Group Reporting in International Corporate Reporting

International Corporate Reporting Chapter 14 Group reporting

Defining a group -IFRS Acquiring entity ( the investor ) and its control over an acquired entity ( the investee ). IFRS 10 applies the principle that an investor controls an investee when it is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power. Power means having existing rights that give the current ability to direct the relevant activities of the investee.

IFRS meaning of control Thus, an investor controls an investee if, and only if, the investor has all the following: power over the investee; exposure, or rights, to variable returns from its involvement with the investee; and the ability to use its power over the investee to affect the amount of the investor s returns.

US GAAP A more rules-based approach. Operationalisation of control is quite different between IFRS and U.S. GAAP, corporations preparing consolidated financial statements under both sets of standards could have significantly different results. Previously based on voting, over 50% indicated control. From early 2000s, look for a variable interests entity. Two tests: Power to direct activities that most significantly impact economic performance; and Potential to receive significant benefits or absorb significant losses. The variable interest entity model is applied first, and if that does not identify control then the voting interests model is applied.

Acquisition accounting versus uniting of interests Acquisition accounting assumes that the parent has acquired all or part of the subsidiary. Goodwill and annual impairment test. Uniting of interests ( pooling of interests) is based on the principle that the shareholders of two economic entities of comparable strength and size have agreed to come together as shareholders of the new united interest. No goodwill recorded. Uniting of interests not permitted in IFRS or US GAAP since early 2000s.

Illustration of acquisition accounting and uniting of interests accounting

Separate companies before acquisition/merger Panel A This table shows the balance sheets of X and Y at the date of acquisition/merger before a share issue. CU = Currency Unit

Panel A X CUm 50 10 60 40 Y CUm 30 15 45 30 Non-current assets Net current assets Net assets Ordinary shares of CU1 each Reserves of retained profit 20 15 Note: CU = Currency Unit 60 45

Share issue and fair value of assets acquired Panel B The shares of X have a market value of CU 2 each. The shares of Y also have a market value of CU 2 each. The terms of the acquisition are that X acquires all of the share capital of Y by issuing shares on a 1 for 1 exchange.

Recording the issue of shares in the balance sheet of X Panel B (contd) There are two ways of recording the issue of shares in the balance sheet of X One is to record the issue of shares at market value of CU 60m (CU 30m share capital issued plus CU 30m share premium.) The other is to record the issue of shares at nominal (par) value, recording only the CU 30m share capital issued. Assume that applying fair values to the non-current assets of Y plc reveals that the book value undervalues these assets by CU 5m.

Balance sheet of X after share issue Panel C There are two different balance sheets for X. The first records the investment in Y at the fair value (in this case market value) of the shares issued. This balance sheet will be used for the acquisition method in consolidating with Y. The second records the investment in Y at the nominal value of the shares issued. This balance sheet will be used for the uniting of interests method in consolidating with Y.

Fair value of shares issued Nominal value of shares issued Panel C: Two versions of balance sheet of X CUm 50 60 10 120 70 30 20 120 CUm 50 30 10 90 70 Non-current assets Investment in Y Net current assets Net assets Ordinary shares of CU1 each Share premium Reserves of retained profit 20 95

Calculation of goodwill for acquisition method Panel D For the acquisition method a calculation of goodwill is required, taking account of the fair value adjustment to the net assets of Y.

Panel D: Calculation of goodwill CUm CUm Cost of shares based on market value Less ownership interest at date 60 of acquisition Share capital Fair value adjustment Reserves of retained profit Goodwill 30 5 15 (50) 10

Consolidated balance sheets Panel E The balance sheets of X and Y are now consolidated. The investment in Y is eliminated. The reserves of retained profit under acquisition accounting are those of X only. The reserves of retained profit under uniting of interests are the total reserves of both companies.

Acquisition Uniting Panel E: Consolidated balance sheets of interests CUm CUm 10 85 25 120 70 30 20 120 Goodwill Non-current assets Net current assets Net assets Ordinary shares of CU1 each Share premium Reserves of retained profit 80 25 105 70 35 105

End of illustration

Common control When the controlling party before and after a business combination is the same, the combination is described as being under common control. Example: Entity A owns 100% of the voting interest of entities B and C. Entity C owns 100% of the voting interest in entity D. Entity B then acquires all the voting interests in entity D from entity C. This transaction is a common control transaction because entities B, C and D are under the control of entity A before and after the transaction.

Reasons for changes under common control Group restructuring. e.g. for tax efficiencies, regulatory requirements, release of distributable reserves from dividend traps , in preparation for a spin-off.

Common control, contrast IFRS and US GAAP IFRS not in a specific standard entities develop and consistently apply an accounting policy; management can elect to apply the acquisition method of accounting or the predecessor cost method to a business combination involving entities under common control. US GAAP -specific rules for common control transactions. Combinations of entities under common control are generally recorded at predecessor cost, reflecting the transferor s carrying amount of the assets and liabilities transferred.

Pushdown accounting The acquired company s standalone financial statements are adjusted to reflect the acquirer s accounting basis rather than the target s historical costs. A typical approach would be to increase the target s net assets to fair value in its standalone financial statements. Goodwill is then calculated as the extent to which the purchase price exceeds the new fair value.

Pushdown accounting, contrast IFRS and US GAAP IFRS No specific standard US GAAP FASB guidance makes pushdown accounting optional for all companies, in any change-in- control event. Election is available to the acquired company and any subsidiaries. Must be applied also in standalone financial statements.

Operating segments IFRS and US GAAP harmonised. IFRS 8 aligned with SFAS 8 Management approach, process of identifying operating segments begins with the information used by the entity s chief operating decision maker to assess performance and to make decisions about future allocations of resources. The standards then set out disclosure requirements for each segment.

Operating segments debate Concern in European Parliament when IAS 14 was replaced by IFRS 8. Seen as pressure from US GAAP to lower the rigour of defining segments, and also reducing disclosures. US GAAP is now Codification Topic 280 Aspects for continuing debate: Segment identification Criteria for aggregation Segment disclosure requirements

Goodwill Recognition and measurement Defined in IFRS 3 Business Combinations as an asset. It represents the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised. This approach to definition focuses on the nature of goodwill rather than its measurement.

Goodwill impairment 2001, FASB removed the policy of amortisation of goodwill. Previously goodwill was amortised over its useful life, which could be up to 40 years in US GAAP. Other countries applied different asset life, e.g. the international accounting standard of that time allowed up to 20 years. IFRS revised to align with US GAAP. Amortisation replaced by annual impairment test.

Negative goodwill, also called bargain purchase Price paid for the shares of a subsidiary is less than the value of the net assets acquired. Called a bargain purchase if the reason is that the deal appears to be a good bargain for the acquirer. IASB regards bargain purchases as unusual and requires the acquirer to reassess all components of the computation to ensure that the measurements are based on all available information as of the acquisition date. If the excess remains after that reassessment, then the acquirer recognises a gain in profit or loss on the acquisition date. All of the gain is attributed to the acquirer.

Equity method of accounting Apply to an investment in an associate or to a joint venture. At the date of acquisition, the investment is recorded at cost in the group balance sheet. Subsequent balance sheets, investment in the associate or joint venture is reported as cost plus the investing company s share of the post- acquisition retained profits of the investee. Increase or decrease in value of the investee from one balance sheet date to the next is reported as achange in group reserves.

Equity method (contd) Only one line in the balance sheet to report the entire investment in the associate or joint venture. Income statement shows a single line reporting the group s share of the profit of the associate. Sometimes called one-line consolidation . Specific application of the proprietary theory, emphasises ownership or proprietorship, where the owner is in a position to exercise significant influence over commercial and financial policy decisions.

Illustration of equity accounting

Planet plc paid 160 million at the start of year 1 to acquire 40% of the share capital of Sun plc. Balance sheets at end of year 1 Planet CUm 100 160 120 Sun CUm 600 Non current (fixed) assets Investment in Sun at cost Current assets minus current liabilities Long term liabilities 80 (50) 330 300 (200) 480 400 Ownership interest at the start of the year) Retained profits for year 1 30 330 80 480

Planets share of the profit of Sun is (40% x 80) = 32m (No dividends were paid or received in either company) Profit and loss accounts for year 1 Planet Sun CUm 345 310 CUm 300 200 100 20 80 Sales Cost of sales Trading profit Interest paid Net profit 35 5 30

Calculations for equity accounting Balance sheets at end of year 1 Planet Sun Adjust -ment Including associate (1) As reported by Sun CUm 600 (2) 1+2=(3) CUm 100 160 120 CUm CUm 100 192 120 Non current (fixed) assets Investment in Sun at cost +32 80 Current assets minus current liabilities Long term liabilities (50) 330 (200) 480 (50) 362 +32 Ownership interest (share capital plus reserves) at the start of the year) Retained profits for year 1 300 400 300 30 330 80 +32 +32 62 362 480

Profit and loss accounts for year 1 Planet Plc Sun plc Parent s share 40% Including associate (1) As reported by Sun (2) 1+2=(3) CUm 345 310 CUm 300 200 CUm CUm 345 310 Sales Less Cost of sales Trading profit Share of associate s net profit 35 100 35 32 +32 Less Interest paid 5 20 5 Net profit 30 80 62

End of illustration

Proportionate consolidation Permitted under IAS 31, withdrawn by IFRS 11. Entity theory emphasises the economic unity of all entities in the group and treats all shareholders similarly, whether controlling or not. Leads to the accounting practice of proportionate consolidation where the group balance sheet shows the investing company s percentage interest in each category of asset and liability and the income statement shows the percentage interest in each element of operating activity.

Accounting for an associate Defined by significant influence. Holding of 20% or more of the voting power of the investee (held directly or indirectly, through subsidiaries) is presumed to give rise to significant influence, unless it can be clearly demonstrated that this is not the case. Holding of less than 20% of the voting power is presumed not to give rise to significant influence, unless it can be clearly demonstrated that there is in fact significant influence.

Equity accounting for associate under IFRS (contd) Evidence of significant influence: representation on the board of directors of the investee, or equivalent; participation in policy-making processes, e.g. decisions about dividends and other distributions; material transactions between the investor and the investee; interchange of managerial personnel; or provision of essential technical information. Must conform with group accounting policies

Equity accounting for associate under US GAAP Equity investee s accounting policies do not have to conform to the investor s accounting policies if the investee follows an acceptable alternative US GAAP treatment. Equity method used but there are some differences from IFRS Standards in the timing of derecognition when significant interest is lost. Exemption from applying the equity method of accounting is available to a broader group of entities under US GAAP. (Alternative is fair value through profit or loss)

Accounting for joint arrangement, IFRS 11 Joint arrangement is an arrangement of which two or more parties have joint control. Joint control is the contractually agreed sharing of control of an arrangement. It exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. Two types. Joint operation (rights over specific assets and obligations) or Joint venture (rights over the net assets of the arrangement).

Joint operator Joint operator reports, in respect of its interests in a joint arrangement: its assets, including share of any assets held jointly; its liabilities, including share of any liabilities incurred jointly; its revenue from the sale of its share of the output arising from the joint operation; its share of revenue from the sale of the output by the joint operation; and its expenses, including its share of any expenses incurred jointly.

Joint venture, IFRS Joint venturer accounts for its investment in the joint venture using the equity method in accordance with IAS 28. No disclosure requirements under IAS 28, but IFRS 12 (para 20) includes a principles-based requirement for the reporting entity to disclose the nature, extent and financial effects of its interests in joint arrangements and associates. Companies may interpret this requirement in different ways.

Joint arrangements US GAAP There are differences between IFRS Standards and US GAAP in the definition or types of joint arrangements. These differences may result in different arrangements being considered joint ventures, which could affect reported figures, earnings, ratios, and covenants. Under US GAAP, the proportionate consolidation method is allowed for unincorporated entities in certain industries.

Foreign currency translation IAS 21 Questions for a standard How to include foreign currency transactions and foreign operations in the financial statements of an entity How to translate financial statements into a presentation currency. Which exchange rate(s) to use. How to report the effects of changes in exchange rates in the financial statements.

IAS 21 definitions Functional currency is the currency of the primary economic environment in which the entity operates. Presentation currency is the currency in which the financial statements are presented. An exchange difference results from translating a given number of units of one currency into another currency at different exchange rates.

IAS 21 procedure for consolidation For consolidated financial statements the presentation currency is normally the parent company s national currency. For most of a group s foreign subsidiaries their functional currency will be their national currency. The consolidation process will first involve a translation of the subsidiary s financial statements from its functional currency to the group s presentation currency.

IAS 21 process (contd) Closing rate of exchange is used for the translation of the balance sheet, as follows: Assets and liabilities are translated at the closing rate at the reporting date. Income and expenses are translated at exchange rates at the dates of the transactions. All resulting exchange differences are recognised in other comprehensive income .

US GAAP Relatively few differences between IAS 21 and US GAAP. One is that under US GAAP there is no hierarchy of indicators to determine the functional currency of an entity, whereas a hierarchy exists under IFRS Standards.

Hyperinflation IAS 29 describes characteristics of the economic environment that indicate hyperinflation is present. Under US GAAP hyperinflation is clearly defined and deemed to exist when the cumulative rate of inflation over a three-year period exceeds 100%. The International Practices Task Force (IPTF) (SEC Regulations Committee) monitors inflation rates and publishes countries of hyperinflation. Nov 2018: Angola. Argentina, South Sudan, Sudan, Suriname and Venezuela.

Hyperinflation accounting, IFRS Apply indexation to reflect purchasing power at the reporting date, followed by translation to the presentation currency. IAS 29 takes the position that reporting operating results and financial position in the local hyperinflationary currency without restatement is not useful. Requires financial statements prepared in the currency of a hyperinflationary economy to be stated in terms of the measuring unit current at the end of the reporting period.