Accounting Update on Business Combinations and Consolidation 28 June 2005

Transcription

1 Accounting Update on Business Combinations and Consolidation 28 June 2005 Lam CFA FCCA FCPA(Practising) MBA MSc BBA CPA(US) Introduction An entity shall consider whether all of its financial assets in respect of another entity demonstrate Control Joint Control Significant Influence Subsidiary (HKFRS 3 and and HKAS 27) 27) Joint Venture (HKAS 31) 31) Associate (HKAS 28) 28) Financial Asset (HKAS and and 39) 39) 1

2 Introduction HKFRS 3 replaces HKAS 22 (or SSAP 30) HKAS 27 amends SSAP 32 HKAS 31 amends SSAP 21 HKAS 28 amends SSAP 10 Subsidiary (HKFRS 3 and and HKAS 27) 27) Joint Venture (HKAS 31) 31) Associate (HKAS 28) 28) HKAS 36 and 38 are amended as a result of the above amendments Intangible Assets (HKAS 38) 38) Impairment of of Assets (HKAS 36) 36) Today s Agenda Key Issues HKFRS 3 Business Combinations Cases and Examples HKAS 27 Consolidated and Separate Financial Statements HKAS 31 Interests in Joint Ventures (Update Only) HKAS 28 Interests in Associates (Update Only) HKAS 36 and 38 Impairment of Assets & Intangible Assets (Update Only) 2

3 Business Combinations (HKFRS 3) 28 June 2005 Lam CFA FCCA FCPA(Practising) MBA MSc BBA CPA(US) Business Combinations Summary Use purchase method for all business combinations within the scope of HKFRS 3 Prohibit uniting of interests (or merger or pooling of interests) In applying the purchase method: Not amortise goodwill acquired in business combination Instead, test goodwill for impairment annually, or more frequently if required Recognise negative goodwill immediately in the income statement as a gain Recognise an intangible item acquired in a business combination as an asset separately from goodwill if it meets the requirements in HKFRS 3 Simultaneous revision in HKAS 36 and HKAS 38 Prohibit reversals of impairment losses for goodwill Not amortise intangible asset with an indefinite; but test impairment annually, or more frequently if required 3

4 Objective To specify the financial reporting by an entity when it undertakes a business combination In particular, HKFRS 3 specifies that all business combinations should be accounted for by applying the purchase method Therefore, the acquirer: a) recognises the acquiree s identifiable assets, liabilities and contingent liabilities at their fair values at the acquisition date, and b) recognises goodwill, which is subsequently tested for impairment rather than amortised Objective Scope Method of accounting Application of the method Disclosure To specify the financial reporting by an entity when it undertakes a business combination In particular, HKFRS 3 specifies that all business combinations should be accounted for by applying the purchase method Therefore, the acquirer: a) recognises the acquiree s identifiable assets, liabilities and contingent liabilities at their fair values at the acquisition date, and b) recognises goodwill, which is subsequently tested for impairment rather than amortised 4

5 Scope Scope Entities shall apply HKFRS 3 when accounting for business combinations, except for business combinations: a) in which separate entities or businesses are brought together to form a joint venture b) involving entities or businesses under common control c) involving two or more mutual entities d) in which separate entities or businesses are brought together to form a reporting entity by contract alone without the obtaining of an ownership interest (for example, to form a dual listed corporation) Scope Scope Business combination is defined as the bringing together of separate entities or businesses into one reporting entity. may result in a parent-subsidiary relationship in which the acquirer is the parent and the acquiree a subsidiary of the acquirer. In such circumstances, the acquirer applies HKFRS 3 in its consolidated financial statements. Parent is defined as an entity that has one or more subsidiaries. Subsidiary is defined as an entity, including an unincorporated entity such as a partnership, that is controlled by another entity (known as the parent). Control is defined as the power to govern the financial and operating policies of an entity or business so as to obtain benefits from its activities. 5

6 Method of Accounting Scope Method of accounting All business combinations shall be accounted for by applying the purchase method. Uniting of interest (pooling of interest or merger) method is no longer allowed. Purchase method views a business combination from the perspective of the combining entity that is identified as the acquirer. Application of the Method Scope Method of accounting Application of the method Applying the purchase method involves the following steps: a) Identifying an acquirer b) Measuring the cost of the business combination; and c) Allocating, at the acquisition date, the cost of the business combination to the assets acquired and liabilities and contingent liabilities assumed 6

7 Application of the Method a) Identifying an acquirer An acquirer shall be identified for all business combinations The acquirer is the combining entity that obtains control of the other combining entities or businesses Indication of control similar to the previous SSAP 30 Indication as an acquirer similar to the previous SSAP 30 HK incorporated company Definition of subsidiary still follows section 2(4) of the Companies Ordinance Application of the Method a) Identifying an acquirer Indication of Control Control is the power to govern the financial and operating policies of an entity or business so as to obtain benefits from its activities. Presumed to have control when an entity acquires more than onehalf of that other entity s voting rights, unless demonstrated contrary Even if no such voting rights, it might have control by obtaining: a) power over more than one-half of the voting rights of the other entity by virtue of an agreement with other investors; or b) power to govern the financial and operating policies of the other entity under a statute or an agreement; or c) power to appoint or remove the majority of the members of the board of directors or equivalent governing body of the other entity; or d) power to cast the majority of votes at meetings of the board of directors or equivalent governing body of the other entity. More in HKAS 27 7

8 Application of the Method a) Identifying an acquirer Indication as an Acquirer When 2 entities are combined in a business combination, the entity that is likely to be the acquirer would be: a) the entity with the greater fair value; b) the entity giving up cash or other assets (if the combination is effected through an exchange of voting ordinary equity instruments for cash or other assets); and c) the entity whose management is able so to dominate the resulting combined entity. Application of the Method a) Identifying an acquirer Indication as an Acquirer In a business combination effected through an exchange of equity interests, the entity that issues the equity interests is normally the acquirer. However, in some cases such as as reverse acquisitions, the acquirer is the entity whose equity interests have been acquired and the issuing entity is the acquiree. 8

9 Application of the Method a) Identifying an acquirer Example Reverse Acquisition Before Business Combination After Business Combinations Owner A Owner B Owner A Owner B 100% 100% 10% 90% Entity A Entity B Entity A acquires Entity B by issuing shares to Owner B Entity A 100% Entity B Legal Acquirer Acquirer under HKFRS 3 Which entity is the legal acquirer? Which entity is the acquirer under HKFRS 3? Application of the Method b) Measuring the cost of business combinations The acquirer shall measure the cost of a business combination as the aggregate of: a) the fair values, at the date of exchange, of i. assets given, ii. liabilities incurred or assumed, and iii. equity instruments issued by the acquirer, in exchange for control of the acquiree; plus b) any costs directly attributable to the business combination 9

10 Application of the Method b) Measuring the cost of business combinations A business combination may involve more than one exchange transaction (e.g. successive share purchases) When this occurs: a) the cost of the combination is the aggregate cost of the individual transactions; and b) the date of exchange is the date of each exchange transaction (i.e. the date that each individual investment is recognised in the financial statements of the acquirer) whereas the acquisition date is the date on which the acquirer obtains control of the acquiree Application of the Method b) Measuring the cost of business combinations If there is an adjustment to the cost of the combination contingent on future events the acquirer shall include the amount of that adjustment in the cost of the combination at the acquisition date if the adjustment is probable and can be measured reliably 10

11 Application of the Method Example On 3 September 2004, the CEO of YPC met Mr. Peter Chan, the major shareholder of HPC, and expressed their intention to acquire a controlling interest in HPC by a share offer of one YPC share for every three shares of HPC. The closing prices of shares HPC and YPC on that day were HK$0.15 and HK$0.60 respectively. The number of ordinary shares in issue of HPC and YPC were 600 million and 500 million, respectively. Assume the shareholders of HPC accept the offer and YPC has finally acquired a 55% interest in HPC. You are an accounting manager of YPC and you should determine the date of acquisition and the cost of acquisition. (HKICPA QP FPE 2004 Dec. Paper 1 Q3a) Application of the Method Example HKFRS 3 defines that that the the acquisition date date is is the the date date on on which the the acquirer effectively obtains control of of the the acquiree. In In assessing whether control has has effectively been transferred, the the substance of of the the acquisition needs to to be be considered. Control is is not not deemed to to have been transferred to to the the acquirer until until all all conditions necessary to to protect the the interests of of the the parties involved have been satisfied. In In general, YPC YPC will will assume control when the the consideration passes. Control may may also also be be deemed to to have been transferred when YPC YPC entered into into a legally enforceable contract with with the the shareholders of of HPC to to acquire a controlling interest from from him, him, or or when YPC s offer offer became unconditional after after securing more than than 50% 50% of of HPC s shares from from the the shareholders. 11

12 Application of the Method Example The The cost cost of of a business combination is is the the aggregate of: of: a) a) the the fair fair values, values, at at the the date date of of exchange, of of assets assets given, given, liabilities incurred or or assumed, and and equity equity instruments issued issuedby by the the acquirer, in in exchange for for control control of of the the acquiree; plus plus b) b) any any costs costs directly directly attributable to to the the business combination The The published price at at the the date date of of exchange of of a quoted equity instrument provides the the best best evidence of of the the instrument s fair fair value and and shall shall be be used, except in in rare rare circumstances. Other evidence and and valuation methods shall shall be be considered only only in in the the rare rare circumstances. Date of of exchange is is defined that, that, when a business combination is is achieved in in a single exchange transaction, the the date date of of exchange is is the the acquisition date date Therefore, the the cost cost of of acquisition of of HPC should be be the the fair fair value, at at the the date date of of acquisition, of of YPC s shares issued in in exchange for for HPC s shares plus plus any any costs directly attributable to to the the acquisition. Application of the Method c) Allocating to assets acquired and liabilities and contingent liabilities assumed At the acquisition date, the acquirer shall allocate the cost of a business combination by: recognising the acquiree s identifiable assets, liabilities and contingent liabilities that satisfy the recognition criteria at their fair values at that date, except for non-current assets (or disposal groups), that are classified as held for sale in accordance with HKFRS 5, which shall be recognised at fair value less costs to sell Any difference between a) the cost of the business combination and b) the acquirer s interest in the net fair value of the identifiable assets, liabilities and contingent liabilities so recognised shall be accounted for as goodwill or negative goodwill 12

13 Application of the Method c) Allocating to assets acquired and liabilities and contingent liabilities assumed Recognition criteria: 1. Asset 2. Liability 3. Contingent liability Application of the Method c) Allocating to assets acquired and liabilities and contingent liabilities assumed Recognition criteria: 1. Asset other than an intangible asset Probable that its future economic benefit will flow in Its fair value can be measured reliably 2. Liability other than a contingent liability Aligned with HKAS 37 Probable that an outflow of resources with economic benefit will be required to settle the obligation Its fair value can be measured reliably 3. Contingent liability or intangible asset Its fair value can be measured reliably Any special? 13

14 Application of the Method c) Allocating to assets acquired and liabilities and contingent liabilities assumed Implies that an in-process R&D project (cannot be recognised under HKAS 38) is recognised if the project meets The definition of an intangible asset (an identifiable non-monetary asset without physical substance) Meets identifiability criterion Separable, or Arises from contractual or other legal rights, and Its fair value can be measured reliably But subsequent expenditure follows HKAS 38 Probable criterion included in the fair value estimation 3. Contingent liability or intangible asset Its fair value can be measured reliably Any special? Application of the Method c) Allocating to assets acquired and liabilities and contingent liabilities assumed Under HKAS 37, contingent liability cannot be recognised Under HKFRS 3, contingent liability is recognised only if its fair value can be measured reliably After their initial recognition, the acquirer shall measure contingent liabilities that are recognised separately in accordance with HKFRS 3 at the higher of: a) the amount that would be recognised in accordance with HKAS 37, and b) the amount initially recognised less, when appropriate, cumulative amortisation recognised (in accordance with HKAS 18 Revenue) 3. Contingent liability or intangible asset Its fair value can be measured reliably Any special? 14

15 Application of the Method Example On 1 June 2005, Advance Corp. acquires Good Vision which is involved in researching medicine for SARS but the medicine has not been developed yet. The fair value of the research project on 1 June 2005 is HK$10 million. At year end 31 Dec. 2005, the development of the medicine has been started but the testing of the medicine has only been planned to start in 2nd quarter of Expenditure on the project from 1 June to 31 Dec is HK$ 1 million. At At date date of of acquisition, even the the development of of the the medicine has hasnot been started, Advance Corp. shall shall still still recognise the the fair fair value of of SARS medicine research project as as it it meets the the definition of of intangible asset and and the the fair fair value can can be be measured reliably. However, the the expenditure after after the the acquisition date date cannot be be recognised as as it it cannot fulfil fulfil the the recognition criteria in in HKAS Application of the Method c) Allocating to assets acquired and liabilities and contingent liabilities assumed Minority interest Any minority interest in the acquiree is stated at the minority s proportion of the net fair value of the identifiable assets, liabilities and contingent liabilities No choice (benchmark and alternative treatment) now 15

16 Application of the Method c) Allocating to assets acquired and liabilities and contingent liabilities assumed Goodwill Goodwill acquired in a business combination should be recognised as an asset and initially measured at its cost After initial recognition, goodwill shall be measured at cost less any accumulated impairment losses Goodwill acquired in a business combination shall not be amortised Instead, such goodwill should be tested for impairment annually, or more frequently if events or changes in circumstances indicate that it might be impaired (in accordance with HKAS 36) Application of the Method c) Allocating to assets acquired and liabilities and contingent liabilities assumed Negative goodwill No name for negative goodwill now If goodwill is negative, the acquirer shall: a) reassess the identification and measurement of the acquiree s identifiable assets, liabilities and contingent liabilities and the measurement of the cost of the combination; and b) after that reassessment, recognise immediately in profit or loss any excess remaining (negative goodwill) 16

17 Application of the Method c) Allocating to assets acquired and liabilities and contingent liabilities assumed Business combination achieved in stages When it involves more than one exchange transaction (e.g. occurs in stages by successive share purchases) each exchange transaction shall be treated separately by the acquirer, using the cost of the transaction and fair value information at the date of each exchange transaction, to determine the amount of any goodwill associated with that transaction. results in a step-by-step comparison of the cost of the individual investments with the acquirer s interest in the fair values of the acquiree s identifiable assets, liabilities and contingent liabilities at each step Before qualifying as a business combination, a transaction may qualify as an investment in an associate and be accounted for in accordance with HKAS 28 Investments in Associates using the equity method Application of the Method d) Initial accounting determined provisionally The initial accounting for a business combination involves identifying and determining: a) the fair values to be assigned to the acquiree s identifiable assets, liabilities and contingent liabilities, and b) the cost of the combination. If the initial accounting for a business combination can be determined only provisionally by the end of the period in which the combination is effected because either a) the fair values to be assigned to the acquiree s identifiable assets, liabilities or contingent liabilities or b) the cost of the combination can be determined only provisionally, the acquirer shall account for the combination using those provisional values. 17

18 Application of the Method d) Initial accounting determined provisionally The acquirer shall recognise any adjustments to those provisional values as a result of completing the initial accounting: a) within 12 months of the acquisition date; and b) from the acquisition date. Therefore: i) the carrying amount of an identifiable asset, liability or contingent liability that is recognised or adjusted as a result of completing the initial accounting shall be calculated as if its fair value at the acquisition date had been recognised from that date. ii) goodwill or negative goodwill shall be adjusted from the acquisition date by an amount equal to the adjustment to the fair value at the acquisition date of the identifiable asset, liability or contingent liability being recognised or adjusted. iii) comparative information presented for the periods before the initial accounting for the combination is complete shall be presented as if the initial accounting had been completed from the acquisition date. Application of the Method Case HKEX (2004 Annual Report) Early adopted all new and revised HKFRS and HKAS The early adoption of HKFRS 3, HKAS 36 and HKAS 38 has resulted in a change in the accounting policy for goodwill. Prior to this, goodwill was: amortised on a straight-line basis over a period of not exceeding 20 years; and assessed for impairment at each balance sheet date. In accordance with the provisions of HKFRS 3: the Group ceased amortisation of goodwill from 1 January 2003; accumulated amortisation as at 31 December 2002 has been eliminated with a corresponding decrease in the cost of goodwill; from the year ended 31 December 2003 onwards, goodwill is tested annually for impairment, as well as when there are indications of impairment. 18

19 Disclosure Scope Method of accounting Application of the method Disclosure The disclosure requirements of HKFRS 3 are mainly 3 areas and should enables users of its financial statements to evaluate the nature and financial effect of business combinations that were effected: a) during the period b) after the balance sheet date but before the financial statements are authorised for issue the financial effects of gains, losses, error corrections and other adjustments recognised in the current period that relate to business combinations changes in the carrying amount of goodwill during the period Disclosure Scope Method of accounting Application of the method Disclosure When a HK incorporated company acquires an enterprise which would be a subsidiary as defined in HKFRS 3 but is not accounted for as a subsidiary as a result of section 2(4) of the HK Companies Ordinance it should disclose in the notes details of the effect on the group accounts had the enterprise be accounted for as a subsidiary under HKFRS 3 19

20 Impact Case HSBC assessed that the impact of those changes from IFRS 3 would be high Its US SEC filing further stated that: Goodwill recorded at 31 December 2003 will be the subject of impairment testing thereafter. In the event of impairment, the absence of previous amortisation is likely to lead to larger impairment charges than would have been required under UK GAAP. The cessation of goodwill amortisation will impact the income statement. Impact Case The acquisition of HK Telecom in 2000 Consideration HK$ 225 billion Goodwill 172 billion Impairment loss in billion (more than half of the consideration was impaired immediately) At that time, the impairment loss was not reflected in the income statement of that year In future, the impairment should be reviewed annually (or more frequently) and reflected in the income statement in that year 20

21 Consolidated and Separate Financial Statements (HKAS 27) 28 June 2005 Lam CFA FCCA FCPA(Practising) MBA MSc BBA CPA(US) Consolidated and Separate Financial Statements Main Issues Scope Presentation of Consolidated Financial Statements Scope of Consolidated Financial Statements Consolidation Procedures Separate Financial Statements Disclosure HK Incorporate Companies 21

22 Scope HKAS 27 Consolidated and Separate Financial Statements shall be applied in the preparation and presentation of consolidated financial statements for a group of entities under the control of a parent. Consolidated financial statements are the financial statements of a group presented as those of a single economic entity. A group is a parent and all its subsidiaries. HKAS 27 shall also be applied in accounting for investments in subsidiaries, jointly controlled entities and associates when an entity elects, or is required by local regulations, to present separate financial statements Presentation of Consolidated Financial Statements A parent, other than a parent descried below, shall present consolidated financial statements in which it consolidates its investments in subsidiaries in accordance with HKAS 27. A parent is an entity that has one or more subsidiaries. A subsidiary is an entity, including an unincorporated entity such as a partnership, that is controlled by another entity (known as the parent). A parent need not present consolidated financial statements if and only if: a) the parent is a wholly-owned subsidiary, or is a partially-owned subsidiary of another entity and its other owners do not object such non-presenting b) the parent s debt or equity instruments are not traded in a public market; c) the parent did not file, nor is it in the process of filing, its financial statements with a regulatory organization for issuing instruments in a public market; and d) the ultimate or any intermediate parent of the parent produces consolidated financial statements available for public use that comply with HKFRSs or IFRSs. 22

23 Presentation of Consolidated Financial Statements Section 124(2) of the HK Companies Ordinance permits a holding company not to prepare group accounts if the company is a whollyowned subsidiary of another company at the end of its financial year. Accordingly, a HK incorporated parent company can only take advantage of the exemption of HKAS 27 if it also satisfies the exemption allowed under the above section. Scope of Consolidated Financial Statements Consolidated financial statements shall include all subsidiaries of the parent. As amended by HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations: If on acquisition a subsidiary meets the criteria to be classified as held for sale in accordance with HKFRS 5, it shall be accounted for in accordance with HKFRS 5 (not HKAS 27) It implies that Control intended to be temporary should still meet HKFRS 5 Control of an entity, which is operating under severe long-term restrictions that significantly impair its ability to transfer funds to the parent, is no longer a reason to exclude a subsidiary As defined, a subsidiary is an entity, including an unincorporated entity such as a partnership, that is controlled by another entity (known as the parent) Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities Refer to KPMG s notes What is is Control? 23

24 Scope of Consolidated Financial Statements Control Control is presumed to exist when the parent owns, directly or indirectly, more than half of the voting power of an entity unless, in exceptional circumstances, it can be clearly demonstrated that such ownership does not constitute control. Control also exists when the parent owns half or less of the voting power of an entity when there is: a) power over more than half of the voting rights by virtue of an agreement with other investors; b) power to govern the financial and operating policies of the entity under a statute or an agreement; c) power to appoint or remove the majority of the members of the board of directors or equivalent governing body and control of the entity is by that board or body; or d) power to cast the majority of votes at meetings of the board of directors or equivalent governing body and control of the entity is by that board or body. Similar to HKFRS 3 What is is Control? Scope of Consolidated Financial Statements Control Dutch Motorcycles B.V. will exchange in Nov its 100% interest in BVI Holdings for 100,000 ordinary shares in HKCL. HKCL is currently a wholly owned subsidiary of Dutch Motorcycles B.V. It is incorporated under HK Companies Ordnance but has remained dormant since its incorporation. The group structure before and after the proposed share exchange is as follows: Before the share exchange Example After the share exchange BVI Holdings Shenzhen Motorcycles Dutch Motorcycles BV 100% 100% 80% HKCL Write a memorandum to Mr. Wong addressing HKCL s obligation to prepare consolidated financial statements for the year ending 31 December (From CPA QP FPE) Dutch Motorcycles BV 100% HKCL HKCL 100% BVI Holdings 80% Shenzhen Motorcycles 24

25 Scope of Consolidated Financial Statements Control Example Main Points HKCL is is incorporated in in Hong Kong under the the Co. Co. Ordinance HKCL is is the the parent of of BVI BVI Holdings and and Shenzhen Motorcycles. A group is is required to to lay lay group accounts, in in the the form form of of consolidated financial statements. Co. Co. Ordinance a wholly-owned subsidiary, like like HKCL, not not have to to prepare consolidated financial statements. Under HKAS 27, 27, HKCL controls BVI BVI Holdings and and Shenzhen Motorcycles and and is is required to to prepare consolidated financial statements in in accordance with with HKAS HKAS also also exempts a parent to to prepare consolidated financial statements but but there are are more restrictions and and additional disclosures required. Scope of Consolidated Financial Statements Control Potential voting rights refer to the situation that an entity may own share warrants, share call options and other instruments that are convertible into ordinary shares, or other similar instruments that have the potential, if exercised or converted, to give the entity voting power or reduce another party s voting power of another entity. Potential voting rights that are currently exercisable or convertible are considered when assessing control. Potential voting rights are not currently exercisable or convertible when, for example, they cannot be exercised or converted until a future date or until the occurrence of a future event. In assessing whether potential voting rights contribute to control, the entity examines all facts and circumstances that affect potential voting rights, except the intention of management and the financial ability to exercise or convert. What is is Control? 25

26 Scope of Consolidated Financial Statements Control Loss of of Control When a parent loses the power to govern the financial and operating policies of an investee It can occur with or without a change in absolute or relative ownership levels It could occur, for example, when a subsidiary becomes subject to the control of a government, court, administrator or regulator It could also occur as a result of a contractual agreement What is is Control? Scope of Consolidated Financial Statements Control Special Purpose Entities An entity may be created to accomplish a narrow and well-defined objective. Such a special purpose entity (SPE) may take the form of a corporation, trust, partnership or unincorporated entity. The sponsor or creator frequently transfers assets to the SPE, obtains the right to use assets held by the SPE or performs services for the SPE. An entity that engages in transactions with an SPE may in substance control the SPE. A beneficial interest in an SPE may, for example, take the form of a debt or equity instrument, a participation right, a residual interest or a lease. Some beneficial interests may simply provide the holder with a fixed or stated rate of return, while others give the holder rights or access to other future economic benefits of the SPE s activities What is is Control? 26

27 Scope of Consolidated Financial Statements Control Special Purpose Entities HKAS 27 requires the consolidation of entities that are controlled by the reporting entity. Thus, an SPE should be consolidated when the substance of the relationship between an entity and the SPE indicates that the SPE is controlled by that entity. What is is Control? Scope of Consolidated Financial Statements Control Special Purpose Entities The followings, for example, may indicate a relationship in which an entity controls an SPE and consequently should consolidate the SPE: a) in substance, the activities of the SPE are being conducted on behalf of the entity according to its specific business needs so that the entity obtains benefits from the SPE s operation; b) in substance, the entity has the decision-making powers to obtain the majority of the benefits of the activities of the SPE or, by setting up an autopilot mechanism, the entity has delegated these decision making powers; c) in substance, the entity has rights to obtain the majority of the benefits of the SPE and therefore may be exposed to risks incident to the activities of the SPE; or d) in substance, the entity retains the majority of the residual or ownership risks related to the SPE or its assets in order to obtain benefits from its activities. What is is Control? 27

28 Scope of Consolidated Financial Statements Control Example 49.97% Is it Control or Significant Influence? Why not over 50%? Scope of Consolidated Financial Statements Control Subsidiary excluded from consolidation A subsidiary is NOT excluded from consolidation because the investor is a venture capital organisation, mutual fund, unit trust or similar entity. its business activities are dissimilar from those of the other entities within the group. Relevant information is provided by consolidating such subsidiaries and disclosing additional information in the consolidated financial statements about the different business activities of subsidiaries. For example, the disclosures required by HKAS 14 Segment Reporting help to explain the significance of different business activities within the group. What is is Control? 28

29 Scope of Consolidated Financial Statements Control Example A proposal is set out for Sport, a HK incorporated company, to subscribe a US$9,420,000 convertible debenture ( CD ) issued by PT Sincere. The main features of the CD are as follows: 1. The CD is a ten-year convertible debenture, carrying a coupon rate of 8% p.a. in arrears; 2. The CD is convertible to PT Sincere s equity shares at any time from the date of issue to the maturity date at the following conversion price per share: Conversion price = [(Audited net profit after tax) x 8 Outstanding amount] / 1.5 Million Sporty has the right to appoint PT Sincere s President (who is equivalent to the Chairperson of the Board of Directors) and two out of the remaining five vicepresidents (who are equivalent to a director) until the maturity of the CD. In accordance with PT Sincere s articles, the President has a casting vote at board meetings if there is a tie in the votes cast by the six presidents. Assume that Sporty decided to invest in PT Sincere and chose to subscribe to the convertible debenture on 5 January Explain how should the investment be classified and accounted for in Sporty s consolidated financial statements for the year ending 30 September (CPA QP FPE 2003 Dec Paper I Q3) Scope of Consolidated Financial Statements Control Example Main Points Sporty is is incorporated in in HK HK subject to to the the Co. Co. Ordinance, It It only only has has a right right to to appoint half half of of the the directors of of PT PT Sincere. Thus, it it does not not control the the board of of PT PT Sincere. Even the the right right to to acquire a controlling interest under the the convertible option, it it does not not control more than than half half of of the the voting power. HKAS defines using the the control concept, broader than than Co. Co. Ord. Ord. Since Sporty has has the the right right to to appoint half half of of the the directors and and the the President, who who has has a casting vote, it it is is a strong indication that that Sporty in in substance controls PT PT Sincere under the the HKAS The The call call option under the the CD CD implies potential voting rights under HKAS In In short, PT PT Sincere is is not not a subsidiary of of Sporty under the the Co. Co. Ord., but but is is a subsidiary of of Sporty under HKAS Accounting treatments 29

30 Consolidation Procedures General procedures In preparing consolidated financial statements, an entity combines the financial statements of the parent and its subsidiaries line by line by adding together like items of assets, liabilities, equity, income and expenses. In consolidation, the following steps are taken: a) the carrying amount of the parent s investment in each subsidiary and the parent s portion of equity of each subsidiary are eliminated (see HKFRS 3, which describes the treatment of any resultant goodwill); b) minority interests in the profit or loss of consolidated subsidiaries for the reporting period are identified; and c) minority interests in the net assets of consolidated subsidiaries are identified separately from the parent shareholders equity in them. Minority interests in the net assets consist of: i) the amount of those minority interests at the date of the original combination calculated in accordance with HKFRS 3; and ii) the minority s share of changes in equity since the date of the combination. Consolidation Procedures Entity A acquired 80% of Entity X at year end by issuing 1,600 shares of HK$1 each and their financial statements are set out below: A X Non-current assets Property, plant & equipment 1,500 2,000 Current assets Inventories Cash at bank Current liabilities Account payables (100) (600) Line by Line Consol Example 3, (700) Net current assets Net assets 1,600 2,000 3,600 Share capital Reserves 1,500 1,800 1,600 2,000 Minority interest (Assume fair value = carrying amount) (3,600 x 20%) 1,700 1,500 3, ,600 30

31 Consolidation Procedures General procedures When potential voting rights exist the proportions of profit or loss and changes in equity allocated to the parent and minority interests are determined on the basis of present ownership interests and do not reflect the possible exercise or conversion of potential voting rights. Consolidation Procedures Intragroup balances, transactions, income and expenses Intragroup balances, transactions, income and expenses shall be eliminated in full. Examples include: Income, expenses and dividends Profits and losses resulting from intragroup transactions that are recognised in assets, such as inventory and fixed assets Intragroup losses may indicate an impairment that requires recognition in the consolidated financial statements. HKAS 12 Income Taxes applies to temporary differences that arise from the elimination of profits and losses resulting from intragroup transactions 31

32 Consolidation Procedures Same example: Entity A sold inventories at a price of HK$100 to Entity X with a margin of 20% and X immediately disposed of goods of HK$60. A X Non-current assets Property, plant & equipment 1,500 2,000 Current assets Inventories Cash at bank Current liabilities Account payables (100) (600) ( ) Unrealised profit = 40 x 20% = $8 Line by Line Consol 3, (700) Example Net current assets Net assets 1,600 2,000 3,592 Share capital Reserves 1,500 1,800 1,600 2,000 Minority interest (Assume fair value = carrying amount) (1,500-8) 1,700 1,492 3, ,592 Consolidation Procedures Same reporting date of parent and subsidiaries The financial statements of the parent and its subsidiaries used in the preparation of the consolidated financial statements Shall be prepared as of the same reporting date. When the reporting dates are different, the subsidiary prepares additional financial statements as of the same date as the financial statements of the parent unless it is impracticable to do so. When the financial statements of a subsidiary used in the preparation of consolidated financial statements are prepared as of a reporting date different from that of the parent adjustments shall be made for the effects of significant transactions or events that occur between that date and the date of the parent s financial statements. In any case, the difference between the reporting date of the subsidiary and that of the parent shall be no more than 3 months. The length of the reporting periods and any difference in the reporting dates shall be the same from period to period. 32

33 Consolidation Procedures Uniform accounting policies Consolidated financial statements shall be prepared using uniform accounting policies for like transactions and other events in similar circumstances. If different accounting policies are adopted for like transactions and events in similar circumstances, appropriate adjustments are made to its financial statements in preparing the consolidated financial statements Consolidation Procedures Income and expenses of a subsidiary Included in the consolidated financial statements from the acquisition date, as defined in HKFRS 3. until the date on which the parent ceases to control the subsidiary. The difference between the proceeds from the disposal of the subsidiary and its carrying amount as of the date of disposal, including the cumulative amount of any exchange differences that relate to the subsidiary recognised in equity (per HKAS 21) is recognised in the consolidated income statement as the gain or loss on the disposal of the subsidiary. 33

34 Consolidation Procedures Minority Interests (MI) MI is that portion of the profit or loss and net assets of a subsidiary attributable to equity interests that are not owned, directly or indirectly through subsidiaries, by the parent MI shall be presented in the consolidated balance sheet within equity, separately from the parent shareholders equity MI in the profit or loss of the group shall also be separately disclosed Consolidation Procedures Entity A acquired 80% of Entity X at year end by issuing 1,600 shares of HK$1 each and their financial statements are set out below: A X Non-current assets Property, plant & equipment 1,500 2,000 Current assets Inventories Cash at bank Current liabilities Account payables (100) (600) Line by Line Consol 3, (700) Example Net current assets Net assets 1,600 2,000 Share capital Reserves 1,500 1,800 1,600 2,000 Minority interest 100 3,600 1,700 1,500 3, ,600 34

35 Consolidation Procedures Minority Interests (MI) Losses applicable to the minority in a consolidated subsidiary may exceed the minority interest in the subsidiary s equity. The excess, and any further losses applicable to the minority, are allocated against the majority interest except to the extent that the minority has a binding obligation and is able to make an additional investment to cover the losses. If the subsidiary subsequently reports profits, such profits are allocated to the majority interest until the minority s share of losses previously absorbed by the majority has been recovered If a subsidiary has outstanding cumulative preference shares that are held by minority interests and classified as equity the parent computes its share of profits or losses after adjusting for the dividends on such shares, whether or not dividends have been declared Consolidation Procedures Cease to be a Subsidiary An investment in an entity shall be accounted for in accordance with HKAS 39 from the date that it ceases to be a subsidiary provided that it does not become an associate as defined in HKAS 28 or a jointly controlled entity as described in HKAS 31. (HKAS 27 para. 31) The carrying amount of the investment at the date that the entity ceases to be a subsidiary shall be regarded as the cost on initial measurement of a financial asset in accordance with HKAS 39 35

36 Separate Financial Statements Separate financial statements are those presented by a parent, an investor in an associate or a venturer in a jointly controlled entity, 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 investees. The financial statements of an entity that does not have a subsidiary, associate or venturer s interest in a jointly controlled entity are not separate financial statements. Same requirements apply to entities having associates or jointly controlled entities elect to present separate financial statements Separate Financial Statements When separate financial statements are prepared investments in subsidiaries, jointly controlled entities and associates (that are not classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with HKFRS 5) shall be accounted for either: At At cost or In In accordance with HKAS The same accounting shall be applied for each category of investments. Investments in subsidiaries, jointly controlled entities and associates that are classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with HKFRS 5 shall be accounted for in accordance with HKFRS 5 36

37 Separate Financial Statements When separate financial statements are prepared investments in subsidiaries, jointly controlled entities and associates (that are not classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with HKFRS 5) shall be accounted for either: At At cost or In In accordance with HKAS Investment is recognised at cost Recognise income from the investment only to the extent that the investor receives distributions from accumulated profits of the investee arising after the date of acquisition Distributions received in excess of such profits are regarded as a recovery of investment and are recognised as a reduction of the cost of the investment Investments in jointly controlled entities and associates that are accounted for in accordance with HKAS 39 in the consolidated financial statements shall be accounted for in the same way in the investor s separate financial statements Disclosure In Consolidated Financial Statements The following disclosures shall be made: a) the nature of the relationship between the parent and a subsidiary when the parent does not own, directly or indirectly through subsidiaries, more than half of the voting power; b) the reasons why the ownership, directly or indirectly through subsidiaries, of more than half of the voting or potential voting power of an investee does not constitute control; c) the reporting date of the financial statements of a subsidiary when such financial statements are used to prepare consolidated financial statements and are as of a reporting date or for a period that is different from that of the parent, and the reason for using a different reporting date or period; and d) the nature and extent of any significant restrictions (e.g. resulting from borrowing arrangements or regulatory requirements) on the ability of subsidiaries to transfer funds to the parent in the form of cash dividends or to repay loans or advances. 37

38 Disclosure In Separate Financial Statements When separate financial statements are prepared for a parent that elects not to prepare consolidated financial statements, those separate financial statements shall disclose: a) the fact that the financial statements are separate financial statements; that the exemption from consolidation has been used; the name and country of incorporation or residence of the entity whose consolidated financial statements that comply with HKFRSs or IFRSs have been produced for public use; and the address where those consolidated financial statements are obtainable; b) a list of significant investments in subsidiaries, jointly controlled entities and associates, including i) the name, ii) country of incorporation or residence, iii) proportion of ownership interest and, iv) if different, proportion of voting power held; and c) a description of the method used to account for the investments listed under (b). Disclosure In Separate Financial Statements When a parent (other than a parent discussed before), venturer with an interest in a jointly controlled entity, or an investor in an associate prepares separate financial statements, those separate financial statements shall disclose: a) the fact that the statements are separate financial statements and the reasons why those statements are prepared if not required by law; b) a list of significant investments in subsidiaries, jointly controlled entities and associates, including i) the name, ii) country of incorporation or residence, iii) proportion of ownership interest and, iv) if different, proportion of voting power held; and c) a description of the method used to account for the investments listed under (b); and shall identify the financial statements prepared in accordance with paragraph 9 of HKAS 27, HKAS 28 and HKAS 31 to which they relate. 38

39 HK Incorporated Companies Section 2(4) of the HK Companies Ordinance has a different definition on subsidiary HK incorporated company may not consolidate a company that does not meet the definition of a subsidiary in the HK Companies Ordinance In preparing consolidated financial statements of a HK incorporated company, only companies that fall within the definition of a subsidiary as set out in section 2(4) of the HK Companies Ordinance may be consolidated. When a HK incorporated company holds an entity which would be a subsidiary as defined in HKAS 27 but is not accounted for as a subsidiary as a result of the HK Companies Ordinance, it should disclose in the notes details of the effect on the consolidated financial statements had the requirements of HK Companies Ordinance not applied. Interests in Joint Ventures (HKAS 31) 28 June 2005 Lam Lam CFA FCCA FCPA(Practising) MBA MSc BBA CPA(US) 39

40 Forms of Joint Venture A joint venture is a contractual arrangement whereby 2 or more parties undertake an economic activity that is subject to joint control. HKAS 31 identifies 3 broad types of joint ventures : Jointly controlled operations Jointly controlled assets Jointly controlled entities The following characteristics are common to all joint ventures: a) 2 or more venturers are bound by a contractual arrangement; and b) the contractual arrangement establishes joint control. Jointly Controlled Entities Recognition of jointly controlled entities: A venturer shall recognise its interest in jointly controlled entity using either Proportionate Consolidation An entity has a choice or Equity Method When proportionate consolidation is used, one of the two reporting formats identified in HKAS 31 shall be used. 40

41 Jointly Controlled Entities Recognition of jointly controlled entities: Proportionate Consolidation a method of accounting whereby a venturer s share of each of the assets, liabilities, income and expenses of a jointly controlled entity is combined line by line with similar items in the venturer s financial statements, or reported as separate line items in the venturer s financial statements A venturer recognises its interest in a jointly controlled entity using one of the two reporting formats for proportionate consolidation irrespective of whether it also has investments in subsidiaries or whether it describes its financial statements as consolidated financial statements. Jointly Controlled Entities Recognition of jointly controlled entities: Proportionate Consolidation When recognising an interest in a jointly controlled entity, it is essential that a venturer reflects the substance and economic reality of the arrangement, rather than the joint venture s particular structure or form. In a jointly controlled entity, a venturer has control over its share of future economic benefits through its share of the assets and liabilities of the venture. The application of proportionate consolidation means that the balance sheet of the venturer includes its share of the assets that it controls jointly and its share of the liabilities for which it is jointly responsible. The income statement of the venturer includes its share of the income and expenses of the jointly controlled entity. 41