CHAPTER 9 RECONSTRUCTION SPECIALISED ENTITIES AND SPECIALISED TRANSACTIONS This is study guide entry E1a and E2a, b, c. An overview is more than enough for the above. You are not expected to know any unique quirks that might apply to unusual entities like government departments, charities or banks. But you are expected to know that all entities face similar accounting problems and all entities use the same IFRS to solve their problems. This is examined by placing the exam scenarios in an industry like retail, football, manufacture or charity. The examiner expects you to know that the answer is the same independent of the industry. You are also expected to be able to identify an entity that is struggling to survive. Further you should be aware of the classic reconstruction to avoid liquidation. This is the debt equity swap. A debt financier may accept equity in exchange for debt to help the borrower to survive a cash flow crisis. This was a favourite technique of governments during the recent financial crisis. The borrower simply moves the debt from liabilities into equity. 468
CHAPTER 9 RECONSTRUCTION GROUP RECONSTRUCTION An entity within a group with financial difficulties would demonstrate the following characteristics: 1. huge accumulated trading losses 2. huge unpaid loan interests 3. no dividends payout 4. the market lacks confidence in the company s future 5. late payment to suppliers and account payables To prevent liquidation, the parent would need to raise finance, namely Debt Finance and Equity Finance or to reorganise the group to streamline operations or to dispose a loss making subsidiary. Debt Finance The loan would be secured on the entities assets. This would result in increased finance cost and the cost of debt would be high. However, debt financing is only possible if the entity have assets to mortgage as securities. Equity Finance Assets are not reqired to be mortgaged in equity financing, thus, it may be suitable for entities that have little assets or have their assets fully mortgaged. Payment of dividends would be at the discretion of the directors subject to the availability of distributable profits i.e. credit balance in the retained earnings. If an entity has huge accumulated trading losses in its retained earnings, it would need to eliminate such losses in order to attract equity investors. 469
CHAPTER 9 RECONSTRUCTION Group Reorganisation 1. Transfer shares ownership among parent and subsidiaries Before: P S1 S2 After: P S1 S2 The group structure has changed from a Fellow Subsidiary to a Verticle Group in order to change the reporting structure and ease the Parent Company to having manage S1 and S2 directly. This is achieved by P transferring its shares in S2 to S1 at the existing carrying amount (not at market value). Alternatively, the group structure may be moved from a Vertcle Group (Tall Business Structure) to a Fellow Subsidiary (Flat Business Structure). The reason maybe Parent Company wish to exercise direct control over its subsidiaries. This is achieved by S1 issuing shares in S2 as dividends to P i.e. dividend in specie and the final group structure would be P owning shares and control both S1 and S2 directly. 470
CHAPTER 9 RECONSTRUCTION Before: P S1 S2 S3 After: P S1 S2 S3 As can be seen, share ownership in S3 has been transferred from S1 to S2 in the form of cash. Possible reasons are as follows: a. Parent Company intends to sell S1 but not S2. b. Parent Company intends to sell S2 and S3 as a disposal group but not S1. c. To group S2 and S3 together for management purposes as S2 and S3 may exist in the same industry or geaographical location. 471
CHAPTER 9 RECONSTRUCTION 2. Creating a new Parent Company Before: Shareholders S2 Private Limited After: Shareholder S1 Limited S2 Private Limited In this case, the individual shareholders are the founders of S2 which is a private company. As S2 expands, the shareholders may have the intention to gain access to public equity investments by flotation. Thus, S1, a clean company, is established as it is easier to prepare prospectus for public listing. This is achieved by S1 issuing its own shares to the shareholders in exchange of S2 shares. 3. Divisionalisation Before and after: P S1 S2 In divisionalisation, the group structure remains the same but the Net Asset and Trade of S2 have been transferred to S1 leaving S2 to be dormant company without assets and trade. Shares are not transferred among P, S1 and S2 who continue to exist as legal entities. 472
CHAPTER 9 RECONSTRUCTION Decany (Dec 2011 Q2) Decany owns 100% of the ordinary share capital of Ceed and Rant. All three entities are public limited companies. The group operates in the shipbuilding industry, which is currently a depressed market. Rant has made losses for the last three years and its liquidity is poor. The view of the directors is that Rant needs some cash investment. The directors have decided to put forward a restructuring plan as at 30 November 2011. Under this plan: 1. Ceed is to purchase the whole of Decany s investment in Rant. The purchase consideration is to be $98 million payable in cash to Decany and this amount will then be loaned on a long-term unsecured basis to Rant; and 2. Ceed will purchase land with a carrying amount of $10 million from Rant for a total purchase consideration of $15 million. The land has a mortgage outstanding on it of $4 million. The total purchase consideration of $15 million comprises both five million non-voting shares issued by Ceed to Rant and the $4 million mortgage liability which Ceed will assume; and 3. A dividend of $25 million will be paid from Ceed to Decany to reduce the accumulated reserves of Ceed. The statements of financial position of Decany and its subsidiaries at 30 November 2011 are summarised below: Decany Ceed Rant $m $m $m Non-current assets Tangible non-current assets at depreciated cost/valuation 600 170 45 Cost of investment in Ceed 130 Cost of investment in Rant 95 Current assets 155 130 20 980 300 65 Equity and reserves Share capital 140 70 35 Retained earnings 750 220 5 890 290 40 Non-current liabilities Long-term loan 5 12 Current liabilities Trade payables 85 10 13 980 300 65 As a result of the restructuring, several of Ceed s employees will be made redundant. According to the detailed plan, the costs of redundancy will be spread over two years with $4 million being payable in one year s time and $6 million in two years time. The market yield of high quality corporate bonds is 3%. The directors feel that the overall restructure will cost $2 million. 473
CHAPTER 9 RECONSTRUCTION Required: (a) (i) Prepare the individual entity statement of financial position after the proposed restructuring plan; (13 marks) (ii) Set out the requirements of FRS 110 Consolidated Financial Statements as regards the reorganisation and payment of dividends between group companies, discussing any implications for the restructuring plan. (5 marks) (b) Discuss the key considerations of the proposed plans for the restructuring of the group. (5 marks) Professional marks will be awarded in part (b) for clarity and expression of your discussion. (2 marks) (25 marks) 474
CHAPTER 9 RECONSTRUCTION Group Reconstruction A, B, C, D (Dec 2004 Q2) The following statements of financial position relate to A, B, C and D, all public limited companies, as at 30 November 2011. A B C D $m $m $m $m Tangible non-current assets 1,700 1,000 500 300 Investment in B at cost 1,250 Investment in C at cost 800 Investment in D at cost 450 Net current assets 1,400 800 350 100 5,600 1,800 850 400 Equity Ordinary share capital 2,950 700 450 325 Retained earnings 2,650 1,100 400 75 5,600 1,800 850 400 A 1 billion shares; B 500 million shares; C 300 million shares; D 200 million shares The directors of A have decided to restructure the group at 30 November 2011 and have agreed upon the following plan: (i) A is to dispose of its holding in D to B in exchange for 110 million shares of B, plus a cash consideration of $50 million. The current value of the shares of the four companies is as follows as at 29 November 2011: $ A 6 B 3 85 C 2 90 D 2 10 (ii) Goodwill arising on consolidation was impairment tested at 30 November 2011. The impairment loss when allocated only affected goodwill. (iii) The following information is also relevant to the group reconstruction. The subsidiaries were all 100% owned by A at the date of the reconstruction and the acquisition details are set out below: Retained Fair value of Carrying value earnings at Date of net assets at of goodwill at Subsidiary acquisition acquisition acquisition 30 Nov 2011 after impairment test $m $m $m B 450 01/12/09 1,200 30 C 250 01/12/09 700 20 D 50 01/12/10 420 15 (iv) Any increase in the fair value of the net assets at acquisition is attributable to non-depreciable land. B, C and D have not issued any shares since acquisition other than the share issues proposed in the restructuring plan. 475
CHAPTER 9 RECONSTRUCTION (v) Local legislation requires shares issued on a reconstruction to be valued at nominal value and shares cannot be issued at a value that is less than their nominal value. Inter group transfers of investments should be made at their carrying value. Required (a) (i) Explain the impact of the group reconstruction on the individual accounts of A, B, C and D, showing suitable computations. (7 marks) (ii) Prepare the individual statement of financial position of A, B, C and D and a consolidated statement of financial position of the A group after the group reconstruction at 30 November 2011. (14 marks) (b) Prepare an analysis showing the composition of the group retained earnings of A at 30 November 2011 after the reconstruction. (4 marks) (25 marks) 476
P2 JUNE 2015 EXAM TIPS Section A Q1 (50 marks = 15 min reading time + 1.5 exam hour) Q1 Consolidated Statement of Financial Position (CSOFP) of: a. Complex Group with Foreign Subsidiary (Effective control and Dr NCI Cr COI for Vertical and D-Shaped Group) b. Disposal (Subsi to Subsi, Subsi to Assc) and Calculate gain (loss) on disposal when control is lost. Treasury transaction from Subsi to Subsi. c. Piecemeal Acquisition (AFS to Subsi, Subsi to Subsi) Fair value to equity previous COI of AFS when gained control. d. Full and Proportionate goodwill with impairment, fair value adjustments, inter-company sales, adjustments to Parent Co s books, errors of omission and correction of error adjustments. Or Consolidated Statement of Cash Flows (CSOCF) some chance of being tested To make up for 50 marks in Q1, the remaining 15 marks could be: - Corporate Governance, - Framework - Internal Control, - Ethics and - Sustainability & Environmental Reporting. Section B (25 marks each choose 2 from 3 = 45min per question including reading, planning and writing time) Please be familiar with all the following FRS before entering the exam hall: FRS 16 PPE on Cost Model, Revaluation Model and transfers from RR to RE FRS 20 Government Grants using deferral methods FRS 36 Impairment of a Group of Assets FRS 38 IA on recognition criteria and its measurements FRS 40 Investment Properties FRS 37 2 criteria on Provision for Restructuring, Onerous contract provision. FRS 32 Splitting of a Convertible Bond FRS 39 Hedge Accounting, Derivatives and Impairment of Financial Assets IFRS 9 Classification of financial assets and impairment FRS 18 Revenue recognition FRS 17 Finance Lease and Sales and Leaseback FRS 19 Defined Benefit Schemes FRS 12 - Deferred tax FRS 102 Equity & Cash-settled SBP FRS 105 2 criteria for NCA HFS and impairment before classification FRS 21 Foreign exchange gains and losses using matching principle The IIRC The Integrated Report (see Chapter 4) 3