CONSOLIDATION ACCORDING TO INTERNATIONAL ACCOUNTING STANDARDS IAS 17

CONSOLIDATION ACCORDING TO INTERNATIONAL ACCOUNTING STANDARDS (IAS) 17 JANUARY 2001 HİLTON CONVENTION CENTER

CONSOLIDATION ACCORDING TO INTERNATIONAL ACCOUNTING STANDARDS SEMINAR OUTLINE (1) Introduction 09. 15 - 09. 30 IAS 27 “Consolidated Financial Statements and Accounting For Investments” - General Outlook and Main Discrepancies with the Turkish practice 09. 30 - 10. 30 Coffee break 10. 30 - 10. 45 Other International Accounting Standards in conjunction with the preparation of consolidated financial statements 10. 45 - 11. 30 - IAS 28 “Accounting for Investments in Associates” - IAS 25 “Accounting for Investments” - IAS 39 “Financial Instruments: Recognition and Measurement” - IAS 31 “Financial Reporting of Interest in Joint-Ventures” - IAS 22 “Business Combinations” - SIC 12 “Special Purpose Entities”

CONSOLIDATION ACCORDING TO INTERNATIONAL ACCOUNTING STANDARDS SEMINAR OUTLINE (2) Essentials of consolidation work 11. 30 - 13. 00 - Identification of subsidiaries that are subject to line-by-line consolidation, control concept - Subsidiaries that are exempt from consolidation - Proportionate consolidation - Equity method - Intra-group balances and profits - Consolidation journal entries - Consolidation of subsidiaries abroad - Minority interests - Reporting dates and uniform accounting policies - Disclosures relating to consolidated financial statements Lunch 13. 00 - 14. 00

CONSOLIDATION ACCORDING TO INTERNATIONAL ACCOUNTING STANDARDS SEMINAR OUTLINE (3) Examples relating to the consolidation of the financial statements of ABC Bank Concerns in meeting current and future consolidation requirements Coffee break Q&A …………………. . . 14. 00 - 15. 30 - 16. 00 - 16. 15 - 17. 15

CONSOLIDATION ACCORDING TO INTERNATIONAL ACCOUNTING STANDARDS INSTRUCTORS ZEYNEP URAS TERRY HARDING ADNAN AKAN TALAR GÜL Partner, Assurance and Business Advisory Services, Pw. C Istanbul Director, Global Corporate Reporting Unit, Pw. C London Senior Manager, Assurance and Business Advisory Services, Pw. C Istanbul Senior Manager, ABAS, Pw. C Istanbul

CONSOLIDATION UNDER IAS RELATED STANDARDS AND INTERPRETATIONS Business Combinations IAS 22 Accounting for Investments IAS 25 -39 Consolidated Financial Statements and Accounting for Investments in Subsidiaries IAS 27 Accounting for Investments in Associates IAS 28 Financial Reporting of Interests in Joint-Ventures IAS 31 Special Purpose Entities SIC 12

IAS - 27 Consolidated Financial Statements and Accounting For Investments in Subsidiaries - SUMMARY (1) • A subsidiary is defined as a company controlled by another enterprise. • If a parent has one or more subsidiaries, consolidated financial statements are required. • Intermediate parents are generally exempt from preparing consolidated financial statements • All subsidiaries must be included, unless control is temporary or if there are severe long-term restrictions on the transfer of funds from the subsidiary to the parent. • The difference between reporting dates of consolidated subsidiaries should be no more than three months from the parent’s.

IAS - 27 Consolidated Financial Statements and Accounting For Investments in Subsidiaries - SUMMARY (2) • Uniform accounting policies should be followed for the parent and its subsidiaries or, if this is not practicable, the enterprise must disclose that fact and the proportion of items in the consolidated financial statements to which different policies have been applied. • In the parent’s separate financial statements, subsidiaries may be shown at cost, at revalued amounts, or using the equity method.

Significant differences between IAS and current consolidation practice in Turkey (1) • • • Definitions of subsidiaries, joint-ventures and associates Periodicity of consolidated financial statements Scope of consolidation Subsidiaries not consolidated Consolidation of subsidiaries abroad

Significant differences between IAS and current consolidation practice in Turkey (2) • • Special Purpose Entities (SPEs) Segment information Consolidation of joint-ventures Consolidation of associates

Significant differences between IAS and current consolidation practice in Turkey (3) • Determination of goodwill • Treatment of positive goodwill • Treatment of negative goodwill

Significant difference between IAS and the new banking law (nr. 4389) According to the new banking law the shareholders and the entities controlled by them need to be consolidated. The basic principle of consolidation according to IAS is “control”, thus entities that are not controlled such shareholders and other subsidiaries of shareholders cannot be consolidated under IAS.

CONSOLIDATION UNDER IAS RELATED STANDARDS AND INTERPRETATIONS Business Combinations IAS 22 Accounting for Investments IAS 25 -39 Consolidated Financial Statements and Accounting for Investments in Subsidiaries IAS 27 Accounting for Investments in Associates IAS 28 Financial Reporting of Interests in Joint-Ventures IAS 31 Special Purpose Entities SIC 12

IAS 28 Accounting for Investments in Associates (1) • An associate is an enterprise, other than a subsidiary or joint venture, over which the investor has significant influence. Significant influence means the power to participate in financial and operating policy decisions. Such influence is presumed to exist if the investor owns more that 20 per cent of the associate. • Associates should be accounted for by the equity method in consolidated financial statements. However, if an investment was acquired and held exclusively with an intent to dispose of it in the near future, it should be accounted for by the cost method.

IAS 28 Accounting for Investments in Associates (2) • Under the equity method, the investor recognises its proportionate share of the associate’s reported net profit or loss whether or not remitted as a dividend. The investor must amortise any goodwill implicit in the investment. • An investor should discontinue using the equity method if (a) it ceases to have significant influence over the associate operates under long-term restrictions that impair its ability to transfer funds to the investor.

IAS 25 Accounting for Investments • Long-term investments should be valued at cost, at revalued amount, or for marketable equity securities at the lower of cost or market on a portfolio basis. • Permanent diminutions in value should be recognised and measured on an individual basis.

IAS 39 - Financial Instruments: “Recognition and Measurement” • • • All financial assets and liabilities (includes derivatives) on B/S financial assets initially at cost then mostly at FV Financial liabilities generally at amortised cost FV changes either : all to P&L or some to Equity

IAS 39 - Financial Instruments: “Recognition and Measurement” (continued) • Hedge accounting allowed if meet criteria • Derecognition only when control transferred • Significant extra disclosures

IAS 31 Financial Reporting of Interests in Joint Ventures • Jointly controlled entities should be recognised in consolidated financial statements as follows: 1. The benchmark treatment is proportionate consolidation 2. The allowed alternative is the equity method • However, interests held for resale or under severe long-term restrictions should be treated as investments.

IAS 22 Business Combinations (1) Two types of business combinations Uniting of interest: A uniting of interests in an unusual business combination in which an acquirer cannot be identified. Such combinations must be accounted for by the pooling of interest method. A business combination in which the shareholders of the combining enterprises combine control over the whole of their net assets and operations, to achieve a continuing mutual sharing in the risks and benefits attaching to the combined entity such that neither party can be identified as the acquirer.

IAS 22 Business Combinations (2) Criteria: 1. enterprises are exchanged or pooled. 2. rights and interests in the combined entity, relative to each other, after the combination as before.

IAS 22 Business Combinations (3) • Carrying amounts on the books of the combining companies are carried forward. • No goodwill is recognised. • Prior financial statements are restated as if the two companies had always been combined.

IAS 22 Business Combinations (4) Acquisitions: All other combinations must be accounted for as acquisitions (purchases). A business combination in which one of the enterprises (the acquirer) obtains control over the net assets and operations of another enterprises (the acquire) in exchange for the transfer of assets, incurrence of a liability, or issue of equity. • For an acquisition, assets and liabilities should be recognised if it probable that an economic benefit will flow and if there is a reliable measure of cost or fair value. • Assets and liabilities of the acquired company are included in the consolidated financial statements at fair value (acquirer’s purchase price).

IAS 22 Business Combinations (5) • The difference between the cost of the purchase and the fair value of the net assets is recognised as goodwill. • The benchmark treatment is not to apply fair valuation to the minority’s proportion of net assets; the allowed alternative is to fair value the whole of the net assets. • Goodwill should be amortised on a systematic basis over its useful life. The amortisation period should reflect the best estimate of the period during which future economic benefits are expected to flow to the enterprise. There is a rebuttable presumption that the useful life of goodwill not exceed twenty years from initial recognition.

SIC 12 - Consolidation of Special Purpose Entities • Consolidate when substance of relationship indicates that Special Purpose Entity (SPE) is controlled • SPE is controlled when enterprise is exposed to the significant risk and rewards indident to activities of SPE • Professional judgement to be applied

Identification of Subsidiaries that are subject to Line–by–line Consolidation, Control Concept · A parent which issues consolidated financial statements should consolidate all subsidiaries except for certain subsidiaries. Control · is presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than one half of the voting power.

Identification of Subsidiaries that are subject to Line–by–line Consolidation, Control Concept (Continued) 1. Control also exists even when the parent owns one half or less of the voting power of an enterprise when there is: a) Power over more than one half of voting rights by virtue of an agreement with other investors b) Power to govern the financial and operating policies of the enterprise under a statute or an agreement c) Power to appoint or remove the majority of the members of the board of directors; or d) Power to cast the majority of votes at meetings of the board of directors.

Subsidiaries that are exempt from consolidation • A subsidiary should be excluded from consolidation when: a) Control is intended to be temporary because the subsidiary is acquired and held exclusively with a view to its subsequent disposal in the near future; or b) It operates under severe long–term restrictions, which significantly impair its ability to transfer funds to the parent.

Proportionate Consolidation · The parent reports interest in the assets, liabilities, income and expenses of the jointly controlled entity · The consolidated balance sheet includes only the parent’s share of the assets that it controls jointly and its share of the liabilities for which it is jointly responsible · The consolidated income statement of the parent includes its share of the income and expenses of the jointly controlled entity.

Equity Method · The investment is initially recorded at cost · The carrying amount is increased or decreased to recognise the investor’s share of the profits or losses the investee after the date of acquisition · Distributions received reduce the carrying amount of the investment

Equity Method (Continued) ·Goodwill accounted for in the same way as it would be in the case of line-by-line consolidation ·Adjustments to the carrying amount are necessary if there are changes in the investee’s equity that have not been included in the income statement such as revaluation of fixed assets, foreign exchange translation differences and adjustment of differences arising on business combinations.

Treatment of Intra-group Balances and Profits • Intragroup balances and intragroup transactions and resulting unrealised profits should be eliminated in full. • Unrealised losses resulting from intragroup transactions should also be eliminated unless cost cannot be recovered.

Consolidation Journal Entries Balance Sheet net-off entries - Investments/ Capital - Trade Receivables /Trade Payables - Loans given /Borrowings - Bank deposits /Deposits Balance sheet unrealised profit eliminations - Inventories - Property, plant and equipment - Construction-in-progress

Consolidation Journal Entries (continued) Income Statement net-off entries - Sales / cost of sales - Other income /expense - Financial income /expense - Dividend income /distribution - Minority interest adjustment

Consolidation of Subsidiaries Abroad In translating the financial statements of a foreign entity for incorporation in its financial statements, the reporting enterprise should use the following procedures: (a) the assets and liabilities, both monetary and non- monetary, of the foreign entity should be translated at the closing rate; (b) income and expense items of the entity should be translated at exchange rates at the dates of the transactions, except when the foreign entity reports in the currency of a hyperinflationary economy, in which case income and expense items should be translated at the closing rate; and (c) all resulting exchange differences should be classified as equity until the disposal of the net investment.

Consolidation of Subsidiaries Abroad (Continued) • The incorporation of the financial statements of a foreign entity in those of the reporting enterprise follows normal consolidation procedures, such as the elimination of intra-group balances and intra-group transactions of a subsidiary. • The financial statements of a foreign entity that reports in the currency of a hyperinflationay economy should be restated in accordance with International Accounting Standard IAS 29, Financial Reporting in Hyperinflationary Economies, before they are translated into the reporting currency of the reporting enterprise.

Minority interests • Minority interests should be presented in the consolidated balance sheet separately from liabilities and the parent shareholders’ equity. • Minority interests in the income of the group should also be separately presented. • The excess losses applicable to the minority are charged against the majority interest except to the extent that the minority has a binding obligation to, and is able to, make good the losses.

Reporting Dates and Uniform Accounting Policies • When the financial statements used in the consolidation are drawn up to different reporting dates, adjustments should be made for the effects of significant transactions or other events that occur between those dates and the date of the parent’s financial statements. • In any case such difference should be no more than 3 months. • Consolidated financial statements should be prepared using uniform accounting policies for like transactions or other events in similar circumstances.

Disclosures relating to consolidated financial statements Selected required disclosures under IAS 27 are as follows: ·Listing of significant subsidiaries including proportion of voting power held ·Reasons for not consolidating a subsidiary ·The nature of the relationship between the parent and a subsidiary, of which the parent does not own, directly or indirectly, more than one half of the voting powers. ·The effect of acquisitions and disposals of subsidiaries on the financial and the results.

Examples relating to the consolidation of the financial statements of ABC Bank

Examples relating to the consolidation of the financial statements of ABC Bank (Continued) (1) 50% + (50% x 60%) (20% x 60%) + (35% x 80%) (3) 20% + (30% x 60%) d+i direct+ indirect shareholdings M Minority interest

Examples relating to the consolidation of the financial statements of ABC Bank (Continued) Sub A Sub B Sub C J/V X J/V Y Loans given Interest income 70 120 50 100 200 40 50 20 46 100 Amounts expressed in TL billions Deposits 50 100 80 50 100 Interest expense 25 50 40 26 50

Loan and Deposit Net-off adjustments Loan Net-off (DR) Bank borrowings Sub A B C J/V X Y 70 120 50 50 76 (CR) Loans given Deposits Net-off (DR) Deposits (CR) Banks 366 293 Sub A B C J/V X Y 50 100 80 25 38

Interest Income/ Expense Net-off Adjustments Interest income Net-off (DR) Interest income (CR) Sub A B C J/V X Y Interest expense Net-off (DR) Sub A B C J/V X Y (CR) Interest expense 171 40 50 20 23 38 25 50 40 13 19 147

Elimination of unrealised profits Example: On 1 January 2000 ABC Bank sold computers to Sub B for TL 400 billion. Book value of the computers at the time of the sale amounted to TL 250 billion. Computers were acquired in 1998. ABC Bank depreciates such assets at 20% p. a. on a straight line basis, making full provision in the year of purchase and none in the year of sale. Sub B will depreciate these computers in 2 years.

Elimination of unrealised profits (Continued) At 31 December 2000 the position would be: ABC Bank’s books Sale proceeds Less: net book value (625 -375) Profit on disposal 400 (250) 150 Sub B’s books Cost of the computers Less: depreciation for 2000 (400 x 50%) Net book value 400 (200) 200

Elimination of unrealised profits (Continued) Assuming the transfer of the asset had not been made, the asset would be reflected in the books of ABC Bank at: Cost 625 Less: accumulated dep’n at the date of transfer (2 years) (250) depreciation charge for 2000 (125) Net book value so the correcting journal entry would be: (DR) Profit on sale of assets Accumulated depreciation (CR) Cost- computers depreciation charge Minority interests 250 150 75 150 60 15

Cancelling Cost of Investment against Net Assets Acquired ABC Bank acquired 100% of the share capital of ISR A. Ş. for TL 20, 000 billion on 31 December 2000 for cash. The book value and the fair value of the net assets of ISR A. Ş. amounted to TL 6, 000 billion and TL 16, 000 billion, respectively. The excess of fair value over book value is attributable to the investment portfolio of ISR A. Ş. . ABC Bank Management believes that the excess of cash paid over the fair value of the net assets of ISR A. Ş. will be realised in 4 years.

Cancelling Cost of Investment against Net Assets Acquired (continued) Computation of goodwill Cash payment 20, 000 Less: fair value of the net assets of ISR A. Ş. (16, 000) Resulting goodwill 4, 000 At 31 December 2000 following journal entry is made in the books of ABC Bank: (DR) Investment at ISR 16, 000 Goodwill 4, 000 (CR) Cash 20, 000

Cancelling Cost of Investment against Net Assets Acquired (continued) Following journal entry is made in the books of ABC Bank at 31 December 2001. (DR) amortisation expense (CR) accumulated amortisation 1, 000 Following consolidation eliminating adjustment is made at 31 December 2000: (DR) Share capital – ISR 6, 000 Investment portfolio 10, 000 (CR) Investment at ISR 16, 000

Equity accounting – Associated Companies ABC Bank’s books at 31 December 2000 Cost of investment at ASC: Dividends received from ASC in 2000 relating to the distribution of profits in 1999: 250 30 Net assets of ASC amounted to TL 1, 800 billion at 31 December 2000. The related consolidating entry would be: (DR) Investment in associates (1, 800 x 25%) – 250 ) 200 Dividend income 30 (CR) Income from associates Retained earnings – ASC 200 30

Concerns in meeting current and future consolidation requirements • Banks, financial institutions and industrial corporations have all different chart of accounts. • Banks and subsidiaries have diverging accounting policies such as valuation of marketable securities and investments, treatment of deferred taxes, recognition and measurement of derivative instruments, general provisions and accounting of financial leasing transactions. • Off-balance sheet items differ based on their risks and type. • Classification of balance sheet accounts is different • Technical insurance reserves - where to put ? Should they be considered in the calculation of capital adequacy ratios ?

Concerns in meeting current and future consolidation requirements (continued) • Under which risk group to classify the assets and off-balance sheet items of non-bank subsidiaries in the calculation of consolidated capital adequacy ratio ? • Timing differences between insurance companies and banks which act as insurance intermediaries in recognition of premium income and acquisition costs (commissions) • Reinsurance companies will have difficulties in meeting the reporting dead-lines for issuance consolidated accounts