Week 6: Consolidations Part 1.

Consolidation: Part 1
Is the process of preparing a single set of financial statements for a group of entities under the
control of one of those entities. This involves combining the financial statements of individual
entities to show the financial position and performance of a group as if it were a single economic
entity and covers takeovers, group reporting and wholly owned subsidiaries.

Checklist
• explain why group accounts are needed?
• explain the importance of the acquisition date?
• prepare the worksheet entries at the acquisition date, being the business combination
valuation entries and the pre-acquisition entries
• prepare the worksheet entries in periods subsequent to the acquisition date, adjusting for
movements in assets and liabilities since acquisition date and dividends from pre-acquisition
equity
• prepare the worksheet entries where the subsidiary revalues its assets at acquisition date
• record the pre-acquisition eliminatory entry?
• account for pre and post dividends?

Ex-dividend
The ex-dividend date is usually set for stocks two business days before the record date. If you
purchase a stock on its ex-dividend date or after, you will not receive the next dividend payment.
Instead, the seller gets the dividend. If you purchase before the ex-dividend date, you get the
dividend.
Cum dividend
Dividend declared before acquisition, out of pre-acquisition profits, that is payable to the new owner
of the shares.
Effect on Consolidation
Must eliminate Dividend Payable in Subsidiary and Dividend Receivable in Parent's balance sheet.

Acquisition analysis of revalued asset with tax implications

Reference: Page 935-937
The analysis at acquisition date consists of comparing the fair value of the consideration transferred
and the net fair value of the identifiable assets and liabilities of the subsidiary at acquisition date.
The net fair value of the subsidiary could be calculated by revaluing the assets and liabilities of the
subsidiary from the carrying amounts to fair values, remembering that under AASB 112 Income
Taxes where there is a difference between the carrying amount and the tax base caused by the
revaluation, the tax effect of such a difference has to be recognised.

However, in calculating the net fair value of the subsidiary, because particular information is
required to prepare the valuation and pre-acquisition entries, the calculation is done by adding the
recorded equity of the subsidiary (which represents the recorded net assets of the subsidiary) and
the differences between the carrying amounts of the assets and liabilities and their fair values,
adjusted for tax.

The equity relating to the differences in fair value and carrying amounts for assets and liabilities
recorded by Sub Ltd — as well as for assets and liabilities not recognised by the subsidiary but
recognised as being acquired as part of the business combination — is referred to in this chapter as
the business combination valuation reserve (BCVR). This reserve is not an account recognised in the
subsidiary’s records, but it is recognised in the consolidation process as part of the business
combination.
For example, for land there is a difference of $20  000 in the fair value carrying amount and, on
revaluation of the land to fair value, a business combination valuation reserve of $14  000 $20  000 *
(1 − 30%) is raised.
In consolidation accounting, the focus changes from a single business entity to that of a single
economic entity, otherwise known as a `group entity'. The approved accounting standard on
consolidation accounting (AASB 10) indicates that business entities other than companies (for
instance, trusts, or government departments) can be members of a group entity.

In any group entity, one of the legal entities will always have the status of a parent (P) entity,
because of its ability to somehow control the operations of one or more subsidiary (S) entities. A
group entity can consist of a parent company controlling dozens (or even hundreds) of subsidiary
companies.

P Ltd

legal entities
x% (P and S)

S Ltd
single economic entity
(PS group)
The direction of the solid arrow, together with the percentage figure next to it, represents the level
of share ownership that P Ltd holds in S Ltd. Usually (but not necessarily always), if P Ltd holds
sufficient shares in S Ltd, it will be able to exercise control over the operations of S, thereby forming
the PS group.

AASB 10 specifically prohibits levels of share ownership as being automatic indicators of a parent-
subsidiary relationship. The standard acknowledges that a sufficient level of share ownership could
indicate the existence of control, but not necessarily. The facts surrounding each situation would
need to be examined closely in order to establish the existence of control. Relevant facts could
include, among other things, an ability to appoint a majority to a company's board of directors, or an
ability to cast more than 50 percent of the votes at a company's annual general meeting.

In essence, AASB 10 ignores the form or shape of a relationship, and looks only at the substance
(that is, the actual nature) of the relationship. A control relationship is said to exist only if the
substance of the relationship indicates that this is so. In taking this position, AASB 10 is clearly
signalling that outward appearances can be deceptive and/or misleading. Although control often
goes hand in hand with share ownership, there is no guarantee that the two things will always co-
exist.

The objective of consolidation accounting

To prepare financial statements for the group entity, known as "consolidated accounts".
Group entities (that is, single economic entities) prepare consolidated financial statements because
the Corporations' Law requires them to do so (S.295). The Law also requires the financial
statements to comply with applicable accounting standards (S.296). An applicable accounting
standard is one that has been approved by the Australian Accounting Standards Board. The
standard AASB 10 "Consolidated Financial Statements" is an applicable accounting standard, and it
also requires that single economic entities prepare consolidated financial statements.

It is important to appreciate that the requirement to prepare consolidated financial statements does
not cancel or over-ride the requirement for individual legal entities to prepare their own SCI or SFP
reports. Each individual company must prepare an SCI and an SFP each year (Ss.292 and 293) in
addition to any consolidated accounts required under S.295.
Preparing consolidated accounts
(a) Intragroup dealings

When two companies belonging to the same group entity transact or deal with each other, the
transaction is perfectly valid from a legal entity perspective. When P buys something from S, or sells
something to S (intragroup dealings), the transaction is a valid one from the viewpoints of both P
and S.

However, from the viewpoint of that single economic entity otherwise known as the PS group,
intragroup dealings are NOT valid. As a single entity in its own right, the PS group cannot buy things
from itself, nor can it sell things to itself, nor can it make a profit out of itself. Neither can the PS
group owe money to itself, or be owed money from itself. A useful analogy can be drawn between a
group entity and the legal entities of which it is comprised, and a family unit comprised of various
individuals.

Individual members of a family can transact with each other, and perhaps even make profits in the
process. But if the focus changes from the individuals that make up the family, to the family unit
itself, transactions within the family are not valid when it comes to measuring changes in wealth.
For example, if a sister sells a video machine to her brother for at a $100 profit, her wealth as an
individual person has clearly increased. But the wealth of the family unit to which she belongs has
neither increased nor decreased, since both brother and sister belong to the same family.

Returning now to companies and the economic groups to which they belong, the principle is clear - a
group cannot validly transact with itself. This is NOT to say that transactions within the group
(intragroup transactions) are somehow illegal, or that they should not occur. This would be
unreasonable, as well as silly. Companies sell things to each other all the time - they always have
done so, and they always will do so. Sometimes the companies involved belong to the same group
entity, at other times no special relationship exists between them. (Extending the earlier analogy of
a human family, sometimes sisters sell video machines to their brothers, at other times they sell
them to people outside the family.)

There is nothing illegal, or undesirable, going on when intragroup dealings take place. But although
the transactions are valid from a legal entity perspective, they are not valid from a group
perspective. What this implies is that if we wish to measure comprehensive income and financial
position for an individual company (and, by law, we are obliged to do so), then ALL transactions will
have to be taken into account, regardless of whether or not companies belong to the same group.
But if we wish to measure comprehensive income and financial position for a company group (and
once again, by law, we are obliged to do so), then transactions occurring within the same group
must be ignored. This is what I mean when I say that intragroup transactions are "not valid" from a
group perspective. Clearly, this is quite different from saying that intragroup transactions are illegal
or undesirable!

(b) Group level items

There are some things (thankfully, not too many!) that exist ONLY at group level, and NEVER at legal
entity level. You will probably find this fact difficult to grasp at this early stage, because this is
possibly the first time that you have encountered such a notion in your accounting studies to date.
To the extent that this is true, you will have no mental image that you can rely on, but some brief
comments might help. There are two possible reasons why group level items exist.

(1) None of the legal entities within the group has recorded the item in its own books and
records. Take the example of "stock in transit". If P sells merchandise to S, and the goods are loaded
on a truck for delivery to S, then for a certain period of time (sometimes days or weeks, depending
on how far apart P and S are geographically) the merchandise will not be recorded in the books of
either P or S. The goods will not be included in the asset "stock on hand" of P because the goods
have already left P's warehouse. Neither will the goods be included in the asset "stock on hand" of S
because the goods have not yet arrived at S's warehouse. The stock is literally in transit within the
group (within the imaginary “circle” surrounding P and S). The PS group therefore has an item that
exists only at group level - the group asset "stock in transit". Neither P nor S has recorded this asset
in their own books and records.

(2) It is conceptually impossible for some items to exist at legal entity level. In the context of
consolidation accounting, there are certain things that are UNABLE to be recorded in the books and
records of a legal entity, and that therefore can only exist at group level. One example of this is the
notion of a "non-controlling interest" (NCI). NCI adjustments are the most difficult part of
consolidation accounting, and for that reason are normally left until last by lecturers. For the
moment, however, simply take it on faith that there are certain things whose nature is such that
they only have meaning at a group level. Such items cannot be visualised, nor can they have
meaning, at legal entity level. It is a conceptual impossibility.

Perhaps an example from economics might help here. Gross Domestic Product (GDP) measures the
output of entire economies. Yet it does not make sense to speak of GDP in the context of individual
human beings. This is because "an economy" exists at a level beyond that of individual human
beings. The concept of GDP exists only at a particular level (an entire economy), and cannot exist at
lower levels (the individual human being).

The accounting problems

By now it should be abundantly clear that the accountant is facing a number of possible accounting
problems. Group financial statements must be prepared. To do this, the individual financial
statements of the legal entities must be added together. But the legal entity statements will reflect
any intragroup dealings which, although perfectly valid from a legal entity perspective, are not valid
from a group perspective. Not only this, but the legal entity financial statements will not include
items that can only exist at group level, but that must be included in the group financial statements
in order to produce accurate consolidated accounts. How can the accountant solve these
accounting problems?

Consolidation adjustments are NOT made in the books and records of the legal entities. Instead,
they are made in a specially constructed group-level record called a consolidation journal.

Some (but not all) consolidation adjustments are repeated year after year for as long as the group
entity is in existence, and each time consolidated accounts are prepared.

Various items (for example, particular assets) are carried forward in a legal entity's books year after
year from one accounting period to the next. Suppose that some of these items, although valid from
a legal entity point of view, are not valid from a group viewpoint (for instance, an intragroup
shareholding). That is to say, the items in question lead to accurate legal entity financial statements,
but would distort group financial statements. Since these items are carried forward in the legal
entity books from one accounting period to the next, then plainly group level distortions will also be
carried forward in the legal entity books from one accounting period to the next.

As was explained earlier, the starting point for the preparation of consolidated financial statements
is always the financial statements of the legal entities within the group. But legal entity financial
statements are based on, and reflect, legal entity books and records. Not only this, but
consolidation adjustments are NEVER made in legal entity books. Weaving all of these threads
together leads to one conclusion - some consolidation adjustments are repeated year after year for
as long as the group entity is in existence, and are required each time consolidated accounts are
prepared. Of course, the actual dates appearing in the consolidation journal will change each year,
but the debits and credits will be the same. This is because some (but not all) group level distortions
are ALWAYS reflected in legal entity financial statements, and must be adjusted for each time group
financial statements are prepared.
What is meant by the term “control”?
An investor controls an investee when the investor is exposed, or has rights, to variable returns
from its involvement with the investee and has the ability to affect those returns through its
power over the investee.

For what purposes are the consolidated financial statements prepared?

Possible objectives are:
- supply of relevant information
- supply of comparable information
- accountability of management
- reporting of risks and benefits
The purpose of the pre-acquisition entry is to:
- prevent double counting of the assets of the economic entity
- prevent double counting of the equity of the economic entity
- recognise any gain on bargain purchase