Bcvr entries

WORKSHOP WEEK 7: CHAPTER 26 AASB3 BUSINESS COMBINATIONS AND CHAPTER 27 AASB3 AND AASB12

SUGGESTED SOLUTIONS

Online practice exercises available through Wiley+

Chapter 26

Comprehensive Questions

1. What is a group, a parent and a subsidiary?

According to Appendix A of AASB 10/IFRS 10 Consolidated Financial Statements:

· A group is formed by a parent and all its subsidiaries.

· A parent is an entity that controls one or more entities.

· A subsidiary is an entity that is controlled by another entity, a parent.

3. What are the key elements of control?

Based on the definition of control from Appendix A of AASB 10/IFRS 10, paragraph 7 of AASB 10/IFRS 10 identifies three elements that must be held by an investor in order for it to have control:

· Power over the investee

· Exposure or rights to variable returns from the parent’s involvement with the subsidiary

· The ability to use the power over the subsidiary to affect the amount of the parent’s returns.

8. What is the link between ownership interest and control?

As paragraph B35 of AASB 10/IFRS 10 states, where an investor holds more than half of the voting rights of the investee, the investor has power over the investee in the absence of other evidence. Different classes of shares may have different voting rights. However, unless otherwise specified in the company’s constitution, each shareholder has one vote for each share held. Therefore, it is normally assumed that the percentage of ownership interest of an investor is equivalent to the percentage of voting rights that this investor holds in the investee. As such, it is normally assumed that an investor that has more than 50% ownership interest in an investee has the power over the investee. Given that the shares give to the shareholders the right to receive dividends, it is further assumed that an investor holding more 50% ownership interest has control. Of course, a shareholder with less than 50% ownership interest may still have control if there is any other evidence that the shareholder 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. Also, a shareholder with more than 50% ownership interest may not have control, especially if most of the shares held are non-voting shares.

11. What are the reasons for preparing consolidated financial statements?

Some of the reasons for which the regulators require the parent entity to prepare consolidated financial statements are as follows:

i. To supply relevant information to investors in the parent entity. The information obtained from the consolidated financial statements is relevant to investors in the parent entity. A shareholder’s wealth in the parent is dependent not only on how that entity performs, but also on the performance of the other entities controlled by the parent. To require these investors in analysing their investment to source their information from the financial statements of each of the entities comprising the group would place a large cost burden on those investors.

ii. To allow comparison of the group with similar entities. Some entities are organised into a group structure such that different activities are undertaken by separate entities within the group. Other entities are organised differently, with some having all activities conducted within the one entity. Access to consolidated financial statements makes comparisons across the group an easier task for the users of financial statements.

iii. To assist in the discharge of accountability by management of the group. A key purpose of financial reporting is the discharge of accountability by management. Entities that are responsible or accountable for managing a pool of resources — being the recipients of economic benefits and responsible for payment of obligations — are generally required to report on their activities and are held accountable for the management of those activities. The consolidated financial statements report the assets under the control of the group management as well as the claims on those assets.

iv. To report the risks and benefits of the group as a single economic entity. There are risks associated with managing an entity, and an entity rarely obtains control of another without also obtaining significant opportunities to benefit from that control. The consolidated financial statements allow an assessment of these risks and benefits. Note, however, that the benefits from intragroup transactions are eliminated when preparing consolidated financial statements, as those statements should only reflect the effects of transactions with external parties.

Exercise 26.8

Determining subsidiary status

In the following independent situations, determine whether a parent–subsidiary relationship exists, and which entity, if any, is a parent required to prepare consolidated financial statements under AASB 10/IFRS 10.

1. Road Ltd is a company that was hurt by the global financial crisis. As a result, it experienced major trading difficulties. It previously obtained a significant loan from Wile E. Bank, and when Road Ltd was unable to make its loan repayments, the bank made an agreement with Road Ltd to become involved in the management of that company. Under the agreement between the two entities, the bank had authority for spending within Road Ltd. Road Ltd’s managers had to obtain authority from the bank for acquisitions over $10 000, and was required to have bank approval for its budgets.

2. Runner Ltd owns 80% of the equity shares of Beep Beep Ltd, which owns 100% of the shares of Looney Ltd. All companies prepare reports under Australian accounting standards. Although the shares of Beep Beep Ltd are not traded on any stock exchange, its debt instruments are publicly traded.

3. Coyote Ltd is a major financing company whose interest in investing is return on the investment. Coyote Ltd does not get involved in the management of its investments. If the investees are not managed properly, Coyote Ltd sells its shares in that investee and selects a more profitable investee to invest in. It previously held a 35% interest in Tunes Ltd as well as providing substantial convertible debt finance to that entity. Recently, Tunes Ltd was having cash flow difficulties and persuaded Coyote Ltd to convert some of the convertible debt into equity so as to ease the effects of interest payments on cash flow. As a result, Coyote Ltd’s equity interest in Tunes Ltd increased to 52%. Coyote Ltd still wanted to remain as a passive investor, with no changes in the directors on the board of Tunes Ltd. These directors were appointed by the holders of the 48% of shares not held by Coyote Ltd.

In each of these circumstances the following principle from the Basis of Conclusions to AASB 10/IFRS 10 should be used:

BC41 The definition of control includes three elements, namely an investor’s:

(a) power over the investee;

(b) exposure, or rights, to variable returns from its involvement with the investee; and

(c) the ability to use its power over the investee to affect the amount of the investor’s returns.

Note also that paragraph 4 of AASB 10/IFRS 10 states that an entity that is a parent shall present consolidated financial statements except:

(a) a parent need not present consolidated financial statements if it meets all the following conditions:

(i) it is a wholly-owned subsidiary or is a partially-owned subsidiary of another entity and all its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements;

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

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

(iv) its ultimate or any intermediate parent produces consolidated financial statements that are available for public use and comply with International Financial Reporting Standards (IFRSs).

1. This question will be looked at under two scenarios:

(i) Road Ltd is not a subsidiary of any other entity.

The key issue is whether the fact that the bank has authority in relation to acquisitions and approval of budgets is sufficient to give the bank the status of a parent.

The bank will receive a return from Road Ltd in the form of interest on the loan.

Wile E. Bank

Has:

· Power over Road Ltd, as it has rights arising from the legal contract

· It can affect some of the relevant activities e.g. acquisitions, but not others such as appointment of key management personnel.

Road Ltd will not be a subsidiary of Wile E. Bank because:

· The bank is not exposed to variable returns from its involvement with Road Ltd. The interest payments are not affected by the profitability of Road Ltd.

· It cannot use its power over Road Ltd to affect the amount of its returns, as the returns are fixed interest payments.

(ii) Road Ltd is a wholly owned subsidiary of another entity, Chuck Jones Ltd.

The key issue in this scenario is whether the authority given to the bank in relation to acquisitions and budget approval is sufficient to state that Chuck Jones Ltd does not control Road Ltd.

The key issue is whether Chuck Jones Ltd still has power over Road Ltd given the arrangements with the bank.

Relevant activities over which a parent should have power include:

(a) selling and purchasing of goods or services;

(b) managing financial assets during their life (including upon default);

(c) selecting, acquiring or disposing of assets;

(d) researching and developing new products or processes; and

(e) determining a funding structure or obtaining funding.

Decisions about relevant activities include:

(a) establishing operating and capital decisions of the investee, including budgets; and

(b) appointing and remunerating an investee’s key management personnel or service providers and terminating their services or employment.

The key issue then is whether Chuck Jones Ltd has the ability to direct the relevant activities i.e. those activities that most significantly affect the investee’s returns.

It is probable that Chuck Jones Ltd no longer controls Road Ltd as the bank can: veto any changes to significant transactions for the benefit of Chuck Jones Ltd. It can deny the company its ability to make acquisitions, and it can reject moves within a budget to undertake changes in inventory production.

In conclusion, a parent-subsidiary relationship does not exist in this case and therefore no one needs to prepare consolidated financial statements.

2.

Beep Beep Ltd

80% 100%

Looney Ltd

Runner Ltd

The issue is whether Beep Beep Ltd needs to prepare a set of consolidated financial statements for itself and Looney Ltd, as Beep Beep Ltd is the parent of Looney Ltd (by virtue of owning 100% of the shares in Looney Ltd), but at the same time Beep Beep Ltd is a subsidiary of Runner Ltd, the ultimate parent..

Note all criteria from paragraph 4 of AASB 10/IFRS 10 are required to be met. In this example:

(i) Looney Ltd is a wholly owned subsidiary of Beep Beep Ltd

(ii) The ultimate parent, Runner Ltd, prepares reports under AASBs, which comply with IFRSs

However, the debt instruments of Beep Beep Ltd are traded publicly which means that it breaches 4(a)(iii) above. Hence Beep Beep Ltd is not exempt from preparing consolidated financial statements.

Both Runner Ltd and Beep Beep Ltd would be required to prepare consolidated financial statements.

3. Coyote Ltd currently holds 52% of the shares of Tunes Ltd. It does not want to become involved in the management of Tunes Ltd, and the directors are appointed by the non-controlling interest (NCI).

Control is not based on actual control but on the capacity to control. Coyote Ltd

· has power over the investee via its share ownership

· is exposed to variable returns via dividends arising from its share ownership

· has the ability to affect those returns as it can become involved in management whenever it wishes, given its superior voting power.

Coyote Ltd is a parent of Tunes Ltd and hence must prepare consolidated financial statements unless the criteria from paragraph 4 of AASB 10/IFRS 10 are all met.

Further, when Coyote Ltd held a 35% interest in Tunes Ltd it also held convertible debt in that entity which could, if converted, give it an equity interest of 52%. In this situation, Coyote Ltd was a parent of Tunes Ltd and should have prepared consolidated financial statements unless the criteria from paragraph 4 of AASB 10/IFRS 10 are all met. It would appear under the circumstances that the conversion was substantive i.e. economically feasible, and currently exercisable.

Chapter 27

Comprehensive Questions

1. Explain the purpose of the acquisition analysis in the preparation of consolidated financial statements.

According to AASB 3/IFRS 3 and as described in chapter 25, entities need to account for business combinations using the acquisition method. As part of the acquisition method, an acquisition analysis is conducted at acquisition date because it is necessary to recognise all the identifiable assets and liabilities of the subsidiary at fair value (including those previously not recorded by the subsidiary), and to determine whether there has been any goodwill acquired or whether a gain on bargain purchase has occurred. The acquisition analysis is considered the first step in the consolidation process as it identifies the information necessary for making both the business combination valuation and pre-acquisition entry adjustments for the consolidation worksheet. The end result of the acquisition analysis will be the determination of whether there is any goodwill acquired or gain on bargain purchase.

4. Explain the purpose of the business combination valuation entries in the preparation of consolidated financial statements.

The purpose of these entries is to make consolidation adjustments so that in the consolidated statement of financial position the identifiable assets, liabilities and contingent liabilities of the subsidiary are reported at fair value. This is to fulfil step 3 of the acquisition method required to account for business combinations by AASB 3/IFRS 3.

5. Explain the purpose of the pre-acquisition entries in the preparation of consolidated financial statements.

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

A simple example such as that below could be used to illustrate these points:

A Ltd has acquired all the issued shares of B Ltd for $150. The balance sheets of both companies immediately after acquisition are as follows:

Share capital $200 Share capital $100

Reserves 100 Reserves 50

300 150

Shares in B Ltd 150 --

Cash 150 Cash 150

300 150

Having acquired the shares in B Ltd, A Ltd records as an asset the investment account ‘Shares in B Ltd’ at $150. This asset represents the actual net assets of B Ltd; that is, the ownership of the shares gives A Ltd the right to the assets and liabilities of B Ltd. To include both the asset investment account ‘Shares in B Ltd’ and the assets and liabilities of B Ltd in the consolidated statement of financial position would double count the assets and liabilities of the subsidiary. On consolidation, the investment account is therefore eliminated.