Advanced Financial Accounting Chapter 5 – Consolidation accounts

Advanced Financial Accounting

Chapter 5 – Consolidation accounts

What is consolidated accounts?

A group exists if a dominant company (holding company or parent undertaking)
controls another company know as the subsidiary undertaking. Group accounts
extend the reporting entity, the holding company or parent company to include other
entities that are subject to its control and influence. This involves treating the net
assets and activities of subsidaries held by the holding company as if they were part
of the holding company’s own new assets and activities. The overall aim is to
present the results of the group as if they were those of a single entity.

According to FRS2, the purpose of consolidated financial statements is to present

financial information about a parent undertaking and its subsidiary undertaking as a
single economic entity to show the economic resources controlled by the group.

What is a subsidiary?
Under the Companies Act 1989, a subsidiary undertaking is one in which the parent:
• Has a majority of voting rights,
• Is a member and can appoint or remove a majority of the board,
• Is a member and controls alone a majority of voting rights by agreement with
other members,
• Has the right to exercise a dominant influence through the Memorandum and
Articles or a control contract;
• Has a participating interest and either actually exercises a dominant influence
over it or manages both on a unified basis.

Prepare a consolidate accounts

Goodwill
Purchases goodwill is the difference between the cost of an acquired entity and the
aggregate of the fair values of an entity’s identifiable assets and liabilities (Capital).

Goodwill is calculated through:

Cost of investment xxx
Less: Shareholders’ funds at the date of acquisition
Share capital xx
Pre-acquisition retained earnings xx xx
Goodwill arising on acquisition xxx

Balance of the goodwill account:

Goodwill arising on acquisition xxx
Less: Amortisation of goodwill (from acquisition to now) xx
Balance of goodwill xxx

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Retained earnings
The retained earnings or reserves of a group is:
Parent company’s retained profit + Parent company’s share of post acquisition
profit

Consolidated retained earnings is calculated through:

Parent company’s balance xxx
Group’s share of post acquisition profit xx
Less: Goodwill written off xx
xxx

Minority interests
In a situation where the holding company acquires less than 100 per cent, say 75 per
cent of the issued ordinary shares and therefore owns 75 per cent of the net assets,
the practice is to include all resources that are under the control of the directors of
the holding company in the consolidated accounts. The shares and reserves that
have not been acquired by the holding company, ie the 25 per cent, are transferred
to a separate liability heading called the minority interest to indicate the amount that
does not belong to the holding company.

Minority is calculated by:

Shareholders’ funds at balance sheet date * percentage not acquired

Financed by
A consolidate accounts is financed by:
Share capital (Parent company’s)
+ Profit and loss (Parent’s P/L + post-acquisition profit)
+ Minority interest (at balance sheet date)

Calculation of goodwill on consolidation or cost of control

There are several cases for acquisition of subsidiaries, these include:
• Acquisition at balance sheet date
• Acquisition before the balance sheet date
• Acquisition involving pre-acquisition loss
• Acquisition involving minority interest
• Acquisition of subsidiary during the year

Refer to the background information below, and find out the following for each of the
cases, at 31 December 2000:
a) Goodwill arising on consolidation
b) Consolidated retained earnings
c) Balance sheet

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The balance sheet of Alpha Ltd and Beta Ltd on 31 December 2000 were as follows:
Alpha Ltd Beta Ltd
$ $
Fixed assets
Tangible 500,000 90,000
Investments 70,000 shares in Beta Ltd 190,000 -
690,000 90,000
Net current assets 30,000 40,000
720,000 130,000

Capital and reserves

Called-up share capital 550,000 70,000
Profit and loss account 170,000 60,000
720,000 130,000

Different cases of acquisitions:

Acquisition date Retained profit at the time % holding

of acquisition
Case 1 31 Dec 2000 $60,000 100
Case 2 1 Jan 2000 $30,000 100
Case 3 1 Aug 2000 $40,000 100
Case 4 1 Jan 2000 -$20,000 100
Case 5 1 Jan 2000 $30,000 80
Case 6 1 Aug 2000 $40,000 80
Case 7 1 Jan 1998 -$20,000 80

Consolidation adjustments
There always transactions between companies in the same group. These inter-
company transactions should be eliminated when group accounts are prepared. The
main problem is how to account for the unrealised profit on goods transferred by one
group company to the other. If goods transferred from one group to the other at a
profit remain unsold at the end of the financial year, the unrealized profit will e
eliminated on consolidation.

The main consolidation adjustments are:

• Profit on unsold stock
• Inter-company balances
• Items in transit
• Transfer of fixed assets
• Fair value of fixed assets

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Profit on unsold stock

Profit on unsold stock may happen in both goods transferred from and to parent
company to subsidiary.

If the goods are transferred from parent company:

Dr consolidated retained earnings account
Cr consolidated stock figure

If the goods are transferred from subsidiary to parent company

Dr consolidated retained earnings
Dr minority interest (with the minority’s share of the unrealised profit)
Cr consolidated stock (with the total amount of unrealised profit)

Inter-company balances
All inter-company balances should be eliminated (delete through offsetting each
other) when preparing the consolidated balance sheet. These balances may arise
from loan between the parent and subsidiary companies, dividend proposed by the
subsidiary, and goods purchases from subsidiary.

Items in transit
This refers to cash and goods transferred from one group company to the other but
are in transit at the balance sheet date. Goods and cash in transit would cause the
inter-company balances to differ. If this happens, we need to debit the items in transit
(cash or goods) account and credit the transferor (which send the cash/goods)
company’s account in the books of the transferee (which receive the cash/goods).

Example
Alpha is the parent company of Beta Ltd. At 31 December 2000, the following
balances appeared in the balance sheets of the two companies.
Alpha Beta
$ $
Beta Ltd – debtor 15,000
Alpha Ltd – creditor 12,000

The difference in the two balances is due to cash transferred by Beta Ltd (transferor)
to Alpha Ltd (transferee), which was in transit at the balance sheet date.

Required
Explain the consolidation adjustments required.

Transfer of fixed assets

Transfer of fixed assets from the subsidiary to parent company or vice versa would
give rise to inter-company adjustments if the transfer is made at a price other than
the book value or the cost of the fixed asset. The unrealized profit would have to be
eliminated.

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The unrealized profit of the asset is calculated by:

Written down value based on selling price – written down value based on cost.

If the transfer is from parent company to subsidiary, the unrealized profit is to be

eliminated from the group’s retained earnings. While if the transfer is from subsidiary
to parent company, it is to be eliminated from both retained earnings and minority
interest as well.

Example
Alpha Ltd acquired 90 percent of the voting shares of Beta Ltd on 1 January 1999.
On the 1 Jul, Beta bought machinery from Alpha. This machinery was manufactured
by Alpha for $100,000 and sold to Beta at a profit of 20 percent on the selling price.
Beta which still owned the machinery at 31 December 1999, wrote off depreciation at
the rate of 10 percent on cost, charging a full year’s depreciation in 1999.

Required
Explain the adjustments required for consolidation purpose.

Fair value of fixed assets

If the fair value of the fixed assets at the date of acquisition is different from the book
value, the fixed assets need to be revaluated to reflect the revaluation surplus. The
revaluation reserve is a pre-acquisition reserve and should affect the goodwill
computation.

Dr Tangible fixed assets

Cr Revaluation reserve

However, the additional depreciation that charged for the revaluation is a post-
acquisition expenses, therefore it is to be deducted from the post-acquisition profit
when calculating both consolidated retained earnings and minority interest.

Negative Goodwill
Negative goodwill is to be recognized in the profit and loss account over the period
(number of years) in which the non-monetary assets (stocks and tangible fixed
assets) acquired by the parent company are recovered (selling of stock and
depreciation of fixed assets).

Example:
Negative goodwill: $15,000
Fixed assets (at date of acquisition): $90,000
Stocks (at date of acquisition): $70,000
Stocks were sold during the year, and depreciation charged on the fixed assets
amounted $10,000.

Required
Calculate the goodwill written back to profit and loss account.

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Exercises

Exercise 5.1

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Exercise 5.2

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Exercise 5.3

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Exercise 5.4

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Exercise 5.5

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Exercise 5.6

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Exercise 5.7

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