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HA2032 - Corporate and Financial Accounting - Holmes Institute

Assessment - Corporate Takeover Decision Making and the Effects on Consolidation Accounting

Learning Outcome 1. Explain the legislative requirements in company formation and how to account for equity, capital and distributions;

Learning Outcome 2. Explain the methods of raising company funds, that is, using share capital or debt, and how to account for each;

Learning Outcome 3. Demonstrate the ability to prepare consolidated financial statements and how the data is collected, adjusted and interpreted.

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Executive Summary

Equity accounting is used when a company acquires a stake in another company that gives it significant influence over the other company but does not give it management control. Acquisition of a stake between 20% and 50% in the other company is considered to give significant influence to the acquirer company. When a company gets management control by acquiring a stake of more than 50%, consolidated accounting is used.

In consolidated accounting all the revenues, profits, assets and liabilities of the acquired company is consolidated with the acquirer company. In equity accounting only the share of net profit and value of stake in the acquired company is reported on the financial statements of the acquirer.

Introduction

Part A is about differences in accounting treatment in Consolidation accounting and Equity accounting. Consolidation accounting is done when a company acquires a significant stake in another company, so that it gains management control of the company. Equity accounting is done when a company acquires a smaller stake in another company, so that it does not gain significant control of the other company (Jonathan & Peter 2017).

Part B is about accounting treatment of profits booked on professional services and sales that are provided by subsidiary of a company.

Part C is about non-controlling interest (NCI) that a company has in other companies. It is about how when preparing consolidated financial statements of the company, these NCIs should be accounted for. What the separate disclosure requirements regarding NCI are and so on.

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Question: Prepare a detailed response to the Chairman and the board, which outlines the key differences in methodology between Consolidation Accounting and Equity Accounting.

Solution:

Part A
JKY Ltd is thinking of taking over a smaller company, FAB Ltd. FAB is a company listed on ASX. It operates in the same industry as JKY. JKY is considering what acquisition strategy is most suitable. One option is direct purchase or acquisition of JKY. In this case consolidated accounting will have to be used after the acquisition. All the assets and liabilities of FAB will be consolidated with the assets and liabilities of JKY. The other option is acquiring the shares of FAB gradually and first gaining significant influence. Significant influence means that JKY can affect the operating and financial decisions of FAB but will not be having control over it. An equity stake between 20% and 50% in the other company is considered to give the company significant influence, but not control, in the other company. In this case the equity method of accounting will be used.

In the equity method of accounting, as per AASB 128 Investment in Associates, only the share of profit or loss from the acquired company's profit or loss will be shown in the profit or loss statement of the acquirer (AASB 128 2019). So JKY will only have to show its share of net income or loss of FAB on its income statement if it goes for acquiring significant influence route, instead of the direct purchase or acquisition route. On the balance sheet value of equity of JKY's stake in FAB will be shown. This equity value will be adjusted according to JKY's share in the net profit or loss of FAB. So when FAB will post a profit, the value of JKY's stake in FAB will be increased. When FAB will post a loss, the value of JKY's stake in FAB will be reduced. When dividends are paid by FAB to JKY, the value of JKY's stake in FAB will be reduced by the amount of dividends.

In the disclosures or footnotes to the financial statements, a summary of FAB's financial information will have to be given (AASB Standard 3 2019). This information will include information about total assets, total liabilities, total revenues and total profits of FAB.

The advantage of acquiring significant influence route is that reporting requirements will be lesser than in the direct acquisition route. In case FAB posts profits, net profit margin of JKY will go up. This is because JKY will only have to report its share in the net profit of FAB on the income statement of JKY. It will not have to report its share of revenues in the revenues of FAB. Therefore the net profit margin (net profit / sales) of JKY will go up, as it will be reporting higher net profit but the same amount of sales (Clarke, Walsh, & Flanagan 2015).

If JKY chooses direct purchase or acquisition method, then it will be acquiring control of FAB. In this case it will get management control of FAB. Everything is reported in a consolidated manner as per AASB 10. There are no advantages such as increase in net profit margin just because of accounting treatment that come with equity method of accounting. In this case net profit margin of the consolidated entity will only go up if FAB actually has higher net profit margin that JKY.

This process of preparing consolidated financial statements of the two entities has to be repeated in every financial quarter and year. So reporting requirements will be much more complex if JKY opts for the direct purchase or acquisition route. The cost of financial reporting will therefore be higher (Kim & Henderson 2015).

This example can explain the difference between the equity reporting method and consolidated reporting method. Suppose JKY acquires only significant influence in FAB and not full control. In this case it will have to use equity method for accounting its stake in FAB. JKB has 30% stake in FAB. In the one year period after the acquisition, net profit of FAB is $1000. JKY's share of this net profit will be $300 (1000*30%). JKY will report this $300 as profit from associates in its income statement for the year. At the time of acquisition of this stake, the book value of equity of FAB was $20000. Value of equity of the stake of JKY in FAB will be $6000 ($20000* 30%). JKY will report this $6000 as the value of its stake in JKY at the time of acquisition of the stake. We assume here that FAB does not give any dividend from its profits of $20,000 in the year. So value of equity of JKY's stake in FAB at the end of one year will increase by $300. This $300 is its share in the net profit of FAB in the year.

Now suppose it was a direct acquisition. In this case consolidated accounting will have to be used. So the entire profit of FAB in the year, i.e. $1000, will be shown in the income statement of JKY , as part of consolidated profit. Revenues and other costs of both the entities will also be consolidated. In the balance sheet total assets of both the entities will be shown along with total liabilities.

However there are certain advantages too of the direct acquisition route. FAB operates in the same industry as JKY. Therefore this is a strategic investment for FAB. By making direct acquisition of FAB, JKY will get management control of JKY. This management control will enable it to manage FAB according to the way it wants.

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Question: Discuss the key principles and provide examples which explain how intra-group transactions should be treated.

Solution:

Part B
A partially owned subsidiary of JKY Ltd sold inventory and provided financial services to the parent company at a profit. There are two issues involved here. First is whether the profits of the subsidiary be reduced by the amount of profit that it made on the sales to parent entity. The second issue is how the non-controlling interests will be affected in the subsidiary's annual profit calculation if changes are made to the profit of the subsidiary because it made sales to the parent entity at a profit.

The profit and sales of the subsidiary in the consolidated financial statements should be reduced by the amount made to the parent, JKY Ltd, if the inventory that it bought from the subsidiary remains unsold by the end of the financial year (AASB Standard 127 2019). If the inventory has been sold then there is no need for reducing the sales and profits in the consolidated financial statements. The final sales figure and profits to be included in the consolidated statements are the sales price and price realized by JKY Ltd.

As per AASB 10 and AASB 127, at the time of preparing consolidated statements of JKY and the subsidiary, revenues realized from the sale of professional services by the subsidiary to JKY should not be included in consolidated revenues. This is because consolidated revenues represent the revenues of the group (Needles & Powers 2013). They do not include revenues that are generated from selling goods and services to companies or entities within the group.

The changes to consolidated revenues and profits will reduce the profits attributed to NCIs in the consolidated financial statements of JKY and the subsidiary. NCIs are shareholders who own stake that does not give them majority control in the company. Usually these shareholders are those that have a significant amount of stake in the company, usually in the range of 5% and 10% (Clinton & Van der Merwe 2015). This kind of stake can influence the decisions of the company but cannot control it. Companies, in their financial statements, show the amount of profits or losses that are attributed to NCIs or minority stakeholders because of their stake in the company. Any changes in the profit and loss calculations, is bound to affect the profit and loss attributed to NCIs.

This example will help in understanding better the issue that is here. Suppose the subsidiary sold JKY inventory at a price of $100. On this sale to JKY, the subsidiary made a profit of $30. JKY owns 51% stake in the subsidiary. So $15.3 of the profit of $30 will accrue to JKY because of the profit of $30 made by the subsidiary. Now the inventory that JKY bought from the subsidiary remains unsold by the end of the financial year. At the time of preparing the consolidated financial statements of JKY and the subsidiary, consolidated revenue will not include the $100 revenue that the subsidiary made on sales of inventory to JKY. The distinction that is important to note here is that consolidated financial statements, represent the performance of the entire group, as per AASB 127. Therefore if sales or profits are made by transactions within group companies then they are not included in consolidated numbers. On those sales and profits are included in consolidated financial statements that are made to entities or customers outside the group.

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Question: Discuss the effects of the NCI disclosure requirement as a separate item in the consolidation process.

Part C
AASB 127 requires that the stake held by Non-Controlling Interests (NCIs) should be reported as a separate item of owner's equity. There is also the issue of allocation of other comprehensive income or profit to NCIs.

AASB 127 clearly states that minority interests or NCIs in consolidated profit & loss statement should be clearly and separately identified. This means the profit or loss attributed to the NCIs should be clearly given in a separate line in the consolidated financial statements. It also states that in the consolidated balance sheet, the net assets or equity (equity is the difference between assets and liabilities; so it is net assets) of NCIs should be stated separately from the parent shareholders' equity. It states further that the equity for NCIs in the balance sheet should have two elements (AASB Standard 127 2019). One is the value of their equity at the date when the original combination took place. The other element is change in value of equity of minority interests since the date of acquisition.

According to AASB 10 Consolidated Financial Statements, a company has to prepare consolidated financial statements of all its subsidiaries (AASB Standard 3 2019). This consolidated statement will combine all the assets and liabilities of companies in the group. Total consolidated revenues and other costs will have to be reported in the consolidated income statement of the group entities. Profit or loss attributed to minority interests or NCIs will have to be reported in the consolidated profit & loss statement. Minority interests are those financial institutions or shareholders who own minority stakes in the subsidiary, post its acquisition by the parent company.

What changes will therefore be required so that the financial statements are correctly stated? The first change is that the assets of the subsidiary should be fairly valued. Fair value of the assets can be calculated from their market value. In cases of assets whose market value is not available, their fair value can be calculated by calculating the present value of the expected economic benefits from using that asset during its remaining economic life (Accounting Coach 2019). Fair value of the liabilities of the subsidiary should also be calculated. This way the fair value of net assets or equity of the subsidiary can be calculated. From the fair value of equity of the subsidiary, the fair value of equity of NCI can also be calculated. The fair or current value of equity of NCIs should be stated separately in the balance sheet, along with the historical value of their equity at the time of business combination.

Other comprehensive income includes revenues, expenses and gains that have not been realized. So if the company is holding bonds as financial investment and the market value of the bonds goes up, then this gain will be recorded in Other Comprehensive Income. When the company sells these bonds and realizes the gain, the gain will not be included in other comprehensive income, but will be included in the main income statement.

Other Comprehensive Income is given below the main incomes statement (CreditPulse, 2018). Other comprehensive income is not included in the main income statement also because their inclusion will increase volatility of net income or loss. This increase in volatility will happen because the value of unrealized gains and losses keeps on changing.

Some common items that are included in other comprehensive income are gains or losses that are made on investments held for sale (such as the bond example given above); gains or losses that are made on derivative instruments that are held for the purpose of hedging; foreign currency gains and losses; and gains and losses on pension plans (Jonathan & Peter 2017). Other comprehensive income becomes part of shareholder's equity in the balance sheet. Below common equity and retained earnings lines, they are given as accumulated other comprehensive income.

Since other comprehensive income is part of equity of the company it should be allocated to NCIs too. This allocation should be done in proportion to the percentage of equity stake that NCIs own in the company. The share of NCIs in the other comprehensive income should be added to the value of their equity on the balance sheet. The value of other comprehensive income that is attributed to NCIs should be reduced from the total comprehensive income in the year and the remaining value should be allocated to the shareholders of the parent company.

Conclusion
The essential difference between equity accounting and consolidated accounting is that only the share in profit or loss of the company in which stake is acquired is included in the income statement of the acquirer company. In the balance sheet of the acquirer company, only the value of its equity stake in the other company in which stake is acquired is included.

While preparing consolidated statements, only those revenues and profits should be included that arise from sales to outside entities and not to those within the group.

Profit and loss attributed to NCIs and the value of their stake should be stated in the income statement and balance sheet.

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