Business combination valuation reserve account

1. Prepare The Acquisition Analysis At 1 January 2017 2. Prepare The Business Combination Valuation Entries And Pre-Acquisition Entries At 1 Januart 2017 3. Prepare The Business Combination Valuation Entries And Pre-Acquisition Entries At 31 December 2017

1. Prepare the acquisition analysis at 1 January 2017

2. Prepare the business combination valuation entries and pre-acquisition entries at 1 Januart 2017

3. Prepare the business combination valuation entries and pre-acquisition entries at 31 December 2017

4. Prepare the consolidation worksheet journal entries to eliminate the effects to intragroup transactions at 31 December 2017

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.

Similarly, A Ltd has equity of $300, which represents its net assets including the investment account, ‘Shares in B Ltd’. Because the investment in the subsidiary represents the actual net assets of B Ltd, or, in other words, the equity of the subsidiary, the equity of the parent effectively includes the equity of the subsidiary. To include both the equity of the subsidiary at acquisition date and the equity of the parent in the consolidated statement of financial position would double-count the pre-acquisition equity of the subsidiary. On consolidation, the equity of the subsidiary at acquisition date is therefore eliminated.

9. Explain how the existence of a gain on bargain purchase affects the pre-acquisition entries, both in the year of acquisition and in subsequent years.

In the presence of a gain on bargain purchase, the pre-acquisition entry at acquisition date should recognise this gain as a part of the consolidated profit for the period starting at acquisition date, and not eliminate it. This is because it is considered to belong to post-acquisition equity. In subsequent periods after the acquisition date, the gain on bargain purchase is included in retained earnings (opening balance) and therefore reduces the adjustment to the opening balance of retained earnings posted in pre-acquisition entries.

11. Why are some adjustment entries in the previous period’s consolidation worksheet also made in the current period’s worksheet?

The consolidation worksheet entries do not affect the underlying financial statements or the accounts of the parent or the subsidiary. As the consolidation is done every year based on the individual financial statements or the accounts of the parent or the subsidiary, the entries in the consolidation worksheet from previous years do not carry over and they need to be repeated, sometimes exactly the same as in previous years, something with some adjustments. For example, if the last year’s profits are required to be adjusted on consolidation, then retained earnings (opening balance) will need to be adjusted in the current period. Similarly, a BCVR entry to recognise at fair value the land on hand at acquisition is made in the consolidation worksheet for each year that the land remains in the subsidiary. The entry does not change from year to year. Again the reason is that the adjustment to the carrying amount of the land is only made in a worksheet and not in the actual records of the subsidiary itself. However, the BCVR entries for non-current assets subject to depreciation need to be adjusted from year to year.

Exercise 27.5

Undervalued and unrecorded assets, unrecorded liabilities

In 2012, Stan Ltd acquired 40% of the issued shares of Lee Ltd for $72 000. This

acquisition did not give Stan Ltd control of Lee Ltd, because the ownership of Lee Ltd

was held by a small number of shareholders (Lee Ltd was developed as a family

business in 2001). On 1 July 2016, Stan Ltd approached these family members following

a death in the family and persuaded them to sell the remainder of the shares in Lee Ltd

to Stan Ltd for $137 700 on a cum div. basis.

Information about the two companies at 1 July 2016 included:

· Stan Ltd recorded its original investment in Lee Ltd at fair value, with changes in fair value being recognised in profit or loss. At 1 July 2016, the investment was recorded at $91 800.

· The equity of Lee Ltd at 1 July 2016 consisted of $144 000 share capital and $36 000 retained earnings.

· Included in the assets and liabilities recorded by Lee Ltd at 1 July 2016 were goodwill of $5400 (net of accumulated impairment losses of $3600) and dividend payable of $4500.

· On the acquisition date all the identifiable assets and liabilities of Lee Ltd were recorded at carrying amounts equal to their fair values except for inventories for which the fair value of $39 600 was $3600 greater than its carrying amount, and equipment for which the fair value of $94 500 was greater than the carrying amount, this being cost of $108 000 less accumulated depreciation of $18 000.

· Stan Ltd discovered that Lee Ltd had two assets that had not been recorded by Lee Ltd. These were internally generated patents that had a fair value of $45 000 and in-process research and development for which Lee Ltd had expensed $90 000, but Stan Ltd considered that an asset was created with a fair value of $18 000.

· In the notes to the financial statements at 30 June 2016, Lee Ltd had reported the existence of a contingent liability relating to guarantees for loans. Stan Ltd determined that this liability had a fair value of $9000 at 1 July 2016.

The tax rate is 30%.

Required

1. Prepare the acquisition analysis at 1 July 2016.

2. Prepare the consolidation worksheet entries for Stan Ltd’s group at 1 July 2016.

1. Acquisition analysis at 1 July 2016

Net fair value of identifiable assets

and liabilities of Lee Ltd = ($144 000 + $36 000) (equity)

– $5 400 (goodwill)

+ $3 600 (1– 30%) (BCVR – inventories)

+ ($94 500 – ($108 000 – $18 000)) (1 – 30%)

(BCVR – equipment) + $45 000 (1 – 30%) (BCVR – patents)

+ $18 000 (1 – 30%) (BCVR – research)

– $9 000 (1 – 30%) (BCVR – liability)

= $218 070

Net consideration transferred = $137 700 – $4 500 x 60% (dividend)*

= $135 000

Previously held equity interest = $91 800 (fair value)

Goodwill acquired = ($135 000 + $91 800) – $218 070

= $8 730

Recorded goodwill = $5 400

Unrecorded goodwill = $8 730 – $5 400

= $3 330

* As the dividend was declared prior to the acquisition and the acquisition of the remaining interest of 60% is cum div., 60% of the dividend is recognised as a refund of the consideration transferred. It is assumed that the other 40% of the dividend related to the previously held interest was already recognised by the parent prior to the acquisition as dividend receivable.

2. Consolidation worksheet entries for Stan Ltd’s group at 1 July 2016

Business combination valuation entries at 1 July 2016

The BCVR entries at acquisition date will need to recognise:

· adjustments to fair value for inventories and equipment

· the previously not recognised patents and in-process research at fair value

· the previously not recognised contingent liability at fair value

· the unrecorded part of the goodwill acquired.

Inventories Dr 3 600

Deferred tax liability Cr 1 080

Business combination valuation reserve Cr 2 520

Accumulated depreciation Dr 18 000

Equipment Cr 13 500

Deferred tax liability Cr 1 350

Business combination valuation reserve Cr 3 150

*Alternative BCVR entries for Equipment

Accumulated depreciation Dr 18 000

Equipment Cr 18 000

Equipment Dr 4 500

Deferred tax liability Cr 1 350

Business combination valuation reserve Cr 3 150

The above alternative BCVR entries for equipment demonstrate the 2 steps for the recognition of a change in fair value on consolidation for a depreciable non-current asset:

1. Write back all of the accumulated depreciation for the asset at date of acquisition.

2. Recognise the increase/decrease to the asset’s fair value with the tax effect.

Patents Dr 45 000

Deferred tax liability Cr 13 500

Business combination valuation reserve Cr 31 500

In-process research Dr 18 000

Deferred tax liability Cr 5 400

Business combination valuation reserve Cr 12 600

Business combination valuation reserve Dr 6 300

Deferred tax asset Dr 2 700

Guarantee payable Cr 9 000

Accumulated impairment losses – goodwill Dr 3 600

Goodwill Cr 3 600

Goodwill Dr 3 330

Business combination valuation reserve Cr 3 330

Pre-acquisition entries at 1 July 2016

Retained earnings (1/7/16) Dr 36 000

Share capital Dr 144 000

Business combination valuation reserve Dr 46 800*

Shares in Lee Ltd Cr 226 800**

*$2 520 (BCVR – inventories) + $3 150 (BCVR – equipment) + $31 500 (BCVR – patents) + $12 600 (BCVR – research) – $6 300 (BCVR – contingent liability) + $3 330 (BCVR – unrecorded goodwill)

** $91 800 (previously held interest) + $135 000 (net consideration transferred)

Dividend payable Dr 4 500

Dividend receivable Cr 4 500

As the dividend was declared prior to the acquisition out of pre-acquisition equity and it is now entirely recognised by Stan Ltd as receivable (40% from before the acquisition and 60% at acquisition as the acquisition is cum div.), 100% of the dividend payable and the dividend receivable related to it are eliminated in the pre-acquisition entry.

Exercise 27.7

Undervalued assets, pre-acquisition reserves transfers

On 1 July 2016, Mutt Ltd acquired all the issued shares of Jeff Ltd for $174 800. At this date the equity of Jeff Ltd consisted of share capital of $80 000 and retained earnings of $68 800. All the identifiable assets and liabilities of Jeff Ltd were recorded at amounts equal to fair value except for:

The patent was considered to have an indefinite life. It was estimated that the plant had a further life of 10 years, and was depreciated on a straight-line basis. All the inventories were sold by 30 June 2017.

In May 2017, Jeff Ltd transferred $20 000 from the retained earnings on hand at 1 July 2016 to a general reserve. In June 2017, Jeff Ltd conducted an impairment test on the patent and on the goodwill acquired. As a result, the goodwill was considered to be impaired by $1200. The tax rate is 30%.

Required

1. Prepare the acquisition analysis at 1 July 2016.

2. Prepare the consolidation worksheet entries for Mutt Ltd’s group at 1 July 2016.

3. Prepare the consolidated worksheet entries for Mutt Ltd’s group at 30 June 2017.

1. Acquisition analysis at 1 July 2016

Net fair value of identifiable assets

and liabilities of Jeff Ltd = ($80 000 + $68 800) (equity)

+ ($72 000 – $60 000) (1 – 30%) (BCVR – patent)

+ ($48 000 – $40 000) (1 – 30%) (BCVR – plant)

+ ($28 000 – $21 600) (1 – 30%) (BCVR – inventories)

= $167 280

Consideration transferred = $174 800

Goodwill = $174 800 – $167 280

= $7 520

2. Worksheet entries at 1 July 2016

(1) Business combination valuation entries

The BCVR entries at acquisition date will need to recognise:

· adjustments to fair value for patent, plant and inventories

· the goodwill acquired.

Patent Dr 12 000

Deferred tax liability Cr 3 600

Business combination valuation reserve Cr 8 400

*Accumulated depreciation Dr 40 000

Plant Cr 32 000

Deferred tax liability Cr 2 400

Business combination valuation reserve Cr 5 600

*Alternative BCVR entries for Plant

Accumulated depreciation Dr 40 000

Plant Cr 40 000

Plant Dr 8 000

Deferred tax liability Cr 2 400

Business combination valuation reserve Cr 5 600

The above BCVR entries demonstrate the 2 steps for the recognition of a change in fair value on consolidation for a depreciable non-current asset:

1. Write back all of the accumulated depreciation for the asset at date of acquisition.

2. Recognise the increase/decrease to the asset’s fair value with the tax effect.

NB: From these 2 journal entries it is easier to see that the depreciation adjustments then required at the end of each year for consolidation purposes are based on the $8 000 increase to fair value. That is, the additional amount of the asset that needs to be depreciated.

In this question….$8,000 / 10 years = $800 per year.

Inventories Dr 6 400

Deferred tax liability Cr 1 920

Business combination valuation reserve Cr 4 480

Goodwill Dr 7 520

Business combination valuation reserve Cr 7 520

(2) Pre-acquisition entries

Retained earnings (1/7/16) Dr 68 800

Share capital Dr 80 000

Business combination valuation reserve Dr 26 000

Shares in Jeff Ltd Cr 174 800

3. Worksheet entries at 30 June 2017

(1) Business combination valuation entries

The BCVR entries are affected by the following events that took place during the period from acquisition to 30 June 2017:

· the depreciation of the plant during the current period

· the sale of the inventories during the current period

· the impairment of the goodwill during the current period.

For the other asset not affected by the above events (i.e. the patent), the BCVR entries at 30 June 2017 will be the same as those at acquisition date, 1 July 2016.

Patent Dr 12 000

Deferred tax liability Cr 3 600

Business combination valuation reserve Cr 8 400

Accumulated depreciation Dr 40 000

Plant Cr 32 000

Deferred tax liability Cr 2 400

Business combination valuation reserve Cr 5 600

Depreciation expense Dr 800

Accumulated depreciation Cr 800

($8 000 / 10 years)

Deferred tax liability Dr 240

Income tax expense Cr 240

(30% x $1 000)

Cost of sales Dr 6 400

Income tax expense Cr 1 920

Transfer from business combination

valuation reserve Cr 4 480

Goodwill Dr 7 520

Business combination valuation reserve Cr 7 520

Impairment loss – goodwill Dr 1 200

Accum. impairment losses – goodwill Cr 1 200

(2) Pre-acquisition entries

The first pre-acquisition entry at 30 June 2017 is the same as the one at 1 July 2016 because 1 July 2016 is the beginning of the period ended 30 June 2017. The other pre-acquisition entries need to reverse the current period transfers from pre-acquisition equity, i.e.:

· from business combination valuation reserve due to the sale of inventories(i.e. the amount of $4,480 that represents the BCVR for inventories).

· from pre-acquisition retained earnings to general reserve (i.e. the amount of $20,000 that was transferred in May 2017).

The reason for reversing those current period transfers from pre-acquisition equity in the other pre-acquisition entries is because the first pre-acquisition entry eliminates the amounts that were in the equity accounts at the beginning of the current period, but some of the equity is not in the same accounts as at the beginning of the current period – by reversing those current period transfers and having that together with the first pre-acquisition entry we make sure all pre-acquisition equity is eliminated.

Retained earnings (1/7/16) Dr 68 800

Share capital Dr 80 000

Business combination valuation reserve Dr 26 000

Shares in Jeff Ltd Cr 174 800

Transfer from business comb. valuation reserve Dr 4 480

Business combination valuation reserve Cr 4 480

General reserve Dr 20 000

Transfer to general reserve Cr 20 000

Exercise 27.9

Undervalued assets, pre-acquisition reserves transfers

Ethan Ltd acquired all the issued shares (ex div.) of Darren Ltd on 1 July 2015 for $110 000. At this date Darren Ltd recorded a dividend payable of $10 000 and equity of:

All the identifiable assets and liabilities of Darren Ltd were recorded at amounts equal to their fair values at acquisition date except for:

Of the inventories, 90% was sold by 30 June 2016. The remainder was sold by 30 June 2017. The machinery was considered to have a further 5-year life and it is depreciated on a straight-line basis.

Both Darren Ltd and Ethan Ltd use the revaluation model for land. At 1 July 2015, the balance of Ethan Ltd’s asset revaluation surplus was $13 500.

In May 2016, Darren Ltd transferred $3000 from the retained earnings at 1 July 2015 to a general reserve.

The tax rate is 30%.

The following information was provided by the two companies at 30 June 2016.

Required

1. Prepare the acquisition analysis at 1 July 2015.

2. Prepare the consolidation worksheet entries for Ethan Ltd’s group at 30 June 2016.

3. Prepare the consolidated financial statements for Ethan Ltd’s group at 30 June 2016.

1. Acquisition analysis at 30 June 2015

Net fair value of identifiable assets

and liabilities of Darren Ltd = ($54 000 + $36 000 + $18 000) (equity)

+ ($16 000 – $14 000) (1 – 30%) (BCVR – inventories)

+ ($94 000 – $92 500) (1 – 30%) (BCVR – machinery)

= $110 450

Consideration transferred = $110 000

Gain on bargain purchase = $110 450 – $110 000

= $450

As the acquisition of shares is ex div., the dividend declared by the subsidiary prior to the acquisition is not considered in the acquisition analysis.

2. Worksheet entries at 30 June 2016

(1) Business combination valuation entries

The BCVR entries are affected by the following events that took place during the period from acquisition to 30 June 2016:

· the sale of 90% of the inventories during the current period

· the depreciation of the machinery during the current period.

The BCVR entry for the inventory unsold during the current period will be the same as the BCVR entry for inventory at acquisition date, but only for the 10%.

Cost of sales Dr 1 800

Income tax expense Cr 540

Transfer from business combination

valuation reserve Cr 1 260

Inventories Dr 200

Deferred tax liability Cr 60

Business combination valuation reserve Cr 140

Accumulated depreciation Dr 7 500

Machinery Cr 6 000

Deferred tax liability Cr 450

Business combination valuation reserve Cr 1 050

Depreciation expense Dr 300

Accumulated depreciation Cr 300

(1/5 x $1 500)

Deferred tax liability Dr 90

Income tax expense Cr 90

(30% x $300)

(2) Pre-acquisition entries

At 1 July 2015:

Retained earnings (1/7/15) Dr 36 000

Share capital Dr 54 000

Asset revaluation surplus Dr 18 000

Business combination valuation reserve Dr 2 450

Gain on bargain purchase Cr 450

Shares in Darren Ltd Cr 110 000

At 30 June 2016:

The pre-acquisition entries at 30 June 2016 are affected by:

· the transfer from business combination valuation reserve as a result of the sale of 90% of the inventories during the current period

· the transfer from pre-acquisition equity to general reserve of $3 000 during the current period.

The first pre-acquisition entry is the same as the one at 1 July 2015. The other pre-acquisition entry needs to reverse:

· the current period transfer from business combination valuation reserve due to the sale of 90% of the inventories

· the current period transfer from pre-acquisition retained earnings to general reserve.

Retained earnings (1/7/15) Dr 36 000

Share capital Dr 54 000

Asset revaluation surplus Dr 18 000

Business combination valuation reserve Dr 2 450

Gain on bargain purchase Cr 450

Shares in Darren Ltd Cr 110 000

Transfer from business combination

valuation reserve Dr 1 260

Business combination valuation reserve Cr 1 260

General reserve Dr 3 000

Transfer to general reserve Cr 3 000

3. Consolidated financial statements for Ethan Ltd’s group at 30 June 2016.

In order to prepare the consolidated financial statements, the consolidation worksheet at 30 June 2016 is first prepared based on the entries above. The consolidation worksheet at 30 June 2016 is then:

Ethan

Ltd

Darren

Ltd

Adjustments

Group

Dr

Cr

Profit before tax

120 000

12 500

1

1

300

1 800

450

2

130 850

Income tax expense

56 000

4 200

90

540

1

1

59 570

Profit

64 000

8 300

71 280

Retained earnings (1/7/14)

80 000

36 000

2

36 000

80 000

Transfer from BCVR

-

-

2

1 260

1 260

1

0

144 000

44 300

151 280

Transfer to general reserve

0

3 000

3 000

2

0

Retained earnings (30/6/15)

144 000

41 300

151 280

Share capital

360 000

54 000

2

54 000

360 000

BCVR

-

-

2

2 450

1 050

140

1 260

1

1

2

0

General reserve

10 000

3 000

2

3 000

10 000

514 000

98 300

521 280

Asset revaluation surplus (1/7/14)

13 500

18 000

2

18 000

13 500

Gains

5 000

2 000

7 000

Asset revaluation surplus (30/6/15)

18 500

20 000

20 500

532 500

118 300

541 780

Liabilities

42 500

13 000

1

90

450

60

1

1

55 920

575 000

131 300

597 700

Land

160 000

20 000

180 000

Plant and machinery

360 000

125 600

6 000

1

479 600

Accumulated depreciation

(110 000)

(33 000)

1

7 500

300

1

(135 800)

Inventories

55 000

18 700

1

200

73 900

Shares in Darren Ltd

110 000

-

110 000

2

0

575 000

131 300

124 600

124 600

597 700

ETHAN LTD

Consolidated Statement of Profit or Loss and Other Comprehensive Income

for the financial year ended 30 June 2015

Profit before income tax $130 850

Income tax expense 59 570

Profit for the period $71 280

Other comprehensive income

Gains on revaluation of assets 7 000

Total comprehensive income $78 280

ETHAN LTD

Consolidated Statement of Changes in Equity

for the financial year ended 30 June 2015

Comprehensive income for the period $78 280

Retained earnings at 1 July 2014 $80 000

Profit for the period 71 280

Retained earnings at 30 June 2015 $151 280

Share capital at 1 July 2014 $360 000

Share capital at 30 June 2015 $360 000

Asset revaluation surplus at 1 July 2014 $13 500

Increments 7 000

Asset revaluation surplus at 30 June 2015 $20 500

General reserve at 1 July 2014 $10 000

General reserve at 30 June 2015 $10 000

ETHAN LTD

Consolidated Statement of Financial Position

as at 30 June 2015

Current Assets

Inventories $73 900

Non-current Assets

Property, plant and equipment:

Land 180 000

Plant & machinery $479 600

Accumulated depreciation (135 800) 343 800

Total Non-current Assets $523 800

Total Assets $597 700

Equity

Share capital $360 000

Retained earnings 151 280

General reserve 10 000

Asset revaluation surplus 20 500

Total Equity $541 780

Liabilities $55 920

Total Equity and Liabilities $597 700

Exercise 27.11

Undervalued and unrecorded assets, unrecorded liabilities, pre-acquisition reserves transfers

On 1 August 2013, Erik Ltd acquired 10% of the shares in Finn Ltd for $8000. Erik Ltd used the fair value method to measure this investment with movements in fair value being recognised in profit or loss. At 1 July 2015, the fair value of this investment was $15 400. The original investment in Finn Ltd was due to the fact that Finn Ltd was undertaking research into particular microbiological elements that could influence the profitability of Erik Ltd. With the continuing success of this research, Erik Ltd decided to acquire the remaining shares (cum div.) in Finn Ltd.

On 1 July 2015, Erik Ltd made an offer to buy the remaining shares in Finn Ltd for $151 000 cash. This offer was accepted by the shareholders of Finn Ltd. On 1 July 2015, immediately after the business combination, the statement of financial position of Finn Ltd was as follows.

On analysing the financial statements of Finn Ltd, Erik Ltd determined that all the assets and liabilities recorded by Finn Ltd were shown at amounts equal to their fair values except for:

The plant and equipment is expected to have a further 4-year useful life and is depreciated on a straight-line basis. The inventories were all sold by 30 June 2016.

Finn Ltd had expensed all the outlays on research and development. Erik Ltd considered that an asset was created and placed a fair value of $12 000 on this asset. The research and development is amortised evenly over a 10-year period. Finn Ltd also had reported a contingent liability at 30 June 2015 in relation to claims by customers for damaged goods. Erik Ltd placed a fair value of $3000 on these claims. The claims by customers were settled in May 2016 for $2800.