Teaching note

CONSOLIDATED FINANCIAL STATEMENTS:

A PERFECT STRANGER YOU’LL GET TO KNOW

Antonio Marra

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INDEX  

1.      THE  CONSOLIDATION  FINANCIAL  STATEMENTS:  IAS  27  and  IFRS  3  ..................................................  5  

1.1  Combining  Financial  Statements:  An  Overview  ................................................................................  9  

2.      CONSOLIDATION  ACCOUNTING  FOR  SUBSIDIARIES  .......................................................................  12  

2.1  Pre-­‐Consolidation  Adjustments  ......................................................................................................  15  

2.2.  Consolidation  Adjustments  ...........................................................................................................  17  

2.2.1  Elimination  of  investment  ...........................................................................................................  17  

2.2.2  Elimination  of  intra-­‐group  transactions  .......................................................................................  23  

3.        ACCOUNTING  FOR  JOINT  VENTURES  AND  ASSOCIATES  ................................................................  28  

3.1  Accounting  for  Joint  Ventures  (IAS  31)  ...........................................................................................  29  

3.2.  Accounting  for  Associates  (IAS  28)  ................................................................................................  32  

 

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The aim of this note is to provide a framework about the basic consolidation concept under IAS 27, IFRS 3, IAS 31 and IAS 28. The structure of the note is as follows: after an overview on IAS 27 and IFRS 3, that are the main references of consolidation accounting, it shall be provided some descriptions about the concept of control, subsidiary and consolidated financial statement under the accounting principles and it shall be explained the principal steps of consolidation process of company financial statements included in the scope of consolidation. After that, it shall be explained the consolidation process under two particular cases: association and joint ventures. Some examples and exercises are used to clarify consolidation accounting under International Accounting Standards.

1. THE  CONSOLIDATION  FINANCIAL  STATEMENTS:  IAS  27  and  IFRS  3   The issue of consolidation arises when one company controls another one (normally by acquiring its shares), but the latter continues to exist as a separate entity and to keep its own assets and liabilities. From an accounting point of view, this is the case in which we have a group of companies and we have to a prepare consolidated financial statement. With respect to the preparation of consolidated financial statements, the key accounting standards of reference are:

ü IAS 27 Consolidated and Separate Financial Statements; ü IFRS 3 Business Combinations; ü IAS 28 Investments in Associates; ü IAS 31 Interests in Joint Ventures.

The recent changes to IAS 27 and IFRS 3, which were both revised in January 2008, mark the culmination of a joint project between the International Accounting Standards Board and the Financial Accounting Standards Board designed to improve financial reporting and international convergence. The requirements of IFRS 3 (2008) come into effect for those business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after 1st July 2009 (early adoption is permitted). Once an investment ceases to fall within the definition of a subsidiary (IFRS 3), it should be accounted for as an associate under IAS 28 or as a joint venture under IAS 31, as appropriate.

The objective of IAS 27 is to enhance the relevance, reliability, and comparability of the information contained in: • consolidated financial statements that a parent prepares for the group of entities it controls; and • separate (non-consolidated) financial statements that a parent, investor, or venture elects to provide, or is required by local regulation to provide. Consolidated financial statements are the financial statements of a group presented as those of a single economic entity and separate financial statements are those presented by a parent, an investor in an associate or a venturer in a jointly controlled entity, in which the investments are accounted for on the basis of the direct equity interest rather than on the basis of the reported results and net assets of the investees. Also note that with respect to separate financial statements, paragraph

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7 adds: “the financial statements of an entity that does not have a subsidiary, associate or venturer’s interest in a jointly controlled entity are not separate financial statements.” In other words, in the context of IAS 27, the term “separate financial statements” only relates to the (non-consolidated) statements of an entity that has an ownership interest in one or more other entities, and does not relate to entities that do not have such interests. The standard specifies the circumstances in which consolidated financial statements are required, as well as providing guidance on the required accounting for changes in ownership levels, including changes that result in the loss of control of a subsidiary. IAS 27 also includes requirements for disclosure of information in order to allow financial-statement users to evaluate the nature of the relationship between the parent entity and its subsidiaries. As already stated above, IAS 27 is applied in the preparation and presentation of consolidated financial statements for a group of entities under the control of a parent. In addition, when an entity presents separate financial statements (by choice or to comply with local regulations), the standard must be applied for accounting the investments in subsidiaries, jointly controlled entities, and associates. IAS 27 does not deal with accounting for business combinations; IFRS 3 Business Combinations covers this topic. The most common case in which we prepare consolidated accounts is when a company acquires enough equity to control another company. In order to understand better who has to prepare consolidated accounts, control must be defined. IAS 27 defines control as the power to govern the operating and financial policies of an entity so as to obtain benefits from its activities. The controlling company is called parent company or “holding”, while an entity, the controlled one, including an unincorporated entity such as a partnership, that is controlled by another entity is called subsidiary. A subsidiary exists when control is the continuing power to determine its strategic, operating, investing, and financing policies, without the co-operation of others. When the subsidiary isn’t totally owned by a parent, non-controlling interest exists. It is the equity in a subsidiary not attributable, directly or indirectly, to a parent. Those shareholders of the subsidiary other than the parent are referred to as “noncontrolling” or “minority” shareholders. The claim of these shareholders on the income and net assets of the subsidiary is referred to as the “noncontrolling” interest and it must be reported in the consolidated financial statement. Consolidated financial statements are required to include all of the parent’s subsidiaries (par. 12). Subsidiaries are identified on the basis of control by the parent. Control is presumed to exist when the parent acquires more than half of the voting rights of another enterprise, but control may also exist solely based on power.

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Paragraph 13 explains that a parent may control a subsidiary even if the parent owns less than 50% of the voting rights if, for example:

• the parent has power over more than one half of the voting rights as the result of an agreement with other investors; or

• there is a statute or an agreement that allows the parent to govern the financial and operating policies of the subsidiary; or

• the parent can appoint or remove the majority of the members of the board of directors, or can cast the majority of votes at a meeting of the board of directors.

In assessing whether control exists, the entity should also consider any potential voting rights that may come about — for example, as a result of share warrants, share call options, or convertible debt or equity instruments that are owned by the entity. The existence and effect of potential voting rights that are currently exercisable or convertible, including potential voting rights held by another entity, are considered when assessing whether an entity has the power to govern the financial and operating policies of another entity. Potential voting rights are not currently exercisable or convertible when, for example, they cannot be exercised or converted until a future date or until the occurrence of a future event. In assessing whether potential voting rights contribute to control, the entity examines all facts and circumstances (including the terms of exercise of the potential voting rights and any other contractual arrangements whether considered individually or in combination) that affect potential voting rights, except the intention of management and the financial ability to exercise or convert. By contrast, in this assessment should not be taken into account the following factors:

(i) intention to who owns the rights exercised / converted: the intention of exercise of potential voting rights, in fact, does not affect the existence of "power to control" but only its effective exercise;

(ii) the financial capacity of holders of such rights: such evaluation, in fact, would be difficult and arbitrary.

International Accounting Standards do not mention any case of exclusion from consolidation. In particular, are not excluded from consolidation:

(IAS 27 – par. 13) Control is presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity unless, in exceptional circumstances, it can be clearly demonstrated that such ownership does not constitute control. Control also exists when the parent owns half or less of the voting power of an entity when there is: (a) power over more than half of the voting rights by virtue of an agreement with other investors; (b) power to govern the financial and operating policies of the entity under a statute or an agreement; (c) power to appoint or remove the majority of the members of the board of directors or equivalent governing body and control of the entity is by that board or body; or (d) power to cast the majority of votes at meetings of the board of directors or equivalent governing body and control of the entity is by that board or body.  

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• subsidiaries on a temporary basis, for example, companies intended to be sold in the

short term (consistent with IFRS 5); • subsidiaries whose activities are dissimilar from those of other companies in the group; • subsidiaries to which the parent exercises control in the presence of severe and

sustained restrictions that significantly impair its ability to transfer funds to the parent. On the other hand, company must be excluded from consolidation when the parent loses control on it. There is a “loss of control” when the parent company has no longer the power to determine financial and managerial policies of its subsidiary. This can also occur without changes in the percentage of shares held: for example, it might occur when a subsidiary is subject to the control of a government agency, court, a commissioner or a regulatory authority.

There are four cases in which a parent doesn’t have to present consolidated financial statements.

(IAS 27 – par. 34) If a parent loses control of a subsidiary, it: (a) derecognizes the assets (including any goodwill) and liabilities of the subsidiary at their carrying amounts at the date when control is lost; (b) derecognizes the carrying amount of any non-controlling interests in the former subsidiary at the date when control is lost (including any components of other comprehensive income attributable to them); (c) recognizes:

(i) the fair value of the consideration received, if any, from the transaction, event or circumstances that resulted in the loss of control; and

(ii) if the transaction that resulted in the loss of control involves a distribution of shares of the subsidiary to owners in their capacity as owners, that distribution; (d) recognizes any investment retained in the former subsidiary at its fair value at the date when control is lost; (e) reclassifies to profit or loss, or transfers directly to retained earnings if required in accordance with other IFRSs, the amounts identified in paragraph 35; and (f) recognizes any resulting difference as a gain or loss in profit or loss attributable to the parent.  

(IAS 27 – par. 10) A parent need not present consolidated financial statements if and only if: (a) the parent is itself a wholly-owned subsidiary, or is a partially-owned subsidiary of another entity

and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements;

(b) the parent’s debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets);

(c) the parent did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organization for the purpose of issuing any class of instruments in a public market;

(d) the ultimate or any intermediate parent of the parent produces consolidated financial statements available for public use that comply with International Financial Reporting Standards.

 

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1.1     Combining  Financial  Statements:  An  Overview    Most large corporations own controlling interests in other companies. These interests appear in the balance sheet of the parent company among assets, in most cases at cost. Using this valuation method does not give any indication of the value of the subsidiary.

Consolidation accounting is a method of combining the financial statements of subsidiaries with that of the parent company. Consolidated statements combine the balance sheet, income statement and other financial statements of the holding with those of the subsidiaries into an overall set of statements as if the parent and its subsidiaries were a single entity. In different words, the assets, liabilities, revenues and expenses of each subsidiary are added to the parent’s accounts as if the parents had acquired directly the assets and liabilities of the subsidiary instead of investing in its shares. So, the purpose of a set of consolidated statements is to show the financial situation of the group of companies as if they were one company only. Therefore, the consolidation process consists not only in adding up the individual companies financial statements, but also in making them consistent with each other and in eliminating all those items that wouldn’t be there if the activity were actually performed by the parent company only (thus avoiding double counting).

After all consolidation procedures have been applied, the preparer should review the resulting statement and ask: “Do these statements appear as if the consolidated companies were actually a single company?”.

Actually, the consolidation process can be described in a number of steps, as follows: 1. collect the individual companies’ financial statements; 2. make them uniform as concerns:

- the dates they are referred to (difference among the reporting dates cannot be longer than 3 months)

- the accounting policies - the reporting currency (if necessary, translation takes place) - the format

3. add the single items of the “uniform” individual statements; 4. eliminate “double counting”.

In order to understand better what consolidation means, let’s start from a very simple example. Let’s suppose we have a company, ETA, that wants to perform a new activity. In order to perform the new activity ETA can decide to:

o buy the necessary assets and perform the activity directly; or o buy all the shares of a separate company, BETA, that owns the necessary assets ,

and perform the activity indirectly by controlling BETA. Now let’s suppose that the balance sheet of ETA at the moment it decides to start the new activity is the following:

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Balance Sheet ETA Cash 400 Liabilities 600 Other Assets 600 Owners’ equity 400 The cost of the assets necessary to perform the new activity is 100.

Balance Sheet ETA

Cash 300 Liabilities 600

Other Assets 600 Owners’ equity 400

Plants 100

If we want to prepare the consolidated balance sheet of the two companies, we need to go back to the financial situation that we would have if the activity were performed directly by ETA.

In practice, in consolidation accounting, we start from the addition of the two balance sheets and then we eliminate all those items that would not be there if the two companies were only one.

Balance Sheet ETA+BETA Cash 300 Liabilities 600 Other Assets 600 Owners’ equity 500 à 400 Investments 100 Plants 100

When consolidated accounts are prepared on a date subsequent to acquisition, the investments in subsidiary and the subsidiary’s owners’ equity are not the only items to be eliminated in the consolidation process. All intercompany items (also called mirror items) like receivables and payables with other subsidiaries, costs and revenues, profits and losses deriving from transactions carried out between two companies included in the same consolidated financial statement must be eliminated, since they would not appear in the financial statements if the subsidiaries’ activities were performed by the parent company directly.

Balance Sheet ETA Cash 300 Liabilities 600 Other Assets 600 Owners’ equity 400 Investments 100

Balance Sheet BETA

Plants 100 Owners’ equity 100

v If ETA decides to perform the new activity directly, after the purchase of the assets (e.g. plants), this is its balance sheet.

v If ETA decides to perform the new activity by purchasing the shares of a new company, BETA, which owns only the necessary plants, these are the opening balances of the two companies balance sheets.

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Those transactions or relations that are entirely within the consolidated entity are not reflected in the consolidated financial statements because they are viewed as occurring within a single accounting entity and, therefore, do not qualify for inclusion in the consolidated statements.

Companies are not required to prepare a “journal book” for their consolidation accounting. Most of them use worksheets similar to the one reported below.

(1) Elimination of investments and related O.E.

The first columns of the worksheet are reporting the individual financial statements of all the companies included in the consolidation area. After that, we always have an “aggregate” column, that results simply from summing up the values reported, for each item, in the individual financial statements. For each “consolidation entry” we use a different column. On the top of it we report a number so that we can describe the entry at the bottom of the worksheet. Note that, because of the double-entry system, the total assets always equals total liabilities + owners’ equity. This must be true in each column of the worksheet. Finally, the consolidated financial statements result, for each item, from summing up the values in the aggregate column and those reported in each following column.

Assets   A   B   Aggregate   (1)   Consolidated  Cash   300   300   300  Investments   100   100   -100   0  Plants   100   100   100  Other assets   600   600   600  Total assets   1000   100   1100   -100   1000  

Liabil.+O.E.  Liabilities   600   600   600  Owners' equity   400   100   500   -100   400  Total liab.+O.E.   1000   100   1100   -100   1000  

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2. CONSOLIDATION  ACCOUNTING  FOR  SUBSIDIARIES    

For the technicalities of consolidation accounting, we must refer to IFRS 3. According to IFRS 3, the so-called acquisition method shall be applied when accounting for any kind of business combinations and, therefore, for consolidation. According to this method, all the identifiable assets and liabilities of the subsidiary must be measured at their fair values at the moment of the acquisitions. These may include assets and liabilities which were not previously recognized in the financial statements of the acquiree (typically intangible assets). Assets and liabilities of the subsidiary must be measured at 100% of their fair value even if the parent company owns less than 100% of the share capital of the former. The 100% recognition of assets and liabilities, irrespective of the percentage of ownership in the controlled entity, does not directly apply to goodwill. According to the latest applicable version of IFRS 3, goodwill can indeed be recorded either only for the part acquired by the parent company or in full (treatment called “full goodwill method”). Under the “full goodwill method”, also the goodwill pertaining to minority interests is recognized in the consolidated financial statements. Under the most recent review of the US GAAP, the “full goodwill method” is the only one accepted for US companies starting from 2009. As a consequence, companies using IAS/IFRS are possibly going to prepare their consolidated accounts according to a different method in comparison to US companies, in case they opt for the partial recognition of goodwill. IFRS 3 requires that the financial statements are prepared in according to the so-called “modified theory of the parent”. The new IFRS 3 revised 2008 provides for the possibility of application of the "entity theory" (or full of goodwill).

(IAS 27 – par. 18) In preparing consolidated financial statements, an entity combines the financial statements of the parent and its subsidiaries line by line by adding together like items of assets, liabilities, equity, income and expenses. In order that the consolidated financial statements present financial information about the group as that of a single economic entity, the following steps are then taken: (a) the carrying amount of the parent’s investment in each subsidiary and the parent’s portion of equity of each subsidiary are eliminated (see IFRS 3, which describes the treatment of any resultant goodwill); (b) non-controlling interests in the profit or loss of consolidated subsidiaries for the reporting period are identified; and (c) non-controlling interests in the net assets of consolidated subsidiaries are identified separately from the parent’s ownership interests in them. Non-controlling interests in the net assets consist of:

(i) the amount of those non-controlling interests at the date of the original combination calculated in accordance with IFRS 3; and

(ii) the non-controlling interests’ share of changes in equity since the date of the combination.  

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The main features of the modified theory of the parent are as follows: Ø the full accounting method: assets, liabilities, costs and revenues of all companies

included in the consolidation must be accounted for their full amount (100%), regardless of the share participation of the parent company in the subsidiaries. Separate recognition is given in the consolidated balance sheet to the noncontrolling interest’s claim on the subsidiary’s net assets and in the consolidated income statement to the earnings assigned to the noncontrolling shareholders. The share attributable to minority shareholders should then be separately highlighted in the "equity attributable to minority interests" and the "net result attributable to minority interests”;

Ø inclusion of 100% of the fair value of assets and liabilities of the company at the date of

acquisition: in a consolidation, the assets and liabilities of the subsidiaries must be "retranslated" to its fair value refer to the date of acquisition of each company. Fair value is defined in IFRS 3 as the amount for which an asset could be exchanged or a liability paid in an arm's length transaction between knowledgeable and willing parties. This valuation of assets and liabilities of companies subsidiaries often implies the emergence of surplus or minus values compared with the book value of these assets and liabilities in the individual subsidiaries. These differences in the consolidated balance sheet are stated at 100%, regardless of parent's stake in the individual subsidiaries. The share attributable to minority shareholders should then be attributed to these separately. IAS 12 (Income taxes) states that when the fair value recognized in a business combination (including consolidation) is not recognized for tax purposes (i.e. the fiscal regulation does not consider the adjustment to fair values for its purposes), the deferred tax effect shall be recorded. For example if an increase in a plant is recorded while applying the acquisition method, but it is not recognized by tax regulation, a deferred tax liability shall be recorded in the liabilities side. This liability represents actually an adjustment to the fair value recognized in the asset due to the loss of a “fiscal benefit” that the acquirer would have through depreciation if, instead of buying the shares of the subsidiaries, it had bought the asset directly (when assets are bought directly, the fiscal regulation recognizes the whole fair value paid for them). The deferred tax effect can give rise to both deferred tax liabilities and deferred tax assets but on goodwill no tax effect must be recognized (in order not to increase its value).

Ø recognition of goodwill, positive or negative, derived from the difference between (i) the

purchase price paid for the stake in a subsidiary and (ii) the acquirer's interest in the fair value of the parent assets/liabilities of the subsidiary at the acquisition date. This difference must be treated in this way:

- if the difference is positive (i.e. price > fair value of equity parent company) it must be included as asset in the consolidated accounts and will be referred to as "goodwill";

- if the difference is negative (i.e. price <fair value of equity parent company), first, it should be reviewed the fair value estimation of assets and liabilities of the subsidiary. Thus, one can check if there is any overstated fair value of the

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assets of subsidiary (and/or - by mistake – liabilities have not been taken into account, including potential ones). If, even at the end of that process of “fair value revision", a residual negative difference exists (price < fair value), this must be allocated to income statement.

With the new IFRS 3, goodwill attributable to minority interests is also recognized.

Ø recognition of minority interests, as determined in proportion to its interest in the fair value of assets and liabilities of the subsidiary at the acquisition date: the interests of minority shareholders (or members other than the parent) in the subsidiaries are separately highlighted and thus valued % minority interests * equity of the subsidiary at the date of purchase.

The construction of the consolidated financial statements is a process that develops more "steps" later, strongly interrelated with each other:

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All adjustments made to the aggregated financial statement to obtain the consolidated financial statements (pre-consolidation adjustments and consolidation itself) must be operated at 100%. Only at the end of the consolidation process, the portion of the outcome of the group and all the changes reflect the effect of pre-consolidation and consolidation adjustments are allocated to minorities.

2.1  Pre-­‐Consolidation  Adjustments  Accounts that make up the consolidated financial statement must be homogeneous. For this reason, it is necessary to standardize all financial statements of the company included in the consolidation area. Subsidiaries must "adapt" their financial statement to that of the parent. The process of homogenization involves: a) the form and content of financial statements; b) closing date of financial statements; c) currency adopted; d) accounting principles and policies adopted. a) Form and content of FS IAS 1 does not require a specific structure, but requires a minimum content of information that each scheme must state. The consolidated balance sheet and income statement scheme are the same of separate annual financial statements. However in consolidated financial statements some items are reported, where necessary, in separate financial statement, that arise from the process of consolidation, such as “translation reserve” and “shareholders' equity attributable to minority interests” (balance sheet accounts), “negative goodwill” and “income (loss) attributable to minority interests” (income statement accounts). b) Closing date of financial statement The financial statements of the parent and its subsidiaries, which are used in preparation of consolidated financial statements, shall be referred to the same date.

• When the date of one or more subsidiaries financial statement is different from that of the parent company, the subsidiary (or subsidiaries) prepares, for consolidation purposes, an interim financial statement reported at the closing date of the parent company.

• When drawing up an interim financial statement is not feasible, the closing date of the subsidiary (or subsidiaries) and the parent company financial statements is allowed to be different. On condition that:

i. the difference between the closing dates do not exceed three months; ii. the duration of exercise and the difference between the closing dates remain

constant over time; iii. adjustments are made for significant transactions and events occurred between

the closing date of the subsidiary and the parent company financial statement. c) Currency adopted If the scope of consolidation includes the companies holding their accounts in a functional currency different from the currency presentation of the consolidated financial statements, it is

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necessary to proceed with the translation of financial statements denominated in currencies other than the presentation currency of the consolidated financial statements. The method of translation used is the so-called current exchange rates method.

The current exchange rate method provides that:

• income statement items (including the profit for the year) are translated at: o the effective exchange rate at the date of each transaction, or o the average exchange rate of the financial year;

• balance sheet items, except for the profit of the financial year, are translated at: o the exchange rate at the reporting date ("closing") of the consolidated financial

statements (so-called "exchange rate"). If the rate used for converting values of income statement not coincides with that used for the balance sheet, it causes a “difference of translation”, to be classified in a special capital reserve referred to as "translation reserve." d) Accounting principles and policies adopted The consolidated financial statement provides the representation of the economic and financial situation of a group as a single company with many divisions/internal functions. It cannot happen that a fact is noted in a different way if it happened in either division or function: for example same goods cannot be measured by different criteria depending on where it is located the stock. In fact, the financial statement of companies included in the consolidation area must be prepared using uniform accounting policies for similar transactions and events in similar circumstances. To make a correct aggregation, separate financial statements must be prepared in accordance with uniform accounting principles and assessment criteria. For example, the aggregation of financial statements of two companies that operate in the same field, one reports in the income statement costs of research and development at the time of consumption and the other capitalizes them both under the same conditions, cannot properly represent the consolidated income statement. Another example of an incorrect representation occurs when a group company accounts for its service contracts on the basis of fees under the criterion of percentage of completion, and another company, in the same situation, under the method of the order completed. The uniformity of the valuation principles should be implemented as a general rule and a preliminary in the budgets of individual companies through proper harmonization activities. This requires a manual setting out of the accounting consolidation rules and methods of evaluation and classification adopted in the consolidated level. Operationally this can be achieved: • by applying to subsidiaries in their individual accounts the accounting policies adopted to consolidate, to the extent that these principles are not inconsistent with local law; • by requiring the subsidiaries to provide individual budgets for the consolidation process appropriately adjusted to conform to the principles used for the consolidated financial statements. It is necessary to standardize valuation principles adopted by group companies for accounting similar transactions and events.

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The logical path to follow to make adjustments to harmonize accounting principles and valuation criteria is as follows:

1) identify the accounting actually made by the company subsidiary ("effective” accounting). This entry is reflected in the aggregated sheet;

2) identify the accounting that the company would have made to adopt principles and policies consistent with those followed by the group ("correct" accounting);

3) according to the differences between the “correct” and the "effective" accounting, identify the corrections of consolidated financial statements.

2.2.  Consolidation  Adjustments  

2.2.1  Elimination  of  investment  The first adjustment that needs to be made in consolidated financial statement is the elimination of the carrying value of investments held by the parent in consolidated companies. To understand the meaning of this adjustment, consider a simple example. Suppose a company DUFFY, newly formed, which has the following balance sheet. Pattern 1

Balance Sheet DUFFY (1.1.X) Cash 1500 Equity 1500

DUFFY shareholders decide to undertake the business of snack manufacturing. They can choose between directly purchase necessary equipment to perform this activity or invest in a company that already carries out this activity: they choose to buy 100% stake in DUCK, which already has the plant and has started production from a few days. Pattern 2

Balance Sheet DUCK (2.1.X) Plant 600 Equity 600

DUFFY pays participation in DUCK at a price of 600, equal to the value of the plant it holds. After the purchase of the stake in DUCK, the financial position of DUFFY is the following. Pattern 3

Balance Sheet DUFFY (2.1.X) hp: investment in DUCK

Investment in DUCK 600 Equity 1500 Cash 900

Now assume that you want to prepare consolidated financial statements of the group consisting of DUFFY and DUCK as of 2.1.x, after DUFFY bought the stake in DUCK. It starts (step 1) the sum of the financial statement (for simplicity, only the balance sheet) of companies of the group (DUFFY and DUCK) of the date of 2.1.x (pattern 2 + 3). As a result, the following aggregated balance sheet of the date of 2.1.x.

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Pattern 4 Balance Sheet DUGGY+DUCK (2.1.X)

Investment in DUCK 600 Equity 2100 Cash 900 Plant 600

Separate financial statements of DUFFY and DUCK are all uniform (hp.), so there is no need for any adjustment pre-consolidation (step 2).

Before beginning the consolidation process (step 3), the following question: what should be the consolidated financial statements of the group composed of DUFFY and DUCK? As indicated above, this statement should represent the group as if it were a single company with many divisions/ internal functions, each ideally be referred to a subsidiary. Now apply the definition to this case. The consolidated financial statements must be the situation where DUCK is not a legally independent company, but a division or function within DUFFY. This situation would occur if Alfa, instead of investing their money in buying the stake in DUCK, had purchased directly the plant of DUCK. In this case, the balance of the DUFFY would be as follows.

Pattern 5

Balance Sheet DUFFY (2.1.X) hp: investment in DUCK as a division

Cash 900 Equity 1500 Plant 600

Pattern 5 shows financial situation that consolidated financial statements should provide. Thus, the consolidated financial statements of DUFFY and DUCK at 2.1.X is as follows.

Pattern 6

Balance Sheet DUFFY+DUCK (2.1.X) Cash 900 Equity 1500 Plant 600

Now, through the consolidation process (step 3), it is necessary to "adjust" the aggregated balance sheet (Pattern 4) to move to the consolidated financial statements (Pattern 6). For this purpose it is necessary to identify the differences between the consolidated financial statement (the "end point") and the aggregated balance sheet (the "starting point").

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Balance Sheet DUFFY+DUCK (2.1.X) Investment in DUCK 600 Equity 2100

Cash 900

Plant 600

Balance Sheet DUFFY+DUCK (2.1.X) Cash 900 Equity 1500 Plant 600

The consolidated, compared to the aggregated, financial statement:

- does not contain the account "Investment in DUCK" (600); - has the account “Equity” less for 600.

This difference coincides with the value of Beta book value assets. Therefore, the adjustments to be made to the aggregated balance sheet in order to secure the consolidated financial statement are:

1. write-off of carrying value (or cost) of participation in DUCK 2. write-off of DUCK book value equity at the purchase date.

In most cases, the cost of participation does not match with the book value equity of the subsidiary.

Through the consolidation adjustments described above, it would be to elide from the balance sheet a value (the cost of participation) higher/lower than the value that would be elided from liabilities/equity (the equity of the company owned). This is because, compared to the cost of investment, not all “elements” that have resulted in costs are eliminated. Therefore, it should identify which "elements", more than book value equity of subsidiary, have determined the purchase cost of participation.

We must break down the price paid for the acquisition in all its determinants.

The purchase price paid for the participation is ideally attributable to the following:

ü book value equity of the subsidiary; ü surplus/minus values on assets and liabilities of the subsidiary. In the consolidated

financial statements, in fact: (i) the subsidiaries assets and liabilities must be “retranslated” to its fair value related to the acquisition date of each company and (ii) it should be recognized any assets or liabilities other than goodwill, which, although not recorded in the subsidiaries financial statements, satisfy the requirements for the accounting according to IAS/IFRS;

ü tax effect on surplus/minus values on assets and liabilities of the subsidiary. When the values of assets and liabilities recognized for tax purposes are different from their fair value recognized in the consolidated (see above), there are “temporary differences” that may give rise to liability (or asset) for deferred taxes. These deferred tax liabilities (or assets) must be collected separately from the related plus/minus values (see above);

Which adjustments should be made to the aggregated balance sheet to obtain the consolidated balance sheet?

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ü higher (or lower) price paid because of the future earnings of the company subsidiaries or good (or bad) deal. The difference between (i) cost of acquisition and (ii) the acquirer's interest in the fair value of subsidiary net assets/liabilities at the acquisition date, must be treated in this way:

o if positive (acquisition price > fair value equity attributable to the parent), it must be included as assets, the so called "goodwill”, in the consolidated financial statement;

o if negative (acquisition price < fair value equity attributable to the parent), estimates of fair value assets / liabilities of the subsidiary should be revised; the negative difference – if still there - must be allocated to income statement.

With reference to goodwill we do not account for any deferred tax liabilities.

In summary, therefore, the purchase price of participation can be so composed:

The correct adjustment of elimination of investment is: Ø reversal of the value of the investment; Ø write-off of subsidiary book value equity at acquisition date; Ø recognition of surplus/minus values at acquisition date; Ø recognition of deferred tax on surplus/minus values at acquisition date; Ø recognition of goodwill (or negative difference).

It should be noted that the elimination of the investment should be made taking as reference the value of the book value and the fair value of subsidiary assets and liabilities reported at the purchase date by the parent company. You should not take changes in book value and fair value of assets and liabilities that may have occurred between the date of acquisition of the participation and the date on which it proceeds to its consolidation into account. Therefore, elimination of participation is always the same, regardless of when completing the consolidation. The date of purchase of the stake by the parent company is also the time at which revenues and expenses of the subsidiary are enclosed in consolidated financial statement.

Now consider the case where the investment in the subsidiary is not totalitarian. In this case you must take into account that the parent has only bought a percentage in book value equity and surplus/minus values on assets and liabilities of subsidiary. The breakdown of the purchase price of the investment, illustrated above, must therefore be reformulated as:

+ book value equity at acquisition date +(-) surplus/minus values on assets and liabilities at acquisition date -(+) tax effect on surplus/minus values on assets and liabilities at acquisition date +(-) goodwill (or negative difference of consolidation)

+ pro-quota book value equity of subsidiary at acquisition date +(-) pro-quota surplus/minus values on assets and liabilities at acquisition date -(+) pro-quota tax effect on surplus/minus values on assets and liabilities at acquisition date +(-) goodwill (negative difference of consolidation)

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The consolidation adjustment will therefore be the following (correction a): 1) reversal of the investment value; 2) write-off of book value pro-quota of the subsidiary at the acquisition date; 3) recognition of plus/minus values pro-quota at the acquisition date; 4) recognition of deferred tax on plus/minus values pro-quota at the acquisition date; 5) recognition of goodwill (or negative difference).

Now, let’s have a look at the computation of noncontrolling interest. How should be treated interests of minorities in controlled and consolidated company? When a subsidiary is less than wholly owned, the general approach to consolidation is the same as discussed previously, but the consolidation procedures must be modified slightly to recognize the noncontrolling interest. IFRS 3 requires:

- the consolidation of investments using the “full method”: assets, liabilities, costs and revenues of all companies included in the consolidation must be recognized for their full amount (100%), regardless from the percentage the parent company owns in its subsidiaries; - the inclusion of the full amount (100%) of surplus/minus values on assets and liabilities of the subsidiaries based on their fair value at the acquisition date. So it is necessary to include the gross surplus/minus values and, separately, the related tax effect, not only for the parent company but also for the portion attributable to minority interests; - the recognition of goodwill, positive or negative, defined as the difference between (i) the price paid for the purchase of a stake in a subsidiary and (ii) the controlling interests in the fair value of assets/liabilities of subsidiary. Goodwill is attributable to the parent company.

Non controlling interests in subsidiary have to be determined with reference to related participation at fair value of assets and liabilities of subsidiary at the acquisition date. Non controlling interests are separately highlighted in the account “equity attributable to third parties”= % of interests * subsidiary fair value equity at acquisition date. To recognize non controlling interests, it is necessary:

§ to include book value attributable to minority interests, as % of interests * subsidiary fair value equity at the acquisition date;

§ to recognize the portion of surplus/minus values attributable to minority; § to point out the tax effect on surplus/minus values; § the reversal of subsidiary equity attributable to the parent to that attributable to

minority. The consolidation adjustment will therefore be the following (correction b):

1. registration of equity attributable to minority interests; 2. write-off of book value of the subsidiary attributable to minority interests at the

purchase date; 3. recognition of surplus/minus values attributable to minority interests at the purchase

date; 4. recognition of deferred tax on surplus/minus values attributable to minority interests

at the purchase date.

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If you "join" the consolidation adjustments a) and b), you determine the overall consolidation adjustment (adjustment a+b) ):

1. reversal of the value of the investment; 2. write-off of 100% subsidiary book value at the purchase date; 3. recognition of 100% gross surplus/minus values at the purchase date; 4. recognition of 100% deferred tax on surplus/minus values at the purchase date; 5. recognition of goodwill (or negative difference); 6. registration of equity attributable to minority interests.

Example On January 1, X company A buys 80% of shares in company B. The cost of the investment is € 11.000. The equity of B, on the same date, is € 10.000. The fair value of assets and liabilities of B equals their book value, except for the following: Book value Fair value gross surplus

Property 6.000 8.000 2.000

Patents 1.000 3.000 2.000

Consider that the tax rate applied by the two companies is 50%. We proceed to accounting entry of the elimination of participation in Beta in accordance with IFRS 3, attributing the positive difference as goodwill. The company applies the “full goodwill method”. In such a case, assume that the fair value of the non-controlling interests is 2.750€. Debit Credit B equity 10.000 Property 2.000 Patents 2.000 Goodwill 1.750 Participation in B 11.000 Deferred tax liabilities 2.000 Minority interests 2.750

The consolidated balance sheet is reported as follows:

A B Aggregate (1) ConsolidatedBalance SheetASSETSNon current assetsProperty, plants and equipment 5.000 6.000 11.000 2.000 13.000 Patents 2.000 4.000 6.000 2.000 8.000 Goodwill - 1.750 1.750 Investments 11.000 11.000 11.000- - TOTAL ASSETS 18.000 10.000 28.000 5.250- 22.750 LIABILITIES and OWNERS' EQUITYOwners' equityCommon Stock 18.000 10.000 28.000 10.000- 18.000 Minority interests 2.750 2.750 Deferred tax liabilities 2.000 2.000 TOTAL LIAB+O.E. 18.000 10.000 28.000 5.250- 22.750 (1) Recognition of surplus value (4.000) on patents and property. Elimination of investment (11.000) and subsidiary equity (10.000). Recognition of deferred tax liabilities (4.000*0,5=2.000)

Recognition of (full) goodwill (1.750): 13.750 (purchase price + fair value minority) – 10.000 (BV equity) – net surplus value (2.000).

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At the time of consolidation, it should be recognized any surplus/minus value on assets and liabilities of the controlled company in order to express its fair value. It must also be recorded any assets or liabilities, other goodwill, which, although not recorded in subsidiaries separated financial statements, meet the "conditions" for enrollment in financial statements in accordance with IAS/IFRS. The surplus/minus values are linked to the assets to which they refer to. In particular: - if they are related to depreciable assets, the surplus/minus values are amortized over the useful life of assets to which they relate; - if they are related to non-depreciable assets, the surplus/minus values may be, together with the assets to which they relate, subject to impairment test in accordance with IAS 36. This is a "value audit" of whether the carrying value of an asset is less than its "real" (defined "recoverable amount"). If the recoverable amount is lower, the company shall recognize an impairment loss amounting the excess of book value of the asset over its recoverable amount. For all the adjustments described above must consider the possible deferred tax effect. Every year, goodwill shall be subjected to impairment ruled by IAS 36.

2.2.2  Elimination  of  intra-­‐group  transactions  The elimination of intra-group transactions consists in:

• the elimination of intra-group receivables and payables, costs, and revenues; • the elimination of intercompany profits and losses:

o the elimination of intercompany profits and losses included in value of inventories;

o the elimination of intercompany profits and losses included in value of fixed assets;

• the elimination of intra-group dividends. o the allocation of the minority.

The consolidated financial statement provides the representation of the economic and financial situation of the group as a single entity: a company with many divisions/internal functions (set up by different companies that are included in consolidation area). Transactions that occur between group companies are equivalent, in view of the consolidated financial statement, to transactions between divisions/functions within a company. Such transactions, therefore, since are not transaction with "third parties", should not even be recognized in the general accounting system. The consolidated financial statement should represent only those operations that group companies have made with third parties outside the group. Those values, which arise from intra-group transactions, must be eliminated.

Some examples:

o the supply of goods from one company to another within the group are equivalent, from a consolidated financial statement point of view, to the "transfer" of goods from one warehouse to another, within the same company. This must not be detected by the general ledger system as a sale of goods, in view of the consolidated financial statements, therefore, it will have no relief;

o financing provided by a holding company to subsidiaries is equal, in perspective of the consolidated financial statement, to the “liquidity transfer” from a division to another

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within the same company. This operation does not qualify as a funding, so in the consolidated financial statement, it will have no relief.

Through the consolidation process, therefore, the following values must be eliminated from aggregated balance sheet:

a) intra-group receivables and payables, income and expenses; b) intra-group profits and losses; c) intra-group dividends.

a) The elimination of intercompany payables and receivables

Trading or financing operations within companies group determine payables and receivables, costs and revenues. For the group, seen as a company, these items are irrelevant (the entity “group”, in fact, has credit and debt of equal amount, or cost and revenues of equal amount) and, indeed, cause an undue "swelling" of the items balance. These items should be reversed in the consolidated financial statement. In particular, should be removed:

§ intra-group receivables and payables not yet settled at the end of the year; § intra-group revenues and expenses recognized during the financial year.

The procedure for removal of intra-group transactions is based on the assumption that there is equivalence between accounts of each company. This equivalence exists if all group companies have correctly pointed out such operations. If, by mistake or imperfect information, there is no equivalence between accounts, we need to "reconcile" the values of intra-group transactions ensuring that they are properly recognized by all companies. After the reconciliation, you can proceed with their elimination. The logical path to follow to make adjustments to eliminate intercompany payables and receivables, revenues and expenses is as follows: 1) identify which values of credit/debt, costs/revenues, arising from intra-group transactions, are recorded in the financial statements of companies included in consolidated financial statement; 2) make sure there is mutual equivalence between accounts; if this equivalence is not present, reconcile intra-group values; 3) delete the mutual accounts (receivables and payables, costs and revenues). It should be noted that:

• adjustments of elimination of intra-group receivables and payables, costs and revenues are be fully operated at 100%;

• the reversal of intra-group receivables and payables, costs and revenues does not require the detection of intra-group deferred tax effects; such consolidation adjustment, in fact, do not cause changes in the operating result.

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b) The elimination of intercompany profits and losses

In the consolidated financial statement, group result should be that generated by the group with any third party and not the one that individual companies have achieved working together. So, any intra-group profits and losses which relate to assets still included in the heritage group at year-end, must be removed. This consolidation adjustment is intended to eliminate the impact of intra-group operation, as reporting in the absence of the transaction itself. This is achieved by: 1) adjusting the carrying value of assets "subject" of the intra-group transaction that are still in the balance sheet of the acquiring company; the value of these goods must be "brought back" to that they would have if they wouldn’t have been transferred from one to another group company; 2) adjusting the income items related to those goods that are "generated" by the intra-group transaction. The economic result of companies involved in the transaction, in fact, has changed as a result of intra-group transaction: this change must be eliminated. It should not be eliminated intercompany losses that express an actual decrease in value of the property that is necessary to represent. From the elimination of intra-group emerge temporary differences, must therefore detect the deferred tax assets or liabilities arising from these differences. Adjustments to eliminate intercompany profits and losses should be fully operating, at 100%.

The elimination of intercompany profits and losses included in the value of inventories

In the case of profits (or losses) included in the value of inventories, intra-group profits (or losses) must be eliminated to the extent that it is linked to the assets are still in the warehouse of the acquirer at year-end. The logical path to be followed for the adjustment in question is divided into the following steps:

1. calculate the total intercompany profit (or loss) result; 2. calculate the intercompany profit (or loss) "is not made with third parties"; that is total

intercompany result (1) multiplied by the percentage of goods that are still in the warehouse of acquiring company at year-end;

Example A has a 80% stake in B (acquires on January, 1 X). During the year, A provided services to B for a total fees of € 500. Alfa has recognized the related revenue under “operating revenues” while Beta the related costs under “operating costs”. On 31.12.X the transaction is settled only partially, and intercompany payables and receivables are recognized for € 300. We proceed to the elimination of costs and revenues, intercompany receivables and payables for the construction the consolidation at 31.12.X. Debit Credit Revenues from services 500 Service costs 500 Payables v/parent 300 Receivables v/subsidiary 300

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3. reduce (increase) the closing balance of inventory by the amount of intercompany profit (or loss) “ that is not made with third parties”(2).

The elimination of intercompany profits and losses included in the value of long-lived assets In case of profits (or losses) included in the value of long-lived assets, you must:

• report the transferred assets (still held by the acquirer at year-end) at the carrying amount that would have been in absence of intercompany transaction;

• reverse any gains/losses realized as a result of alienation; • adjust depreciation to report them as there would be in absence of alienation.

From a consolidated viewpoint, depreciation must be based on the cost of the asset to the consolidated entity, which is the asset’s cost to the related company that originally purchased it from an outsider. Eliminating entries are needed in the consolidation workpaper to restate the asset, associated accumulated depreciation, and depreciation expense to the amounts that would appear in the financial statements if there had been no intercompany transfer. The logical process to follow for the adjustment is as follows:

1. identify the accounting effect that the intercompany transaction has led, with particular reference to gains/losses, sold assets and their depreciation. This entry is reflected in aggregated balance sheet;

2. identify the values that the items affected by the transaction (gains/losses, sold assets and depreciation) would have had in the absence of operation. This entry is that must be reflected in the consolidated financial statement;

3. as a result of differences found between values (1) and (2), identify corrections to be made to the aggregated balance sheet for obtaining the consolidated financial statement.

Example A has a totalitarian participation in B. During the year A sold to B n. 100 units of the product Win at a unit price of € 50. Alfa had paid for the purchase of the goods in question a unit cost of € 40. On 31.12.X none of the units purchased by B has been sold to third parties. Assume that the tax rate is 50%. We proceed to eliminate intercompany profit not obtained from third parties, including the value inventories of B, for the construction of the consolidated financial statement at 31.12.X. Debit Credit Closing inventory (IS) 1.000 Closing inventory (BS) 1.000 Deferred tax assets 500 Taxes 500

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c) The elimination of intercompany dividends

It is necessary to eliminate intra-group dividends, in order to avoid double counting of the same within the group, as in the company that distributes dividend as in the company that perceives it. The consolidation adjustment in question is to eliminate the accounting effects of intra-group dividends. These effects are the following:

• recognition of financial income by the company of the group that receives dividends; • reduction in reserves of the company that distributed dividends; • recognition of the portion of dividends attributable to minority.

The logical process to follow for the adjustment in question is as follows:

1. identify the effects of the transaction listed above; 2. eliminate these effects through: - the elimination of financial income, measured by the company group that receives

dividends; - the reintegration of the reserves of the company that distributes dividends; - the decrease in shareholders' equity attributable to minority interests of the amount

of dividends received by them. It should be noted that, in the elimination of the investment, the equity allocated to third parties was determined referring to the equity of the subsidiary at the purchase date, without regarding to any reduction in reserves during the year following the distribution of dividends. The equity interest should therefore be reduced in the consolidation of the amount already received by them as a dividend. In fact, they have already received "liquidity" as distributed dividends and, therefore, this liquidity should not be "assigned" again at year end as a minority interests. From the elimination of intra-group dividends arises “differences temporary”. These differences, however, are very low compared to adjustment amounts. In fact, art. 89 c.2 (TUIR) provides that “the distribution of profits…not a component of income for the year in which are perceived as excluded from the income of company or receiving entity for 95% of their amount”. Do not constitute an intra-group transaction the distribution of dividends by the parent company to its shareholders. In this case, those who receive the dividend, the shareholders of parent, are “outsiders" to the group (except in cases where there are cross-shareholdings between the parent and subsidiaries). The group, in fact, is made by the parent company and its subsidiaries, not by individuals or companies which control the parent. In the consolidated financial statements, assets, liabilities, costs and revenues of all companies included in the consolidation must be enrolled for their entire amount (100%), irrespective of the shareholding of the parent in the subsidiaries. All the pre-consolidation and consolidation adjustments must be made at 100%. The portion attributable to minority shareholders must then be separately highlighted in “equity attributable to minority interests” and “net income attributable to minority interests”. Shareholders' equity attributable to minority interests is determined and entered in the consolidated balance sheet by adjusting the elimination the investment and is partially modified at the time of elimination of intra-group dividends. Net profit attributable to

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minority interests is determined and entered at the end of the consolidation process. It is calculated as follows: (net result of subsidiary +/- adjustment on net result)* % minority interests. The logical process to follow for the adjustment is the following:

1. determine the net result of the controlled entity; 2. select the consolidation process (pre-consolidation and consolidation itself) which led

to a change result and answer the following question: the adjustment resulted in a change in the operating result of the subsidiary?

a. if so, the adjustment should be considered when calculating the result of minority;

b. if not, the adjustment should not be considered in the calculation of the minority;

3. determine the portion of net result attributable to minority by considering 1) and 2a).

 

3.  ACCOUNTING  FOR  JOINT  VENTURES  AND  ASSOCIATES   (IAS 27 Paragraph 5) - A parent or its subsidiary may be an investor in an associate or a venturer in a jointly controlled entity. In such cases, consolidated financial statements prepared and presented in accordance with this Standard are also prepared so as to comply with IAS 28 Investments in Associates and IAS 31 Interests in Joint Ventures. “Crossing an accounting boundary” describes a change in the method of accounting (e.g. measurement at fair value, equity accounting, proportionate consolidation or full consolidation) as a result of increasing or decreasing an equity interest in another entity. Prior to the 2008 revisions, a controlling interest achieved in stages was dealt with as a series of separate acquisition transactions with goodwill recognized as the sum of the goodwill arising on the separate transactions. On disposal, various approaches were used to measure residual interests, but commonly these were measured by reference to the residual proportion of previous carrying amounts (e.g. the residual share of net assets and goodwill). Under the 2008 revisions, a business combination accounted for under IFRS 3 occurs only at the time that one entity obtains control over another, and does not apply to previous or subsequent transactions not involving a change in control. Any change in equity interests which crosses an accounting boundary ,causing a change in the method of accounting, is regarded as a significant economic event.

Example A holds a 100% stake in B. During the year B uses reserves accumulated in the previous year for distribution to its shareholders a dividend of 2.000. Alfa accounts for the amount perceived as financial income. We proceed to eliminate the effect of distribution of intercompany dividends. Debit Credit Financial income 2.000 Reserves 2.000

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Such a transaction is therefore accounted for as if the original asset (in case of an increase in equity interest), or the residual asset (in case of a reduction in equity interest), were disposed of for fair value, and immediately reacquired for the same fair value. The implications of this change of principle are:

• a previously-held interest (say, 10%) which is accounted for under IAS 39 Financial Instruments:

• recognition and measurement, and which is increased to a controlling interest (say, 75%) through a business combination, is measured again to fair value at acquisition date, and any gain recognized in profit or loss. Similarly, gains previously recognized in other comprehensive income are reclassified to profit or loss where required by the relevant IFRSs;

• a previously-held interest (say, 40%) which is accounted for as an associate under IAS 28 Investments in Associates or as a jointly controlled entity under IAS 31 Interests in Joint Ventures, and which is increased to a controlling interest (say, 75%) through a business combination, is measured again to fair value, and any gain recognized in profit or loss;

• on disposal of a controlling interest, any retained interest in the former subsidiary is measured at fair value on the date that control is lost. This fair value is reflected in the calculation of the gain or loss on disposal attributable to the parent, and becomes the initial carrying amount for subsequent accounting for the retained interest under IAS 28, IAS 31 or IAS 39 as appropriate;

• similar considerations apply to the partial disposal of an interest in an associate or a jointly controlled entity where the residual interest is accounted for as a financial asset under IAS 39.

3.1 Accounting  for  Joint  Ventures  (IAS  31)   IAS 31 shall be applied in accounting for interests in joint ventures and the reporting of joint venture assets, liabilities, income and expenses in the financial statements of venturers and investors, regardless of the structures or forms under which the joint venture activities take place. However, it does not apply to venturers’ interests in jointly controlled entities held by: (a) venture capital organisations, or (b) mutual funds, unit trusts and similar entities including investment-linked insurance funds that upon initial recognition are designated as at fair value through profit or loss or are classified as held for trading and accounted for in accordance with IAS 39 Financial Instruments: Recognition and Measurement. According to IAS 31, a joint-venture is a contractual arrangement whereby two or more parties undertake an economic activity which is subject to joint control (par.3). Joint control is the contractual agreed sharing of control over an economic activity and the parties who have joint control over a joint-venture are called venturers. The following characteristics are common to all joint ventures: (a) two or more venturers are bound by a contractual arrangement; (b) the contractual arrangement establishes joint control.

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The contractual arrangement establishes joint control over the joint venture. Such a requirement ensures that no single venturer can control the activity unilaterally. The contractual arrangement may be evidenced in lots of ways, for example by a contract between the venturers or minutes of discussion between the venturers. It is important to stress that in joint ventures there is no one venture who can control the activity by itself. It may happen that one venturer is appointed as the operator or manager of the JV but he/she will still have to act within the financial and operating policies agreed by all venturers. A joint ventures can take several different forms. We focus on the so-called jointly controlled entities, that are examples of joint ventures where a distinct entity is formed and in which each venturer has an interest. IAS 31 requires either proportionate consolidation (preferred method) or equity method (allowed alternative method) to be used for jointly controlled entities (par. 30). In the proportionate consolidation:

• only the venturer’s share of assets, liabilities, revenues and expenses are included in the consolidated financial statements, differently from normal consolidation;

• there is no indication of minority interests; • all the consolidation adjustments we have already seen with reference to

consolidation accounting for subsidiaries must be carried out in the proportionate method too.

The venturer, who is including the joint-venture in its financial statements according to the proportionate method, may choose to report the share of assets, liabilities, expenses and revenues of the joint-venture together with its own (summing them up line by line like we do in normal consolidation) or to show them as separate items. Both formats are allowed by IAS 31 (par. 34). The major difference between the consolidation for subsidiaries and the proportionate method is that in the latter all the adjustments are made in proportion to the share of ownership of the reporting entity. For example, if company A has to prepare consolidated financial statements including the joint-venture B, and if company A has 33% of shares of the joint-venture, all the adjustments must be made only for 33% of their value. Of course the value of the investment must be eliminated in full, since it is already corresponding to the share of ownership of the reporting entity (it represents the cost of the share capital owned by the venturer). EXERCISE – The proportionate method On January 1, X company H acquires 60% of the share capital of company JV. Even if H owns more than 50% of the share capital of JV, the latter is a joint-venture based on a contractual agreement with another shareholder. The cost of the investment in JV is 6.000 €. On the date of the acquisition, JV owners’ equity is 5.000 €. On the same date, the fair value of assets and liabilities of JV equals their book value, except for some patents, which are not recorded in the balance sheet of JV and whose fair value is estimated to be equal to 2.000 €. The expected residual useful life of the patents is 5 years.

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The difference between the cost of the investment and the fair value of the O.E. of the subsidiary is assigned to goodwill. During the accounting period X, the two companies carry out the following intra-group transactions:

• H lends money to JV; the total amount lent is 500 € and this will be reimbursed all together in 2 years. In relation to this transaction, the two companies recorded interests for 30 €. These interests have already been paid at the end of the accounting period;

• H sells goods to JV for a total amount of 300 €. The goods are still in the inventory of JV at the end of the accounting period and the intra-group profit included in their value is 100 €. Such transaction will be paid in the following accounting period.

• Deferred tax income are calculated as 50% of the taxable income.

Required: Prepare the financial statements of the group H and JV on Dec. 31, X. USE THE PROPORTIONATE METHOD TO CONSOLIDATE JV. The individual financial statements of the two companies on the same date are reported in the worksheet.

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SOLUTION – The proportionate method

Income StatementOperating revenues 15000 13650 28650 -5460 -180 23010Operating expenses 14100 13000 27100 -5200 240 -120 22020Operating income 900 650 1550 -260 0 -240 0 -60 990Financial revenues 50 50 0 -18 32Financial expenses 250 100 350 -40 -18 292Earnings before taxes 700 550 1250 -220 0 -240 0 -60 730Income tax expense 120 300 420 -120 -120 -30 150Net income 580 250 830 -100 0 -120 0 -30 580Net income of the minoriy shareholders

Balance SheetASSETSNon current assetsProperty, plant and equipment 2900 3600 6500 -1440 5060Goodwill 2400 2400Other intangible assets 1200 -240 960Investments 6000 6000 0 -6000 0Financial receivables 1000 1000 2000 -400 -300 1300Deferred tax assets 30 30Current assets 0Inventories 260 750 1010 -300 -60 650Trade receivables 500 1500 2000 -600 -180 1220TOTAL ASSETS 10660 6850 17510 -2740 -2400 -240 -300 -30 -180 11620LIABILITIES AND O.E.Group O.E.Common stock 6700 3000 9700 -1200 -1800 6700Retained earnings 1350 2000 3350 -800 -1200 1350Net income 580 250 830 -100 -120 -30 580Minority interests 0Common stock and reserves 0Net income 0Non current liabilities 0Financial payables 230 900 1130 -360 -300 470Deferred tax liabilities 600 -120 480Current liabilities 1800 700 2500 -280 -180 2040TOTAL LIABILITIES + O.E. 10660 6850 17510 -2740 -2400 -240 -300 -30 -180 11620

(1) Eliminated 40% of all the items in JV's financial statements(2) Eliminated the investment and the OE of JV. Recognized surpluses and goodwill.(3) Amortization of the surplus on patents(4) Eliminated 60% of financial revenues/expenses and receivables/payables(5) Eliminated 60% of the effects of the intragroup sale of goods(6) Eliminated 60% of the trade receivables and payables still existing

H JV Aggregate 5 6Consolidated

on 31/12/X1 2 3 4

3.2.   Accounting  for  Associates  (IAS  28)   IAS 28 shall be applied in accounting for investments in associates. However, it does not apply to investments in associates held by: (a) venture capital organizations, or (b) mutual funds, unit trusts and similar entities including investment-linked insurance funds that upon initial recognition are designated as at fair value through profit or loss or are classified as held for trading and accounted for in accordance with IAS 39 Financial Instruments: Recognition and Measurement. Such investments shall be measured at fair value in accordance with IAS 39, with changes in fair value recognized in profit or loss in the period of the change. An entity holding such an investment shall make the disclosures required by paragraph 37(f). According to IAS 31, an associate is an entity over which the investor has significant influence and that is neither a subsidiary nor an interest in a joint venture.

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Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies. If an investor holds, directly or indirectly (e.g. through subsidiaries), 20 per cent or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case. Conversely, if the investor holds, directly or indirectly (e.g. through subsidiaries), less than 20 per cent of the voting power of the investee, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated. A substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence. The existence of significant influence by an investor is usually evidenced in one or more of the following ways:

§ representation on the board of directors or equivalent governing body of the investee; § participation in policy-making processes, including participation in decisions about

dividends or other distributions; § material transactions between the investor and the investee; § interchange of managerial personnel; or § provision of essential technical information.

According to IAS 28, the equity method shall be used to account for associates, except when:

– the investment is classified as held for sale (IFRS 5) – conditions similar to the ones stated for the exemption from consolidation exist

Under the equity method: a. the investment in an associate is initially recognized at cost and the carrying amount is

increased or decreased to recognize the investor’s share of the profit or loss of the investee after the date of acquisition. The investor’s share of the profit or loss of the investee is recognized in the investor’s profit or loss;

b. one must use the same procedures used for the consolidation of subsidiaries; c. distributions received from an investee reduce the carrying amount of the investment.

Adjustments to the carrying amount may also be necessary for changes in the investor’s proportionate interest in the investee arising from changes in the investee’s equity that have not been recognized in the investee’s profit or loss. Such changes include those arising from the revaluation of property, plant and equipment and from foreign exchange translation differences. The investor’s share of those changes is recognized directly in equity of the investor.

In applying the equity method, we must use many of the procedures applied for the consolidation of subsidiaries. Rules about the uniformity of financial statements (concerning the date, the accounting policies and the currency) are stated also for the application of the equity method. The equity method is a sort of “synthetic consolidation” in which the balance sheet and income statement items are not consolidated line by line but synthetically, by adjusting the value of the investments in the balance sheet of the reporting entity.

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EXERCISE 1. – The equity method On January 1 X company ALFA acquires 40% of the share capital of company BETA. ALFA has a significant influence on the decisions of company BETA. The cost of the investment is 6,000. On the date of the acquisition, the book value of the owners’ equity of BETA was 8,000. On the same date, the fair value of the assets and liabilities of BETA equals their book value except for the following:

The expected residual useful life of the buildings is 10 years; for patents it is 20 years. The tax rate applied by the two companies is 50%. During year X:

- company BETA records net earnings for 2,300; - ALFA sells merchandise to BETA. The selling price is 3,000, the cost of the goods sold

is 1,000. At the end of the period, all the merchandise is still in the inventory of BETA; - BETA sells to ALFA a plant whose net carrying amount was 5,000 (historical cost =

7,000). The selling price is 6,000. Both companies use a depreciation rate of 10%; - BETA declares and pays dividends for a total amount of 400.

Required: Estimate the value of the investments in BETA to be recorded in the financial statements of company ALFA on the following dates:

- January 1 X - December 31 X

Book value Fair value Buildings 10.000 11.000 Patents 0 6.000

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SOLUTION- The equity method

§ January 1, X On January 1 X, the value of the investments in the balance sheet of company ALFA equals the cost, that is 6.000.

§ December 31, X In order to measure the value of the investments using the equity method on a date subsequent to the acquisition, we need to identify the elements included in the cost of the investment and define how much is the surplus on the assets/liabilities and the value of the goodwill of company BETA. Total cost of the investment = 6.000 OE of the associate = 8,000*40%= 3.200 Surplus on buildings net of taxes = (11,000-10,000) *(1-0,50)*40% = 200 Surplus on patents net of taxes= 6,000 *(1-0,50)*40% = 1.200 Goodwill = 6,000 – (3,200+200+1,200) = 1.400 -------------------- Value of the investments on Jan. 1, X 6.000 + net earnings of BETA = 2,300*40% +920 - depreciation on buildings = 200/10 - 20 - amortization on patents =1200/20 -60 - elimin. intragroup profits on merchandise = (3,000-1,000)*(1-0,50) *40% -400 - elimin. intragroup profits on plants = -220 (*) - elimination of dividends = 400*40% -160 Increase in the value of the investments +60 Total value of the investments on Dec. 31, X 6.060 -------------------- (*) This is calculated as follows:

- Intragroup gain to be eliminated = 6.000-5.000 = 1.000 - Adjustment to the depreciation:

BETA would have recorded depreciation expense for 700 ALFA records depreciation for 600 The depreciation expense must be increased by 100 Total effect on earnings (before taxes) = -1,000-100 = - 1.100 Total effect on earnings (net of taxes) = -1,100*50% = - 550 Share pertaining to company ALFA = -550*40% = - 220

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EXERCISE 2 – The equity method On January 1 X, company ALFA acquires 30% of the share capital of company BETA. ALFA has a significant influence on the decisions of company BETA. The cost of the investment is 9,000. On the date of the acquisition, the book value of the owners’ equity of BETA was 12,000. On the same date, the fair value of the assets and liabilities of BETA equals their book value except for the following:

The expected residual useful life of the buildings is 15 years; for patents it is 30 years. The tax rate applied by the two companies is 40%. During year X:

- company BETA records net earnings for 3,450; - ALFA sells merchandise to BETA. The selling price is 4,500, the cost of the goods sold

is 1,500. At the end of the period, all the merchandise is still in the inventory of BETA; - BETA sells to ALFA a plant whose net carrying amount was 7,500 (historical cost =

10,500). The selling price is 9,000. Both companies use a depreciation rate of 15%; - BETA declares and pays dividends for a total amount of 6 - 00.

Required: Estimate the value of the investments in BETA to be recorded in the financial statements of company ALFA on the following dates:

- January 1 X - December 31 X

SOLUTION- The equity method

§ January 1, X On January 1 X, the value of the investments in the balance sheet of company ALFA equals the cost, that is 9.000.

§ December 31, X In order to measure the value of the investments using the equity method on a date subsequent to the acquisition, we need to identify the elements included in the cost of the investment and define how much is the surplus on the assets/liabilities and the value of the goodwill of company BETA.

Book value Fair value Buildings 15.000 16.500 Patents 0 9.000

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Total cost of the investment = 9.000 OE of the associate = 12,000 * 30%= 3,600 Surplus on buildings net of taxes = (16,500-15,000) *(1-0,40)*30% = 270 Surplus on patents net of taxes= 9,000 *(1-0,40)*30% = 1.620 Goodwill = 9,000 – (3,600+270+1,620)= 3,510 ------------------- Value of the investments on Jan. 1, X 9,000 + net earnings of BETA = 3450*30% +1035 - depreciation on buildings = 270/15 - 18 - amortization on patents =1620/30 -54 - elimin. intragroup profits on merchandise = (4500-3500)*(1-0,40) *30% -540 - elimin. intragroup profits on plants = -207 (*) - elimination of dividends = 600*30% -180 Increase in the value of the investments +36 Total value of the investments on Dec. 31, X 6.036 ------------------- (*) This is calculated as follows:

- Intragroup gain to be eliminated = 9,000-7,500 = 1,500 - Adjustment to the depreciation:

BETA would have recorded depreciation expense for 1575 ALFA records depreciation for 1350 The depreciation expense must be increased by 225 Total effect on earnings (before taxes) = -1,500-225 = - 1.725 Total effect on earnings (net of taxes) = -1,725*40% = - 690 Share pertaining to company ALFA = -690*30% = - 207