Download Advanced Financial Accounting: Chapter 2

Advanced Financial
Accounting: Chapter 2
Group Reporting I: Concept and
Context
Tan, Lim & Lee Chapter 2
© 2015
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 parentsubsidiary relationship;
5. The concept of “significant influence” and the notion of “associate”
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, Lim & Lee Chapter 2
© 2015
2
Content
1. Introduction
2. Economic Incentives for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangements
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation Theories
Tan, Lim & Lee Chapter 2
© 2015
3
Introduction
• A primary issue that underpins financial reporting is the identification
of the reporting entity.
Financial information may be reported at three levels
Financial information
Separate financial
statements for the
legal entity
Tan, Lim & Lee Chapter 2
Aggregated reporting
for the economic
entity
© 2015
Disaggregated
reporting for business
units within a legal or
economic entity
4
Introduction
Relationship of control within legal entities
•Shared ownership
•Contractual or statutory
arrangements
Legal Entity
Individual
financial
statement
Tan, Lim & Lee Chapter 2
Control
Effective relationship
© 2015
Legal entity
Individual
financial
statement
5
Introduction
Incentive to extend economic boundaries
Capitalizing
on slack debt
or operating
capacity
Increased
market shares
Tapping on
growth
opportunities
Economies
of scale
and scope
Reduced
risk through
diversification
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Introduction
• Principle of substance over form:
– Notion of a reporting entity extends beyond the legal entity to that of an
economic group of related companies
• The need for consolidated financial statements by the reporting
entity
– If separate financial statements are the only source of information
• FS users will not be able to properly assess extent of the size,
profitability, cash flows and risks of the larger economic entity
• May not be able to obtain a clear picture of group performance as a
whole (i.e. not seeing the forest for the trees)
– Consolidation FS allows investors to asses the risk-return profile of the
combined entity
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Introduction
•
A group of companies better able to deal with economic risk like
–
–
–
Macro-economic risk (e.g changes in government policies)
Industry risk (e.g. technological risks)
Firm-specific risk (e.g. over-reliance on specific human capital)
• 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, Lim & Lee Chapter 2
© 2015
8
Introduction
• Corporate regulations may require separate financial statements to
be prepared by each legal entity
Purpose of separate
Financial Statements
Provide information for
legal and tax purposes
Tan & Lee Chapter 2
Determine the financial
solvency of individual
entities
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Prevent weakness of
individual companies to
be masked by strengths
of other group
companies
9
Introduction
Need for disaggregated Information
Loss of information if only
aggregated information is provided
Source of
disaggregated
information
Separate financial
statements
Segment information
Determine risk profile of individual segments
Tan, Lim & Lee Chapter 2
Strength and weaknesses of specific
operation and geography
10
Introduction
Parent-Subsidiary Relationship
Group
Subsidiary
Parent
(Controlling
entity)
Control
Subsidiary
Consolidation:
Process of preparing
and presenting
financial statements of
parent and subsidiary
as if they were one
economic entity
Subsidiary
Consolidated FS:
Artificial creations
Tan, Lim & Lee Chapter 2
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Content
1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangements
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation Theories
Tan, Lim & Lee Chapter 2
© 2015
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Information Perspective
• Managers with a comparative advantage on information about their
firms are compensated for their ability to provide information on the
future cash flows of these firms (Holthausen and Leftwish, 1983)
Are consolidated financial
statements more
informative than separate
financial statements?
Tan, Lim & Lee Chapter 2
No (Mian and Smith, 1990)
Investors can duplicate “homemade”
consolidated financial statements
[Assumption: intragroup transactions
are small]
Yes (Holthausen, 1990)
The greater the interdependencies
among group companies, the more
informative combined earnings about
future cash flows of the combined
entity
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Information Perspective
• According to Mian and Smiths’ views, a firm is more likely to choose
consolidated reporting when:
–
–
–
–
There are greater interdependencies between parent and subsidiaries
Foreign rather than domestic subsidiaries
Parent provides direct guarantee of the subsidiary’s debt
Parent is in the financial services industry
• Under Holthausen’s view:
– The greater the interdependencies among the group companies, the
higher the likelihood of intragroup transactions
– Difficult for external users to replicate the consolidation process
– Managers have incentives to voluntarily provide consolidated FS that
will enable investors to better predict group’s future cash flows
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Efficient Contracting
•
Whittred (1987) suggests that consolidated information improves wealth for
firms
•
Reason: 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”
•
Hence, a set of consolidated FS performs the same function as a “crossguarantee issued by a parent company
– Undo the effect of separately incorporated companies within the group (e.g. if Sub A is
not able to pay its debt as legal entity, its shortfall is compensated by net assets of
other entities within the group [“Co-insurance” effect])
– Implicit assurance to lenders that debt is financially backed by assets of combined
entity
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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 of companies  sheer increase in size will
result in higher pay out for managers notwithstanding their competency.
– Managers are more likely to over-invest in companies that are specific
and complementary to their skills (Shleifer and Vishny, 1990)
• Information asymmetry may arise by masking financial problems of
individual companies within the group
• Conclusion: Both aggregated (consolidated) and disaggregated
(segment) information are required
Tan, Lim & Lee Chapter 2
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Content
1. Introduction
2. Economic Incentive for the Preparation of
Consolidated Information
3. Economic Motives for Entering into
Intercorporate Arrangement
Arrangements
4. The Concept of Control
5. The Concept of Significant Influence
6. Accounting for Business Combinations
7. Consolidation Theories
Tan, Lim & Lee Chapter 2
© 2015
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Economic Incentives for Entering into
Intercorporate Arrangements
Markets will not reward firm’s diversification with a higher price for its shares if investors can
replicate the firm’s strategies
Sub-optimal consequence
Corporate Diversification
Other reasons
Why Corporate Diversification?
•
Individuals not able to diversify as
efficiently because of indivisibility of
assets and high transaction costs
(i.e. to achieve economies of scale)
Tan, Lim & Lee Chapter 2
•
Firms involved in M&A have stakeholders
(i.e. managers and employees) who are
not able to diversify their risks as well as
shareholders
•
Corporate diversification may mitigate
the problem of under-investment by riskaverse managers
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Economic Incentives for Entering into
Intercorporate Arrangements
Two or more acquirers
gain “joint-control” over
the acquiree (Joint
venture)
Acquirer gains “control”
over the operating and
financial policies of the
acquiree (Consolidation)
Arrangements in M&A
Reciprocal investments
are held by each of the
two firms, as both are
deemed to be equally
dominant (Pooling of
interests)
Tan, Lim & Lee Chapter 2
Acquirer has “significant
influence” over the
operating and financial
policies of the acquiree
(Equity accounting)
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Economic Incentives for Entering into
Intercorporate Arrangements
Risk mitigated by
M&A strategies
Uncertainty
Risk management strategies
•Organic growth or acquisition
•Risk diversification
Information
Control
(Acquisition method)
Tan, Lim & Lee Chapter 2
Joint-venture
(Equity accounting)
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Value
•Combined risks
•Size effects
•Co-insurance effect
•Diversification effect
Significant Influence
(Equity accounting)
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Investing Strategies, Ownership Levels and
the Impact on Financial Reporting
Continuum of intercorporate ownership (under previous accounting standards such
as IAS 27, IFRS 12, IAS 28, IFRS 13 and IAS 31)
Zero
Ownership
20%
Ownership
Passive
Investment
p
u
r
p
o
s
e
ii.
Earn dividend
income
Make capital
gain
Tan, Lim & Lee Chapter 2
100%
Ownership
Active
Investment
Active
Investment
•Associated
company
•Jointventure
•Trading
securities
•Availablefor-sale
securities
i.
50%
Ownership
i.
Exert significant
influence or
control over
investee’s
operation
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•Partially-owned subsidiary
•Fully-owned subsidiary
i.
ii.
iii.
Gain entry intro a new market
Achieve synergistic benefits from
complementary strengths
Gain market dominance
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Investing Strategies, Ownership Levels and
the Impact on Financial Reporting
•
New accounting standards
–
–
–
–
•
IFRS 10: Consolidated Financial statements
Revised IAS 27: Separate Financial statements
IAS 28 Investments in Associates and Joint Ventures
IFRS 11: Joint Arrangements
Definition of control
Under old IAS 27
IFRS 10
Control is determined by the following:
1. Power to govern financial and
operating policies
2. Benefits derived therein, or risk and
rewards
Investor controls an investee when:
1. It is exposed, or has rights to the
variable returns from an investee
2. Has power over investee and ability
to affect those returns
3. Relevant facts and circumstances
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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, Lim & Lee Chapter 2
© 2015
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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
the financial and operating
policies of an entity
Enjoy the benefits
from the exercise
of the power
Example of a scenario where there is no control: Agent or trustee
acting on behalf of a beneficiary
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The Concept of Control under old IAS 27
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 ( *note: use of quantitative criterion is only a
guide)
Ownership of less than 50% of voting power but
there is :
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
body that has control over the entity
Control
Subsidiary
25
The concept of control under IFRS 10
• Under IFRS 10, the following qualitative factors are set out to
determine if investor has control
Power
Control
Ability
Returns
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The concept of control under IFRS 10
•
Determining Power
– The sources of power could be
• Existing rights obtained from shares’ voting rights
• Management contractual arrangements
• Potential voting rights via ownership of convertibles and share options
• Control over key management
• Control over entity that directs the investee’s relevant activities
• Special relationships that could indicate control over investee (e.g.
investee’s key management are current or former employees of investor)
– Rights of minority shareholders need to be considered
– The purpose and design of investee should be considered to identify relevant
activities and decisions over those activities to assess control
• Relevant activities include operating and financial activities
• Decisions over those activities include operating and capital decisions of
investee and appointment etc.
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The concept of control under IFRS 10
•
•
•
Determining Power (continued)
– Investors need to consider which relevant activity most significantly affects the
investee’s return when two investors each control relevant activities
Ability
– Investor must have:
• Substantive rights (i.e. practical ability to exercise those rights)
• Unilateral ability to direct the most significant activities
• NOT be acting as an agent
– The ability to use the power must be current even though it need not be currently
exercisable
– Little barriers that prevent the exercise of those rights
– Investors holding the rights must benefit from exercising those rights
Returns
– Variable returns that investors is exposed to could be (i) all positive (ii) all
negative (iii) either positive or negative
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The concept of control under IFRS 10
• Examples:
1. Investor owns 46% in investee but 54% remaining shares are
dispersed among many investors
• Conclusion: investor has sufficient dominant voting interest (de facto
control) to meet power criterion
2. Investor holds 46% shares, while two other investors own 27% each.
• Conclusion: the two investors hold relatively more voting rights than
investor holding 46%
3. Investor holds 45% interest, while five investors individually hold 11%
interest
• Conclusion: investor has contractual right to appoint, remove and
set remuneration of key management of investee  power over
investee
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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.
100%
Y Co.
50% 50%
B Co.
Z Co.
60%
Situation 1:
X Co. controls
Y Co. and A Co.
Even though
X.Co. indirectly
owns 75%
Break in control
at B and hence
no control over
Z Co.
A Co.
Situation
Tan, Lim & Lee Chapter
2 1
60%
Y Co.
55% 60%
B Co.
Z Co.
40%
50%
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Situation 2:
X Co. controls
Y Co., B Co.
and Z Co.
Does not own
A Co. (<51%)
X Co.
Situation 2
50%
A Co.
30
Legal Ownership versus Effective Control
• IAS 27 is principles-based, and all evidence must be considered for
the existence of control
– Legal ownership is not the only criterion for determining the existence of control
(> 50%)
– Power to govern operating financial policies
– Obtain benefits from activities of the other entity
• Steps in consolidation (IAS 27)
– 1st: Determine if control exists through the levels of investment holding
– 2nd: Once control is established, determine the economic boundaries of the group
and consolidation procedures that should be applied to combined the FS of
parent and subsidiaries
– 3rd: Use the effective percentage ownership to determine the non-controlling
interests’ share (further discussed in chapter 4)
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Potential Voting Rights in the
Determination of Control
•
IAS 27 and IFRS 10 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 party’s voting power over the financial and
operating policies of another entity
– In IFRS 10: potential voting rights (must be substantive) is a factor to consider in
determining if investor has power, and hence control over investee
•
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 such as
exercise price and date
•
It is important that the potential voting rights must be currently exercisable or
convertible to be included in the test of control
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Potential Voting Rights in the
Determination of Control
Illustration of potential voting rights
Issued
ordinary
shares
Percentage
of ordinary
shares
Issued
share
warrants
Potential
shares from
warrants
Total shares
(issued and
potential)
Percentage
of total
shares
Company A
$10,000,000
50%
$5,000,000
$10,000,000
$20,000,000
62.50%
Other
investors
10,000,000
50%
1,000,000
2,000,000
12,000,000
37.50%
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.
• If company A wishes, it can exercise its share warrants immediately and
assume 62.5% ownership over Company B.
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Potential Voting Rights in the
Determination of Control
Situations where potential voting rights may determine control
When one investor has the
right to increase its voting
power or reduce other
investors’ voting power
Currently exercisable share
options even though they are
currently “out of the money”
Tan, Lim & Lee Chapter 2
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Impact of Potential Voting Rights
on the Allocation of Profit
•
Potential voting rights that are currently exercisable or convertible are
considered in determining control BUT excluded in determination for
allocation of profit to parent and NCI
•
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)
•
Generally, the holding of option, warrant, debt or equity instrument does not
give the holder a present right to the economic benefits arising from actual
ownership of shares
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Principal-agent Relationships
•
An investor is an agent when he exercises power on behalf of another investor (IFRS
10)
–
•
Factors to consider if an investor is a principal or agent (IFRS 10):
–
–
–
–
–
•
Agent does not control investee and does not need to consolidate investee
Rights of other parties
Principal’s exposure to variable returns from other interests held
Scope of decision making authority of the principal
Remuneration entitled by principal
Principal’s rights to remove the decision maker without cause
Determining de facto agents
–
–
Need not be contractual relationships between parties and investors
Examples include: (i) related parties of investor, (ii) parties with close business relationships,
(iii) parties that receive interest in investee as loan from investor and (iv) parties whose key
management are same as that of investor
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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, Lim & Lee Chapter 2
© 2015
37
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 of decision-making process
• 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
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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 (IAS 28:7)
Number of directors
representing investors
on board
Participation in
policy-making
processes
Operational
interdependencies
Investor must disclose reasons for not complying with default assumption
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Definition of associate
• “An associate is an entity in which the investor has significant
influence and which is neither a subsidiary nor a joint-venture of the
investor” (IAS 28:2)
• If investee is an associate, the investor is not referred to as the
“parent”
– “parent” applies only to relationships where investor has control over
investee
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40
Direct and Indirect Significant Influence
Multi-level structures
P
80% 50%
X
50%
Y
50%
Situation 1:
P has significant
influence over:
i)
Y (50% direct
interest)
ii) Z (65% indirect
interest) – P has
no control over
Y
P
40% 50%
A
80%
Z
Situation 1
Tan, Lim & Lee Chapter 2
C
20%
Situation 2:
P has significant
influence over:
i)
A (40% direct
interest)
ii) C (50% direct
interest)
iii) B (42% indirect
interest)
B
Situation 2
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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, Lim & Lee Chapter 2
© 2015
42
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)
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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
the equity of
another entity
Purchasing
the net assets of
another entity
Business combinations result from
Assuming the
liabilities of
another entity
Tan, Lim & Lee Chapter 2
Purchasing some of the
net assets of another
entity that together form
one or more business
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Purchase of Net Assets versus
Purchase of Equity
Parent
Acquirer
Acquires controlling interest in
equity of
Buys over net assets
Subsidiary
•
•
•
Acquiree
Parent – Subsidiary relationship
Separate legal entities
- separate FS
Single reporting entity
- Consolidated FS
Tan, Lim & Lee Chapter 2
•
•
•
© 2015
No Parent – Subsidiary relationship
One legal and economic entity
Do not require consolidated
financial statements
45
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, Lim & Lee Chapter 2
© 2015
46
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 subsidiary’s:
•
•
Net profit;
Dividend distribution;
Tan, Lim & Lee Chapter 2
•
•
Share capital
Retained profits and changes in equity
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47
Consolidation Theories
Parent company sells
part of its stake in a
subsidiary to external
shareholders
Parent company
buys a majority
stake in a subsidiary
from existing owners
Tan, Lim & Lee Chapter 2
Reasons why
non-controlling
interest
Parent and non-controlling
arise
shareholders are founding
shareholders of newly
incorporated entity
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Consolidation Theories
Ownership of the combined entity
involving a wholly owned subsidiary
Joint-ownership of the combined entity
involving a partially owned subsidiary
Parent company’s shareholders
Parent company’s shareholders
Parent company
100%
ownership
Non-controlling
shareholders of a
subsidiary
Subsidiary
Wholly owned by the
parent company’s
shareholders
Tan, Lim & Lee Chapter 2
30%
ownership in
subsidiary
Parent company
70%
ownership
Subsidiary
2 groups of shareholders
1) The parent company’s shareholders; and
2) The non-controlling shareholders of the
subsidiary
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49
Comparison of issues
Issues
Who are the primary
users of the consolidated
financial statements?
How should noncontrolling interests be
reported in the
consolidated balance
sheet?
Tan, Lim & Lee Chapter 2
Entity Theory
Both non-controlling
interest and majority
shareholders
Shown as equity in
BS based on:
Consolidated equity
=
Consolidated assets
Consolidated liabilities
© 2015
Parent Theory
Parent company
shareholders
Shown as equity in
BS based on:
Consolidated equity
+
NCI
=
Consolidated assets
Consolidated liabilities
50
Comparison of issues
Issues
Entity Theory
Should net assets of
the subsidiary acquired
be shown at full fair
values or at the
parent’s share of the
fair value?
Fair value of net
assets of subsidiary
at date of acquisition
reported in full
Do non-controlling
shareholders have a
share of goodwill?
Goodwill = asset of
economic unit, and
reflected in full
How should net profit of
partially-owned
subsidiary be reported?
Tan, Lim & Lee Chapter 2
Reported in full as
accruing to both
majority and NCI
© 2015
Parent Theory
NCI net assets of
subsidiary at date of
acquisition shown at
book value
Asset of parent
and restricted to
parent’s share
NCI’s share of current
profit is a deduction of
final profit
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Summary of differences
Attributes
Entity Theory
Parent Theory
Fair value differences in
relation to identifiable
assets and liabilities at
date of acquisition
Recognized in full,
reflecting both parent’s
and NCI’s share of fair
value adjustments
Recognized only in
respect of parent’s
share
Presentation of NCI
As part of equity
Neither as equity or
debt
Goodwill
Goodwill is an entity’s
asset and should be
recognized in full as at
date of acquisition
Goodwill is parent’s
asset
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Proprietary Theory
• Relevant to accounting for joint-ventures
• Parent seen as having a direct interest in a subsidiary’s assets and
liabilities
– Resulting in proportional or pro-rata consolidation (parent’s interest
is directly multiplied to each individual asset or liability of subsidiary and
combined with parent’s assets and liabilities).
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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
subsidiary’s identifiable assets and liabilities (mix of parent and
entity theories)
• IFRS 3 (2008) permits the recognition of non-controlling interests’
share of goodwill
• Movement towards the full entity theory
– IFRS 3 (2008) permits the inclusion of NCI’s share of goodwill as at date
of acquisition
– FASB through SFAS 141 requires the recognition of the NCI’s share of
goodwill
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Illustration 1: Parent versus Entity Theory
Scenario
• P Co purchased 80% interest in S Co on 1/1/20x1
• Consideration transferred: $1,200,000
• NCI: 20%
• BV of equity of S Co 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 of S Co at 31/12/20x1: $1,270,000
• Net profit after tax (NPAT) of S Co: $ 70
• Net profit after tax (NPAT) of P Co: $350
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Illustration 1: Parent versus Entity Theory
Net profit after tax and NCI
Parent theory
NCI’s share of net profit is after tax completed as follows:
= 20% x S’s net profit after tax
= 20% x $70
= $14
Entity Theory
NCI are not shown as a deduction but included in entity-wide NPAT.
Disclosure is made of the amount of NPAT that relates to NCI
= (100% x P’s NPAT) + (80% x S’s NPAT)
= (100% x $350) + (80% x $70)
= $406
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Illustration 1: Parent versus Entity Theory
Good will
Parent Theory
Goodwill = Investment in S – P’s ownership %
X (FV of S’s identifiable net assets at date of acquisition)
= $1,200 – (80% x $1,300)
= $160
Entity theory
Parent’s share of goodwill = $160
NCI’s share of goodwill = Fair value of NCI – share of FV of identifiable
net assets
= $300 – (20% x $1,300)
= $40
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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 S’s 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 S’s equity + FV adjustments)
+ NCI’s share of goodwill
= 20% x ($1,270 + $100) +$40
= $314
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