LEARNING OBJECTIVES

1.         Apply the method of accounting for business combinations (HKFRS 10).
2.         Account for the effects of intra-group trading in the statement of financial position.
3.         Determine appropriate procedures to be used in preparing group financial statements.
4.         Apply the equity method of accounting for associates and joint venture (HKAS 28 (2011)).
5.         Outline and apply the key definitions and accounting methods that relate to interests in joint arrangements (HKFRS 11).
6.         Understand and discuss the issues associated with disclosure of interest in other entities (HKFRS 12).

1.2

Definitions

(a)        Group – A parent and its subsidiaries.                                          (HKFRS 10)
(b)        Parent – An entity that controls one or more entities.                  (HKFRS 10)
(c)        Subsidiary – An entity that is controlled by another entity.         (HKFRS 10)
(d)        Control – An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through power over the investee.
(HKFRS 10)
(e)        Power – Existing rights that give the current ability to direct the relevant activities.                                                                                      (HKFRS 10)
(f)        Relevant activities – Activities of the investee that significantly affect the investee’s returns.                                                                       (HKFRS 10)
(g)        Associate – An entity over which the investor has significant influence.
(HKAS 28)
(h)        Significant influence – is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control of those policies.                                                                             (HKAS 28)

Investment

Criteria

Required treatment

Subsidiary

Control

Full consolidation (HKFRS 3 (revised) / HKFRS 10

Associate

Significant influence

Equity accounting (HKAS 28)

Joint arrangement
(joint venture)

Contractual arrangement

Equity accounting (HKFRS 11 / HKAS 28)

Investment which is none of the above

Asset held for accretion of wealth

As for single company accounts per HKFRS 9

1.4.8

Example 1

An investor acquires 48% of the voting rights of an investee. The remaining voting rights are held by thousands of shareholders, none individually holding more than 1% of the voting rights. None of the shareholders has any arrangements to consult any of the others or make collective decisions. When assessing the proportion of voting rights to acquire, on the basis of the relative size of the other shareholdings, the investor determined that a 48% interest would be sufficient to give it control.

In this case, on the basis of the absolute size of its holding and the relative size of the other shareholdings, the investor concludes that it has a sufficiently dominant voting interest to meet the power criterion without the need to consider any other evidence of power.

1.4.9

Example 2

Investor A holds 40% of the voting rights of an investee and twelve other investors each hold 5% of the voting rights of the investee. A shareholder agreement grants investor A the right to appoint, remove and set the remuneration of management responsible for directing the relevant activities. To change the agreement, a two-thirds majority vote of the shareholders is required.

In this case, investor A concludes that the absolute size of the investor’s holding and the relative size of the other shareholdings alone are not conclusive in determining whether the investor has rights sufficient to give it power. However, investor A determines that its contractual right to appoint, remove and set the remuneration of management is sufficient to conclude that it has power over the investee. The fact that investor A might not have exercised this right or the likelihood of investor A exercising its right to select, appoint or remove management shall not be considered when assessing whether investor A has power.

1.4.15

Principal and agent

(a)        HKFRS 10 introduces the concept of delegated power. If it has the power to direct the activities of an entity that it manages to generate returns for itself, then it is a principal.
(b)        If it is engaged to act on behalf and for the benefit of another party or parties, then it is an agent and does not control the investee when exercising its decision-making authority.
(c)        This is because if that decision-maker has been delegated rights that give the decision-maker power, it must be assessed whether those rights give the decision-maker power for its own benefit, or merely power for the benefit of others.
(d)        As an agent cannot have control over the investee, it does not consolidate the investee.
(e)        A principal may have control over the investee, and if so, would consolidate the investee.

2.1.4

Specific circumstances

(a)       Severe long-term restrictions
Previously, HKAS 27 permitted exclusion from consolidation where the subsidiary was subject to long-term restrictions on the ability to transfer funds to the parent; this exclusion is no longer permitted as it may still be possible to control a subsidiary in such circumstances
(b)       Acquired for resale
A subsidiary acquired exclusively with a view to disposal within 12 months will probably meet the conditions in HKFRS 5 Non-current assts held for sale and discontinued activities for classification as held for sale.

If it does; the effect is that all its assets are presented as a single line item below current assets and all its liabilities are presented as a single line item below current liabilities. So it is still consolidated, but in a different way.
(c)       Materiality
Accounting standards do not normally apply to immaterial items; therefore an immaterial subsidiary need not be consolidated. However, this would need to be kept under review from year to year, and the parent would need to consider each subsidiary to be excluded on this basis, both individually and collectively.

4.1.1

Steps in preparing the consolidated statement of financial position

(W1) Shareholding in the subsidiary

(W2) Consolidation adjustments.

(W3) Net assets of subsidiary

(W4) Goodwill

(*) If fair value method adopted, NCI value = fair value of NCI’s holding at acquisition (number of shares NCI own × subsidiary share price).

(*) If proportion of net assets method adopted, NCI value = NCI % × fair value of net assets at acquisition (from W2).

(W5) Group retained earnings

(W6) Non controlling interest

4.2.1

Basic consolidation adjustments

(a)       Current assets

Cash in transit
Dr. Group Bank/Cash (cash in transit)
Cr. Current account

Goods in transit
Dr. Group inventory
Cr. Current account

(b)       Unrealised profit in inventory

Parent sells to subsidiary
Dr. Group retained earnings
Cr. Group inventory

Subsidiary sells to parent
Dr. Group retained earnings (multiplying the shareholdings)
Dr. NCI (multiplying the proportion of NCI)
Cr. Group inventory

(c)       Unrealised profit in sale of non-current assets

Parent sells to subsidiary
Dr. Group retained earnings
Cr. Group non-current assets

Excessive depreciation
Dr. Accumulated depreciation
Cr. Group retained earnings

Subsidiary sells to parent
Dr. Group retained earnings
Dr. NCI
Cr. Group non-current assets

Excessive depreciation
Dr. Accumulated depreciation
Cr. Group retained earnings
Cr. NCI

(d)       Intra-group lending

Dr. Group loan
Cr. Group investments (or receivables)

(e)       Dividends out of pre-acquisition profits

Dr. Cash
Cr. Investment in subsidiary

4.3.1

Goodwill

Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized.

Goodwill arising on consolidation is the difference between the cost of an acquisition and the fair value of the subsidiary’s net assets acquired.

4.3.2

Treatment of Goodwill

(a)       Positive goodwill:
(i)         Capitalised as an intangible non-current asset.
(ii)        Tested annually for possible impairments.
(iii)       Amortisation of goodwill is not permitted by the standard.

(b)       Impairment of positive goodwill:
If goodwill is considered to have been impaired during the post-acquisition period it must be reflected in the group financial statements. Accounting for the impairment differs according to the policy followed to value the non-controlling interests.

(i)         Proportion of net assets method:

Dr Group reserves
Cr Goodwill

(ii)        Fair value method – the goodwill in the statement of financial position includes goodwill attributable to the non-controlling interest. In this case the double entry will reflect the non-controlling interest proportion based on their shareholding as follows:

Dr Group reserves (% of impairment attributable to the parent)
Dr NCI (% of impairment attributable to NCI)
Cr Goodwill

(c)       Negative goodwill:
(i)         Arises where the cost of the investment is less than the value of net assets purchased.
(ii)        HKFRS 3 does not refer to this as negative goodwill (instead it is referred to as a bargain purchase), however this is the commonly used term.
(iii)       Most likely reason for this to arise is a misstatement of the fair values of assets and liabilities and accordingly the standard requires that the calculation is reviewed.
(iv)       After such a review, any negative goodwill remaining is credited directly to the income statement.

4.4.1

Computation of Non-controlling Interests

HKFRS 3 allows two alternative ways of calculating non-controlling interest in the group statement of financial position. Non-controlling interest can be valued at:
(a)    Proportion of net assets method – NCI value = NCI % × fair value of net assets at acquisition; or
(b)    Fair (full) value method – NCI value = fair value of NCI’s holding at acquisition (number of shares NCI own × subsidiary share price).

4.5.1

Fair value of consideration and net assets

To ensure that an accurate figure is calculated for goodwill:
(a)       the consideration paid for a subsidiary must be accounted for at fair value;
(b)       the subsidiary’s identifiable assets and liabilities acquired must be accounted for at their fair values.

4.6.1

The cost of acquisition

The cost of acquisition includes the following elements:
(a)       Cash paid; and
(b)       fair value of any other consideration, i.e. deferred/ contingent considerations and share exchanges.

4.6.5

Example 3 – Calculation of cost of investment

H Ltd acquires 24 million $1 shares (80%) of the ordinary shares of S Ltd by offering a share-for-share exchange of two shares for every three shares acquired in S Ltd and a cash payment of $1 per share payable three years later. H Ltd’s shares have a nominal value of $1 and a current market value of $2. The cost of capital is 10% and $1 receivable in 3 years can be taken as $0.75.

Required:

(a)       Calculate the cost of investment and show the journals to record it in H Ltd’s accounts.
(b)       Show how the discount would be unwound.

Solution:

(a)    Cost of investment

$50m is the cost of investment for the purposes of the calculation of goodwill.

(b)    Unwinding the discount
$18m x 10% = $1.8m

For the next three years the discount will be unwound, taking the interest to finance cost until the full $24 million payment is made in Year 3.

$000

Cost

X

Add: Share of increase in net assets

X

Less: Impairment loss

(X)

X

6.2

Definitions

(a)       Joint arrangements are defined as arrangements where two or more parties have joint control, and that this will only apply if the relevant activities require unanimous consent of those who collectively control the arrangement. They may take the form of either joint operations or joint ventures. The key distinction between the two forms is based on the parties’ rights and obligations under the joint arrangement.
(b)       Joint operations are defined as joint arrangements whereby the parties that have joint control have rights to the assets and obligations for the liabilities. Normally, there will not be a separate entity established to conduct joint operations.

HKFRS 11 requires that joint operators each recognize their share of assets, liabilities, revenues and expenses of the joint operation over which they have rights and obligations. This may consist of maintaining a joint operation account to record transactions undertaken on behalf of the joint operation, together with balances due to or from other parties to the joint operation.

Example:
A and B decide to enter into a joint operation to produce a new product. A undertakes one manufacturing process and B undertakes the other. A and B have agreed that decisions regarding the joint operation will be made unanimously and that each will bear their own expenses and take an agreed share of the sales revenue from the product.
(c)       Joint ventures are defined as joint arrangements whereby the parties have joint control of the arrangement and have rights to the net assets of the arrangement. This will normally be established in the form of a separate entity to conduct the joint venture activities. The equity method of accounting must be used in this situation.

Example:
A and B decide to set up a separate entity, C, to enter into a joint venture. A will own 55% of the equity capital of C, with B owning the remaining 45%. A and B have agreed that decision-making regarding the joint venture will be unanimous. Neither party will have direct right to the assets, or direct obligation for the liabilities of the joint venture; instead, they will have an interest in the net assets of entity C set up for the joint venture.
(d)       Joint control is defined as contractually agreed sharing of control of an arrangement which exists only when the decisions about the relevant activities require the unanimous consent of the parties sharing control. The key aspects of joint control are described as follows:
(i)        Contractually agreed – contractual arrangements are usually, but not always, written, and provide the terms of the arrangement.
(ii)       Control and relevant activities – HKFRS 10 describes how to assess whether a party has control, and how to identify the relevant activities.
(iii)      Unanimous consent – exists when the parties to an arrangement have collective control over the arrangement and no single party has control.