, the value of the associate will reduce.            associate therefore needs to be robustly supported or the
                                                                       investor is exposed to an immediate impairment as well.
If B winds up operations on expiry of the patent, the value of the
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                                                                                                    CONSOLIDATION PART 3
What does change in proportionate interest mean?                      Reclassification of associate to ‘financial instrument’

An associate issues shares to new investors and the group‘s           IAS 28 says that the carrying amount of an investment when it
interest is diluted, although the entity remains an associate.        stops being an associate is its cost on initial measurement as a
Should the ‗gain or loss‘ arising from dilution be recorded in the    financial asset under IFRS 9.
investing group‘s income statement or directly in equity?
                                                                      IFRS 9 requires such financial assets to be recognised at fair
IAS 28 requires that changes in an investor's proportionate           value. How should these requirements be reconciled when the
interest in an associate that do not arise from the net income of     carrying value of the associate is not equal to its fair value?
the associate should be recognised directly in the equity of the
investor.                                                             Example
                                                                      Entity A held a 30% shareholding in entity B and applied equity
Many have read these words to include gains and losses arising        accounting in accordance with IAS 28. Entity A sold its shares in
on a dilution of the investor's interest in the associate, with any   B, reducing its investment from 30% to 10%.
anti-dilutive transactions also recognized in equity.
                                                                      Entity A lost its significant influence over B as a result of this
However, the examples that follow the proportionate interest
                                                                      transaction. The remaining investment in B will therefore be
guidance do not include dilutions, but are rather example of
                                                                      accounted for as an investment in accordance with IFRS 9.
transactions of the associate that might give rise to equity
movements such as fixed asset revaluations or available for sale
                                                                      The carrying amount of A‘s investment in B immediately before
securities.
                                                                      the transaction was 300. There was also a credit amount of 9
The associate will have debited cash and credited equity in the       included in A‘s equity, representing A‘s share of B‘s increases in
associate‘s financial statements: nothing has occurred in its         equity arising from securities held by B.
income statement. The text in IAS 28 seems to preclude income
statement recognition of gains and losses.                            Entity A received a consideration of 320. The fair value of the
                                                                      remaining 10% investment in B is 160.
However, the lack of dilution in the examples and the fact that
IFRS 10 permits income statement treatment for dilution of            What should entity A recognise in its income statement and in
subsidiaries seems to provide some support for gains and losses       equity?
on associate dilution in the income statement.
                                                                      Solution
However, companies may well be exposed to criticism and               Entity A should recognise a gain on disposal of 129 in the income
                                                                      statement.
regulatory comment if they use income statement recognition.          This gain comprises two components.

                                                                      This first is 120, being the difference between the cash received
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                                                                                                   CONSOLIDATION PART 3
of 320 less
the carrying amount of the proportion sold of 200 (20/30 x 300).       Example: Group structure
                                                                       See the diagrams below.
The second component is the transfer of the credit of 9 from A‘s
equity to the income statement. This is the amount included in
A‘s equity as a result of applying equity accounting to the 30%        Group Structure
interest in B.
                                                                         1.                A
The whole amount is transferred from equity to the income
statement because A no longer has significant influence over B.                    100%         60%
                                                                                    B             C
The remaining 10% investment in B is now classified as an AFS
asset.                                                                                    70%

IAS 28 requires the initial measurement of the AFS asset to be                            20%
the carrying amount immediately prior to losing significant                                D
influence.
                                                                                   60%            25%
The initial measurement of the 10% interest in B is therefore 100
                                                                                           E
(10/30 x 300).

Subsequent measurement of the asset is to fair value, with
changes in fair value recognised directly in profit and loss.

Entity A should therefore recognise a gain of 60 directly in profit
and loss to reflect the revaluation of the remaining 10% interest in
B from its initial measurement of 100 to fair value of 160.


Associates and common control transactions
                                                                       Group Structure
                                                                       2                   A
What is the accounting that is required when a group reorganises       .
and moves its interests in associates around? IAS 28 contains no
specific guidance. It states that the concepts underlying the                      80%            60%
procedures used when an entity acquired a subsidiary are                       B                   C
adopted when an investment in an associate is acquired.                                   20%
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                                                                                                      CONSOLIDATION PART 3

                     90%                                                  Consideration received (fair value of       13
                      D                                                   share of B acquired)                        0
                                                                              Amounts disposed of 20% - (20% x        -35
              85%      E                                                                                90%) x 350
                                                                                        25% - (20% x 85%) x 200       -64
C, which also has some subsidiaries, prepares financial                                                               31
statements under IFRS. It exchanges its interests in its
associates D and E in return for a participating interest in B.          Carrying value of associate investment in B group in C‘s
                                                                         consolidated financial statements:
The transaction has taken place under the control of A. Can C
treat it as if it was a common control business combination? Such         Fair value of 20% of B (includes 30 of     130
combinations are scoped out of IFRS 3 and an entity may choose            notional goodwill)
a policy of using predecessor values.                                     Carrying value of 18% of D                 315
                                                                          Carrying value of 18% of D                 136
If C was able to do this, it would carry its equity investment in B at                                               581
the previous carrying values of its investments in D and E.
                                                                         Solution
C cannot use the common control exemption. This applies to
business combinations only (acquisition of a subsidiary by a             C should recognise a gain or loss to the extent it has disposed of
parent); there is no such                                                part of its interests in D and E. This gain or loss will be based on
exemption in IAS 28.                                                     the consideration received, which is the fair value of the interest
                                                                         received in B.
How should C account for the transaction?                                This means that the equity investment in B will be carried at the
                                                                         fair value of C‘s 20% interest in B, plus the previous carrying
 Entity                        Carrying value  Fair value                values of the retained interests in D and E. C has retained an
                               in C‘s          of 100% of                18% (20% x 90%) interest in D and a
                               consolidated FS business                  17% (20% x 85%) interest in E.
 D                                    350          2.500
 E                                    200          1.000                 There can be no step-up to the fair value of those interests
 B (before transfer)                                650                  because D and E are associates of C before and after the
                                                                         transaction.
The fair value of B‘s net assets before the transaction is 500.
                                                                         EXAMPLE - Accounting for long-term loan to associate
Gain on disposal:

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                                                                                                  CONSOLIDATION PART 3
Entity A has an associate, entity B. Entity A has made a loan to    elimination
entity B. The loan is non-interest bearing and repayable on
demand but entity A does not plan or expect to require              Entity C is a 20% investor in an associate, entity D.
settlement of the loan for the foreseeable future. The loan is      During the year, entity C entered into the following transactions
not collateralised.                                                 with entity D:

Entity A views the loan to the associate as part of its net         - sale of inventory with a cost price of £100 for £200. The stock
investment in the associate in accordance with IAS 28.              has not been sold by entity A at year end; and

How should entity A account for and classify the loan to entity     - providing management services to entity D and invoicing
B?                                                                  £200 for these services.

Entity A should account for the loan in accordance with the         How should entity C account for the revenue arising from the
guidance in IFRS 9, even though it is considered part of the        sale of inventory and management services?
net investment in the associate.
                                                                    Many of the procedures appropriate to the application of the
The loan should be initially recognised at fair value.              equity method are similar to the consolidation procedures.
A loan that is repayable on demand cannot have a fair value
that is less than the amount repayable (IFRS 9).                    Unrealised profits and losses arising from downstream
                                                                    transactions are eliminated to the extent that the investor is
Consequently the loan should be recognised at the amount            transacting with itself. While the inventory remains on the
leant to entity B.                                                  associate‘s balance sheet, the associate will not be recording
                                                                    an expense in its income statement.
Subsequent measurement of the loan should be at amortised
cost, however, the loan will continue to be carried at cost. This   Therefore a consolidation entry, reducing the revenue arising
is because there is no effective interest rate and so no            from the sale of the inventory by £40 (£200 x 20%), is required
amortisation to record under the amortised cost method.             to eliminate the unrealised portion of the gain made in entity C.

The loan may be classified on the balance sheet either as part      The revenue arising from the management services would not
of other receivables, or as part of the investment in associates.   be adjusted, as the management services cost is realised in
The notes to the financial statements should provide an             the associate.
adequate description of the loan balance, so that its nature is
clear to a reader of the financial statements.                      As entity D is equity accounted for, £40 (£200 x 20%) -
                                                                    representing the portion of the cost relating to entity C - will be
                                                                    reflected in the consolidated financial statements of entity C;
EXAMPLE - Associates and extent of inter-group
                                                                    no further elimination entry is therefore required.
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                                                                                                          CONSOLIDATION PART 3
                                                                             accounting to this investment in accordance with IAS 28. During
In the following examples, I/B refers to Income Statement                    the year, entity A sold some of its shares in B, reducing its
and Balance Sheet (SFP).                                                     investment from 30% to 10%.

EXAMPLE 1. - associates                                                      Entity A lost its significant influence over B as a result of this
                                                                             transaction. The
                                                                             remaining investment in B will therefore be accounted for as an
P has an associate A, of which it owns 20%. At the balance                   investment in accordance with IFRS 9.
sheet date A has inventories that it bought from P at a cost
of 100. P made a profit of 25 on the sale.                                   The carrying amount of A‘s investment in B immediately prior to
                                                                             the transaction was 300.There was also a credit amount of 9
As the profit was earned by the parent, the parent’s share of                included in A‘s equity representing A‘s share of B‘s increases in
profit is eliminated.                                                        equity.

                                              I/B      DR          CR        Entity A received cash of 320 in respect of the transaction. The
Revenue (20%*100)                               I           20               fair value of the remaining 10% investment in B is 160.
Cost of sales                                   I                       15
Investment in associate (20%*25)               B                         5   What should entity A recognise in its income statement and in
Reduction of group sales, cost of                                            equity in respect of this transaction?
sales and investment in associate
EXAMPLE 2. - associates                                                      Entity A should recognise a gain on disposal of 129 in the income
P has an associate A, of which it owns 20%. At the balance                   statement. This gain comprises two components. The first is 120,
sheet date P has inventories that it bought from A at a cost                 being the difference between the cash received of 320 and the
of 100. A made a profit of 25 on the sale.                                   carrying amount of the proportion sold of 200 (20/30 x 300).

                                                                             The second component is the transfer of the credit of 9 from A‘s
                                              I/B      DR          CR        equity to the income statement. This is the amount included in
Share of income of associates                   I            5               A‘s equity as a result of applying equity accounting to the 30%
Investment in associate (20%*25)               B                        5    interest in B.
Reduction of group net income, and
investment in associate                                                      The whole amount is transferred from equity to the income
                                                                             statement because A no longer has significant influence over B.
EXAMPLE - Reclassification of associate
                                                                             The remaining 10% investment in B is now classified as a
                                                                             financial asset. IAS 28 requires that the initial measurement of
Entity A held a 30% shareholding in entity B and applied equity
                                                                             the asset is the carrying amount immediately prior to losing
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                                                                                                    CONSOLIDATION PART 3
significant influence.                                                No single venturer alone can control the activity, though one
                                                                      party may be designated as the manager of the activity.
The initial measurement of the 10% interest in B is therefore 100     Unanimous consent on all financial and operating decisions is
(10/30 x 300). Subsequent measurement of the asset is to fair         not necessary for an arrangement to satisfy the definition of a
value with changes in fair value recognised in profit and loss.       joint venture—unanimous consent on only strategic decisions
Entity A should therefore recognise a gain of 60 directly in profit   is
and loss. This reflects the revaluation of the remaining 10%          sufficient.
interest in B from its initial measurement of 100 to fair value of
160.                                                                  Joint ventures have many forms including jointly-controlled:

7.     Cost Method
                                                                            operations
                                                                            assets
 Where the investor has neither control, nor significant                    entities.
influence over the financial and operating decisions of its
investment, income should only be recognised when received            Jointly-controlled operations (example: aircraft
in the form of dividends. This is the cost method.                    manufacture)
                                                                      Here the venturers use there own assets and resources, rather
Dividends, in excess of post acquisition profits, (―liquidating       than forming a separate entity.
dividends‖) should be treated as reductions in the cost of the
investment.                                                           Each venturer bears its own costs and takes a share of the
                                                                      revenue, as determined by the contract.
Losses incurred by the undertaking in which the investment
has been made may create an impairment charge. This would             As the net assets, income and expenses are recognised in the
arise if the fair value of the investment falls below the cost of     accounts of the venturer, no further information is required to
the investment (see IAS 36 workbook).                                 be recorded.
8.     Joint Ventures (see IFRS 11 workbook)                          Jointly-controlled assets (example: oil pipelines)
                                                                      Here the venturers have joint control, and sometimes joint
This text applies IAS 31 that will be valid until 2013.               ownership, of assets provided to the joint venture.

A joint venture is a contractual arrangement, whereby 2, or           Revenues and costs are shared according to the contract.
more, parties undertake an economic activity, which is subject
to joint control.                                                     Each venturer should account for its share in the jointly-
                                                                      controlled assets, any liabilities incurred (including those jointly
These parties are known as the venturers.

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                                                                                                   CONSOLIDATION PART 3
with other venturers), income, gains and expenses of the joint
venture.                                                              The operation includes transporting of the gas, tracking use of
                                                                      the pipeline by customers, invoicing customers, maintenance,
EXAMPLE - Revenue recognition for a pipeline                          etc. The operation of the pipeline is therefore provided using
                                                                      an indeterminate number of acts.
Entity B has won a contract to construct and operate a gas
pipeline. B will construct the pipeline and the associated            The revenue for the operation should therefore be recognised
infrastructure necessary to operate it. It will then operate it for   on a straight-line basis under IAS 18. The revenue recognised
20 years.                                                             under both standards in advance of the cash received gives
                                                                      rise to a financial receivable. IAS 11, IAS 18 and IFRS 9
B will receive fees under the contract over the 20-year period.       require the receivable to be recognised initially at fair value.
It will receive a reimbursement of construction costs over the
five years following construction plus an annual fee over the         Consequently the difference between the gross fees receivable
20-year operating period.                                             under the contract and the present value of the revenue
                                                                      recognised should be recorded as interest income using the
Consequently the profit that B will earn for the construction of      effective interest method as required by IAS 18.
the pipeline is
included within the annual fee it will receive.                       Jointly-controlled entities (example: foreign sales
                                                                      operations)
How should B recognise the revenue it receives for                    Here there is a legal structure to house the joint venture.
constructing and operating the pipeline?
                                                                      Each venturer usually contributes cash or other resources,
The two components of the contract, being the construction of         accounted for as an investment in the jointly-controlled entity.
the pipeline and the operation, should be separated and
accounted for individually. IAS 11, Construction Contracts,           The entity keeps its own accounting records.
should be applied to the construction element and IAS 18,
Revenue, applied to the operating element.                            The venturers should account for their share of the entity
                                                                      through the Equity Method of Accounting (see 5. above). IAS
The present value of the total fees receivable under the              31 currently recommends the use of Proportionate
contract should be allocated to the two components based on           Consolidation as an alternative.
relative fair value.
                                                                      However, the IASB has said that Proportionate Consolidation
The revenue on both components should be recognised on a              will disappear as part of the convergence with USGAAP and
percentage-of-completion basis. The construction component            has issued an exposure draft to that effect. Given its limited
will be recognised on the basis of costs incurred to costs to         future life, it is recommended that Proportionate Consolidation
complete under IAS 11.                                                not be used by practitioners.
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                                                                                                  CONSOLIDATION PART 3
                                                                    the goods received, unless that fair value cannot be estimated
EXAMPLE - Contribution of assets to a joint venture                 reliably.

Entity A and entity B have formed an incorporated joint             IFRS 2 clarifies that there is a rebuttable presumption that the
venture, JV Ltd. JV Ltd prepares its accounts under IFRS.           fair value of the goods received can be estimated reliably.

On formation, entity A contributed property, plant and              In the rare situation where the fair value of the goods cannot
equipment, and entity B contributed intangible assets to the        be reliably measured, an entity should measure their value,
joint venture in exchange for their equity interests.               and the corresponding increase in equity, indirectly, by
                                                                    reference to the fair value of the equity instruments granted.
On formation, how should JV Ltd record the assets
contributed?                                                        As JV Ltd is a newly incorporated company, the fair value of
                                                                    the assets contributed is more determinable than the fair value
JV Ltd should recognise the assets initially at cost in             of the equity instruments granted. JV Ltd should therefore
accordance with the respective standards governing the              measure the assets received and the corresponding increase
assets; in this case, PPE under IAS 16, Property, Plant and         in equity at the fair value of the assets received.
Equipment, and intangible assets under IAS 38, Intangible
Assets.                                                             The previous practice of recording assets at their predecessor
                                                                    carrying values is no longer permissible in the light of IFRS 2.
Cost is defined in the IAS 16 and IAS 38 as ‗the amount of
cash or cash equivalents paid or the fair value of the other        EXAMPLE - Contribution of non-monetary assets to a joint
consideration given to acquire an asset at the time of its          venture in exchange for an equity interest
acquisition or construction or,where applicable, the amount
attributed to that asset when initially recognised, in accordance   Issue
with the specific requirements of other IFRSs, eg, IFRS 2,
Share-based Payment.‘                                               In applying IAS 31 to non-monetary contributions to a jointly
                                                                    controlled entity in exchange for an equity interest in the jointly
The asset contribution by the venturers upon JV Ltd‘s               controlled entity, a venturer shall recognise in profit or loss for
formation is an equity-settled share-based payment transaction      the period the portion of a gain or loss attributable to the equity
within the scope of IFRS 2. The scope exclusion of IFRS 2           interests of other venturers, except when [SIC-13.5]:
does not apply, as the formation of a joint venture does not
meet the definition of a business combination.                      a) the significant risks and rewards of ownership of the
                                                                    contributed non-monetary assets have not been transferred to
For equity-settled share-based payment transactions, IFRS 2         the joint venture;
requires an entity to measure the goods received, and the
corresponding increase in equity, directly, at the fair value of    b) the gain or loss on the non-monetary contribution cannot be
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                                                                                                 CONSOLIDATION PART 3
measured reliably; or                                              contributed by the other venturer (entity B contributed shares).

c) the non-monetary assets contributed are similar to those        50% of fair value of the shares of C received         200
contributed by the other venturers.                                less: 50% of book value of entity A‘s assets contributed
                                                                          (50)
How should management recognise the gain that results from                                                                150
the transfer of non-monetary assets in exchange for an equity
interest in a joint venture?                                       The entries recorded in it‘s A's single-entity financial
                                                                   statements are as follows:
Background                                                         Dr    Investment                    400
Entity D, a joint venture, was established by two venturers as     Cr    Non-monetary assets                           100
follows:                                                           Dr    Gain on disposal                        300

a) entity A contributes its non-monetary assets. The fair value    Entity A recognises the following further entry in its
of the assets contributed is 400, and their book value is 100.     consolidated financial statements, to eliminate the portion of
                                                                   the gain that relates to the share of the non-monetary assets
b) entity B contributes 50% of its shares in one of its            that it still owns and jointly controls:
subsidiaries, entity C. The fair value of 50% of the shares in     Dr      Gain                        150
entity C is 400 and the book value is 76.                          Cr      Investment                          150

Entity A and entity B each own 50% of entity D and exercise        EXAMPLE - Joint venture with a non-coterminous year-
joint control.                                                     end

Solution                                                           Investor F has an overseas joint venture (JV). F prepares
Entity A should recognise a gain of 150 for the following          financial statements to the year ending 30 April and the JV
reasons:                                                           prepares financial statements to the year ending 31 December.

a) the significant risks and rewards of ownership of the           Can investor F use the JV.s December financial statements in
contributed non-monetary assets have been transferred to           preparing its own financial statements in April?
entity D;
                                                                   IAS 31 does not specifically deal with the treatment of non-
b) the gain on the non-monetary contribution can be measured       coterminous yearends. However, IAS 28 is explicit. IAS 28
reliably. Information on both book values and fair values are      requires the use of financial statements drawn up to the same
available; and                                                     date as the investor unless it is impractical to do so.

c) the non-monetary assets contributed are not similar to those    In particular IAS 28 prohibits a difference of more than three
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                                                                                                 CONSOLIDATION PART 3
months between the year-end of the investor and of the
associate.                                                         The sponsor frequently transfers assets to the SPE, obtains
                                                                   the right to use assets held by the SPE or performs services
Therefore, investor F should request the JV to prepare special-    for the SPE, while other parties (‗capital providers‘) may
purpose financial statements drawn up to the year ending 30        provide the funding to the SPE.
April.
                                                                   An entity that engages in transactions with an SPE may in
                                                                   practice control the SPE.
9 Special Purpose Entities / Special Purpose Vehicles (see
IFRS 10+12 workbooks)                                              A beneficial interest in an SPE may, for example, take the form
                                                                   of a debt instrument, an equity instrument, a participation right,
Special Purpose Entities - SPE‘s (also called Special              a residual interest or a lease.
Purpose Vehicles - SPV‘s) are formed to house assets and/or
liabilities that groups wish to eliminate from their balance       Some beneficial interests may simply provide the holder with a
sheets. These may be assets such as loans which are being          fixed or stated rate of return, while others give the holder rights
securitised – the bank wants to raise money on the loans           or access to other future benefits of the SPE‘s activities.
without losing the relationship with the clients.
                                                                   In most cases, the creator or sponsor retains a significant
In the USA, Enron (which subsequently collapsed) used SPE‘s        beneficial interest in the SPE‘s activities, even though it may
to hide large amounts of group loans and to manipulate profits.    own little or none of the SPE‘s equity.

SPE‘s may be set up in tax havens for insurance and leasing        The following circumstances may indicate a relationship in
operations to charge group profits for policies and leases,        which an entity controls an SPE and consequently should
whilst minimising tax.                                             consolidate the SPE:

Such a SPE may take the form of a corporation, trust,                   (i)    the activities of the SPE are being conducted on
partnership or unincorporated entity. SPEs often are created                   behalf of the entity according to its specific business
with legal arrangements that impose strict and sometimes                       needs so that the entity obtains benefits from the
permanent limits on the decision-making powers of their                        SPE‘s operation;
governing board, trustee or management over the operations
of the SPE.                                                             (ii)   the entity has the decision-making powers to obtain
                                                                               the majority of the benefits of the activities of the
Frequently, these provisions specify that the policy guiding the               SPE or, by setting up an ‗autopilot‘ mechanism, the
ongoing activities of the SPE cannot be modified, other than                   entity has delegated these decision-making powers;
perhaps by its creator or sponsor (they operate on so-called
‗autopilot‘).
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      (iii)   the entity has rights to obtain the majority of the    Indicators of control over an SPE
              benefits of the SPE and therefore may be exposed
              to risks incident to the activities of the SPE; or     (a)    Activities

      (iv) the entity retains the majority of the residual or        The activities of the SPE, in substance, are being conducted
           ownership risks related to the SPE or its assets in       on behalf of the reporting entity, which directly or indirectly
           order to obtain benefits from its activities.             created the SPE according to its specific business needs.

                                                                     Examples are:
In general, an SPE is an extension of the group and its
functional currency (see IAS 21 workbook) will be the same of              the SPE is principally engaged in providing a source of
that of its parent.                                                        long-term capital to an entity or funding to support an
                                                                           entity‘s ongoing major or central operations; or
The question for consolidation is whether the group controls
the SPE or not. If so, it must consolidate it. (If not, not.) IFRS         the SPE provides a supply of goods or services that is
10 governs this.                                                           consistent with an entity‘s ongoing major or central
                                                                           operations which, without the existence of the SPE, would
Control over another entity requires having the ability to direct          have to be provided by the entity itself.
or dominate its decision-making, regardless of whether this
power is actually exercised.                                         Economic dependence of an entity on the reporting entity
                                                                     (such as relations of suppliers to a significant customer) does
Control may exist even in cases where an entity owns little or       not, by itself, lead to control.
none of the SPE‘s equity.
                                                                     (b)    Decision-making
The question of control may be obscured by setting up the
SPE to work on pre-determined instructions, after which the          The reporting entity, in substance, has the decision-making
group can suggest that it has no control of the SPE, as the          powers to control or to obtain control of the SPE or its assets,
SPE is working on autopilot.                                         including certain decision-making powers coming into
                                                                     existence after the formation of the SPE. Such decision-
It is then a test of whether the group has the risks and rewards     making powers may have been delegated by establishing an
of the SPE. If so, it must consolidate it.                           ‗autopilot‘ mechanism.

                                                                     Examples are:

                                                                           power to unilaterally dissolve an SPE;

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      power to change the SPE‘s charter or bylaws; or                 ownership risks and the investors are, in substance, only
                                                                      lenders because their exposure to gains and losses is limited.
      power to veto proposed changes of the SPE‘s charter or
      bylaws.                                                         Examples are:

(c)     Benefits                                                         the capital providers do not have a significant interest in the
                                                                         underlying net assets of the SPE;
The reporting entity, in substance, has rights to obtain a               the capital providers do not have rights to the future
majority of the benefits of the SPE‘s activities through a               economic benefits of the SPE;
statute, contract, agreement, or trust deed, or any other                the capital providers are not substantively exposed to the
scheme, arrangement or device.                                           inherent risks of the underlying net assets or operations of
                                                                         the SPE; or
Such rights to benefits in the SPE may be indicators of control
when they are specified in favour of an entity that is engaged        in substance, the capital providers receive mainly
in transactions with an SPE and that entity stands to gain            consideration equivalent to a lender‘s return through a debt or
those benefits from the financial performance of the SPE.             equity interest.

Examples are:

      rights to a majority of any economic benefits distributed by    Implications for special purpose entities (SPEs) - PwC
      an entity in the form of future net cash flows, earnings, net   Inform Jan 2006
      assets, or other economic benefits; or
                                                                      So when would this result in an SPE being classed as a
      rights to majority residual interests in scheduled residual     subsidiary? Take the following example, where a parent
      distributions or in a liquidation of the SPE.                   gained the majority of the benefits arising from an SPE and its
                                                                      operating and financial policies were predetermined.
(d)     Risks
                                                                      Under IFRS10, such an SPE would be treated as a full
An indication of control may be obtained by evaluating the            subsidiary. .
risks of each party engaging in transactions with an SPE.
Frequently, the reporting entity guarantees a return, or credit       Who’s in control?
protection directly or indirectly, through the SPE to outside
investors who provide substantially all of the capital to the         The definition of a parent may give rise to an anomaly in that in
SPE.                                                                  certain situations it may seem that there are two parents. For
                                                                      example, one company may appear to be exercising dominant
As a result of the guarantee, the entity retains residual or          influence, yet another may have the power to do so.
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                                                                   the power to exercise the call options and reverse the decision.
This situation is likely to arise when the shareholder with the
power to exercise
dominant influence chooses to be passive and does not              EXAMPLE - Loans to customers
prevent the other shareholder from actually exercising
dominant influence.                                                Entity A is a parent company that prepares consolidated
                                                                   financial statements. Some of A‘s subsidiaries are in the
Where more than one undertaking appears to be the parent,          business of providing loans to customers.
only one can have control. Control is defined as the ability to
direct the financial and operating policies of another with a      These loans are sold to trusts set up as special purpose
view to gaining economic benefits from its activities.             entities (SPEs) under a securitisation arrangement to achieve
                                                                   lower financing costs.
The shareholder with the power to exercise dominant influence
has control under the revised definitions despite choosing to      Entity A holds a beneficial residual interest in the SPE trusts
be passive.                                                        and consolidates the SPEs under IFRS 10, in its consolidated
                                                                   financial statements.
Practical example
                                                                   A is preparing its separate financial statements in accordance
An example of the ability to exercise control would be call        with IAS 27, Separate Financial Statements,and would like to
options that give a shareholder the power to exercise dominant     account for its investments in its subsidiaries at fair value in
influence. For example, say company A owns five per cent of        accordance with IFRS 9.
company B, but in addition has call options exercisable at any
time that would give it all the voting rights in company B.        Should entity A‘s beneficial interest in its SPEs be accounted
                                                                   for in the same way as its conventional subsidiaries in its
Although company A's management does not intend to                 separate financial statements?
exercise the call options, the existence of the options and
company A's ability to exercise them at any time to gain control   Yes. The SPEs that qualify for consolidation in consolidated
of company B gives company A the power to exercise                 financial statements are subsidiaries in the context of IAS
dominant influence.                                                27.Consequently if A elects to account for its subsidiaries in
                                                                   accordance with IFRS 9 in its separate financial statements,
The presence of the options means that the operating and           this election applies equally to its SPEs.
financial policies are set in accordance with company A's
wishes and for its benefit as the other shareholders of            Entity A may choose to account for its subsidiaries including its
company B are mindful of the options in voting on operating        interest in its SPEs as financial assets, provided it meets the
and financial policies, as should company B make a decision        conditions in IFRS 9 for that classification.
not in accordance with company A's wishes, company A has
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Entity A should apply its accounting policy choice consistently           equity or financial entities; and
to all of its subsidiaries including SPEs.                               Entities in the developmental stage.

                                                                   Vendor financing
Examples of transactions, relationships and structures                Structures designed to help customers finance the
that may be impacted by SIC-12 (now in IFRS 10)                         purchase of products and services (ie, vendor
                                                                        financing), often in collaboration with a financial
Leasing/property                                                        institution.
    Sale-leasebacks of property or equipment;
    Built-to-suit property or equipment subject to an             Insurance
      operating lease (for example, office buildings,                  Insurance associations (reciprocals); and
      manufacturing plants, aeroplanes);                               Reinsurance securitisations.
    Synthetic leases (lease structures that are treated as
      operating leases for accounting purposes, even though        Transactions involving management, officers and
      the lessee is considered the owner for tax purposes);        employees
      and                                                              The transfer or sale of assets to an entity owned by a
    Certain partnerships in property investments.                      single employee or by members of an entity‘s
                                                                        management;
Financial assets                                                       Management of an unconsolidated asset or business by
    Transactions involving the sale/transfer of financial              an entity or its officers; and
      assets such as receivables to an SPE (for example,               The funding of an entity‘s independent equity by another
      factoring arrangements or securitisations);                       entity‘s managing members.
    Transactions involving a commercial paper conduit,
      such as sponsoring a conduit to purchase and securitise      Obligations associated with other entities
      assets from third parties;                                      Certain captive arrangements operated on behalf of an
    Securitisation transactions involving commercial-debt               investor;
      obligations, collateralized bond obligations and                An entity‘s guarantee of:
      commercial-loan obligations; and                                      (i) an unconsolidated entity‘s performance or debt, or
    Entities used to hedge off-balance sheet positions.                    (ii) the value of an asset held by the unconsolidated
                                                                            entity (including explicit and implicit guarantees);
Start-ups, research and development                                   An entity‘s contingent liability should an unconsolidated
    Funding arrangements for research and development;                  entity default;
    Newly formed entities that are designed to manage or             A transaction with an embedded ‗put‘ option that
       fund the start-up of a new product or business;                   enables the entity or an outside party to sell the assets
    Entities sponsored/funded by venture capital, private               and/or operations back to an entity;
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                                                                                               CONSOLIDATION PART 3
      A transaction with an embedded call option and/or                 Investments made through intermediaries in entities that
       operations that were previously sold to another entity;            generate losses from a financial reporting perspective;
      An entity‘s enhancement of another entity‘s credit (for           Tolling arrangements with project finance companies;
       example, via escrow funds, collateral agreements,                 Transactions in which an entity‘s primary counterparties
       discounts on transferred assets and take-or-pay                    are financial institutions (for example, banks, private
       arrangements); and                                                 equity funds and insurance companies);
      An agreement requiring an enterprise to make a                    Arrangements with an entity whose capital structure
       payment if its credit is downgraded.                               (often the equity) is partially owned (or provided) by a
                                                                         charitable trust;
Rights to assets                                                         An unconsolidated entity whose name is included in the
    Rights to use an ‗under construction‘ asset not recorded             entity‘s name;
      in the entity‘s balance sheet (the debt used to fund the           When an entity provides administrative or other services
      construction being recourse only to that specific asset);           on behalf of an unconsolidated entity or services its
    Leasing assets from an entity that financed these assets             assets; and
      with debt that is recourse to the individual asset rather          When an unconsolidated entity provides financing or
      than to all of the lessor entity‘s assets;                          other services exclusively to an entity, its vendors or
    The transfer of financial assets to an entity subject to             customers.
      debt that is recourse only to those financial assets
      rather than to all of the entity‘s assets;                   Source ;SIC-12 and FIN 46R -The substance of control
    Variable lease payments, variable license-fee payments        (PwC)
      or other variable payments for the right to use an asset
      (for example, the payments change with fluctuations in       10. Outsourcing contracts: an accidental business
      market interest rates); and                                  combination?
    Ownership of an asset that an entity holds for tax            IFRS News - March 2006
      purposes but does not record on its balance sheet.
                                                                   Outsourcing contracts are common. Many companies use
Other                                                              outsourcing contracts to reduce costs, increase efficiency and
    Outsourcing arrangement – particularly when an entity‘s       focus on the core business. There are many different types of
      own employees/assets are sold prior to any entity and        outsourcing arrangements, and the financial reporting of them
      will continue to provide services to the seller;             can be complex.
    Sale of assets or operations where the seller retains
      some governance rights and/or an economic interest;          The expected outcome is generally that the outsourcing
    The purchase of businesses or assets by a third party or      arrangement will be treated as a service arrangement, but an
      a newly formed entity on behalf of another company (ie,      outsourcing contract may be classified as a business
      an off-balance-sheet acquisition vehicle);                   combination, lease or service concession.

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                                                                                                 CONSOLIDATION PART 3
Whether it is a business combination, a lease, a construction       Some factors such as a limited contract life can refute the
contract or a service arrangement will depend on the contract       business combination conclusion. The transaction will give rise
with the customer; but the assessment requires management‘s         to a business combination if full control is transferred to the
judgment.                                                           outsourcer for the expected useful life of the assets.

Companies may outsource any or all functions they consider          A business combination is more likely where the ‗outsourcee‘
can be done more efficiently by a third party. This can be a        is assembling similar contracts to extract synergies and asset
function as peripheral as catering for a large head office, or IT   efficiency. A business combination results in the outsourcer
management for a law firm.                                          recording assets and liabilities at fair value and goodwill.

Other less obvious outsourcing contracts might be private           Accidental business combinations are seldom welcomed by
finance initiatives, contract drug manufacturing, prison            senior management or the investor community. It is difficult to
management and waste management services.                           assess whether or not a contract results in a business
                                                                    combination, particularly when existing customer processes
Financial reporting of these contracts raises several questions:    are combined with the existing processes of the outsourcer.
is there a business combination? How should upfront
payments by the outsourcer be treated? How should revenue           The outsourcer should therefore carefully assess agreements
and costs be recognised?                                            as they are being structured to avoid unintended financial
                                                                    reporting effects.
What are the potential implications of IFRIC 4? IFRIC debated
some of these questions as part of the Service Concession           Build and run components
Arrangements exposure draft; however, none have been
definitively answered, and the completion of an interpretation is   A contract may require the outsourcer to build a platform to
not expected soon.                                                  deliver the service (for example, an IT platform, plant or large
                                                                    equipment). This is often referred to as the ‗build‘ phase of the
Have you acquired a business?                                       contract, to be followed by the ‗run‘ phase.

The first step in analysing an outsourcing transaction is to        Management should assess whether the build and run phases
determine whether a business combination has taken place. A         should be accounted for separately. Factors to consider are
large outsourcing contract usually includes some of a               whether the asset and the service are to be delivered
company‘s significant processes.                                    separately, the customer can use the asset separately from the
                                                                    service and whether a reliable measure of revenue for the
The company transfers assets, staff and processes to the            asset and the service can be obtained.
outsourcer. These three in combination should be able to
provide output on their own, which is a business as defined by      The build element, when separable, is generally recognised in
IFRS 3.                                                             accordance with IAS 11, Construction Contracts, as the item is

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                                                                                                  CONSOLIDATION PART 3
being built to the specifications of the customer as a result of a   contract because of the necessary start-up activities are often
negotiated contract.                                                 front-loaded.

The run element is generally recognised as a service contract        Outsourcing is a developing industry, with an increasing
in accordance with IAS 18, Revenue.                                  number of processes being transferred to outsourcers and
                                                                     requiring start-up activities with significant front-loaded
Run revenues and costs                                               expenses. New contracts may be signed at the same time as
                                                                     the outsourcer is adapting its structure to offer new services.
Activities to be delivered under a run component of a bundled
outsourcing contract are usually services, either discrete or        The outsourcer should determine which of these up-front
continuous. Revenue should be recorded on a percentage-of-           expenses relate to the implementation of a specific contract, as
completion basis.                                                    opposed to costs incurred at its discretion to modify or
                                                                     transform its own business. This may depend on the maturity
However, the measurement of completion, given the nature of          of the outsourcer‘s business.
the services delivered, is usually based on ‗output‘ indicators
(volumes of transactions, survey of interventions and similar        Some historical outsourcers are developing their structures to
measures).                                                           face this demand; other corporations are setting up new
                                                                     outsourcing businesses, often starting with their existing IT
Measures of completion based on input measures such as               functions, while many existing IT companies are expanding
costs (cost-to-cost method) is not appropriate for such              into outsourcing.
contracts, as it is unlikely that cost incurred represents the
progress of the service to date.                                     For expenses that relate to the services to be delivered, work
                                                                     in progress is recognised if the costs are recoverable. There
Revenue is generally recorded on a straight-line basis if            will also be numerous other costs (employee restructuring,
services to be delivered are performed by an ‗indeterminate          transfer to a new location, development of new processes) that
number of acts‘.                                                     are normal operating costs of the business that should be
                                                                     expensed as incurred or that may give rise to intangible or
Certain contracts include the payment of an upfront amount by        tangible fixed assets.
the outsourcer to the customer. When services received for
such a payment are not identifiable, the payment usually             Implications of IFRIC 4
represents the granting of a discount. This is recognised as a
reduction of revenue over the service period of the contract.        IFRIC 4, Determining whether an Arrangement contains a
                                                                     Lease, is effective from 1 January 2006. Most outsourcing
Recognition of costs may be even more challenging than               contracts include assets; these outsourcers will need to
recognition of revenue. Contract revenue and expenses ‗are           determine whether their outsourcing contracts include a lease.
recognised respectively by reference to the stage of
completion of the contract activity‘. Expenses in an outsourcing
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                                                                                                  CONSOLIDATION PART 3
The challenge is to assess whether specific assets exist in the      Carve-out financial statements are the separate financial
arrangement. This determination should be made on an asset-          statements of a division or lesser business component(s) of a
by-asset analysis. This includes obtaining a precise                 consolidated or larger entity.
understanding of the use of the asset: is the service based on
that specific asset, or could it be delivered, in accordance with    The term used varies by country and regulator. For example,
the terms of the contract by other means?                            the UK commonly refers to ‗combined‘ financial statements
                                                                     and the US refers to ‗carve-out‘ financial statements.
For example, a catering outsourcer may provide meals for a
customer from its central facilities, which are also used for        When can carve-out/combined financial statements be
other customers; conversely, it may use a dedicated facility         prepared?
constructed solely for the purpose of that customer‘s contract.
If the asset is used solely for the company, it would be a lease     Preparation of carve-out/combined financial statements is
of the specific asset by the customer.                               seldom straightforward. Common issues include:

The asset is not deemed specific to the customer if the              • whether carve-out/combined financial statements can be
outsourcer uses the asset for a number of customers, and no          presented;
lease would exist.
                                                                     • determining what the reporting entity is;
11. Carve-out / combined financial statements
                                                                     • how to measure assets and liabilities; and
IFRS News - March 2008
                                                                     • how to allocate different types of costs, income, taxes etc.
IFRSs provide very limited guidance on the preparation of
carve-out/combined financial statements. The answers to the          Participants agreed that carve-out/combined financial
questions may be different in different countries. Consultation      information should be prepared only when all of the entities
with the relevant experts and lawyers is crucial.                    concerned have been under common control during the track
                                                                     record period and form a ‗reporting entity‘.
What are ‘carve-out’ and ‘combined’ financial statements?
                                                                      ―Carve-out/combined financial statements are usually
The terms ‗carve-out‘ and ‘combined‘ financial statements            prepared in contemplation of a capital market transaction and
have a similar meaning. Combined financial statements are the        might be required by the local regulator.‖ David Smailes
aggregate of the financial statements of segments, separate
entities or groups, which fail to meet the definition of a ‗group‘
                                                                     What are the regulatory requirements and market practice
under IFRS10.
                                                                     regarding the preparation of carve-out/combined financial
                                                                     statements?

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                                                                                               CONSOLIDATION PART 3
Most territories have no specific regulatory requirements for      Making the distinction is important because an audit opinion
the preparation of combined financial statements. The most         cannot be issued for pro forma financial statements.
detailed and structured guidance available is that issued by the
SEC with respect to US GAAP, and the UK Annexure to the            The same principle is applied consistently in all respondents‘
Standard for Investment Reporting (SIR) 2000 for the               territories:
presentation of financial information in an investment circular.
                                                                   • carve-out/combined financial statements present historical
Many territories find this guidance useful. However, since most    financial information prepared by aggregating the financial
carve-out or combined financial information is prepared with a     information of entities under common management and
view to a capital market transaction, experts recommend            control, which did not form a legal group.
entities clear potential issues with the local regulator in
advance, as different regulators may take different views.         • Pro forma financial statements present hypothetical financial
                                                                   information created to present an illustration of how a capital
―The general principles governing preparation of carve-out         market transaction might have affected an ―issuer‖ of
financial statements have been developed over the last two         securities, had a specific transaction or series of
decades and captured through SEC speeches, comment                 transactions been undertaken at the commencement of the
letters and past examples of carve-out financial statements.‖      period being presented, or at the balance sheet date
Neil Dhar                                                          presented.

Conscious about the need to define a framework which               The meaning and interpretation of the term ‗pro forma‘ might
provides guidance to EU preparers, the European Commission         differ from territory to territory, and there might be some
is currently working on a project to issue the equivalent of       differences in the preparation of pro forma financial
SIRs. The first part of the project looks at pro formas.           statements.

―Under French GAAP, aggregating financial statements of            ―In some territories carve-out/combined financial statements
separate legal structures is allowed in certain circumstances.     have been referred to as ‗pro forma‘ and presented as audited
                                                                   historical financial information.
This practice has evolved while transitioning to IFRS to a
model which looks beyond the legal structures and considers        This use of the same term for dissimilar financial information
the business of the reporting entity.‖ Thierry Charron             should not be confused with the concept of illustrative pro
                                                                   forma financial information on which a compilation opinion
What is the difference between carve-out/combined                  rather than an audit opinion is given, as contemplated by the
financial statements and pro forma financial statements?           European Prospectus Regulation and associated guidance.‖
                                                                   David Smailes


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                                                                                               CONSOLIDATION PART 3
―Germany has issued a standard governing the preparation of        All the owner‘s assets and liabilities managed in this way
pro forma financial information (as has the SEC in its             should be included.
Regulation S-X). In all cases, there should be some basis or
framework to support the compilation of pro forma financial        ―A material level of transactions between the businesses or
information.‖ Nadja Picard                                         with common customers/suppliers would make it more difficult
                                                                   to present meaningful carve-out/combined financial statements
What is a ‘reporting entity’, and what are the general             for one of the businesses.‖ David Smailes
indicators that a reporting entity exists for which IFRS
financial statements can be prepared?                              ‗Managed together‘ is not usually interpreted as meaning that a
                                                                   group with two business segments can
The IFRS Framework defines reporting entity as ―an entity for      not present carve-out/ combined financial statements for one
which there are users who rely on the financial statements as      of the two segments.
their major source of financial information about the entity‖.
                                                                   However, presentation of carve-out/combined financial
Capital market specialists look at all the facts to assess         statements would require further analysis of the relationships
whether a reporting entity exists. These include:                  between the two segments to determine whether the business
                                                                   segments are related or interdependent, or if there are any
• Whether the assets and liabilities included in the carve-out     material inter-business relationships.
are legally bound together through:
                                                                   Example
– a legal reorganisation of a group/groups that has occurred       An acquisition company, Newco, has been created. The
after the reporting date, but prior to the publication of the      directors of Newco prepare an IPO prospectus which includes
financial statements;                                              a commitment to use the proceeds of the IPO to acquire a
                                                                   segment of an existing third party company, Opbus.
– a reorganisation that will happen simultaneously with a
proposed IPO, disposal or similar transaction; or                  Opbus did not previously report separate financial information
                                                                   and is a mix of legal entities and divisions.
– an agreement that was signed and in place throughout the
historical financial period. The written agreement cannot be put   The issuer is Newco. The prospectus must include an audited
in place retrospectively; or                                       track record for the business of Newco but this is not
                                                                   represented by Newco‘s legal financial information.
• Whether the assets and liabilities are all owned by the same
party, and whether there is evidence that they have been           Typically the prospectus would therefore include:
managed together as a single economic entity during the track
record period?                                                     • Carve-out/combined historical financial information on Opbus;
                                                                   and
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                                                                                                 CONSOLIDATION PART 3
                                                                   – Will the assets and liabilities be transferred to the carved-out
• Pro forma information for the enlarged Newco group,              group?
illustrating how Newco‘s financial information would have
looked if Newco had already acquired Opbus.                        – Was there any intra group recharge between the parent and
                                                                   the carved-out group, eg legal, accounting, finance expenses?
Example                                                            and

When one entity, which is managed together with others as          – Have the recharges been made on an arm‘s length basis?‖
part of the same business segment, will not be subject to the      Gabriele Matrone
legal reorganisation, should the entity be included in the
reporting entity?                                                  Allocations can only be made to the extent of the costs actually
                                                                   incurred by the larger group. That is, no allocation can be
It is important not to present misleading information: A high      made on a ―what if‖ basis.
level of transactions between the business excluded and the
carve-out group could lead to misleading carve-out financial       For example, allocation would not be made on the basis of
statements.                                                        estimating what the expenses of the carved-out business
                                                                   would have been if it had had its own legal department. Such
For example if the excluded business was a loss-making entity      an approach would be more akin to proforma financial
as a result of transactions with the carve-out group which were    information.
not performed at arm‘s length.
                                                                   Quality of the information is a pre-requisite for the allocations.
                                                                   These must be performed to a standard that allows
This is a complex issue when regulatory approval is sought. It
                                                                   presentation within IFRS financial statements and, in most
requires judgement and should be addressed upfront when
                                                                   cases must be auditable.
planning for carve-out/combined financial statements. Neil
Dhar
                                                                   If quality information does not exist, a preparer should provide
                                                                   sufficient disclosure in the notes to enable readers of the
What are the allocation principles for assets, liabilities,
                                                                   carve-out/combined financial statements to understand how
income and expenses?
                                                                   the future financial position, performance and cash flows of a
The most common areas where allocations have to be made
                                                                   stand-alone business may differ.
are headquarters costs, income taxes, debt and interests.
Each situation is unique and requires consideration based on
                                                                   Whichever method is used to allocate assets, liabilities, income
the facts available.
                                                                   and expenses, clear and meaningful explanations in the notes
                                                                   are essential for a good understanding of the financial
―Factors usually considered when doing the allocation include:     statements.

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                                                                                               CONSOLIDATION PART 3
The UK and SEC material referred to above provides useful
guidance in respect of allocation.

Kennedy Liu shares some recent comments from the Hong
Kong Stock Exchange
―Please disclose the basis of allocation in the basis of
preparation‖                                                       Tax position                   Treatment of tax
                                                                   The entities that comprise the Tax expenses, assets and
―Has management disclosed its judgement that the carveout is       carved-out business filed      liabilities are accounted for in
appropriate in the critical accounting policies?‖                  separate tax returns           accordance with the tax
                                                                                                  returns.
―Has management disclosed details of the carve-out business        The entities that comprise the a) Separate tax return
in the basis of preparation?‖                                      carved-out business were part approach:
                                                                   of a consolidated tax group.   under this method, income tax
―Advise and disclose the basis on how ―common control‖ is                                         is
established.‖                                                                                     recalculated and accounted
                                                                                                  for
―Is it appropriate to use the carve-out approach, or the                                          as if the entity had always filed
discontinued operation approach in preparing the financial                                        tax returns separately.
statements?‖                                                                                      Particular
                                                                                                  attention should be paid to tax
―Does the carve-out satisfy the criteria under UK Standard for                                    losses when the tax asset has
Investment Reporting 2000?‖                                                                       already been used by another
                                                                                                  entity in the group that is not
―Do the carve-out financial statements comply with                                                part of the carved-out
HKFRS/IFRS?‖                                                                                      business.
                                                                                                  Or
How are income taxes dealt with?                                                                  b) Actual tax incurred: this
Respondents identified the following examples:                                                    method would be possible if
                                                                                                  the parent recharged taxes to
                                                                                                  the entities that comprise the
                                                                                                  carve-out/combined business.

                                                                   How should debt and interest expense be allocated?
                                                                   Respondents agreed that intercompany debt between the
                                                                   carved-out business and the parent should be reinstated in the
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                                                                                                  CONSOLIDATION PART 3
carve-out/combined financial statements, along with the             satisfactorily audited.
associated interest expense incurred.
                                                                    An audit opinion might refer to ―true and fair‖ or ―fair
Example                                                             presentation
Financing of 100 was provided in the past. 150 of group debt        in accordance with IFRS‖. However, in certain circumstances,
will be allocated in the restructuring:                             it
100 should be allocated to the carved-out business as it            might be more appropriate to refer to the basis of preparation.
reflects the amount attributable to the carved-out business.        The greater the number of adjustments and allocations that
                                                                    have
However, in certain circumstances, it might also be acceptable      to be made to achieve a carve-out/combined presentation, the
to allocate 150, rolled back to the balance sheet of the earliest   less likely it is that an IFRS opinion can be issued.
year presented along with the related interest expense, as long
as the additional 50 does not represent a pro forma type            ‖Referring to the basis of preparation is widely accepted in the
adjustment.                                                         UK for an opinion given on historical financial information
                                                                    presented in an investment circular under SIR 2000.‖ David
An analysis of the final capital structure (pre transaction)        Smailes
should also be performed.
                                                                    An ‗emphasis of matter‘ paragraph is also commonly used in
―A practical difficulty, arising when interest free loans were      the auditors‘ opinion. This explains that the carved-out
granted by the parent to the entities that comprise the carved-     business
out                                                                 has not operated as a separate entity, and that the financial
business, is that the allocation of the actual interest expense     statements are not necessarily indicative of results that would
requires an analysis of the capital and debt structure of the       have occurred if the business had been a separate stand-
wider group. For example, if the interest free loans were           alone
backed                                                              entity during the period presented, nor is it indicative of future
by interest-bearing loans that are external to the group, the       results of the business.
interest paid on these loans could be used.‖
Gabriele Matrone                                                    ―It is common practice in Hong Kong to issue an unqualified
                                                                    audit opinion without an ‗emphasis of matter‘ paragraph. Even
How much assurance can auditors give on carveout/                   so, it would usually be appropriate to include such disclosures
combined financial statements?                                      in
There is accepted practice of giving some kind of assurance         the notes to the carve-out/combined financial statements.‖
on                                                                  Kenny Liu
carve-out/combined financial statements when the financial
statements are those of a reporting entity and can be

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                                                                                               CONSOLIDATION PART 3
What are the practical challenges faced in the preparation            2) Creating liabilities for future losses.
of carve-out/combined financial statements?                           3) Including fair values and historic cost in the same
                                                                         balance sheet.
The practical challenges vary depending on circumstances.
Respondents highlighted three key areas:                           2. If fair values differ from historic cost, minority interests
1. The structure of the carved-out business:                       will:
Financial statements are easier to prepare when they are an
aggregation of separate legal entities each of which has their        1) Benefit from any increase in valuations.
own stand-alone financial statements. Preparation of                  2) Not benefit from any increase in valuations.
financial statements is more complex when it entails carving          3) Be ignored.
out portions of legal entities.

2. The interactions between the carve-out/combined business
and the rest of the group:                                         3. In a sale of a subsidiary, deferred payments:
The extent of those interactions determines the complexity
of identifying and reinstating inter-company transactions and         1) Are prohibited.
allocating income, expenses, assets and liabilities.                  2) May be discounted to present value.
                                                                      3) Should be excluded from financial statements.
3. The quality of the accounting records, internal controls,
processes and systems:                                             4. On a sale of a subsidiary, remaining goodwill:
The financial statements must be prepared reliably and must
be auditable.                                                         1)   Should be transferred to the Parent‘s balance sheet.
                                                                      2)   Should be amortised over 5 years.
―One practical difficulty we face is segregating working capital      3)   Should be written off in full against group reserves.
balances, such as accounts receivable, accounts payable and           4)   Should remain unchanged in the consolidated balance
inventory.‖ Neil Dhar                                                      sheet.

12.      Multiple Choice Questions
                                                                   5. Loss of control of a subsidiary:
Choose the answer that is closest to what you feel best               1) Should be treated as a disposal.
answers the question:                                                 2) Should be treated as a disposal, but neither gain, nor
                                                                         loss should be recognised.
1. IFRS 3 Business Combinations forbids:                              3) Should be re-valued every year, using an inflation index.

      1) Using fair values.                                        6. The equity method of accounting values the investment:
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                                                                                                    CONSOLIDATION PART 3
                                                                         1)   All assets are pooled.
   1) By measuring the dividend stream, discounted to                    2)   Venturers use their own assets and resources.
      present value.                                                     3)   All assets must be leased.
   2) At cost, plus for the investor‘s share of post-acquisition         4)   Separate accounts are mandatory.
      profits.
   3) At fair value, less cost of disposal.

7. In the equity method of accounting, Goodwill:

   1) Must be shown separately from goodwill derived from          11. In jointly-controlled assets:
      subsidiaries.
   2) Is not calculated.                                                 1) Revenues and costs are shared according to the
   3) Should be amortised over no more than 20 years.                       contract.
                                                                         2) Venturers use their own assets and resources.
                                                                         3) All assets must be leased.
8. An associate is an undertaking in which the investor
                                                                         4) All profits must be shared equally.
has:

   1) Control that is only temporary.                              12. In jointly-controlled entities:
   2) Significant influence, and which is neither a subsidiary,
      nor a joint venture.                                               1)   All assets must be leased.
   3) Control of financial decisions, but not operating                  2)   All profits must be shared equally.
      decisions.                                                         3)   A legal structure houses the joint venture.
   4) Control, but no board membership.                                  4)   No accounts are required.

9. A joint venture is:                                             13.        Self-Test Questions
   1) More than one investor owns shares in a company.
   2) A contractual arrangement, whereby parties undertake
                                                                   1. Sale of Subsidiary
      an economic activity, which is subject to joint control.
   3) Firms of different nationalities sell assets to an
      economic activity.                                           75% of a subsidiary cost 65 in January 2XX6, when 100% of
                                                                   the net assets of the subsidiary were valued at 80.
10. In a jointly-controlled operation:                             Required: Prepare the P & S1 Group Balance Sheet on
                                                                   acquisition and the Parent Balance Sheet after disposal.
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                                                                                                CONSOLIDATION PART 3
                                                                    Fixed Assets                  Shareholders‘
          Parent Balance Sheet (January 2XX6)                                                    Funds
                                                                    Goodwill
Assets                           Liabilities
Cash                       1040 Accounts                      800
                                payable
Accounts                    180                                     The investment in the subsidiary was sold in December 2XX6
receivable                                                          for 100. The Parent Balance Sheet had remained unchanged
Investments                 200 Accruals                      300   prior to the sale.
S1 Investment                65
Fixed Assets                115 Shareholders‘                 500              Parent Balance Sheet (after disposal)
                                Funds
                           1600                             1600    Assets                        Liabilities
                                                                    Cash                          Accounts
                                                                                                 payable
      Subsidiary 1 Balance Sheet (January 2XX6)                     Accounts                      Accruals
                                                                    receivable
Assets                           Liabilities                        Investments                   Shareholders‘
Cash                        400 Accounts                      490                                Funds
                                payable                             S1 Investment                 Profit on sale
Accounts                     20
                                                                    Fixed Assets
receivable
Investments                 100
Fixed Assets                 50 Shareholders‘                  80
                                Funds
                                                                    2. Share Exchange
                            570                               570
                                                                    P owns 100% of S1. This cost 100. When S1 was acquired the
      P & S1 Group Balance Sheet on acquistion                      net assets were 70.

Assets                            Liabilities                       Today the net assets of S1 are 150.
Cash                              Accounts
                                 payable                            S1 retained earnings comprise 10 pre-acquisition profits and
                                                                    80 post acquisition profits.
Accounts                          Accruals
receivable
Investments                        Minority Interest
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                                                                                                CONSOLIDATION PART 3
At the date of the exchange Goodwill of 6 remains to be written                             580                           580
off.

P exchanges the shares of S1 for 60% of S2.                         P/ S1 Consolidated Balance Sheet

Prepare the P/S1 and the P/S2 Consolidated Balance Sheets.
                                                                    Assets                         Liabilities
                   Parent Balance Sheet                             Cash                           Accounts
                                                                                                  payable
Assets                          Liabilities                         Accounts
Cash                       1050 Accounts                      800   receivable
                               payable                              Investments                    Accruals
Accounts                    100 Accruals                      300   Fixed Assets
receivable                                                          Goodwill                       Shareholders‘
Investments                 250                                                                   Funds
S1 Investment               100
Fixed Assets                100 Shareholders‘                 500
                                Funds
                           1600                             1600

                                                                         Parent Balance Sheet (at date of exchange)

         S1 Balance Sheet (at date of exchange)                     Assets                       Liabilities
                                                                    Cash                   1050 Accounts                  800
Assets                           Liabilities                                                    payable
Cash                        400 Accounts                      430   Accounts                100
                               payable                              receivable
Accounts                     30 Share Capital                  60   Investments             250
receivable                                                          S2 Investment           150 Accruals                  300
Investments                 100   Retained                     10   Fixed Assets            100 Shareholders‘             550
                                Earnings                                                        Funds
Fixed Assets                  50 Pre-acquisition                                           1650                           1650
                                Profit
                                  Post-acquisition             80   Shareholder‘s funds = 500 + 50 Profit on sale of S1
                                Profit
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                                                                                                   CONSOLIDATION PART 3
         S2 Balance Sheet (at date of exchange)                                                    payable
                                                                    Accounts                 500
Assets                            Liabilities                       receivable
Cash                        220 Accounts                      480   Investments              200 Accruals                   300
                                payable                             Fixed Assets             100 Shareholders‘              800
Accounts                     80                                                                  Funds
receivable                                                                                  1600                          1600
Investments                 200    Share Capital              120
Fixed Assets                100     Retained                    0
                                  Earnings                          P bought 75% of S for 250. It was purchased with other
                            600                               600   undertakings, and P had determined that S should be sold as
                                                                    quickly as possible, and immediately sought a buyer.

                                                                    At the time of acquisition, the net assets of S had a value of
                                                                    170 (100 Share Capital and 70 Pre-Acquisition Profits).

            P/ S2 Consolidated Balance Sheet                        Now, post-acquisition profits are 100.
                                                                    The parent‘s balance sheet has not changed since the
Assets                             Liabilities                      acquisition.
Cash                               Accounts
                                  payable                           Required: Prepare the Parent Balance Sheet including S
Accounts                           Accruals                         using the Equity Method.
receivable
Investments                        Minority Interests
Fixed Assets                       Shareholders‘
                                  Funds
Negative Goodwill


                                                                                   Subsidiary Balance Sheet
3. Equity Method of Accounting
                                                                    Assets                          Liabilities
       Parent Balance Sheet (before acquisition)
                                                                    Cash                      10    Current Liabilities     300
                                                                    Accounts                 200         Share              100
Assets                          Liabilities
                                                                    receivable                          Capital
Cash                        800 Accounts                      500
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                                                                                                CONSOLIDATION PART 3
                                  Pre-acquisition              70   Cash                    1440 Accounts              1290
                                profits                                                         payable
Fixed Assets                360 Post-acquisition              100   Accounts                 200 Accruals              300
                                profits                             receivable
                            570                               570   Investments              300 Minority Interest      20
                                                                    Fixed Assets             165 Shareholders‘         500
                                                                                                 Funds
     Parent Balance Sheet including S (equity method)               Goodwill                   5
                                                                                            2110                       2110
Assets                            Liabilities
Cash                              Accounts
                                 payable
Accounts                          Accruals                                     Parent Balance Sheet (after disposal)
receivable
Investments S                     Shareholders‘                     Assets                        Liabilities
                                 Funds                              Cash                    1140 Accounts              800
Fixed Assets                      Profits of S                                                   payable
                                                                    Accounts                 180
                                                                    receivable
                                                                    Investments              200 Accruals              300
14.      Suggested Solutions                                        S1 Investment              0
                                                                    Fixed Assets             115 Shareholders‘         500
                                                                                                 Funds                  35
Answers to Multiple Choice Questions:
                                                                                                  Profit on sale
                                                                                            1620                       1620
1.       2)    5.      1)     9.      2)      12.    2)
2.       1)    6.      2)     10.     2)
3.       2)    7.      2)     11.     1)
4.       3)    8.      2)                                           2.

Answers to Self-test Questions:
                                                                    P/ S1 Consolidated Balance Sheet
1.
       P & S1 Group Balance Sheet (January 2XX6)
                                                                    Assets                       Liabilities
Assets                              Liabilities                     Cash                    1450 Accounts              1230
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                                                                                                CONSOLIDATION PART 3
                                  payable                           Assets
Accounts                    130                                                                   Liabilities
receivable                                                          Cash                     550 Accounts              500
Investments                 350 Accruals                      300                               payable
Fixed Assets                150                                     Accounts                 500 Accruals              300
Goodwill                      6 Shareholders‘                 556   receivable
                                Funds                               Investments              200 Shareholders‘ Funds 500
                           2086                             2086    S (250+75)               325
                                                                    Fixed Assets             100 Profits of S(75% of  75
                                                                                                 100)
Notes:                                                                                      1675                     167
Shareholder‘s funds l= 500+80-goodwill (30-6)= 556                                                                     5


P/ S2 Consolidated Balance Sheet

                                                                    Note: Material from the following PricewaterhouseCoopers
Assets                          Liabilities                         publications has been used in this workbook:
Cash                       1270 Accounts                    1280
                               payable                              -Applying IFRS
Accounts                    180 Accruals                      300   -IFRS News
receivable                                                          -Accounting Solutions
Investments                 450 Minority Interests             48
Fixed Assets                200 Shareholders‘                 550
                                Funds
Goodwill                     78
                           2178                             2178

Notes:
Goodwill= 150-72=78
Minority Interests= 40% of 120
Shareholder‘s Funds= 556-(goodwill) 6
3.
   Parent Balance Sheet including S (equity method)


http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng                                                               65

				
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