Advanced Financial

Accounting: Chapter 2
Group Reporting I: Concepts and
Context

Tan & Lee Chapter 2 2009 1

Learning Objectives

Understand:
1. The rationale for group reporting and the complementarity of
reporting by legal and economic entities, and business units;
2. The economic incentives for the provision of consolidated financial
information;
3. The economic context of group reporting merger and acquisition
as risk management strategy and the impact on financial reporting;
4. The concept of control and the determination of the parent-
subsidiary relationship;
5. The concept of significant influence and the notion of associates
6. The concept of a business combination and the scope of IFRS 3;
7. The theories relating to consolidation; and
8. The effects of parent versus entity theories of consolidation
Tan & Lee Chapter 2 2009 2
Content

1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangement
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation Theories
Tan & Lee Chapter 2 2009 3
Introduction

A primary issue that underpins financial reporting is the identification

of the reporting entity.

Components of Financial Reporting

Financial reporting

Disaggregated
Separate financial Aggregated reporting
reporting for business
statements for the for the economic
units within a legal or
legal entity entity
economic entity

Tan & Lee Chapter 2 2009 4

Introduction
Relationship of control within legal entities

Shared ownership
Contractual or statutory
arrangements

Legal Entity Control

Legal entity
Individual
Individual
Effective relationship financial
financial
statement
statement

Tan & Lee Chapter 2 2009 5

Introduction
Incentive to extend economic boundaries

Capitalizing
on slack debt Increased
or operating market shares
capacity

Tapping on Economies
growth of scale
opportunities and scope
Reduced
risk through
diversification

Tan & Lee Chapter 2 2009 6

Introduction

A group of companies better able to deal with economic risk like

Macro-economic risk
Industry risk
Firm-specific risk

Corporate acquisition and diversification may be sub-optimal and

value-destroying if
Motivate by managers self-interest to invest in size rather than value
(Jensen, 1986, Shelefier and Vishny, 1990)
Costs and risks that arise from acquisition strategies, particularly in
unrelated diversification

Synergistic benefits potentially reduced by direct and indirect costs

arising from these strategies
Tan & Lee Chapter 2 2009 7
Introduction
Disaggregated Information
Loss of information if only
aggregated information is provided

Source of
disaggregated
information

Separate financial
Segment information
statements

Determine risk profile of individual segments

Strength and weaknesses of specific

Tan & Lee Chapter 2 operation and geographical 8
Introduction
Parent-Subsidiary Relationship
Group
Subsidiary

Parent Control
Subsidiary Consolidation:
Process of
preparing and
presenting financial
statements of parent
and subsidiary as if
Subsidiary they were one
economic entity

Tan & Lee Chapter 2 2009 9

Content

1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangement
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation Theories
Tan & Lee Chapter 2 2009 10
Information Perspective

Managers with a comparative advantage on information are

compensated for their ability to provide information on the future
cash flows of these firms (Holthausen and Leftwish, 1983)

Are consolidated financial
statements are more
informative than separate
financial statements?
Tan & Lee Chapter 2
No
Investors can duplicate homemade
consolidated financial statements
(Mian and Smith,1990)
Yes
The greater the interdependencies
among group companies, the more
informative combined earnings about
future cash flows of the combined
entity (Holthausen, 1990)
2009 11
Efficient Contracting

Whittred (1987) suggests that consolidated information improves

wealth for firms

Reduced information asymmetry between lenders and borrowers

Lenders fear that borrowers will transfer assets to related companies
Borrowers expropriate a considerable larger sum than what they stand
to lose because of limited liability

Hence, lenders required cross-guarantees issued by parent

companies. Whittred suggests a set of consolidated financial
statements performs the same function as a cross guarantee

Tan & Lee Chapter 2 2009 12

Opportunism

Consolidated financial statements lead to wealth transfers to

managers at the expense of other stakeholders if the acquisition is
motivated by managerial self-interest
Managers enjoy higher compensation, perks and power through
managing a larger group
Managers are more likely to over-invest in companies that are specific
and complementary to their skills

Information asymmetry may arise by masking financial problems of

individual companies within the group

Tan & Lee Chapter 2 2009 13

Content

1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangement
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation Theories
Tan & Lee Chapter 2 2009 14
Economic Incentives for Entering into
Intercorporate Arrangement
Markets will not reward firms diversification if investors can replicate the
firms strategies

Corporate Diversification

Why Corporate Diversification?

Individuals not able to diversify as Firms involved in M&A have

efficiently because of indivisibility of stakeholders who are not able to
assets and high transaction costs diversify their risks as well as
shareholders

Tan & Lee Chapter 2 2009 15

Economic Incentives for Entering into
Intercorporate Arrangement

Acquirer gains control Two or more acquirers

over the operating and gain joint-control over
financial policies of the the acquiree
acquiree

Arrangements in M&A

Reciprocal investments
Acquirer has significant
are held by each of the
influence over the
two firms, as both are
operating and financial
deemed to be equally
policies of the acquiree
dominant

Tan & Lee Chapter 2 2009 16

Economic Incentives for Entering into
Intercorporate Arrangement

Risk mitigated by Uncertainty

M&A strategies

Risk management strategies Value

Organic growth or acquisition Risk
Risk diversification Size effects
Co-insurance effect
Information Diversification

Control Joint-control Significant Influence

Tan & Lee Chapter 2 2009 17

Investing Strategies, Ownership Levels and the
Impact on Financial Reporting
Continuum of intercorporate ownership
Zero 20% 50% 100%
Ownership Ownership Ownership Ownership

Passive Active Active

Investment Investment Investment

Trading Associated Partially-owned subsidiary

securities company Fully-owned subsidiary
Available- Joint-
for-sale venture
securities
i. Earn dividend i. Exert significant i. Gain entry intro a new market
income influence or ii. Achieve synergistic benefits from
ii. Make capital control over complementary strengths
gain investees iii. Gain market dominance
operation

Tan & Lee Chapter 2 2009 18

Content

1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangement
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation Theories
Tan & Lee Chapter 2 2009 19
The Concept of Control

Control
Power to govern the financial and operating
policies of an entity so as to obtain benefits from its activities
(IAS 27:4)

Power to decide on Enjoy the benefits

the financial and operating from the exercise
policies of an entity of the power

Tan & Lee Chapter 2 2009 20

 The Concept of Control
Determination of control
Ownership of more than 50% of voting power:
Control is presumed to exist when the parent owns
directly or indirectly through subsidiaries, more than
one-half of the voting power of an entity unless, in
exception circumstances, it can be clearly
demonstrated that such ownership does not constitute
control

Ownership of less than 50% of voting power but

there is :
Control Subsidiary
a) Power over more than one-half of the voting rights
arising from an agreement with other investors; or
b) Power to govern the financial and operating
policies of an entity arising from a statute or an
agreement; or
c) Power to appoint or remove the majority of the
members of the board of directors or equivalent
governing body; or
d) Power to cast the majority of votes at meetings at
the board of directors or equivalent governing
Tan & Lee
body Chapter
that 2
has control over the entity 2009 21
Direct and Indirect Control
For the test of control, IAS 27 requires consideration of the percentage of
voting rights held direct or indirectly through subsidiaries
Control must be demonstrated at each intermediate level before the ultimate
holding company is said to have control over the lowest-level company
Affiliation structures
X Co. Situation 1: X Co. Situation 2:
X Co. controls X Co. controls
Y Co. and A Co. Y Co., B Co.
100% Break in control 60% and Z Co.
for Z Co. even Does not own
though X.Co. A Co. (<51%)
Y Co. indirectly owns Y Co.
75%
50% 50% 60% 55% 60% 50%

B Co. Z Co. A Co. B Co. Z Co. A Co.

50% 40%

Situation
Tan & Lee Chapter 2 1 2009 Situation 2 22
Legal Ownership versus Effective Control

IAS 27 is principles-based, and all evidence must be considered for

the existence of control

IAS 27 requires potential voting rights, which are currently

exercisable or convertible, to be considered when determining the
existence of control

IAS 27:14: Potential voting rights arise from share warrants, share
call options, debt or equity instruments that are convertible into
ordinary shares, or other similar instruments that have the potential,
if exercised or converted, to give the entity voting power or reduce
another partys voting power over the financial and operating
policies of another entity

Tan & Lee Chapter 2 2009 23

Potential Voting Rights in the
Determination of Control
IAS 27:15: In determining whether potential voting rights contribute
to control, the investor examines all facts and circumstances, such
as terms of exercise of the potential voting rights and any other
contractual terms, but not the intention of management and the
financial ability to exercise or convert

It is important that the potential voting rights must be currently

exercisable or convertible to be included in the test of control

Tan & Lee Chapter 2 2009 24

 Potential Voting Rights in the
Determination of Control

Illustration of potential voting rights

Issued Percentage Issued Potential Total shares Percentage
ordinary of ordinary share shares from (issued and of total
shares shares warrants warrants potential) shares

Company A $10,000,000 50% $5,000,000 $10,000,000 $20,000,000 62.50%

Other
10,000,000 50% 1,000,000 2,000,000 12,000,000 37.50%
investors

Total $20,000,000 100% $6,000,000 $12,000,000 $32,000,000 100.00%

Although Company A owns only 50% of the total issued ordinary shares, its
holding of the share warrants gives it de facto control over Company B

Tan & Lee Chapter 2 2009 25

Potential Voting Rights in the
Determination of Control

Sources of Control

When one investor has the

Currently exercisable share
right to increase its voting
options even though they are
power or reduce other
currently out of the money
investors voting power

Not relevant

Management intention Financial ability

Tan & Lee Chapter 2 2009 26

Impact of Potential Voting Rights
on the Allocation of Profits
IAS 27:19: The proportion of profit or loss and changes in equity
allocated to the parent and non-controlling interests are determined
on the basis of present ownership interests and do not reflect the
possible exercise or conversion of potential voting rights.

However, if the potential voting rights, in substance, gives the holder

access at present to the economic benefits associated with an
ownership interest should be considered( IAS 27:IG 5-6)

Tan & Lee Chapter 2 2009 27

Content

1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangement
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation Theories
Tan & Lee Chapter 2 2009 28
The Concept of Significant Influence

An investor may participate in the policy-making processes of an

investee, although they may not have the power to govern the final
outcome

IAS 28 describes such an investor as having significant influence,

and the investee is deemed an associate of the investor

Special accounting procedures described as the equity method are

applied

Tan & Lee Chapter 2 2009 29

What is Significant Influence?

Significant influence
Power to participate in the financial and operating policy decisions of the
investee but is less than control and is not equivalent to joint control over
those policies (IAS 28:2)

Default assumption:
An investor has ownership of 20% or more of the voting power and equal to
or less than 50% of the voting power in an investee, including potential
voting rights

Other evidences
Number of directors Participation in
Operational
representing investors policy-making
interdependencies
on board processes
Investor must disclose reasons for not complying with default assumption
Tan & Lee Chapter 2 2009 30
Direct and Indirect Significant Influence

Multi-level structures

P Situation 1: P Situation 2:
P has significant P has significant
influence over: influence over:
80% 50% i) Y (50% direct 40% 50% i) A (40% direct
interest) interest)
ii) Z (65% indirect ii) C (50% direct
X Y interest) P has A C interest)
no control over iii) B (42% indirect
50% 50% Y 80% 20% interest)

Z B

Situation 1 Situation 2

Tan & Lee Chapter 2 2009 31

Content

1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangement
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting
Accounting for
for Business
Business Combinations
Combinations
7. Consolidation Theories
Tan & Lee Chapter 2 2009 32
Accounting for Business Combinations

Standards relevant to the preparation and presentation of

consolidated financial statements

IFRS 3 Business Combination (deals with business

combination generally)

IAS 27 Consolidated and Separate Financial

Statements ( applies specifically to the preparation
and presentation of consolidated financial statements
for parent-subsidiary combinations)

Tan & Lee Chapter 2 2009 33

Overview of the Scope of the IFRS 3

Objective of IFRS 3
Specify the requirements governing the method of accounting,
disclosure and presentation of the financial statements of a reporting
entity comprising one or more separate entities that are brought
together in a business combination

Purchasing Purchasing
the equity of the net assets of
another entity another entity

Business combinations result from

Purchasing some of the
Assuming the
net assets of another
liabilities of
entity that together form
another entity
one or more business
Tan & Lee Chapter 2 2009 34
Purchase of Net Assets versus
Purchase of Equity

Parent Acquirer

Acquires controlling interest Buys over net assets

Subsidiary Acquiree

Parent Subsidiary relationship

Separate legal entities
No Parent Subsidiary relationship
- separate FS
One legal and economic entity
Single reporting entity
- Consolidated FS
Tan & Lee Chapter 2 2009 35
Content

1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangement
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation Theories
Tan & Lee Chapter 2 2009 36
Consolidation Theories

Theories relating to consolidation are critical when the percentage of

ownership in a subsidiary is less than 100%

Termed partially owned subsidiary, where the remaining

percentage is owned by shareholders who are collectively referred
to as non-controlling interest (NCI)
Parent Non-controlling interests

90% 10%

Subsidiary
Both parent and non-controlling interest have a proportionate share of
the subsidiarys:
Net profit; Share capital
Dividend distribution; Retained profits and changes in equity
Tan & Lee Chapter 2 2009 37
Consolidation Theories

Parent company sells

part of its stake in a
subsidiary to external
shareholders

Reasons why
non-controlling
Parent company interest Parent and non-controlling
buys a majority arise shareholders are founding
stake in a subsidiary shareholders of newly
from existing owners incorporated entity

Tan & Lee Chapter 2 2009 38

 Consolidation Theories
Ownership of the combined entity Joint-ownership of the combined entity
involving a wholly owned subsidiary involving a partially owned subsidiary

Parent companys shareholders Parent companys shareholders

30%
Parent company ownership in Parent company
Non-controlling subsidiary
100% 70%
ownership shareholders of a ownership
subsidiary
Subsidiary Subsidiary

Wholly owned by the
parent companys
shareholders
Tan & Lee Chapter 2
2 groups of shareholders
1) The parent companys shareholders; and
2) The non-controlling shareholders of the
subsidiary
2009 39
 Comparison of issues
Issues Entity Theory Parent Theory

Who are the primary Both non-controlling Benefit of parent

users of the consolidated interest and majority company shareholders
financial statements? shareholders

Shown as equity Shown as equity

based on: based on:
How should non-
Consolidated equity Consolidated equity
controlling interests be -
reported in the =
Consolidated assets NCI
consolidated balance - =
sheet? Consolidated assets
Consolidated liabilities -
Consolidated liabilities

Tan & Lee Chapter 2 2009 40

Comparison of issues
Issues Entity Theory Parent Theory
Net assets of the
subsidiary acquired be Net asset at date NCI net asset at date
shown at full fair values of acquisition of acquisition shown
or at the parents share reported in full at book value
of the fair value?

Do non-controlling Asset of economic Asset of parent

shareholders have a unit, and reflected and restricted to
share of goodwill? in full parents share

How should net profit of Reported in full as NCIs share of current

partially owned both majority and profit is a deduction of
subsidiary be reported? non-controlling final profit
shareholders
Tan & Lee Chapter 2 2009 41
Summary of differences

Attributes Entity Theory Parent Theory

Fair value differences in Recognized in full,
Recognized only in
relation to identifiable reflecting both parents
respect of parents
assets and liabilities at and NCIs share of fair
share
date of acquisition value adjustments

Neither as equity or
Presentation of NCI As part of equity
debt

Goodwill is an entity
asset and should be Goodwill is parents
Goodwill
recognized in full as at asset
date of acquisition

Tan & Lee Chapter 2 2009 42

Proprietary Theory

Relevant to accounting for joint venture

Parent seen as having a direct interest in a subsidiarys assets and

liabilities
resulting in proportional consolidation.

Tan & Lee Chapter 2 2009 43

The Implicit Consolidation Theory
Underlying IFRS 3
Previously, IAS 22 allowed an acquirer to either recognize or ignore
non-controlling interests share of fair value adjustments of a
subsidiarys identifiable assets and liabilities

IFRS 3 (2008) permits the recognition of non-controlling interests

share of goodwill

Movement towards the full entity theory

Tan & Lee Chapter 2 2009 44

Illustration 1: Parent versus Entity Theory

Scenario
Consideration transferred: $1,200,000
NCI: 20%
BV of equity at acquisition date (1/1/20x1): $1,200,000
(FV BV) of property: $100,000
(Ignore tax effect and depreciation)
FV of NCI: $300,000
BV of equity at 31/12/20x1: $1,270,000

Tan & Lee Chapter 2 2009 45

 Illustration 1: Parent versus Entity Theory

Goodwill
Parent Theory
Goodwill = Investment in S Ps ownership %
X (Fair value of Ss identifiable net assets at date of acquisition)
= $1,200 (80% x $1,300)
= $160
Entity Theory
Parents share of goodwill = $160
Non-controlling interests share of goodwill = Fair value of NCI Share of FV
of identifiable net assets
= $300 (20% x $1,300)
= $300 $260
= $40

Tan & Lee Chapter 2 2009 46

Illustration 1: Parent versus Entity Theory

Presentation of NCI
Parent Theory
Non-controlling interests are shown separately from equity
Non-controlling interests = Non-controlling interest % x BV of Ss equity
= 20% x $1,270
= $254
Entity Theory
Non-controlling interests are deemed to have an equity interest and are thus
presented as a component in equity
Non-controlling interests = Non-controlling interest %
x (BV of Ss equity + FV adjustments)
+ NCIs share of goodwill
= 20% x ($1,270 + $100) +$40
= $314

Tan & Lee Chapter 2 2009 47