Advanced Financial Accounting Chapter 2 Group Reporting I

Advanced Financial Accounting: Chapter 2 Group Reporting I: Concepts and Context Tan & Lee Chapter 2 © 2009 1

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

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

Introduction • A primary issue that underpins financial reporting is the identification of the reporting entity. Components of Financial Reporting Financial reporting Separate financial statements for the legal entity Tan & Lee Chapter 2 Aggregated reporting for the economic entity © 2009 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 & Lee Chapter 2 Control Effective relationship © 2009 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 Tan & Lee Chapter 2 © 2009 6

Introduction • A group of companies better able to deal with economic risk like – – – Macro-economic risk Industry risk Firm-specific risk • Corporate acquisition and diversification may be sub-optimal and value-destroying if – Motivate by managers’ self-interest to invest in size rather than value (Jensen, 1986, Shelefier and Vishny, 1990) – Costs and risks that arise from acquisition strategies, particularly in unrelated diversification • Synergistic benefits potentially reduced by direct and indirect costs arising from these strategies Tan & Lee Chapter 2 © 2009 7

Introduction Disaggregated Information Loss of information if only aggregated information is provided Source of disaggregated information Separate financial statements Segment information Determine risk profile of individual segments Tan & Lee Chapter 2 Strength and weaknesses of specific operation and geographical 8

Introduction Parent-Subsidiary Relationship Subsidiary Group l C Parent ro ont Control Co Subsidiary ntro l Subsidiary Tan & Lee Chapter 2 © 2009 Consolidation: Process of preparing and presenting financial statements of parent and subsidiary as if they were one economic entity 9

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

Information Perspective • Managers with a comparative advantage on information are compensated for their ability to provide information on the future cash flows of these firms (Holthausen and Leftwish, 1983) Are consolidated financial statements are more informative than separate financial statements? Tan & Lee Chapter 2 No Investors can duplicate “homemade” consolidated financial statements (Mian and Smith, 1990) Yes The greater the interdependencies among group companies, the more informative combined earnings about future cash flows of the combined entity (Holthausen, 1990) © 2009 11

Efficient Contracting • Whittred (1987) suggests that consolidated information improves wealth for firms • Reduced information asymmetry between lenders and borrowers – Lenders fear that borrowers will transfer assets to related companies – Borrowers expropriate a considerable larger sum than what they stand to lose because of limited liability • Hence, lenders required cross-guarantees issued by parent companies. Whittred suggests a set of consolidated financial statements performs the same function as a “cross guarantee” Tan & Lee Chapter 2 © 2009 12

Opportunism • Consolidated financial statements lead to wealth transfers to managers at the expense of other stakeholders if the acquisition is motivated by managerial self-interest – Managers enjoy higher compensation, perks and power through managing a larger group – Managers are more likely to over-invest in companies that are specific and complementary to their skills • Information asymmetry may arise by masking financial problems of individual companies within the group Tan & Lee Chapter 2 © 2009 13

Content 1. Introduction 2. Economic Incentive for the Preparation of Consolidated Information 3. Economic Motives for Entering into Intercorporate Arrangement 4. The Concept of Control 5. The Concept of Significant Influence 6. Accounting for Business Combinations 7. Consolidation Theories Tan & Lee Chapter 2 © 2009 14

Economic Incentives for Entering into Intercorporate Arrangement Markets will not reward firm’s diversification if investors can replicate the firm’s strategies Corporate Diversification Why Corporate Diversification? Individuals not able to diversify as efficiently because of indivisibility of assets and high transaction costs Tan & Lee Chapter 2 © 2009 Firms involved in M&A have stakeholders who are not able to diversify their risks as well as shareholders 15

Economic Incentives for Entering into Intercorporate Arrangement Acquirer gains “control” over the operating and financial policies of the acquiree Two or more acquirers gain “joint-control” over the acquiree Arrangements in M&A Reciprocal investments are held by each of the two firms, as both are deemed to be equally dominant Tan & Lee Chapter 2 Acquirer has “significant influence” over the operating and financial policies of the acquiree © 2009 16

Economic Incentives for Entering into Intercorporate Arrangement Risk mitigated by M&A strategies Uncertainty Risk management strategies • Organic growth or acquisition • Risk diversification Information Control Tan & Lee Chapter 2 Joint-control © 2009 Value • Risk • Size effects • Co-insurance effect • Diversification Significant Influence 17

Investing Strategies, Ownership Levels and the Impact on Financial Reporting Continuum of intercorporate ownership Zero Ownership 20% Ownership Passive Investment ii. Earn dividend income Make capital gain Tan & Lee Chapter 2 100% Ownership Active Investment • Associated company • Jointventure • Trading securities • Availablefor-sale securities i. 50% Ownership i. Exert significant influence or control over investee’s operation © 2009 • Partially-owned subsidiary • Fully-owned subsidiary i. iii. Gain entry intro a new market Achieve synergistic benefits from complementary strengths Gain market dominance 18

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

The Concept of Control 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 Tan & Lee Chapter 2 Enjoy the benefits from the exercise of the power © 2009 20

The Concept of Control Determination of control Ownership of more than 50% of voting power: Control is presumed to exist when the parent owns directly or indirectly through subsidiaries, more than one-half of the voting power of an entity unless, in exception circumstances, it can be clearly demonstrated that such ownership does not constitute control Ownership of less than 50% of voting power but there is : a) Power over more than one-half of the voting rights arising from an agreement with other investors; or b) Power to govern the financial and operating policies of an entity arising from a statute or an agreement; or c) Power to appoint or remove the majority of the members of the board of directors or equivalent governing body; or d) Power to cast the majority of votes at meetings at the board of directors or equivalent governing Tan & Lee Chapter 2 © 2009 body that has control over the entity 21

Direct and Indirect Control • • For the test of control, IAS 27 requires consideration of the percentage of voting rights held “direct or indirectly through subsidiaries” Control must be demonstrated at each intermediate level before the ultimate holding company is said to have control over the lowest-level company Affiliation structures X Co. 100% Y Co. 50% B Co. 60% Z Co. Situation 1: X Co. controls Y Co. and A Co. Break in control for Z Co. even though X. Co. indirectly owns 75% A Co. Situation 1 Tan & Lee Chapter 2 60% Y Co. 55% 60% B Co. Z Co. 40% 50% © 2009 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. 22

Legal Ownership versus Effective Control • IAS 27 is principles-based, and all evidence must be considered for the existence of control • IAS 27 requires potential voting rights, which are currently exercisable or convertible, to be considered when determining the existence of control • IAS 27: 14: Potential voting rights arise from “share warrants, share call options, debt or equity instruments that are convertible into ordinary shares, or other similar instruments that have the potential, if exercised or converted, to give the entity voting power or reduce another party’s voting power over the financial and operating policies of another entity Tan & Lee Chapter 2 © 2009 23

Potential Voting Rights in the Determination of Control • IAS 27: 15: In determining whether potential voting rights contribute to control, the investor examines all facts and circumstances, such as terms of exercise of the potential voting rights and any other contractual terms, but not the intention of management and the financial ability to exercise or convert • It is important that the potential voting rights must be currently exercisable or convertible to be included in the test of control Tan & Lee Chapter 2 © 2009 24

Potential Voting Rights in the Determination of Control Illustration of potential voting rights Issued ordinary shares Percentage of ordinary shares Issued share warrants Potential shares from warrants Total shares Percentage (issued and of total potential) shares Company A $10, 000 50% $5, 000 $10, 000 $20, 000 62. 50% Other investors 10, 000 50% 1, 000 2, 000 12, 000 37. 50% Total $20, 000 100% $6, 000 $12, 000 $32, 000 100. 00% Although Company A owns only 50% of the total issued ordinary shares, its holding of the share warrants gives it de facto control over Company B Tan & Lee Chapter 2 © 2009 25

Potential Voting Rights in the Determination of Control Sources of Control When one investor has the 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” Not relevant Management intention Tan & Lee Chapter 2 Financial ability © 2009 26

Impact of Potential Voting Rights on the Allocation of Profits • IAS 27: 19: The proportion of profit or loss and changes in equity allocated to the parent and non-controlling interests are determined on the basis of present ownership interests and do not reflect the possible exercise or conversion of potential voting rights”. • However, if the potential voting rights, in substance, gives the holder access at present to the economic benefits associated with an ownership interest should be considered( IAS 27: IG 5 -6) Tan & Lee Chapter 2 © 2009 27

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

The Concept of Significant Influence • An investor may participate in the policy-making processes of an investee, although they may not have the power to govern the final outcome • IAS 28 describes such an investor as having “significant influence”, and the investee is deemed an “associate” of the investor • Special accounting procedures described as the “equity method” are applied Tan & Lee Chapter 2 © 2009 29

What is Significant Influence? Significant influence Power to participate in the financial and operating policy decisions of the investee but is less than control and is not equivalent to joint control over those policies (IAS 28: 2) Default assumption: An investor has ownership of 20% or more of the voting power and equal to or less than 50% of the voting power in an investee, including “potential voting rights” Other evidences Number of directors representing investors on board Participation in policy-making processes Operational interdependencies Investor must disclose reasons for not complying with default assumption Tan & Lee Chapter 2 © 2009 30

Direct and Indirect Significant Influence Multi-level structures P 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 & 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 © 2009 31

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

Accounting for Business Combinations Standards relevant to the preparation and presentation of consolidated financial statements IFRS 3 Business Combination (deals with business combination generally) IAS 27 Consolidated and Separate Financial Statements ( applies specifically to the preparation and presentation of consolidated financial statements for parent-subsidiary combinations) Tan & Lee Chapter 2 © 2009 33

Overview of the Scope of the IFRS 3 • Objective of IFRS 3 – Specify the requirements governing the method of accounting, disclosure and presentation of the financial statements of a reporting entity comprising one or more separate entities that are brought together in a business combination Purchasing the equity of another entity Purchasing the net assets of another entity Business combinations result from Assuming the liabilities of another entity Tan & Lee Chapter 2 Purchasing some of the net assets of another entity that together form one or more business © 2009 34

Purchase of Net Assets versus Purchase of Equity • • • Parent Acquirer Acquires controlling interest Buys over net assets Subsidiary Acquiree Parent – Subsidiary relationship Separate legal entities - separate FS Single reporting entity - Consolidated FS Tan & Lee Chapter 2 • • © 2009 No Parent – Subsidiary relationship One legal and economic entity 35

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

Consolidation Theories • Theories relating to consolidation are critical when the percentage of ownership in a subsidiary is less than 100% • Termed “partially owned subsidiary”, where the remaining percentage is owned by shareholders who are collectively referred to as “non-controlling interest” (NCI) Parent Non-controlling interests 90% 10% Subsidiary Both parent and non-controlling interest have a proportionate share of the subsidiary’s: • • Net profit; Dividend distribution; Tan & Lee Chapter 2 • • Share capital Retained profits and changes in equity © 2009 37

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 & Lee Chapter 2 Reasons why non-controlling interest Parent and non-controlling arise shareholders are founding shareholders of newly incorporated entity © 2009 38

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 100% ownership Non-controlling shareholders of a subsidiary Subsidiary Wholly owned by the parent company’s shareholders Tan & 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 © 2009 39

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 & Lee Chapter 2 Entity Theory Both non-controlling interest and majority shareholders Shown as equity based on: Consolidated equity = Consolidated assets Consolidated liabilities © 2009 Parent Theory Benefit of parent company shareholders Shown as equity based on: Consolidated equity NCI = Consolidated assets Consolidated liabilities 40

Comparison of issues Issues Entity Theory Net assets of the subsidiary acquired be shown at full fair values or at the parent’s share of the fair value? Net asset at date of acquisition reported in full Do non-controlling shareholders have a share of goodwill? Asset of economic unit, and reflected in full How should net profit of partially owned subsidiary be reported? Tan & Lee Chapter 2 Reported in full as both majority and non -controlling shareholders © 2009 Parent Theory NCI net asset 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 41

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 is an entity asset and should be recognized in full as at date of acquisition Goodwill is parent’s asset Tan & Lee Chapter 2 © 2009 42

Proprietary Theory • Relevant to accounting for joint venture • Parent seen as having a direct interest in a subsidiary’s assets and liabilities – resulting in proportional consolidation. Tan & Lee Chapter 2 © 2009 43

The Implicit Consolidation Theory Underlying IFRS 3 • Previously, IAS 22 allowed an acquirer to either recognize or ignore non-controlling interests’ share of fair value adjustments of a subsidiary’s identifiable assets and liabilities • IFRS 3 (2008) permits the recognition of non-controlling interests’ share of goodwill • Movement towards the full entity theory Tan & Lee Chapter 2 © 2009 44

Illustration 1: Parent versus Entity Theory Scenario • Consideration transferred: $1, 200, 000 • NCI: 20% • BV of equity at acquisition date (1/1/20 x 1): $1, 200, 000 • (FV – BV) of property: $100, 000 (Ignore tax effect and depreciation) • FV of NCI: $300, 000 • BV of equity at 31/12/20 x 1: $1, 270, 000 Tan & Lee Chapter 2 © 2009 45

Illustration 1: Parent versus Entity Theory Goodwill Parent Theory Goodwill = Investment in S – P’s ownership % X (Fair value 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 Non-controlling interests’ share of goodwill = Fair value of NCI – Share of FV of identifiable net assets = $300 – (20% x $1, 300) = $300 – $260 = $40 Tan & Lee Chapter 2 © 2009 46

Illustration 1: Parent versus Entity Theory Presentation of NCI Parent Theory Non-controlling interests are shown separately from equity Non-controlling interests = Non-controlling interest % x BV of 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 Tan & Lee Chapter 2 © 2009 47