Business Combinations

Weeks 7 & 8

Introduction, intragroup transactions &

Non-controlling Interests

D&S Ch 24, 25 & 26

Learning Objectives

• Prepare complex financial statements in accordance with GAAP.

• Examine the purpose and conceptual foundation of consolidated financial statements;

• Prepare consolidated financial statements in the presence of:• intra-group transactions • deferred tax accounting• non-controlling interests

Key issues in group accounting• Consolidated statements – rationale• Control in consolidation decision• Mechanics of consolidation:

• 100% - review• non-controlling interest• indirect interests• step acquisitions• changes in degree of ownership

• Associated entities: equity accounting

• Joint arrangements: assets/liabilities or equity accounting

• Foreign operations: operating, functional, presentation currencies

Group structures

Parent

Subsidiary

100%

Subsidiary

100%

Associate

25%

Investee

5%

J-V Subsidiary

80%

Subsidiary

60%Equity

N-C I

40%Equity

Joint Arrangement

J-V Partner

50% 50%

Consolidation Investment Equity A/cg Equity A/cg orProportionate consolidation

Business combinations/groups

• Combination (NZ IFRS 3) by:• External acquisition (internal restructure excluded)• Acquisition: assets, amalgamation, merger, takeover

• All major co’s are ‘groups’ – NZX, annual reports• Issuers must present ‘consolidated’ statements for parent

plus subsidiaries• CA 1993 (S211(b)); FRA 1993 (S2 & 9)• NZX Rules• GAAP: NZ IFRS 3; NZ IAS 27

Rationale for consolidations• Show results, financial position and cash flows as single

economic entity (NZ IAS 27 #4)• Consolidated income statement:

• result of operations with external parties• eliminate all intra-group transactions & profit

• Consolidated balance sheet:• total assets controlled by group entities• total liabilities owed to outside parties• equity: group & parent (separate disclosure of N-C Interest)

• Cash flow Statement: cash flows with external parties• Preclude ‘creative’ accounting

• Substance v legal form – e.g. control, options, rights• Structures – unincorporated entities; ‘off balance sheet’ events• Transactions – ‘window dressing’; profit creation in intra-group

transactions.

IFRS 3• Accounting for “business combinations”• What is a “business combination”?

– A transaction or other event in which the acquirer obtains control of one or more businesses (App. A and B7 – B12)

• Acquirer: the entity that obtains control of the acquiree.• Control: the power to govern the financial and operating

policies of an entity so as to obtain benefits from its activities.• Business: an integrated set of activities and assets that is

capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits……

Control

3 elements to control:•Power over the investee;

– Existing rights giving current ability to direct the relevant activities

•Exposure or rights to variable returns;– Investor’s returns must have potential to be variable with

investee’s performance•Ability to use power to affect the amount of the investor’s returns.

Why consolidate financial statements?

Alternative methods of consolidation• Entity concept

– Entire group viewed as a single economic entity– Transactions between group members eliminated– Non-controlling interests included

• Proprietary concept– Only the proportionate share of subsidiaries assets and

liabilities included– Excludes proportion of assets and liabilities relating to non-

controlled interests• Parent entity concept

– All assets and liabilities of subsidiaries included and then a liability for non-controlled interests recognised

IFRS 3

• Entity method adopted• At acquisition date, the acquirer shall recognise, separately

from goodwill, the identifiable assets acquired and liabilities assumed and any non-controlling interest in the acquiree. (#10)

• Acquisition date is the date the acquirer obtains control.

IFRS 3 – recognising assets and liabilities

• #15: recognise and classify assets/liabilities based on conditions as they exist at acquisition date

• Exception for leases which are classified in accordance with terms of original contract

• Internally generated intangible assets may be recognised by acquirer

• #22: contingent liabilities are recognised as liabilities provided its fair value can be measured reliably (exception to NZ IAS 37 – no need for liability to be “probable”)

• Acquirer will recognise goodwill (excess of consideration paid over fair value of net assets acquired)

4 Steps to account for business combination

1. Identify acquirer– Obtains control of acquiree

2. Determine acquisition date– Date control obtained

3. Recognise and measure assets/liabilities– Recognise assets/liabilities at acquisition date fair value– Recognise based on conditions at balance date– Exceptions: leases and contingent liabilities

4. Recognise and measure goodwill or gain from bargain purchase.

Accounting requirements

• Combine like items of assets, liabilities, equity, income expenses and cash flows of parent with subsidiaries

• Elimination entries on consolidation worksheet to eliminate acquirer’s investment in acquiree and parent’s portion of acquiree’s equity (may include a component for goodwill)– See worked example 24.4 (24.3 5th ed)

• Eliminate intra-group assets, liabilities, equity, income, expenses and cash flows

Other consolidation issues

• May have a “gain on bargain purchase” where fair value of net assets exceed fair value consideration

• Assets may need to be revalued to fair value – deferred tax implications

• There may be other intangible assets now able to be recognised – brand etc.

Disclosures

• IFRS 12 #10,11,12 give guidance on disclosures• Disclosures required so users understand composition of

group and non-controlling interests• Disclosure requirements of subsidiaries with non-controlling

interests which are material

Intra-group transactions

Such as…….– Dividends– Management fees– Sales of stock/inventory– Transfer of tax losses– Loans

Dividends

• Post-acquisition profits – eliminate from consolidated accounts– WE 25.1

• Pre-acquisition profits – May reflect an impairment in the investment in subsidiary– See WE 25.2

Sale of inventory

• Revenue not recognised until inventory sold external to the group

• Need to eliminate the following:– Sales and purchases amounts– Profit for inventory still on hand within group– Account for deferred tax position as tax has been paid on sales!

• No need to “reverse” these entries as they do not accumulate as only noted on a worksheet

• But do need to account for unrealised profit in opening inventory

Unrealised profit in opening inventory

• Shift income from the previous period, in which inventory still on hand, to period in which inventory ultimately sold to external parties

• Reducing opening inventory reduces cost of goods sold• Dr Opening retained earnings• Cr Cost of goods sold

• Higher profits lead to higher tax expense• Dr Income tax expense• Cr Opening retained earnings

Sale of non-current assets

• Gain/loss on sale needs to be eliminated• Depreciation may be calculated on higher base in purchasing

company• Tax on gain/loss on sale needs to be eliminated

Non-controlling interests

• IFRS 10 defines “parent” as an entity that controls one or more entities

• IFRS 10 defines “subsidiary” as an entity that is controlled by another entity

• Non-controlling interest is an equitable interest in a subsidiary not attributable, directly or indirectly, to a parent– Not called minority interest as a minority interest may still have

control• Entity concept requires non-controlling interests to be

consolidated into group accounts of controlling entity

Disclosures required

• Non-controlling interests must be presented in equity section of group accounts #22

• Entity must disclose:– Profit and loss and each component of other comprehensive

income to owners of the parent and non-controlling interests• When parent remains in control but proportion of equity

changes, the carrying amounts are changed to reflect changes

Calculating non-controlling interests

• # 19 NZ IFRS 3 gives two options for calculating non-controlling interests as present ownership interests that entitle the owners to their proportionate share of the entity’s net assets upon liquidation at either:– Fair value; or– Proportionate share in the acquiree’s identifiable net assets.

• Difference is goodwill – partial versus full goodwill method

Calculation of NCI (3 steps)

1. NCI at date of acquisition – proportionate share of subsidiary net assets (WE 26.1)

or - fair value of consideration (WE26.2)

Dr Contributed Equity XReserves XRetained Earnings XGoodwill (if fair value of consideration) XCr Non Controlling Interest X

(Reclassification of NCI in equity of Subsidiary at date of acquisition)

2. NCI in changes in equity (reserves & retained earnings) since acquisition (to start of current period)

Dr Retained Earnings (change to op. bal after adj) XReserves (change to closing bal) XCr Non-Controlling Interest

X(Reclassification of change from acquisition date)

3. NCI in current year profit (after consolidation adjustments affecting subsidiary profit)

Dr Non-Controlling Interest in profit XCr Non-Controlling Interest

X(Reclassification of NCI in current year profit – after consol

adjustments)

Calculation of NCI (2)