Chapter 18 Consolidated Statement of Financial Position
1. Objectives
1.1 Define a parent, a subsidiary, a group, non-controlling interest, group accounts and consolidated financial statements.
1.2 Discuss the legal requirements of group accounts and the relevant requirements of HKAS 27.
1.3 Explain the disclosure requirements of group accounts under HKAS 27.
1.4 Explain the consolidation procedures and relevant conceptual issues, in particular, with regard to:
(i) goodwill;
(ii) non-controlling interest.
1.5 Prepare the consolidated statement of financial position for a group of companies with a simple structure.
2. Definitions
2.1 |
Definitions |
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In accordance with Section 2(4) of the Companies Ordinance, a subsidiary shall be deemed to be a subsidiary of another company if that another company: HKAS 27 widens the definition of a subsidiary based on the concept of control. It defines a subsidiary as an enterprise that is controlled by another enterprise (known as the parent). For this purpose, control is defined as the power to govern the financial and operating policies of another enterprise so as to obtain benefits from its activities. Adopting the wide definition of a subsidiary in HKAS 27 could result in an enterprise being classified as a subsidiary when the enterprise does not meet the legal definition of a subsidiary under the Companies Ordinance. |
3. Control and Special Purpose Entity
(A) Concept of control
3.1 |
Definition |
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HKAS 27 establishes a parent-subsidiary relationship on the concept of control. Control is the power to govern the financial and operating policies of an enterprise so as to obtain benefits from its activities. |
3.2 Control is presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than one half of the voting power of an enterprise. Control also exists even when the parent owns one half or less of the voting power of an enterprise when there is:
(i) power over more than one half of the voting rights by virtue of an agreement with other investors;
(ii) power to govern the financial and operating policies of the enterprise under a statute or an agreement;
(iii) power to appoint or remove the majority of the members of the board of directors or equivalent governing body; or
(iv) power to cast the majority of votes at meetings of the board of directors or its equivalent.
3.3 |
Example 1 |
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ABC Ltd is considering an investment in Samson, the capital structure of which is as follows: 10,000 class A voting ordinary shares and 10,000 class B non-voting ordinary shares. Both classes of shares have the same dividend rights. Required: Describe the appropriate group accounting for Samson if: (a) ABC Ltd purchases 6,000 class A ordinary shares. Solution: (a) ABC Ltd has purchased 6,000 of the 10,000 class A voting shares. With 60% of the voting shares ABC should control Samson. Samson should therefore be treated as a subsidiary. |
(B) Special purpose entity
3.4 Special purpose entities (SPEs) (also known as vehicles and quasi-subsidiaries) are legally independent entities that are used to take on the loans or liabilities of another enterprise. An enterprise (often referred to as the sponsor) will sell assets to the SPE, but retain the right to use the asset and gain from any future increase in its value. The SPE normally has no assets or capital of its own. It will borrow the money needed to buy the asset from a “capital provider”.
3.5 The purpose of SPEs is to remove assets and liabilities from the balance sheet of the sponsor. This has the effect of improving the return on capital employed and gearing of the sponsor.
3.6 HKAS-Int 12 “Consolidation – Special Purpose Entities” states that an enterprise should consolidate an SPE if it controls that SPE. A reporting enterprise probably has control over an SPE if:
(i) in substance, the activities of the SPE are being conducted on behalf of the enterprise according to its specific business needs so that the enterprise obtains benefits from the SPE’s operation;
(ii) in substance, the enterprise has the decision-making powers to obtain the majority of the benefits of the activities of the SPE;
(iii) in substance, the enterprise has rights to obtain the majority of the benefits of the SPE and therefore may be exposed to risks incident to the activities of the SPE; or
(iv) in substance, the enterprise retains the majority of the residual or ownership risks related to the SPE or its assets in order to obtain benefits from its activities.
4. Exclusion and Exemption of Subsidiaries from Consolidation
(A) Exclusion of subsidiaries
4.1 The rules on exclusion of subsidiaries from consolidation are necessarily strict, because this is a common method used by enterprises to manipulate their results. If a subsidiary which carries a large amount of debt can be excluded, then the gearing of the group as a whole will be improved. In other words, this is a way of taking debt off the balance sheet.
4.2 |
Key Point |
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HKAS 27 prescribes only one circumstance when a subsidiary should be excluded from consolidation. This happen when there is evidence that if there are severe restrictions on the ability of the subsidiary to act independently that are so great that control is lost, then it should not be consolidated. In particular, it notes that loss of control could occur when the subsidiary becomes subject to the control of a government, court, administrator or regulator, or as a result of a contractual agreement, even though there is no indication in share ownership. They should be accounted for under HKAS 39, as investments stated at fair value. |
4.3 The previous Standard required a subsidiary to be excluded from consolidation where control is intended to be temporary: the subsidiary was acquired and is held exclusively with a view to its subsequent disposal within twelve months from acquisition and management is actively seeking a buyer. This exclusion has now been removed; subsidiaries held for sale must be consolidated.
4.4 Subsidiaries held for sale are accounted for in accordance with HKFRS 5 “Non-current Assets Held for Sale and Discontinued Operations”.
4.5 It is important to note that exclusion of subsidiaries from consolidation under the reasoning of dissimilar activities is not permitted under HKAS 27.
4.6 Accounting standards do not apply to immaterial items. Therefore an immaterial subsidiary need not be consolidated.
4.7 Summary:
Reason |
HKAS 27 |
Treatment |
Severe long-term restrictions meaning loss of control |
Mandatory exclusion |
Non-current asset investment per HKAS 39 |
Temporary investment |
Mandatory inclusion |
Consolidate per HKFRS 5 |
Different activities |
Mandatory inclusion |
Consolidate. Prepare HKAS 14 segment information |
Immaterial |
Not applicable |
Optional |
4.8 |
Example 2 |
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(a) X, an international manufacturing group, has a subsidiary undertaking, Z, which is an insurance company. Can the group be exempted from consolidating Z on the grounds of different activities? Does A need to include P in its consolidated accounts? Solution: (a) Z must be included under HKAS 27. (b) It depends on whether A controls P. Control is defined as the power to govern the financial and operating policies so as to obtain benefit. The current freeze on remittances does not in itself prove that A does not control P. So P should be included. The actual relationship between A and P must be investigated to decide whether control exists. |
(B) Exemption from preparing group accounts
4.9 A parent need not present consolidated financial statements if and only if:
(i) it is a wholly-owned subsidiary or it 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 reject to, the parent not presenting consolidated financial statements;
(ii) its securities are not publicly traded;
(iii) it is not in the process of issuing securities in public securities markets; and
(iv) the ultimate or intermediate parent publishes consolidated financial statements that comply with Hong Kong Financial Reporting Standards.
5. Different Reporting Dates and Different Accounting Policies
(A) Reporting dates
5.1 Both Section 127(1) of the Companies Ordinance and HKAS 27 requires that the financial year-ends of all group companies must coincide.
5.2 If the subsidiary does not prepare conterminous financial statements to the same reporting date as the parent, the financial statements of that subsidiary should be adjusted for the effects of significant transactions or other events that occur between the two different dates.
5.3 HKAS 27 includes a further restriction that the difference between reporting dates should not exceed three months.
(B) Accounting policies
5.4 Consolidated financial statements should be prepared using uniform accounting policies for like transactions and other events in similar circumstances.
5.5 If it is not practicable to do so, HKAS 27 requires the reason be disclosed together with the proportions of the items in the consolidated financial statements to which the different accounting policies have been applied.
6. Disclosure Requirements
6.1 The disclosures required by HKAS 27 are as follows:
(i) The reasons for not consolidating the subsidiaries, their summarized financial information, either individually or in groups, including the amount of total assets, total liabilities, revenues and profit or loss.
(ii) The reasons for consolidating the subsidiaries which the parent does not have majority voting control.
(iii) The nature and extent of any significant restrictions (e.g. resulting from borrowing arrangements or regulatory requirements) on the ability of subsidiaries to transfer funds to the parent in the form of cash dividends or to repay loans or advances.
(iv) If the group elected only to present the parent’s financial statements, and not consolidating its subsidiaries, jointly controlled entities and associates, those separate financial statements shall disclose the method of accounting for investments in subsidiaries, jointly controlled entities and associates.
7. The Basic Consolidation of Statement of Financial Position
7.1 |
Steps for Preparing the Consolidated Statement of Financial Position |
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(W1) Shareholding in the subsidiary (W2) Consolidation adjustments. (W3) Net assets of subsidiary
(W4) Goodwill
(*) If fair value method adopted, NCI value = fair value of NCI’s holding at acquisition (number of shares NCI own × subsidiary share price). (*) If proportion of net assets method adopted, NCI value = NCI % × fair value of net assets at acquisition (from W2). (W5) Non controlling interest
(W6) Group retained earnings
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(A) Goodwill
7.2 |
Goodwill |
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Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized. Goodwill arising on consolidation is the difference between the cost of an acquisition and the fair value of the subsidiary’s net assets acquired. |
7.3 |
Treatment of Goodwill |
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(a) Positive goodwill: (b) Impairment of positive goodwill: (i) Proportion of net assets method: Dr Group reserves (ii) Fair value method – the goodwill in the statement of financial position includes goodwill attributable to the non-controlling interest. In this case the double entry will reflect the non-controlling interest proportion based on their shareholding as follows: Dr Group reserves (% of impairment attributable to the parent) (c) Negative goodwill: |
7.4 |
Example 3 |
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The following statements of financial position were extracted from the books of two companies at 31 December 2010.
H acquired all of the share capital of S one year ago. The retained earnings of S stood at $2,000 on the day of acquisition. Goodwill is calculated using the proportion of net asset method. There has been no impairment of goodwill since acquisition. Prepare the consolidated statement of financial position of H Ltd as at 31 December 2010. Solution: W1 Shareholdings in S Ltd.
W2 Net asset of S Ltd
W3 Calculation of Goodwill
W4 Non-controlling interest W5 Group retained earnings
Consolidated statement of financial position as at 31 December 2010
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(B) Non-controlling interests
7.5 |
Computation of Non-controlling Interests |
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HKFRS 3 allows two alternative ways of calculating non-controlling interest in the group statement of financial position. Non-controlling interest can be valued at: |
7.6 |
Example 4 – Proportion of net assets method |
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The draft statements of financial position of H Ltd and S Ltd on 31 December 2010 are as follows.
H Ltd had bought 80% of the ordinary shares of S Ltd on 1 January 2010 when the retained earnings of S Ltd were $15,000. No impairment of goodwill has occurred to date. Prepare the consolidated statement of financial position of H Ltd as at 31 December 2010, assuming that the H group values the non-controlling interest using the proportion of net assets method. Solution: W1 Shareholdings in S Ltd.
W2 Net asset of S Ltd
W3 Calculation of Goodwill
W4 Non-controlling interest
W5 Group retained earnings
Consolidated statement of financial position as at 31 December 2010
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7.7 |
Exercise 1 – Fair value method |
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The draft statements of financial position of H Ltd and S Ltd on 31 December 2010 are as follows.
H Ltd had bought 80% of the ordinary shares of S Ltd on 1 January 2010 when the retained earnings of S Ltd were $20,000. On this date, the fair value of the 20% non-controlling shareholding in S Ltd was $12,500. No impairment of goodwill has occurred to date. Required: Prepare the consolidated statement of financial position of H Ltd as at 31 December 2010, assuming that the H group values the non-controlling interest using the fair value method. |
(C) Fair value of consideration and net assets
7.8 |
Fair value of consideration and net assets |
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To ensure that an accurate figure is calculated for goodwill: |
7.9 The subsidiary’s identifiable assets and liabilities are included in the consolidated accounts at their fair value for the following reasons.
(a) Consolidated accounts are prepared from the perspective of the group, rather than from the perspectives of the individual companies. The book values of the subsidiary’s assets and liabilities are largely irrelevant, because the consolidated accounts must reflect their cost to the group, not their original cost to the subsidiary. The cost to the group is their fair value at the date of acquisition.
(b) Purchased goodwill is the difference between the value of an acquired entity and the aggregate of the fair value of that entity’s identifiable assets and liabilities. If fair values are not used, the value of goodwill will be meaningless.
(D) Calculation of cost of investment
7.10 |
The cost of acquisition |
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The cost of acquisition includes the following elements: |
7.11 Incidental costs of acquisition such as legal, accounting, valuation and other professional fees should be expensed as incurred. The issue costs of debt or equity associated with the acquisition should be recognized in accordance with HKAS 39.
(a) Deferred and contingent consideration
7.12 In some situations not all of the purchase consideration is paid at the date of the acquisition, instead a part of the payment is deferred until a later date – deferred consideration.
(a) Deferred consideration should be measured at fair value at the date of the acquisition, i.e. a promise to pay an agreed sum on a predetermined date in the future taking into account the time value of money.
(b) The fair value of any deferred consideration is calculated by discounting the amounts payable to present value at acquisition.
(c) Each year the discount is then unwound. This increases the deferred liability each year (to increase to future cash liability) and the discount is treated as a finance cost.
(b) Share exchange
7.13 Often the parent company will issue shares in its own company in return for the shares acquired in the subsidiary. The share price at acquisition should be used to record the cost of the shares at fair value.
7.14 |
Example 5 – Calculation of cost of investment |
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H Ltd acquires 24 million $1 shares (80%) of the ordinary shares of S Ltd by offering a share-for-share exchange of two shares for every three shares acquired in S Ltd and a cash payment of $1 per share payable three years later. H Ltd’s shares have a nominal value of $1 and a current market value of $2. The cost of capital is 10% and $1 receivable in 3 years can be taken as $0.75. Required: (a) Calculate the cost of investment and show the journals to record it in H Ltd’s accounts. Solution: (a) Cost of investment
$50m is the cost of investment for the purposes of the calculation of goodwill.
(b) Unwinding the discount
For the next three years the discount will be unwound, taking the interest to finance cost until the full $24 million payment is made in Year 3. |
(E) Fair value of net assets acquired
7.15 HKFRS 3 (revised) requires that the subsidiary’s assets and liabilities are recorded at their fair value for the purposes of the calculation of goodwill and production of consolidated accounts.
7.16 Adjustments will therefore be required where the subsidiary’s accounts themselves do not reflect fair value.
7.17 |
Exercise 2 – Fair value of net assets adjustment |
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H Ltd acquired 80% of the share capital of S Ltd two years ago, when the reserves of S Ltd stood at $125,000. H Ltd paid initial cash consideration of $1 million. Additionally H Ltd issued 200,000 shares with a nominal value of $1 and a current market value of $1.80. It was also agreed that H Ltd would pay a further $500,000 in three years’ time. Current interest rates are 10% pa. The appropriate discount factor for $1 receivable three years from now is 0.751. The shares and deferred consideration have not yet been recorded. Below are the statements of financial position of H Ltd and S Ltd as at 31 December 2010:
At acquisition the fair values of S Ltd’s plant exceeded its book value by $200,000. The plant had a remaining useful life of five years at this date. For many years S Ltd has been selling some of its products under the brand name of “Spearmint”. At the date of acquisition the directors of H Ltd valued this brand at $250,000 with a remaining life of 10 years. The brand is not included in S Ltd’s statement of financial position. The consolidated goodwill has been impaired by $258,000. The H Group values the non-controlling interest using the fair value method. At the date of acquisition the fair value of the 20% non-controlling interest was $380,000. Required: Prepare the consolidated statement of financial position of H Ltd as at 31 December 2010. |
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