Chapter 2 – Separate and Consolidated Financial Statements – Date of Acquisition

In acquiring another company, the acquirer must allocate its purchase price to the FAIR VALUE
of the underlying assets and liabilities acquired.
The Levels of Investment

The acquisition of common stock of another company receives different accounting treatments
depending on the level of ownership and the amount of influence or control caused by stock
ownership.

Level of Ownership Initial Recording (Chapter 2)

Passive Investment - generally 20% ownership At cost including brokers’ fees.

Strategic (Active) Investment:

a. Influential – generally 20% to 50% At cost including brokers’ fees.

ownership

b. Controlling – generally over 50% ownership At cost.

With a 10% passive investment, the investor included only its share of the dividends declared by
the investee as its income. With a 30% influential ownership interest, the investor reported 30%
of the investee income as a separate source of income.
With an 80% controlling interest, the investor (now termed the parent) merges the investee’s (now
a subsidiary) nominal accounts with its own amounts. Dividend and investment income no longer
exist.
A single set of financial statements replaces the separate statement of the entities. If the parent
owned a 100% interest, net income would simply be reported as the same amount of the
consolidated net income. Since this is only 80% interest, the net income must be shown as
distributed between the controlling and non-controlling interests.
The non-controlling interest is the 20% of the subsidiary not owned by the parent. The controlling
interest is the parent income, plus 80% of the subsidiary income.
Acquisition of Net Assets versus Acquisition of Stock (Voting)/Equity

Group – is a business combination in which the acquirer is a “parent” and the acquiree is a
“subsidiary”, and the business combination results from the parent acquiring a controlling interest
in the equity (not net assets) of the subsidiary.

• In this business combination, both parent and subsidiary retain their status as separate legal
entities. However, from an economic perspective, they are a single reporting entity.
Two sets of financial statements must be prepared – separate financial statements for the legal
entity and consolidated financial statements for the group.

• Separate financial statements of the legal entity in accordance with PAS 27 Separate
Financial Statement; and
• Consolidated financial statements, if the legal entity is also a parent, in accordance with
PFRS 10 Consolidated Financial Statement

This is in contrast with a business combination whereby an acquirer buys over the net assets of
another entity. A business combination such as this, which is brought about by the purchase of net
assets (not equity) of the other entity, does not result in a parent-subsidiary relationship.
In this business combination, the legal entities and economic entities are one. The separate
financial statements of the acquirer provide information about the enlarged entity. Likewise, a set
of consolidated financial statements Is not required.

The focus of this chapter is on the business combination in general that results to a parent-
subsidiary relationship which is properly termed as a consolidation. PFRS 3 presumes that there is
a dominant party in a business combination, which may be identified as an “acquirer.”
Classification of Intercorporate Investment
Intercorporate Investment – is any purchase by one corporation of the securities of another
corporation. Broadly speaking, the investment may be in either:

• debt securities or
• equity securities – preferred or common shares
The focus of this text is on equity (ordinary shares/common stock) investments.

The investment of a corporation in the equity of another corporation can broadly be classified as
either passive or strategic:

Passive Investment – is made to earn dividends or to earn profits by actively trading the
investment for short-term profit.

Strategic (active) investment – is made to significantly influence or control the operations of the
investee (acquire) corporation.

Passive Investments
Accounting for passive investments poses no particular problems. They are initially recorded at
COST and are reported at FAIR MARKET VALUE on each period’s statement of financial
position or balance sheet.
The treatment of gains and losses depends on how the company has elected to classify the
investment – a choice that the reporting entity makes for each separate passive equity investments
when the investments is first made.
The choices available under PFRS 9, Financial Instruments, are to report the investments at either:

1. Fair value through profit or loss (FVTPL), or

2. Fair value through other comprehensive income (FVTOCI)

If an equity investment as FVTPL, both:

• dividends and
• The change in fair value from one period to another are reported in the income section of
the statements of comprehensive income (SCI).

If, on the other hand, an equity is classified as FVTOCI:

• dividends from that investment are recognize in net income, but

• changes in the fair value of the investment are reported as other comprehensive income
(OCI); the accumulated gains and losses are reported as a separate component of
stockholders’ equity. The choice to classify an equity investment as FVTOCI is irrevocable
– the choice cannot be changed subsequently.
Strategic (Active) Investments

Strategic Investments – provide a strategic or long-term advantage by giving the investor the
ability to either significantly influence or control the operating or financial decisions of an investee.
Strategic equity investments can take several different forms depending on the investor’s strategic
objectives:

• Controlled entities:
o Subsidiaries (PAS 27 and PFRS10)
o Structured entities (or variable interest entities)
o Associated companies (PAS 28)
o Joint ventures (PFRS 11)

Generally, investments are considered strategic of a company owns, either directly or indirectly
20% or more voting shares of the investee, unless it can clearly be demonstrated that the
investments are passive.
Equity Investments and Reporting Methods under PFRS
As we review consolidation, it is crucial to understand that reporting is not the same as recording.
Consolidated amounts never appear on the parent company’s book-reported numbers are the
results of spreadsheet analysis, either computer-based or manual.
Controlled Entities
There are many aspects of control that accountants must be aware of. The two general types of
controlled entities are subsidiaries and structured entities or variable interest entity – VIE

Subsidiaries
By far the most common type of controlled entity is a subsidiary.

Subsidiary – is a corporation (or an unincorporated entity such as a partnership or trust company)

that is controlled by a parent company that owns, usually, a MAJORITY of the voting shares/rights
of the subsidiary. Since stockholders elect a corporation’s board of directors, holding most of the
shares enables the parent company to control the composition of the subsidiary’s board.

The Concept of Control

Consolidation – is the process of combining the assets, liabilities, earnings and cash flows of a
parent and its subsidiaries as if they were one economic entity. Since an economic and not legal
perspective is adopted, transactions between companies within the economic entity and their
resultant must be eliminated.
A parent is an entity that controls one or more subsidiaries. A group is a parent and all its
subsidiaries.
PFRS 10 Guidance on Control

An investor determines whether it is a parent or assessing or it controls one or more investees. An

investor considers all relevant facts and circumstances when assessing control over an investee.

PFRS 10 uses control as the single basis for consolidation. An investor controls an investee if and
only if the investor has all of the following THREE ELEMENTS of control:
1. Power over the investee – is the ability to direct those activities which significantly affect
the investee’s returns. It arises from rights, which may be straightforward (e.g., through
voting rights) or complex (e.g. through one or more contractual arrangements).
2. Exposure, or rights, to variable returns – from involvement with the investee returns
must have the potential to vary as a result of the investee’s performance and can be positive,
negative or both.
3. The ability to use power over the investee to affect the amount of the investor’s
returns.
Power arises from rights. An investor that holds only protective rights cannot have power over
an investee and so cannot control an investee. Power can be obtained directly from ownership
of the majority of the voting rights or can be derived from other rights, such as:

• Rights to appoint, reassign, or remove key management personnel who can direct relevant
activities;
• Rights to appoint or remove another entity that directs the relevant activities;
 • Rights to direct the investee to enter into or veto changes to, transactions for the benefit of
the investor; and
• Other rights, such as those specified in a management contract

When assessing whether control exists, an investor with decision making rights should establish
whether it is acting as a principal or agent of other parties. An investor that is an agent does not
control an investee when it exercises decision-making rights delegated to it. A number of factors
are considered in making the assessment. For instance, the renumeration of the decision-maker is
considered in determining whether it is an agent.
Control of the Criterion for Consolidation

Control is the criterion for identifying a parent-subsidiary relationship and the basis for
consolidation. The determination of whether one entity controls another is then crucial to the
determination of which entities should prepare consolidated financial statements.
The “Default Presumption”

The presence of control determines the existence of parent-subsidiary relationship. In the context
of PFRS 10 the quantitative criterion of more than 50% of voting power was not mentioned but
not superseded by a new rule.

For practical reasons, the presumption is that ownership of more than 50% of voting power
constitutes control, in the absence of any evidence to the contrary.

However, control also arises from many other sources: statue, contractual arrangements, implicit
or explicit control over the board of directors among others.

A PFRS 10 is based on principles rather than rules, the use of a quantitative criterion is only a
guide. This is known as “default presumption.”

Separate Financial Statements (PAS 27)

PAS 27 defines separate financial statements as “those presented by a parent, an investor in an
associate or a joint venturer in a joint venture in which the investments are accounted for on the
basis of the direct equity interest rather than on the basis of the reported results and net assets of
the investment.
The investor’s separate financial statements reflect the legal interest in the investment and its direct
benefits (dividends) rather than the larger economic entitlements (share of profits) that is brought
by control or significant influence or contractual arrangement or joint control.

As economic boundaries are enlarged through control or significant influence or contractual

arrangement or joint control that an investor possesses over the financial and operating policies of
subsidiaries and associates respectively, another level of reporting is required. The level of
reporting is described as the consolidated financial statements that present the financial statements
of a group as those of a single economic entity.

When the parent acquires a controlling interest in the subsidiary, the parent makes an entry debiting
investment in subsidiary and crediting either cash, debt, or stock (for some combination),
depending on the medium of exchange.
The parent’s investment account represents the parent’s investment in the different asset and
liability accounts of the subsidiary and often includes a significant amount of goodwill. However,
it is recorded in a single account entitled “investment.” the subsidiary, in contrast, continues to
keep its detailed books based on historical book values. These values are not as current as the
market values assessed by the parent at the date of acquisition, but they are detailed as to
classification.
The purpose of consolidated statements is to present, primarily for the benefit of the owners
and creditors of the parent, the results of operations and the financial position of a parent
company and all its subsidiaries as if the consolidated group were a single economic entity.

Consolidated statements ignore the legal aspects of the separate entities but focus instead on the
economic entity under the control of management. The presumption is that most users of financial
statements prefer to evaluate the economic entity rather than the legal entity.
Thus, the preparation of consolidated statements is an example of focusing on substance
rather than form.
Investments at the Date of Acquisition
Recording Investment’s at Cost (Parent’s Books)

The basic guidelines for valuation discussed in Chapter 1 pertaining to business combinations
apply equally to the acquisition of voting stock in another company. Under the acquisition
method, the stock investment at its cost as measure by the fair value of the consideration
given or the consideration received, whichever is more clearly evident.
Treatment of Acquisition-related Direct Costs in the Separate Financial Statements (or
Parent’s Books)

- Does not affect the computation of goodwill, only the manner of recording such costs in
the books of the parent entity

In this chapter, the basis is PAS 27. Despite, the logical analysis in interpreting the general rule,
the author further believes that the original treatment of acquisition-direct costs whether for
business combination or separate or consolidated financial statements, will still be treated as
EXPENSES in the books of the parent entity for the following reasons:
 1. To capitalize the acquisition-related costs as part of the investment seems to defeat the
purpose or substance of the standard which serves as a guide for consolidation procedures.
2. If the parent records the direct costs as part of investment in subsidiary, it may be a problem
when there will be an impairment test which will reveal the costs

The Acquisition Analysis (or Schedule of Determination and Allocation of Excess)

As noted in paragraph 33 of PFRS 3, where the business combination occurs by the parent
exchanging its equity interests for the equity interests of the former owners of the subsidiary, the
acquisition date fair values of the acquiree’s interests may be more reliably measurable than that
of the acquirer’s interests.
The acquirer obtains control by acquiring shares (stock acquisition) in the acquiree. At acquisition
date, an acquisition analysis is undertaken to determine if there has been any goodwill acquired,
or a bargain purchase has occurred.

The acquirer shall recognize goodwill as of the acquisition date, measured as the excess of (I)
over (II) below:

I. The aggregate of:

a. the consideration transferred measured in accordance with PFRS 3 which
generally requires acquisition date fair value
b. the amount of any non-controlling interest in the acquiree measured in
accordance with PFRS 3
c. in a business combination achieved in stages, the acquisition date for value of the
acquirer’s previously held equity interest of the acquiree.
II. The net of the acquisition date amounts of the identifiable assets acquired and the
liabilities assumed measured in accordance with PFRS 3.

When (II) exceeds (I), PFRS 3 regards the giving rise to a gain on a bargain purchase.
Consolidation of Wholly Owned Subsidiaries
There is no question of control in a wholly-owned subsidiary. Many factors have an effect on
the fair value of a company and its market per share of stock including asset values, its earning
power, and general-market conditions.
When one company acquires another, the acquiree’s fair value is based on the consideration
given may be equal, more than, or less than the book value.
In case, there will be a difference between the fair value of the subsidiary and the book value of
the acquiree’s net identifiable assets and this is referred to in this textbook as “ALLOCATED
EXCESS.”
Consolidation of Partially-Owned Subsidiaries
When a subsidiary is less than 100% owned or partially-owned, problem ARISES as to the
determination and recognition of GOODWILL and the NON-CONTROLLING INTERESTS.

PFRS 3 allows goodwill and non-controlling interests in the acquiree at acquisition data to be
measured at either:

• Fully-goodwill approach or Fair Value Basis

• Partial-goodwill approach or Proportional Basis (of the acquiree’s identifiable net
assets).
Fully-goodwill Approach (or Fair Value Basis)

When non-controlling interests are measured at fair value, goodwill attributable to non-controlling
interests will be recognized in the consolidated financial statements.

Under the fair value basis, the non-controlling interests comprise THREE components:

• Share of book value of identifiable net assets of subsidiary;

• Share of identifiable net assets of subsidiary at acquisition date; and
• Share of goodwill in subsidiary at acquisition data
Under the fair value basis, non-controlling interests are determined with reference to either active
market price of equity shares of the subsidiary at acquisition date or other valuation techniques

Fair value per share of non-controlling interests may differ from fair value per share of the acquirer
because a control premium may be paid by the acquirer.

Non-controlling interests’ share of goodwill (NCI-goodwill) is not recognized under the second
option (proportional basis).

Goodwill – is an unidentifiable asset in which its existence is an important motivation for a parent
to acquire a subsidiary. Hence, goodwill is the premium that a parent pays to acquire the subsidiary
and should be separately recognized as an asset in the consolidated financial statements. The
acquirer is required to recognize goodwill acquired in a business combination as an asset.
Goodwill under PFRS 3 may be one of two values depending on the measurement basis for non-
controlling interests as of acquisition date.

It allows two measurement bases for non-controlling interest

Entity Theory – non-controlling interests are deemed to be as important as a stakeholder of the
combined entity similar to the majority shareholders.
Parent Theory – focuses on the information needs of the parent company shareholders.
Proprietary Theory – is less critical to determining choice of consolidation policies. The parent
is seen as having a direct interest in a subsidiary’s assets and liabilities. This perspective results in
pro-rata or proportional consolidation, whereby the parent’s interest is directly multiplied to
each individual.

Eliminations – are changes that prevent certain amounts on the separate entity statements from
appearing on the consolidated statements. Eliminations are necessary to avoid double-counting
(such as intercompany sales) and to cancel out offsetting balances (such as intercompany
receivables and payables).

Adjustments – on the other hand, are made to alter reported amounts to reflect the economic
substance of transactions rather than their nominal amount.

THEORIES
1. At the date of an acquisition which is not a bargain purchase, the acquisition method
consolidated all subsidiary assets and liabilities at fair values.
2. Lisa Co. Paid cash for all of the voting common stock of Victoria Corp. Victoria will continue
to exist as a separate corporation. Entries for the consolidated of Lisa and Victoria would be
recorded in: a worksheet.

3. What is the primary accounting difference between accounting for when the subsidiary is
dissolved and when the subsidiary retains its incorporation? If the subsidiary retains its
incorporation, the consolidation is not formally recorded in the accounting records of the
acquiring company.

4. A company is not required to consolidate a subsidiary in which it holds more than 50% of the
voting stock when the subsidiary is in bankruptcy.
5. Which one of the following is a characteristic of a business combination that should be
accounted for as an acquisition? The transaction establishes an acquisition fair value basis for
the company being acquired.

6. Which of the following is the best theoretical justification for consolidated financial statements?
In form the companies are separate: in substance they are one entity.

7. What is the appropriate accounting treatment for the value assigned to in-process research and
development acquired in a business combination? Capitalize as an asset

8. An acquired entity has a long-term operating lease for an office building used for central
management. The terms of the lease are very favorable relative to current market rates. However,
the lease prohibits subleasing or any other transfer of rights. In its financial statements, the
acquiring firm should report the value assigned to the lease contract as an intangible asset under
the contractual-legal criterion
9. WW Company obtains all of the outstanding stock of JJ Inc. In a consolidation prepared
immediately after the takeover, at what value will JJ’s inventory be consolidated? At the
acquisition date fair value
10. Under PFRS 3, when is a gain recognized in consolidating financial information? When any
bargain purchase is created.
______________________________________________________________________________
_______
Chapter 3 – Separate and Consolidated Financial Statements - Subsequent to Date of
Acquisition
Introduction. This chapter examines procedures for consolidating the financial statements of parent
and subsidiary companies. Some differences in the consolidation process result from different
methods of parent company accounting for subsidiary investments. Investments in voting stock of
other companies may be consolidated, or they may be separately reported in the financial
statements at cost, at fair value, or carrying value of equity. The method of reporting adopted
depends on a number of factors including the size of the investment, the extent to which the
investor exercises control over the activities of the investee, and the marketability of the securities.

• Investor refers to a business entity that holds an investment in voting stock of another
company.
• Investee refers to a corporation that issued voting stock held by an investor/s.
Consolidation workpapers for a parent company/investor that uses the cost model and accounting
are illustrated in the chapter to set the standard for good consolidation procedures. The chapter
examines additional complexities that arise from detailed recording of fair values of a subsidiary's
net assets.

The appendix to this chapter also illustrates the equity method with and without recognition of
goodwill impairment loss. By contrast, this chapter presents a workpaper that develops the
information needed for consolidated balance sheets and income and retained earnings statements.
Consolidated Statements Subsequent to Date of Acquisition

The preparation of consolidated financial statements after acquisition is not materially different in
concept from preparing them at the acquisition date in the sense that reciprocal accounts are
eliminated and remaining balances are combined.
The process is more complex, however, because time has elapsed and business activity has taken
place between the date of acquisition and the date of consolidated statement preparation.
On the date of acquisition, the only relevant financial statement is the consolidated balance sheet;
after acquisition, a complete set of consolidated financial statements statement of comprehensive
income and retained earnings statement.
Separate Financial Statements
PAS 27 paragraph 4 defines separate financial statements as "those presented by a parent, an
investor in an associate or a venturer in a jointly controlled entity, in which ne investments are
accounted for on the basis of the direct equity interest rather than on the basis of the reported results
and net assets of the investees.”
Accounting Treatment required at each Levels of Reporting for Consolidated Financial Statements
(CFS) Purposes

Investment Criteria Investor’s Separate Consolidated Required

Financial Statements Financial treatment in
Statements Group Accounts
(CFS)

Subsidiary Control PAS 27 – Investment PFRS 10 – Full

(51% or is carried at: Investment is Consolidation
more) eliminated and
1. Cost; or
net assets of
2. In accordance
subsidiary are
with PFRS 9
consolidated
(financial
with those of the
statement)
parent
3. Using the
equity method

Associate Significant PAS 27/28 - PAS 29/PFRS Equity accounting

Influence Investment is carried 10 – Investment
(20% - at: is accounted for
50%) using the equity
1. Cost; or
method.
2. In accordance
with PFRS 9
(financial
statement)
3. Using the
equity method

Joint Venture Contractual PAS 27/28; PFRS 11 PAS 29/PFRS Equity accounting
arrangemen – Investment is 10 – Investment
t or joint carried at: is accounted for
control using the equity
1. Cost; or
(20% - method.
2. In accordance
50%)
with PFRS 9
 (financial
statement)
3. Using the
equity method

Investment Asset held PFRS 9 PFRS 9 As for single

which is none of for company accounts
the above accretion of
wealth

Accounting for Subsidiaries, Associates and Joint Ventures in the Parent's Separate
Financial Statements

A parent will usually produce its own single company financial statements and these should be
prepared in accordance with PAS 27, Separate Financial Statements. In these statements,
investments in subsidiaries, associates and joint ventures included in the consolidated financial
statements should be either:

I. At cost, or
II. In accordance With PFRS 9 (Fair Value Option), or

III, Using equity method as described in PAS 28.

Where subsidiaries are classified as held for sale, they should be accounted in accordance with
PFRS 5.
The First Method: Cost Model (formerly Cost Method or Initial Value Method)

PAS 27 does not define "cost" except in the specific set of circumstances of certain types of group
reorganization and in first-time transition to PFRS. PAS 8 Accounting Policies, Changes in
Estimates and Errors requires that in the absence of a specific guidance on PFRS, management
should first refer to the requirements and guidance in IFRS (PFRS) dealing with similar and related
issues.
In PFRS 3, the term "cost "no longer refers to the cost of an acquisition, so the relevant measure
will be: 1. The consideration transferred discussed in Chapter 1.
2. Another point of reference might be PAS 32 Financial Instruments: Presentation and
PFRS 9.
Investments in subsidiaries, associates, and joint ventures, while outside the scope of PAS 32 and
PFRS 9, are clearly financial assets (and therefore financial instruments) as defined in those
standards. The cost model (method) of accounting for inter-corporate investments is consistent
with historical cost basis for most other assets.
Choosing between Cost Model and Equity Method
Consolidated financial statement amounts are the same, regardless of whether a parent company
uses the cost model or equity method to account for a subsidiary’s operations.
Although there appears to have significant differences between the cost model and equity methods,
the:
1. Main difference is one of timing.
2. Eventually, the flow of income that flows from each method are the same.
3. The cost model is slower in recognizing income.
4. The working paper eliminations used in the two methods are different.
The impairment loss is reported in the consolidated income statement for the period in which it
occurs. It is presented on a before-tax basis as part of continuing operations and may appear under
the caption “gains and losses.”

The parent company could handle the impairment in two ways:

1. The parent could record the impairment loss on its books and credit the investment
in subsidiary account.
2. The impairment loss could be recorded only on the consolidated worksheet.

On the date of acquisition, the only relevant financial statement is the consolidated balance sheet;
after acquisition, a complete set of consolidated financial statements-statement of comprehensive
income and retained earnings statements.
Workpaper Format
Accounting workpapers are used to accumulate, classify, and arrange data for a variety of
accounting purposes, including the preparation of financial reports and statements.
Nature of Eliminating Entries
The investment account must be eliminated in the consolidated financial statements because from
a single entity viewpoint a company cannot hold an investment in itself. The subsidiary’s stock
and the related stockholder's equity accounts must be eliminated because the subsidiary’s stock is
held entirely within the consolidated entity and none represents claims by outsiders.

In full consolidation, the subsidiary’s individual assets and liabilities are combined with those of
the parent.

Elimination entries are used in the consolidation worksheet to adjust the totals of the individual
account balances of the separate consolidation companies to reflect the amounts that would appear
if all the legally separate companies were actually a single company.
Eliminating entries appear only in the consolidation worksheets and do not affect the books of the
separate companies.

Consolidated Financial Statement - is essentially a combination of the revenue, expense, gain,

and loss accounts of all consolidated affiliates after elimination of amounts representing the effect
of transactions among the affiliates.
Consolidated Net Income – combined income of the affiliates, after eliminating any
intercompany transactions; all revenues and expenses of the individual consolidating companies
arising from transactions and actions with unaffiliated companies are included in the consolidated
financial statements.
If all subsidiaries are wholly owned, all of the consolidated net income accrues to the parent
company, or the controlling interest.
If one or more of the consolidated subsidiaries is less than wholly owned, apportion of the
consolidated net income accrues to non-controlling shareholders.
Consolidated Retained Earnings Statement – consists of beginning consolidated retained
earnings plus the controlling interest in consolidated net income (or minus the controlling interest
in a consolidated net loss), minus parent company dividends declared.

A parent company may acquire a subsidiary with a negative or debit balance in its retained earnings
account. An accumulated deficit of a subsidiary at acquisition causes NO SPECIAL PROBLEMS
in the consolidation process.