An introduction to. consolidated financial

Chapter 35 An introduction to consolidated financial statements Learning objectives After reading this chapter you should be able to: 1 explain the meaning of the key terms and concepts listed at the end of the chapter; 2 describe the regulatory requirements of the Companies Acts and IFRS 3 with regard to consolidated financial statements; 3 explain the nature of goodwill on acquisition and describe the provisions of IFRS 3 concerning its accounting treatment; 1

4 prepare consolidated statements of financial position, including the entries for goodwill and minority interests; 5 prepare consolidated income statements, including the entries for minority interests and simple examples of intragroup sales. Introduction Throughout this book there are several exercises containing investments, listed or otherwise. The reader should, therefore, by this point be accustomed to the idea that one company may own shares in another company. Where these shares are held on a longterm basis, they are shown as a non-current asset in the final financial statements of the company that owns the shares. They are usually described as Investment in subsidiaries. This chapter is also concerned with investments that are held on a long-term basis, but deals with the situation where the parent company owns a relatively large number of shares in another company; more precisely, usually in excess of 50 per cent of the other company s issued equity share capital, or even all its shares, both of which are said to constitute control of one company by another. The company that owns the shares is referred to as the parent (or holding) company. The company whose shares are owned is referred to as a subsidiary of the parent company. When this situation arises these two companies are said to constitute a group. Thus, a group exists when a parent company has one or more subsidiaries. Where the parent company owns all the issued equity share 2

capital of a subsidiary it is referred to as a wholly owned subsidiary. If the parent company owns more than 50 per cent but less than 100 per cent of the issued equity share capital of a subsidiary it is referred to as a partially owned or partly owned subsidiary. Where a group exists, the law requires consolidated (also known as group) financial statements to be prepared. In simple terms, consolidated financial statements are a combination of the final financial statements of a parent company with those of its subsidiary (or subsidiaries). Thus, where a group exists, a separate set of financial statements must be prepared for each of the following: 1 the parent company; 2 one for each subsidiary; and 3 consolidated financial statements of the parent company and its subsidiary (or subsidiaries). The latter will be included in the annual report of the parent company, along with its own financial statements. Learning Activity 35.1 Examine Viridian Group plc s financial statements. Note how details are provided for both the group and the parent company separately. 3

Identifying business combinations Consolidated financial statements are governed by the Companies Act 2006 1 as well as IFRS 3 Business combinations 2, issued by the IASB and applicable from March 2004 and IAS 27 Consolidated and separate financial statements 3. When two or more separate entities come together to form one reporting entity this is known as a business combination (IFRS 3). In most instances one company gains control (the acquiring company). In these instances consolidated financial statements are required to be prepared. IFRS 3 defines a group as a parent and all its subsidiaries. Wherein a parent is defined as an entity that has one, or more subsidiaries and a subsidiary is defined as an entity, including an unincorporated entity such as a partnership, that is controlled by another entity (the parent). In short, a group may include bodies other than limited companies. However, for simplicity, this chapter is confined to entities that are limited companies, and where there is only one subsidiary. The rules relating to whether a group exists (and thus whether consolidated financial statements must be prepared) are rather complex, in order to avoid companies circumventing the law. They focus on what constitutes a subsidiary. In the introduction a subsidiary was defined in simple terms as being a company where more than 50 per cent of its issued equity share capital is owned by another company. To be more accurate this refers to the company s voting shares. Moreover, this is only meant to be indicative of the main criterion of what constitutes a parent subsidiary relationship, namely where one entity exercises control over another entity. 4

Thus, according to IFRS 3 an entity is the parent of another subsidiary if any of the following apply. a It holds power over more than 50 per cent of the voting rights of the entity with the agreement of other investor; b It has the power to govern the financial and operating policies of the other entity under a stature or an agreement; c It has the power to appoint or remove the majority of the members of the board of directors, or equivalent governing body of the other entity; or d It has the power to cast the majority of votes at meetings of the board of directors or equivalent governing body of the other entity. Control is defined in IFRS 3 as the power to govern the financial and operating policies of an entity so as to benefit from its activities. The Companies Act and IFRS 3 require that parent entities provide financial information about the economic activities of their groups by preparing consolidated financial statements. These are defined in IAS 27 as the financial statements of a group presented as those of a single entity. Preparing group financial statements involves a process of adjusting and combining financial information from the individual financial statements of a parent and its subsidiaries to prepare consolidated financial statements that present financial information for the whole group as a single economic entity. There is one final key term that needs to be explained at this point. As mentioned earlier, some subsidiaries may be only partially owned by a parent company. This means 5

that a minority of its shares are owned by other organisations and/or individuals who also have a financial interest in the entity. These are thus referred to as minority interests. The minority interest is defined in IFRS 3 as that portion of the profit or loss and net assets of a subsidiary attributable to equity interests that are not owned, directly or indirectly through subsidiaries, by the parent (discussed in more detail later). Minority interests are also referred to as non-controlling interests. Goodwill on acquisition When one company buys another company (by purchasing its shares), the price paid is usually greater than the value of its net assets. The excess of the purchase price over the value of its net assets relates to the cost of goodwill. In other words, when a parent company acquires a subsidiary this usually gives rise to what is referred to as goodwill on acquisition, or more accurately, purchased goodwill. This is defined in IFRS 3 as the difference between the cost of an acquired entity and the aggregate of the fair values of that entity s identifiable assets, liabilities and contingent liabilities. The purchased goodwill is calculated in precisely the manner explicit in its definition. This has to be reflected in the consolidated statement of financial position as shown in the next section. There are complex rules about what constitutes the fair values of an acquired entity s identifiable assets and liabilities. These are too advanced for an introductory textbook, and it is sufficient at this stage to point out that book values are not usually fair values. 6

However, for the sake of simplicity, this chapter assumes that the book values are fair values. Goodwill was dealt with in detail in Chapter 28 on changes in partnerships. Students following a syllabus that does not include changes in partnerships, but does include goodwill, are advised to read the two sections entitled the nature of goodwill and the recognition of goodwill in financial statements at this point, if they have not already done so. The most relevant aspect of the latter is that IFRS 3 requires goodwill to be capitalised as an intangible asset and impaired to fair value when/if it diminishes in value (It cannot be revalued upwards). The recommended accounting treatment can be found in Viridian Group plc s financial statements. Viridian Group plc Accounting policies (Note this is just an extract. The accounting policy states how the group determines fair value and how they deal with goodwill on the sale of a subsidiary. This is deemed to be beyond the scope of this text, so is not presented here) Goodwill Goodwill arising on consolidation represents the excess of the cost of acquisition over the fair value of the identifiable net assets of a subsidiary at the date of acquisition. Goodwill 7

is recognised as an asset and reviewed for impairment annually... Goodwill is stated at cost less any impairment in value. The value of goodwill in some instances can be very material and very difficult to value correctly. For example: Real life example In May 2000 Cap Gemini purchased Ernst and Young s consulting practice for $11.3 billion. At the time Ernst and Young had valued the business at $4.745 billion. The difference would be accounted for as goodwill. The consolidated statement of financial position As explained earlier, the statement of financial position of the parent company will normally contain only one entry relating to its subsidiary: the cost of the investment in its subsidiary. That is, the price paid to acquire the shares of the subsidiary. This is shown under the heading of non-current asset: investment in subsidiary. It does not change as a 8

result of consolidation. The consolidated statement of financial position is part of a separate set of consolidated financial statements. The main objective of consolidated statements of financial position is to provide information about the group s financial position to the equity shareholders of the parent company. The consolidated statement of financial position is prepared by aggregating on a line-by-line basis all the assets and liabilities of the parent company with those of its subsidiary. The result is a statement of financial position containing the assets and liabilities of the two entities as if they were owned by a single economic entity. A working ledger account, the cost of control account is usually established when preparing group financial statements. It is used to eliminate the ledger account balances that are not simply combined. The balance on this account is goodwill on acquisition. The cost of the investment in the subsidiary and the equity that is taken over at the date of the business combination are transferred to this account. A simple illustration is given in Example 35.1. Example 35.1 The following are the statements of financial position of Parent plc and Subsidiary Ltd. as at 31 December 20X1: Parent plc Subsidiary Ltd ASSETS million million Non-current assets Property, plant and equipment 3,400 600 Investment in Subsidiary Ltd. 900 9

4,300 600 Current assets 600 400 Total assets 4,900 1,000 EQUITY AND LIABILITIES Equity Equity share capital 3,000 500 Retained earnings 1,700 300 Total equity 4,700 800 Current liabilities 200 200 Total equity and liabilities 4,900 1,000 Parent plc purchased all the equity shares of Subsidiary Ltd. on the 31 December 20X1. The assets and liabilities of Subsidiary Ltd. are shown in its financial statements at what are agreed to be appropriate fair values. Required Prepare a consolidated statement of financial position as at 31 December 20X1. Workings Cost of control account 20X1 Details m 20X1 Details m 31 Dec Inv in Subsidiary 900 31 Dec 100% Share capital 500 Ltd. 100% Retained earnings 300 Goodwill 100 900 900 To check. Purchased goodwill = the price paid less the net assets taken over = 900m 10

( 1,000m 200m) = 100m Parent Group Consolidated statement of financial position as at 31 December 20X1 ASSETS m Non-current assets Property, plant and equipment ( 3,400 + 600) 4,000 Goodwill 100 4,100 Current assets ( 600 + 400) 1,000 Total assets 5,100 EQUITY AND LIABILITIES Equity Equity share capital 3,000 Retained earnings 1,700 Total equity 4,700 Current liabilities ( 200 + 200) 400 Total equity and liabilities 5,100 Notice that only the assets and liabilities of each entity are aggregated. The share capital and retained earnings are not aggregated. The share capital and retained earnings of the subsidiary do not appear on the consolidated statement of financial position. Many authors explain the reason for this as being because the consolidation process simply 11

replaces the investment in the subsidiary shown in the parent company s statement of financial position with the net assets of the subsidiary (and any goodwill). This is true in an accounting sense, but students should remember that the statement of financial position of the parent company does not change as a result of consolidation. A more meaningful way of explaining the exclusion of the subsidiary s capital and reserves perhaps lies in the nature and function of consolidated financial statements. The consolidated statement of financial position is meant to relate to a single economic entity. The net assets of that entity belong to the equity shareholders of the parent company. Thus, only their equity interests are shown on the statement of financial position. As a single economic entity the subsidiary, its shares and its shareholder(s) simply do not exist. Thus, the share capital and reserves of the subsidiary do not appear in the consolidated statement of financial position. There is, however, a much more important legal reason why the reserves of the subsidiary do not appear in the consolidated statement of financial position. This is because they arose prior to its acquisition by the parent company, which is why they are referred to as pre-acquisition reserves. The rest of this chapter focuses on post-acquisition revenue reserves/retained earnings. However, before moving on it is important to appreciate that the above discussion relating to the treatment of pre-acquisition reserves applies to all reserves both revenue and capital. That is, any retained earnings, share premium account and/or revaluation reserve in the financial statements of the subsidiary which arose prior to acquisition must not be included in the consolidated statement of financial position. 12

This brings us to the next important point in consolidated statements of financial position. Whereas pre-acquisition reserves of a subsidiary are not included in a consolidated statement of financial position, post-acquisition reserves are included. This is because they are generated after acquisition and are represented by an increase in the net assets of the subsidiary. Therefore, they belong to the equity shareholders of the parent company (this assumes that all of the share capital is taken over by the parent company. If the parent company only takes over 70% of the equity shares then it will be entitled to 70% of the profits made post-acquisition (discussed later)). In other terms, post-acquisition reserves constitute an increase in the value of the parent company s investment in its subsidiary. The workings for the consolidated reserves are easier to understand if the transactions are shown in the ledger accounts. This is illustrated in Example 35.2, which is a continuation of Example 35.1. Example 35.2 During the year ended 31 December 20X2, Parent plc made a profit of 750 million, and Subsidiary Ltd. made a profit of 250 million. This has resulted in an equivalent increase in their net current assets and reserves as shown below in their statement of financial positions as at 31 December 20X2. 13

Parent plc Subsidiary Ltd. ASSETS million million Non-current assets Property, plant and equipment 3,400 600 Investment in Subsidiary Ltd. 900 4,300 600 Current assets 1,350 650 Total assets 5,650 1,250 EQUITY AND LIABILITIES Equity Equity share capital 3,000 500 Retained earnings 2,450 550 Total equity 5,450 1,050 Current liabilities 200 200 Total equity and liabilities 5,650 1,250 Goodwill on acquisition is considered to have lost 5 million in value over the first year. Required Prepare a consolidated statement of financial position as at 31 December 20X2. Workings Reserves (Subsidiary Ltd.) 20X1 Details m 20X1 Details m 31 Dec Cost of control 300 31 Dec Bal b/d 300 20X2 20X2 31 Dec Consolidated reserves 250 31 Dec Profit for the year* 250 14

*The profit for the year is the movement in reserves. The statement of financial position for 20X2 states that the total reserves in the subsidiary is 550 million, and the statement of financial position for 20X1 states that total reserves was 300 million. The difference 250 million must have been the profit for the year. The profit for the year postacquisition goes to the group, as it is entitled to 100% of it. Reserves (Parent plc) 20X1 Details m 20X1 Details m 31 Dec Consolidated reserves 1,700 31 Dec Bal b/d 1,700 20X2 20X2 31 Dec Consolidated reserves 750 31 Dec Profit for the year 750 *The profit for the year is the movement in reserves. The statement of financial position for 20X2 states that the total reserves in the subsidiary is 2,450 million, and the statement of financial position for 20X1 states that total reserves was 1,700 million. The difference 750 million must have been the profit for the year. All of the profits of the parent are the groups. The only group specific adjustment is the impairment of goodwill by 5 million. The double entry for this will be: Debit Credit Debit: Income statement group (hence retained earnings) 5 million Credit: Goodwill account 5 million Being the impairment of goodwill by 5 million in the year ended 31 December 20X2 15

Consolidated reserves 20X2 Details m 20X2 Details m 31 Dec Goodwill impairment 5 1 Jan Reserves (Parent plc) 1,700 31 Dec Reserves (Subsidiary Ltd.) 250 31 Dec Balance c/d 2,695 Reserves (Parent plc) 750 2,700 2,700 20X3 1 Jan Balance b/d 2,695 Parent Group Consolidated statement of financial position as at 31 December 20X2 ASSETS m Non-current assets Property, plant and equipment ( 3,400 + 600) 4,000 Goodwill ( 100 5) 95 4,095 Current assets ( 1,350 + 650) 2,000 Total assets 6,095 EQUITY AND LIABILITIES Equity Equity share capital 3,000 Retained earnings 2,695 Total equity 5,695 Current liabilities ( 200 + 200) 400 Total equity and liabilities 6,095 16

Minority interests So far in this section it has been assumed that the subsidiary is wholly owned. As has already been mentioned, a subsidiary may be partially owned by its parent company, in which case there will be a minority interest, as defined earlier. What needs to be explained at this stage is why minority interests appear in consolidated statements of financial position. The reason is essentially that one of the basic underlying principles of consolidation is that consolidated financial statements are prepared on the basis that the parent and subsidiary are a single economic entity. That is, all the assets and liabilities of the parent and subsidiary are aggregated without regard to the proportion of the subsidiary s voting shares that are owned by the parent. However, it must be recognised that a proportion of these net assets is owned/financed by the other (minority) shareholders. This is achieved by entering the value of the minority interest on the consolidated statement of financial position as a part of the group s capital. The movement in minority interests is best explained using a ledger account. At this stage, when consolidating, it is recommended that the subsidiary s equity accounts and two group ledger accounts are opened, the cost of control and minority interests. This is illustrated in Examples 35.3 and 35.4. The latter is a continuation of the former. Example 35.3 17

The following are the statements of financial position of Holding plc and Subsidy Ltd. as at 30 June 20X1: Holding plc Subsidy Ltd. ASSETS million million Non-current assets Property, plant and equipment 3,760 600 Investment in Subsidy Ltd. 540 4,300 600 Current assets 600 400 Total assets 4,900 1,000 EQUITY AND LIABILITIES Equity Equity share capital 3,000 500 Retained earnings 1,700 300 Total equity 4,700 800 Current liabilities 200 200 Total equity and liabilities 4,900 1,000 Holding plc purchased 60 per cent of the equity shares of Subsidy Ltd. on 30 June 20X1 at a price of 540 million. The assets and liabilities of Subsidy Ltd. are shown in its financial statements at what are agreed to be appropriate fair values. Required Prepare a consolidated statement of financial position as at 30 June 20X1. 18

Workings Cost of control account 20X1 Details m 20X1 Details m 31 Dec Inv. in Subsidy Ltd. 540 31 Dec 60% Share capital 300 60% Retained earnings 180 Goodwill 60 540 540 Subsidy Ltd. reserves 20X1 Details m 20X1 Details m 31 Dec Cost of control (60%) 180 31 Dec Balance b/d 300 31 Dec Minority interests (40%) 120 300 300 Subsidy Ltd. Share capital 20X1 Details m 20X1 Details m 31 Dec Cost of control (60%) 300 31 Dec Balance b/d 500 31 Dec Minority interests (40%) 200 500 500 Minority interests 20X1 Details m 20X1 Details m 31 Dec Reserves Subsidy (40%) 120 31 Dec Balance c/d 320 31 Dec Share capital: Subsidy (40%) 200 320 320 20X2 1 Jan Balance b/d 320 19

Holding group Consolidated statement of financial position as at 31 December 20X2 ASSETS m Non-current assets Property, plant and equipment ( 3,760 + 600) 4,360 Goodwill 60 4,420 Current assets ( 600 + 400) 1,000 Total assets 5,420 EQUITY AND LIABILITIES Equity attributable to owners of the parent Equity share capital 3,000 Retained earnings 1,700 4,700 Non-controlling interests 320 Total equity 5,020 Current liabilities ( 200 + 200) 400 Total equity and liabilities 5,420 Example 35.4 During the year ended 30 June 20X2, Holding plc made a profit of 750 million, and 20

Subsidy Ltd. made a profit of 250 million. This has resulted in an equivalent increase in their net current assets and reserves as shown below in their statement of financial positions as at 30 June 20X2. Holding plc Subsidy Ltd. ASSETS million million Non-current assets Property, plant and equipment 3,760 600 Investment in Subsidy Ltd. 540 4,300 600 Current assets 1,350 650 Total assets 5,650 1,250 EQUITY AND LIABILITIES Equity Equity share capital 3,000 500 Retained earnings 2,450 550 Total equity 5,450 1,050 Current liabilities 200 200 Total equity and liabilities 5,650 1,250 Goodwill on acquisition is considered to have lost 3 million in value over the first year. Required Prepare a consolidated statement of financial position as at 30 June 20X2. Workings 21

Subsidy Ltd. reserves 20X1 Details m 20X1 Details m 31 Dec Cost of control (60%) 180 31 Dec Balance b/d 300 31 Dec Minority interests (40%) 120 300 300 20X2 20X2 31 Dec Consolidated reserves (60%) 150 31 Dec Profit for the year 250 31 Dec Minority interests (40%) 100 250 250 Reserves (Holding plc) 20X1 Details m 20X1 Details m 31 Dec Consolidated reserves 1,700 31 Dec Bal b/d 1,700 20X2 20X2 31 Dec Consolidated reserves 750 31 Dec Profit for the year 750 2,450 2,450 Consolidated reserves 20X2 Details m 20X2 Details m 31 Dec Goodwill impairment 3 1 Jan Reserves (Parent plc) 1,700 31 Dec Profit (Subsidy Ltd.) 60% 150 31 Dec Balance c/d 2,597 Profit (Holding plc) 100% 750 2,600 2,600 20X3 1 Jan Balance b/d 2,597 Minority interests 20X1 Details m 20X1 Details m 31 Dec Reserves Subsidy (40%) 120 22

31 Dec Balance c/d 320 31 Dec Share capital: Subsidy (40%) 200 320 320 20X2 20X2 1 Jan Balance b/d 320 31 Dec Balance c/d 420 31 Dec Profit in year subsidy (40%) 100 420 420 20X3 1 Dec Balance b/d 420 Holding group Consolidated statement of financial position as at 30 June 20X2 ASSETS m Non-current assets Property, plant and equipment ( 3,760 + 600) 4,360 Goodwill ( 60-3) 57 4,417 Current assets ( 1,350 + 650) 2,000 Total assets 6,417 EQUITY AND LIABILITIES Equity attributable to owners of the parent Equity share capital 3,000 Retained earnings 2,597 5,597 Non-controlling interests 420 Total equity 6,017 Current liabilities ( 200 + 200) 400 23

Total equity and liabilities 6,417 The consolidated income statement The income statement of a parent company will normally contain only one entry relating to its subsidiary the dividends received from the subsidiary. This is referred to in published financial statements as income from shares in subsidiaries. It does not change as a result of consolidation. The consolidated income statement is part of a separate set of consolidated financial statements. The main objective of consolidated income statements is to provide information about the group s financial performance to the equity shareholders of the parent company. The principles of preparing a consolidated income statement are much the same as those relating to the consolidated statement of financial position. That is, most of the items in the parent company s income statement are aggregated on a line-by-line basis with those in the subsidiary company s income statement. However, there are complications arising from what are referred to as intragroup transactions and items. These take two main forms, intragroup sales and the dividends paid to the parent company by its subsidiary. Since the consolidated income statement is intended to reflect the trading activities of the group as a single economic entity, these must be eliminated. In arithmetic terms, they cancel each other out. This is illustrated in 24

Example 35.5. Example 35.5 The following are the income statements of Parent plc and Subsidiary Ltd. for the year ended 31 December 20X2: Parent plc Subsidiary Ltd. million million Turnover 10,050 3,300 Cost of sales (6,700) (2,200) Gross profit 3,350 1,100 Distribution costs (550) (275) Administrative expenses (350) (125) Dividends from Subsidiary Ltd. 150 Profit before taxation 2,600 700 Income tax (1,200) (300) Profit for the year 1,400 400 Parent plc acquired all the equity shares of Subsidiary Ltd. on the 31 December 20X1. During the year Parent plc sold goods for 50 million, to Subsidiary Ltd. who has sold them all to third parties during the year. Parent plc paid a dividend of 650 million during the year and Subsidiary Ltd. paid a dividend during the year of 150 million. Required 25

Prepare a consolidated income statement for the year ended 31 December 20X2. Parent group Consolidated income statement for the year ended 31 December 20X2 m Turnover ( 10,050 50 + 3,300) 13,300 Cost of sales ( 6,700 + 2,200 50) (8,850) Gross profit 4,450 Distribution costs ( 550 + 275) (825) Administrative expenses ( 350 + 125) (475) Profit before taxation 3,150 Income tax ( 1,200 + 300) (1,500) Profit for the year 1,650 Any impairment of goodwill on acquisition would also have to be entered in the consolidated income statement. Using the data in Example 35.2, this will reduce the profit by 5 million. The Parent group consolidated statement of financial position will be as shown in Example 35.2. The figure for reserves on this consolidated statement of financial position would be computed as follows: m Balance at 31 Dec 20X1 (given on the consolidated statement of financial position in Example 35.1) 1,700 Profit for the year ( 1,650 5) 1,645 Dividends paid (650) Balance at 31 Dec 20X2 2,695 26

Minority interest As already discussed, a subsidiary may be only partially owned by its parent company, in which case there will be a minority interest, as defined earlier. The minority interest will not only be reflected in the consolidated statement of financial position, but also appear in the consolidated income statement. The reason is essentially that one of the basic underlying principles of consolidation is that consolidated financial statements are prepared on the basis that the parent and subsidiary are a single economic entity. That is, the revenue and costs of the parent and subsidiary are aggregated without regard to the proportion of the subsidiary s voting shares that are owned by the parent. However, it must be recognised that a proportion of the profit (or loss) of the subsidiary belongs to the other (minority) shareholders. Therefore, the group profit for the year is analysed into profit attributable to the owners of the parent and profit attributable to non-controlling interests (i.e. minority interests). This is illustrated in Example 35.6. Example 35.6 The following are the income statements of Holding plc and Subsidy Ltd. for the year ended 30 June 20X2: Holding plc Subsidy Ltd. 27

million million Turnover 10,050 3,300 Cost of sales (6,700) (2,200) Gross profit 3,350 1,100 Distribution costs (550) (275) Administrative expenses (290) (125) Dividends from Subsidiary Ltd. 90 Profit before taxation 2,600 700 Income tax (1,200) (300) Profit for the year 1,400 400 Holding plc acquired 60 per cent of the equity shares of Subsidy Ltd. on 30 June 20X1. Holding plc paid a dividend of 650 million during the year and Subsidy Ltd. paid a dividend during the year of 150 million. Required Prepare a consolidated income statement for the year ended 30 June 20X2. Workings Minority interest = 40 per cent = 400m 160m Holding Group Consolidated income statement for the year ended 30 June 20X2 m Turnover ( 10,050 + 3,300) 13,350 Cost of sales ( 6,700 + 2,200) (8,900) 28

Gross profit 4,450 Distribution costs ( 550 + 275) (825) Administrative expenses ( 290 + 125) (415) Profit before taxation 3,210 Income tax ( 1,200 + 300) (1,500) Profit for the year 1,710 Profit attributable to: Owners of the parent 1,550 Non-controlling interests 160 1,710 Notice that the profit for the year in the consolidated income statement that is attributable to the equity holders of the parent company equals the profit for the year of the parent/holding company plus its share of the profit for the year of the subsidiary, less the dividend received from the subsidiary. That is, in the above example 1,400m + (60 per cent 400m) - 90= 1,550 m. Any impairment of goodwill on acquisition would also have to be entered in the consolidated income statement. Using the data in Example 35.4, this will reduce the group profit/retained profit by 3 million. The Holding group consolidated statement of financial position will be as shown in Example 35.4. The figure for reserves on this consolidated statement of financial position would be computed as follows: Balance at 30 June 20X1 (given on the consolidated m 29

statement of financial position in Example 35.3) 1,700 Retained earnings for the financial year ( 1,550 3) 1,547 Dividend paid (650) Balance at 30 June 20X2 2,597 The figure for minority interest on this consolidated statement of financial position can also be computed as follows: m Balance at 30 June 20X1 (given on the consolidated statement of financial position in Example 35.3) 320 Minority interest in consolidated income statement 160 480 Dividends paid to minority shareholders ( 150 90) or (40% 150) (60) Balance at 30 June 20X2 420 This increase in the minority interest on the consolidated statement of financial position of 160m 60m = 100m is their share of the profit less the dividends paid to them from their share of the profit. Those students who conceptualise the preparation of the consolidated income statement as an arithmetic combination of the income statements of the parent and subsidiary may have observed that 100m was in a sense lost in the process. It has now reappeared as the increase in minority interest in the consolidated statement of financial position. 30

Learning Activity 35.2 Visit the website of a large listed/quoted public limited company that has a subsidiary whose shares are also listed, and find their latest annual report and financial statements. Examine the contents of the income statement, statement of financial position and notes to the financial statements, paying particular attention to the items relating to goodwill and minority interests. Summary The Companies Act 2006 as well as IFRS 3 and IAS 27 require the preparation of consolidated financial statements where a group exists. A group is defined as a parent and all its subsidiaries. There are detailed legal regulations regarding when a parent subsidiary relationship exists. The main criteria include: where the parent holds over at least 50%, or has influence over at least 50% of the voting rights in the subsidiary; or has the power to govern the financial or operating policies of the subsidiary either under statute or by an agreement; or has the power to appoint or remove the majority of the board of directors; or has to power to cast a majority of votes at board meetings. Control refers to the power that a parent has to govern the operating and financial policies of the subsidiary so as to have benefits from its activities. Consolidated financial statements are defined in IFRS 3 as the financial statements of 31

a group presented as those of a single economic entity. Consolidation is the process of adjusting and combining financial information from the individual financial statements of a parent and its subsidiaries to prepare consolidated financial statements that present financial information for the group as a single economic entity. Consolidated financial statements include a consolidated income statement and a consolidated statement of financial position. These are prepared by aggregating on a lineby-line basis most of the items in the parent s financial statements with those in the subsidiaries financial statements while at the same time eliminating certain intra-group items, referred to above as adjustments. The process of consolidation usually gives rise to goodwill on acquisition. This must be accounted for in accordance with IFRS 3 (i.e. impaired), which refers to it as purchased goodwill. Where a subsidiary is only partially owned by the parent, the process of consolidation also gives rise to minority interests in both the consolidated income statement and the consolidated statement of financial position. A minority interest is defined in IAS 27 as that portion of the profit or loss and net assets of a subsidiary attributable to equity interests that are not owned, directly or indirectly through subsidiaries, by the parent. The group profit for the year is analysed into profit attributable to the owners of the parent and profit attributable to non-controlling interests (i.e. minority interests). The minority interest is also shown in the consolidated statement of financial position as part of the group s overall equity capital, and represents their share of the subsidiary s net assets. 32

Key terms and concepts Consolidated financial statements Control Cost of control Group Minority interest Non-controlling interests Parent Pre-acquisition reserves Post-acquisition reserves Purchased goodwill Subsidiary References 1. Companies Act (2006), HM Stationery Office. 2. International Accounting Standards Board, (2008), International Financial Reporting Standard 3 Business Combinations, (IASB). 3. International Accounting Standards Board, (2008), International Accounting Standard 27 Consolidated and Separate Financial Statements, (IASB). 33

Review questions 35.1 Define each of the following in accordance with the Companies Act 2006, IFRS 3 Business Combinations (IASB, 2008) and International Accounting Standard 27 Consolidated and Separate Financial Statements (2008): a a group; b a subsidiary; c consolidated financial statements; d consolidation. 35.2 Describe fully the provisions of IFRS 3 with regard to what constitutes a parent and a subsidiary. 35.3 a Explain the nature of goodwill arising on the acquisition of a subsidiary and how it is measured. b Describe the requirements of IFRS 3 Business Combinations (IASB, 2008) with regard to the accounting treatment of purchased goodwill. 35.4 a Explain the objective(s) of consolidated financial statements. b Describe in general terms the principles of consolidation. 35.5 Parhold plc has bought for cash of 12 million all the voting shares of Subsid plc, whose net assets have been valued at 10 million. Describe how this transaction would affect: 34

a the statement of financial position of Parhold plc; and b the statement of financial position of Parhold Group, given that Subsid plc is the only subsidiary. You need only describe the effects on these statements of financial position on the date of acquisition of Subsid s shares. 35.6 Given the circumstances in Question 35.5 above, describe how this relationship between Parhold plc and Subsid plc would affect the following at the end of the first accounting year after acquisition: a the financial statements of Subsid plc; b the financial statements of Parhold plc; and c the consolidated financial statements of Parhold Group. 35.7 a Define a minority interest in accordance with International Accounting Standard 27 Consolidated and Separate Financial Statements (2008). b Explain why minority interests arise in consolidated financial statements in the context of the principles of consolidation. c Describe the effects of a minority interest on the consolidated financial statements. Exercises 35.8 Level II 35

At 1 January 20X0 H Ltd. acquired 80 per cent of the share capital of S for 160,000. At that date the share capital of S consisted of 100,000 equity shares of 1 each and its reserves totalled 40,000. Goodwill on acquisition of subsidiaries was impaired by 15,000 in 20X0, 10,000 in 20X1 and 3,800 in 20X2. In the consolidated statement of financial position of H and its subsidiary S at 31 December 20X2 the amount appearing for goodwill should be: a 16,000; b 19,200; c 28,800; or d 4,000? (ACCA) 35.9 Level II At 1 January 20X0 H Ltd. acquired 60 per cent of the share capital of S for 180,000. At that date the share capital of S consisted of 200,000 shares of 50p each. The reserves of H and S are stated below: At 1 Jan 20X0 At 31 Dec 20X2 H 280,000 340,000 S 50,000 180,000 In the consolidated statement of financial position of H and its subsidiary S at 31 December 20X2, what amount should appear for the minority interest in S? a 92,000; b 280,000; 36

c 152,000; d 112,000. (ACCA) 35.10 Level II H Ltd. acquired 75 per cent of the share capital of S for 280,000 on 1 January 20W6. Goodwill arising on consolidation has been fully impaired. Details of the share capital and retained earnings of S are as follows: At 1 January 20W6 At 31 December 20X2 Share capital 200,000 200,000 Retained earnings 120,000 180,000 At 31 December 20X2 the retained earnings of H amounted to 480,000. What figure should appear in the consolidated statement of financial position of H and S for the retained earnings at 31 December 20X2? a 530,000; b 525,000; c 485,000; d 575,000. (ACCA) 35.11 Level II 37

Statements of financial position for A plc and B plc as at 31 December 20X0 ASSETS A plc B plc Non-current assets 000 000 Property, plant and equipment 1,000 200 1,000 200 Current assets 1,450 290 Total assets 2,450 490 EQUITY AND LIABILITIES Equity Equity share capital 1,200 150 Revaluation reserve 40 Retained earnings 400 10 Total equity 1,600 200 Non-current liabilities Long-term loan 450 90 Current liabilities 400 200 Total liabilities 850 290 Total equity and liabilities 2,450 490 Other information: A plc purchased 100% of the equity shares of B plc for 300,000 Required 38

a Prepare A s statement of financial position after the purchase (assume the purchase was made in cash). b Prepare the statement of financial position for the group after the acquisition. 35.12 Level II Using the information from 35.11 Assume that in this scenario A plc 80% of equity shares of B plc for 240 Required a Prepare A s statement of financial position after the purchase (assume the purchase was made in cash). b Prepare the statement of financial position for the group after the acquisition. 35.13 Level II Using the information from 35.11 Assume that in this scenario A plc 80% of equity shares of B plc for 140 Required 39

a Prepare A s statement of financial position after the purchase (assume the purchase was made in cash). b Prepare the statement of financial position for the group after the acquisition. 35.14 Level II The following are the statements of financial position of Gold plc and Silver plc as at 1 January 20X1: Gold plc Silver plc ASSETS 000 000 Non-current assets Property, plant and equipment 13,600 2,500 Investment in Silver plc 3,600 17,200 2,500 Current assets 2,000 1,000 Total assets 19,200 3,500 EQUITY AND LIABILITIES Equity Equity share capital 5,000 1,000 Share premium 4,000 800 Revaluation reserve 3,000 200 Retained earnings 6,800 1,200 Total equity 18,800 3,200 Current liabilities 400 300 Total equity and liabilities 19,200 3,500 40

Gold plc purchased all the equity shares of Silver plc on 1 January 20X1. The assets and liabilities of Silver plc are shown in its financial statements at what are agreed to be appropriate fair values. Required Prepare a consolidated statement of financial position as at 1 January 20X1. 35.15 Level II (This is a continuation of Exercise 35.11.) The following are the income statements and statements of financial position of Gold plc and Silver plc for the year ended 31 December 20X1: Income statements Gold plc Silver plc 000 000 Turnover 20,100 6,600 Cost of sales (13,400) (4,400) Gross profit 6,700 2,200 Distribution costs (1,100) (550) Administrative expenses (700) (250) Dividends from Silver plc 300 Profit before taxation 5,200 1,400 Income tax (2,400) (600) 41

Profit for the year 2,800 800 Gold plc Silver plc ASSETS 000 000 Non-current assets Property, plant and equipment 13,600 2,500 Investment in Silver plc 3,600 17,200 2,500 Current assets 3,500 1,500 Total assets 20,700 4,000 EQUITY AND LIABILITIES Equity Equity share capital 5,000 1,000 Share premium 4,000 800 Revaluation reserve 3,000 200 Retained earnings 8,300 1,700 Total equity 20,300 3,700 Current liabilities 400 300 Total equity and liabilities 20,700 4,000 Other information Gold plc paid a dividend of 1,300,000 during the year and Silver plc paid a dividend of 300,000 during the year. Required Prepare a consolidated income statement for the year and a consolidated statement 42

of financial position as at 31 December 20X1. Goodwill has not diminished in value. 35.16 Level II The following are the statements of financial positions of Wood plc and Stone plc as at 1 May 20X1: Wood plc Stone plc ASSETS 000 000 Non-current assets Property, plant and equipment 10,000 3,000 Investment in Stone plc 4,800 14,800 3,000 Current assets 4,000 2,500 Total assets 18,800 5,500 EQUITY AND LIABILITIES Equity Equity share capital 6,000 1,500 Share premium 4,500 750 Revaluation reserve 2,500 650 Retained earnings 5,300 2,100 Total equity 18,300 5,000 Current liabilities 500 500 Total equity and liabilities 18,800 5,500 43

Wood plc purchased 80 per cent of the equity shares of Stone plc on 1 May 20X1 at a price of 4,800,000. The assets and liabilities of Stone plc are shown in its financial statements at what are agreed to be appropriate fair values. Required Prepare a consolidated statement of financial position as at 1 May 20X1. 35.17 Level II (This is a continuation of Exercise 35.13.) The following are the income statements and statements of financial position of Wood plc and Stone plc for the year ended 30 April 20X2: Income statements Wood plc Stone plc 000 000 Turnover 15,680 3,400 Cost of sales (9,840) (2,300) Gross profit 5,840 1,100 Distribution costs (725) (225) Administrative expenses (875) (275) 44

Dividends from Stone plc 160 Profit before taxation 4,400 600 Income tax (1,800) (150) Profit for the year 2,600 450 Statements of financial position Wood plc Stone plc ASSETS 000 000 Non-current assets Property, plant and equipment 10,000 3,000 Investment in Stone plc 4,800 14,800 3,000 Current assets 5,000 2,500 Total assets 19,800 5,500 EQUITY AND LIABILITIES Equity Equity share capital 6,000 1,500 Share premium 4,500 750 Revaluation reserve 2,500 650 Retained earnings 6,400 2,350 Total equity 19,400 5,250 Current liabilities 400 250 Total equity and liabilities 19,800 5,500 Other information Wood plc paid a dividend of 1,500,000 during the year and Stone plc paid a dividend of 200,000 during the year. 45

Required Prepare a consolidated income statement for the year and a consolidated statement of financial position as at 30 April 20X2. Goodwill has not diminished in value. 35.18 Level II P buys 70% of the shares of S on 31 Dec 20X0. The statements of financial position of the two companies on 31 December 20X1 are as follows: P: Statement of financial position as at 31 Dec 20X1 S: Statement of financial position as at 31 Dec 20X1 ASSETS ASSETS Non-current assets Non-current assets Property, plant and equipment 39,000 Property, plant and equipment 8,400 Investment in S Ltd 7,800 46,800 8,400 Current assets 22,200 Current assets 4,900 Total assets 69,000 Total assets 13,300 EQUITY AND LIABILITIES Equity EQUITY AND LIABILITIES Equity Share capital 50,000 Share capital 10,000 Retained earnings 4,800 Retained earnings 1,700 Profit for 20X1 9,200 14,000 Loss for 20X1 (400) 1,300 General reserve 5,000 General reserve 2,000 Total equity 69,000 Total equity 13,300 46

Required Prepare the consolidated statement of financial position at 31 December 20X1 assuming goodwill is impaired during the year to half of its original value. 35.19 Level II Fresh Ltd. acquired 80% of Stale Ltd. on 1 January 20X1, when the balance on Fresh Ltd. s retained earnings was 160,000 and the balance on Stale Ltd. s retained earnings was 100,000. There have been no share issues since this date by either company. Both companies adopt a policy of not paying any dividends. Summary statement of financial position for both companies as at 31 December 20X1 Fresh Ltd. Stale Ltd. ASSETS Sundry net assets 144,000 220,000 Investment in Stale 200,000 - Total assets 344,000 220,000 EQUITY Equity share capital 80,000 80,000 Share premium 70,000 20,000 Retained earnings 194,000 120,000 Total equity 344,000 220,000 47

Additional information At the end of the year, the directors conduct an impairment review and conclude that the value of goodwill is now 20,000. Required a) Calculate the goodwill on consolidation (all workings must be shown). b) Prepare the consolidated statement of financial position as at 31 December 20X1. 48