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consolidations
This article is aimed primarily at candidates studying consolidations
for Paper 2.5, Financial Reporting. It will also benefit candidates
studying for Paper 3.6, Advanced Corporate Reporting.
Recent examination performance on the Paper 2.5 consolidation
question (always Question 1) has shown that most candidates have a
sound understanding of basic consolidation techniques. This article looks
at some of the more difficult areas, where candidates often experience
problems, namely: fair values of consideration and adjustments to
an acquired subsidiarys identifiable assets, liabilities and contingent
liabilities; elimination of intra-group trading and other transactions;
and goodwill impairment. It is based on relevant International Financial
Reporting Standards (IFRSs), but much of it is also relevant to other
adapted papers, including those based on UK GAAP.
FAIR VALUE ADJUSTMENTS
In calculating goodwill, and the initial carrying amount of acquired assets
and liabilities, IFRS 3, Business Combinations requires that both the
consideration paid by the parent company (or parent) and the net assets
of the acquired subsidiary are valued at their fair values. Fair value is
defined (in several IFRSs) as the amount for which an asset could be
exchanged, or a liability settled, between knowledgeable and willing
parties in an arms length transaction. Consideration paid may be in
the form of assets given (normally cash), liabilities assumed, or shares
or other financial instruments issued by the acquirer, plus any direct
costs attributable to the business combination. The relevance of this
requirement has previously been examined in the following ways:
Determining the number of shares a parent issues in an acquisition
(usually on the basis of a specified share exchange), and applying
the stock market price of the parents shares at the date of the
acquisition. Often the question will say that the share issue has not
yet been recorded in the parents financial statements. Candidates
will therefore have to record both an increase in the nominal value of
the parents share capital and any premium (determined by the stock
market value) on the issue.
problem areas in group accounts
relevant to Professional Scheme Papers 2.5 and 3.6
Occasionally, cash consideration may be deferred (ie not paid at the
date of acquisition) to a specified date after the acquisition. Where
this period is significant (usually one or more years) the amount of
the cash consideration will need to be discounted to a present value,
at the rate for cost of capital given in the question. Candidates often
manage to determine the present value of such consideration, but
then fail to account for the unwinding of the discounted amount, or
fail to show the liability in the balance sheet. In the period after the
acquisition, the parent should accrue a finance charge (at the rate of
the cost of capital) in its income statement (which is consolidated),
and add this to the carrying amount of the deferred consideration (a
liability) in its balance sheet (which is also consolidated).
The most common form of fair value adjustment is that made to the
assets of the acquired subsidiary. The amount of the required adjustment
is normally given in the question. The simplest of these adjustments
would be to a non-depreciating, non-current asset (normally land). The
amount of the adjustment should be added to the carrying amount of
the asset (as it appears in the subsidiarys books), and the total included
in the consolidated balance sheet (think of this as a debit entry). The
amount of the adjustment should also be included in the calculation of
goodwill (the equivalent of a credit entry, similar to creating a revaluation
reserve). Note sometimes in practice (but not in a Paper 2.5
examination question) a subsidiary will actually revalue its assets to fair
values (in its entity financial statements) prior to consolidation, to assist
the consolidation process. This is sometimes referred to as push down
accounting, whereby the fair values determined by the parent are pushed
down into the subsidiarys books.
Where a fair value adjustment relates to a depreciating non-current
asset, the above technique is also performed, but there is a further
complication. In the post-acquisition period, the depreciation of acquired
assets must be based on their fair values. In the subsidiarys own
(entity) financial statements, depreciation will have been based on the
assets carrying amount. Thus the consolidated financial statements will
require a fair value depreciation adjustment. The amount of this may be
given in the question, or candidates may have to calculate it based on
the remaining life (and depreciation policy) at the date of acquisition.
The amount of this adjustment (assuming the fair value is greater than
the carrying amount) reduces both the subsidiarys post-acquisition
profits (which will also affect any minority interests) and the carrying
amount of the asset.
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Inventories may also require fair value adjustments. Raw materials
and bought-in components are normally valued at their replacement cost;
finished goods should be valued at net selling price less a reasonable profit
allowance. It is also possible (but not common in Paper 2.5 examination
questions) that liabilities will require fair value adjustments. This may be
as simple as recognising a liability that the subsidiary had not accounted
for (eg an account payable inadvertently not recorded by the subsidiary),
or the restatement of a loan to fair value due to a change in interest rates
since it was taken out. A further complication is that IFRS 3 requires the
recognition of any contingent liabilities of the subsidiary, provided they
can be reliably measured. Such liabilities would not be recognised in the
subsidiarys financial statements, other than by way of a note. The IASB
recognises that this requirement creates an inconsistency with IAS 37,
Provisions, Contingent Liabilities and Contingent Assets.
EXAMPLE 1
Holdrite purchased 80% of the issued share capital of Staybrite on
1 April 2005. Details of the purchase consideration given at the date of
purchase are:
a share exchange of three shares in Holdrite for every five shares in
Staybrite
the issue to the shareholders of Staybrite 8% loan notes, redeemable
at par on 31 March 2008 on the basis of $100 loan note for every
125 shares held in Staybrite
a cash sum of $121 for every 100 shares in Staybrite, payable on
1 April 2007. Holdrites cost of capital is 10% per annum.

The market price of Holdrites shares at 1 April 2005 was $4.50 per
share. In order to help fund the acquisition of new operating capacity
for Staybrite, Holdrite also subscribed for a 10% $4m loan note (2008)
issued by Staybrite immediately after the acquisition. A fair value exercise
was carried out at the date of acquisition of Staybrite, with the following
results:
Carrying amount Fair value
$000 $000
Land 20,000 23,000
Plant 25,000 30,000
Inventory 5,000 6,000
The fair values have not been reflected in Staybrites financial
statements.
In addition, a note to Staybrites financial statements gave details
of a contingent liability in respect of outstanding litigation. The directors
of Holdrite considered that $5m would be a reliable measurement of
this contingent liability. The details of each companys share capital and
reserves at 1 April 2005 are:
Holdrite Staybrite
$000 $000
Equity shares of $1 each 20,000 10,000
Share premium 5,000 4,000
Retained earnings 18,000 8,000

Required
Calculate the goodwill arising on the acquisition of Staybrite.
Answer
Goodwill in Staybrite:
$000 $000 $000
Consideration
Shares
(10,000 x 80% x 3/5 x $4.50) 21,600
8% loan notes
(10,000 x 80% x $100/125) 6,400
Deferred cash payment
($9,680/1.21 see below) 8,000
36,000
Less
Equity shares 10,000
Share premium 4,000
Pre-acquisition reserves 8,000
Less contingent liability (5,000) 3,000
Fair value adjustment
(3,000 + 5,000 +1,000) 9,000
26,000 x 80%
(20,800)
Goodwill 15,200
The gross cash consideration will be $9,680 (10,000 x 80%/100 x
$121). If $1 was invested for two years, carrying an interest rate of
10%, it would be worth $1.21.
Note: the 10% loan note issued after acquisition is not part of the
consideration.
INTRA-GROUP ADJUSTMENTS
The objective of consolidated financial statements is to present the
results of the parent and all the entities over which it has control (ie a
group) as if they were a single entity.
It follows from this that an entity cannot trade with itself, nor
make a profit from any transaction within the group. Thus any
intra-group transactions need to be eliminated (cancelled) as part of
the consolidation process. This article will consider the most common
examples of such transactions: intra-group sales, the transfer of
non-current assets, and the provision of loans.
Intra-group sales
If one member of a group sells goods to another, these sales are recorded
by the seller in revenue, and by the purchaser in cost of sales at the
same amount (the transfer price). Provided the purchaser has sold on
the goods to an entity that is not a member of the group, it is a simple
matter to eliminate the intra-group sale from revenue and cost of sales
(at the same amount) when consolidating the income statements. This
elimination would have no effect on the balance sheet. Occasionally,
candidates eliminate the selling price from revenue and the cost price
from cost of sales this is incorrect.
A problem arises when some of the goods from the intra-group sale are
still in the inventory of the purchasing company at the year end. As these
goods have not left the group, any profit added by the supplying company
has not been realised and must therefore be eliminated. Once the amount
of the unrealised profit has been determined, it is deducted from gross
profit (by increasing cost of sales) and also deducted from the carrying
amount of the consolidated inventory on the balance sheet. This deduction
reduces the balance sheet value of the inventory to the cost of the group.
Occasionally, a non-current asset is transferred within the group (say
from a parent to a subsidiary). The parent may have manufactured the asset
as part of its normal production (and therefore included the sale in revenue),
or it may have transferred an asset previously used as part of its own
non-current assets. If the transfer is done at cost (which is probably unlikely
in an examination question), then the first example would be equivalent to
a company constructing its own non-current asset. The required elimination
would therefore be to remove the cost of the asset from both revenue and
cost of sales. In the second example, no elimination would be required.
The situation is also complicated if the transfer contains a profit
element. In its entity financial statements, the parent would report this
profit in its income statement. This would be either as a normal sale or as
a profit on disposal if it represented the transfer of a non-current asset. The
consequences in the subsidiarys financial statements are that the carrying
amount of the asset would be overstated (in terms of cost to the group),
and future depreciation charges would also be overstated (when compared
to depreciation based on cost to the group). At the date of sale/transfer,
the profit is unrealised, and in financial statements prepared at this date,
the profit would be eliminated from the (parents) income statement (and
retained earnings) and from the carrying amount of the asset.
The adjustment required in subsequent years is more complex.
Instinctively, one might eliminate the whole of the profit from the
parents retained profits and the carrying amount of the asset (the same
adjustment as on the date of the sale/transfer). A further adjustment
might then be made to increase the subsidiarys profit by the excess
depreciation, recorded in the income statement and retained earnings
(this would also affect any minority interests), and also to increase the
carrying amount of the asset by this amount. Some commentators and
textbooks use this method and it will be marked as correct. However, it
should be understood that depreciation is effectively a measure of the
realisation of an asset. Thus, in subsequent accounting periods, it is only
the unrealised profit left in the carrying amount of the asset that should
be eliminated from the parents profit, and from the carrying amount of
the asset. Both methods give the same carrying amount for the asset, but
the excess depreciation that was added back to the subsidiarys profit in
the first method is instead netted off the initial amount of the unrealised
profit, before being deducted from the parents profits. As well as being
more conceptually correct, the second method is easier to apply.
Intra-group loans
It is quite common for a parent to provide a loan to a subsidiary on which
interest will usually be paid and received. The parent will normally show
the loan as an investment, with any interest received included in its income
statement. Conversely, the subsidiary will show the loan as a non-current
liability (assuming repayment is due in more than one years time), and
will show any interest paid as a financing cost in its income statement. It
is a relatively simple matter to eliminate the asset (investment) against the
liability (loan) in the consolidated balance sheet, and the interest received
against the interest paid in the consolidated income statement. One point
to watch out for is that a subsidiary may have issued, for example, $5m
of loan notes of which the parent has purchased only $3m. In these
circumstances, only the $3m (and the proportionate interest) should be
eliminated. Thus, the consolidated financial statements would show a loan
of only $2m together with proportionate interest paid (ie the amounts that
relate to parties outside the group).
EXAMPLE 2
Continuing the group situation in Example 1. In the post-acquisition
period, Holdrite sold goods to Staybrite for $72,000. Holdrite achieved a
mark-up on these goods of 20% on cost. At the year end, Staybrite still
had $42,000 (at the transfer price) of these goods in its inventory.
On 1 April 2005, Holdrite sold an item of plant to Staybrite for
$120,000. Holdrite had manufactured this plant at a cost of $100,000
and treated it as a normal sale. Staybrite is depreciating this plant on a
straight-line basis over a five-year life with no estimated residual value.
On 1 October 2005, Staybrite issued a $2m 8% (actual and effective
rate) loan note, redeemable in 2010. Holdrite had subscribed for
$800,000 of this issue. All due interest had been paid by 31 March 2006.
Required
Using the journal format, show the adjustments required for the above
transactions when preparing the consolidated financial statements for
the year ended 31 March 2006.
Answer
Dr Cr
$ $
Revenue 72,000
Cost of sales 72,000
Elimination of intra-group sales:
Profit (made by Holdrite) 7,000
Inventory 7,000
Elimination of URP from inventory (of Staybrite):
A mark-up of 20%
(ie 1/5th on cost) is equivalent to 1/6th
on selling price, therefore unrealised
profit (URP) is $42,000/6 = $7,000
Revenue 120,000
Cost of sales 100,000
Depreciation charge 4,000
Non-current assets plant 16,000
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Elimination of the sale and cost of sale (effectively own costs have been
capitalised as a non-current asset). Reduction of carrying amount of the
plant by the URP over the remaining life of the plant (20,000/5 years x
4 years). Reduction of depreciation to be based on cost to group. Note:
in the balance sheet, the effect of the first three entries relating to the
plant in the income statement will reduce group retained earnings by
$16,000.

Dr$ Cr$
8% loan note (non-current liability) 800,000
Investments 800,000
Interest received 32,000
Interest paid 32,000
Elimination of intra-group investment/loan and related interest (ie
8% on $800,000 for six months). Note: after these adjustments, the
consolidated balance sheet will show 8% loan notes of $1.2m, and the
income statement will include interest paid of $48,000.
Tutorial note
Although the above answers are framed as journal entries, it should
be appreciated that they are not actual journal entries. Consolidated
adjustments are merely workings they do not exist in any companys
books.
GOODWILL IMPAIRMENT
IFRS 3, Business Combinations changed the required subsequent
accounting treatment for consolidated goodwill. Prior to its introduction,
many companies amortised goodwill over its estimated useful life (a
practice still continued in many jurisdictions, including the UK). IFRS 3
prohibited amortisation of goodwill in favour of an annual impairment
test, which may be applied more frequently, if there are indications of
impairment. The detailed procedures for impairment testing of goodwill are
contained in IAS 36, Impairment of Assets. Many Paper 2.5 examination
questions may simply say how much (if any) the goodwill impairment is,
or possibly express it as a percentage of the goodwill (a rather contrived
scenario). It is a simple matter to account for a given impairment loss; it is
charged to the income statement (normally as an operating expense), and
credited to the carrying amount of goodwill on the balance sheet.
It is useful to consider the process of testing for goodwill in a little
more depth. Any asset is said to be impaired if its carrying amount is
more than its recoverable amount. Goodwill generates cash flows in
combination with other assets these are known as cash generating
units or CGUs. The impairment test must be done by comparing the
carrying amount of the CGU containing the goodwill with its recoverable
amount. For a consolidation question, the simplest form of CGU would
be the assets of an acquired subsidiary (note: liabilities do not normally
form part of a CGU). IFRS 3 has an interesting view of goodwill where
there is a minority interest. It says that the traditional goodwill calculated
on consolidation represents only the goodwill owned by the parent, and
that there also exists (but is not recognised) a proportionate amount of
goodwill relating to the minority. Thus, when determining any impairment
to a CGU, it is necessary to gross up the recognised goodwill in
respect of any minority interest. The grossed up goodwill is referred to
as notional goodwill. Following this concept, IFRS 3 argues that the
(determined) recoverable amount of a CGU is based on all its assets, and
therefore should be compared to the carrying amount of all the CGUs
assets (which must include the unrecognised minority share of goodwill).
It is interesting to note that this thinking has been carried through
in an exposure draft of amendments to IFRS 3, which proposes actual
recognition of the minority interest (in future to be called non-controlling
interest) share of goodwill when preparing a consolidated balance sheet.
Once determined, an impairment loss must first be allocated to
goodwill (based on the notional amount), then any remaining loss
allocated pro rata to the CGUs other assets. If the amount of the
impairment loss is less than the notional goodwill, the remaining goodwill
balance is reduced by the minority interest percentage prior to it being
reported in the consolidated balance sheet.
EXAMPLE 3
At 31 March 2006, the following information is available for two CGUs:
CGU 1 CGU 2
$m $m
Goodwill 90 60
Other assets 140 120
Minority interest 25% 40%
Recoverable amount 180 90
Required
Show the assets of the CGUs after impairment testing.
Answer
CGU 1 CGU 2
$m $m
Goodwill 30 nil
Other assets 140 90
CGU 1
The goodwill of $90m relates to a controlling interest of 75%: unrecorded
goodwill relating to the minority interest would therefore be $30m
(90/75% x 25%), giving notional goodwill of $120m, and notionally
adjusted assets of $260m ($120m + $140m other assets). This gives
an impairment loss of $80m ($260m - $180m recoverable amount).
The whole of this loss would be allocated to goodwill, leaving a balance
of $40m ($120m - $80m). When preparing the balance sheet after the
impairment, the $40m is reduced to $30m reflecting only the parents
share (75%) of the goodwill.
Note: the net assets are now shown at $170m ($30m goodwill +
$140m other assets), which appears to be below the recoverable amount
of $180m. However, there is $10m of unrecognised goodwill relating to
the minority interest.
CGU 2
A similar analysis to that applied to CGU 1 would give a notional
goodwill figure of $100m ($60m/60%) and a notional carrying amount
of all assets of $220m ($100m + $120m other assets). This means
the impairment loss for CGU 2 is $130m ($220m - $90m recoverable
amount). $100m of this amount would be allocated to goodwill
(reducing it to zero) and the other assets would be written down to
$90m ($120m - $30m remaining loss). This $30m would be applied
pro rata to each of the asset groups (property, plant etc) that make up
the other assets.
The issues discussed in this article are summarised in Example 3.

EXAMPLE 3
Highveldt, a public listed company, acquired 75% of Samsons ordinary
shares on 1 April 2005. The purchase consideration consisted of:
a share exchange of one share in Highveldt for two shares in
Samson. The market price of Highveldt shares at the date of
acquisition was $4 each
an immediate $1.75 per share in cash
a further amount of $81m payable on 1 April 2006. Highveldts cost
of capital is 8% per annum.
Highveldt has only recorded the consideration of $1.75 per share.
The summarised balance sheets of the two companies at 31 March
2006 are shown below:
Highveldt Samson
$m $m $m $m
Tangible non-current assets 570 380
Investments 150 nil
720 380
Current assets 130 90
Total assets 850 470
Share capital and reserves:
Ordinary shares of $1 each 270 80
Reserves:
Share premium 80 40
Revaluation reserve 40 nil
Retained earnings
1 April 2005 160 120
year to 31 March 2006 190 350 101 221
740 341
Non-current liabilities
10% loan note nil 60
Current liabilities 110 69
Total equity and liabilities 850 470
The following information is relevant:
i Highveldt has a policy of revaluing land and buildings to fair value.
At the date of acquisition, Samsons land and buildings had a
fair value of $20m in excess of their carrying amounts, and at
31 March 2006 this had increased by a further $4m (ignore any
additional depreciation).
ii Samson had established a line of products under the brand name of
Titanware. Acting on behalf of Highveldt, a firm of specialists had
valued the brand name at $40m with an estimated life of 10 years as
at 1 April 2005. The brand is not included in Samsons balance sheet.
iii Immediately after acquisition, Highveldt sold Samson an item of
plant for $15m that it had manufactured at a cost of $10m. The
plant had an estimated life of five years (straight-line depreciation)
and no residual value.
iv On 1 October 2005 Samson issued $60m 10% (actual and effective
rate) loan notes. Highveldt subscribed for $20m of this issue.
Samson has not paid any interest on this loan, but it has recorded
the amount due as a current liability. Highveldt has also accrued for
its interest receivable on this loan.
v Post-acquisition, Samson sold goods at a price of $18m to Highveldt;
$5m of these goods were still in the inventory of Highveldt at
31 March 2006. Samson applied a mark-up on cost of 25% to these
goods.
vi A post-acquisition impairment test on the notionally-adjusted
consolidated goodwill (ie the goodwill relating to the parent and the
minority interest) concluded that it should be written down by $20m.
Required
Prepare the consolidated balance sheet of Highveldt at 31 March 2006.
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Answer
Consolidated balance sheet of Highveldt at 31 March 2006
$m
Tangible non-current assets (570 + 380 + 24 - 4 URP) (w (4)) 970
Intangible non-current assets:
Brand (40 - 4) 36
Consolidated goodwill (w (1)) 60
Investments (150 - 105 cash - 20 loan note) 25
1,091
Current assets (130 + 90 - 1 URP (w (2)) - 1 intra-group interest) 218
Total assets 1,309

Share capital and reserves:
Ordinary shares of $1 each (270 + 30 (w (1))) 300
Reserves:
Share premium (80 + 90 (w (1))) 170
Revaluation reserve (w (3)) 43
Retained earnings (w (4)) 396
909

Minority interest (w (2)) 101
1,010
Non-current liabilities:
10% loan note (60 - 20 intra-group) 40
Current liabilities (110 + 69 - 1 intra-group interest) 178
Deferred consideration (75 + 6 (w (1))) 81
Total equity and liabilities 1,309

Workings
(1) Goodwill calculation $m $m
Investments at cost
Share exchange (80 x 75%/2 x $4) 120
Immediate cash (80 x 75% x $1.75) 105
Deferred consideration (see below) 75
300
Less
Ordinary shares 80
Share premium 40
Pre-acquisition profit 120
Fair value adjustments: brand (see below) 40
land and buildings 20
300 x 75% (225)
Goodwill on acquisition 75
Impairment (see below) (15)
60
The $120m share issue would be recorded as share capital of $30m
(30m x $1), and share premium of $90m (30m x $3).
The deferred consideration of $81m must be discounted for one year,
at the cost of capital of 8%, to $75m (81/1.08). The $6m difference is
the accrued finance charge for the year to 31 March 2006.
Although the internally-generated brand cannot be recognised in
Samsons entity financial statements, it should be recognised in the
consolidated balance sheet on the acquisition of Samson. This is because
the valuation process, as described in the question, is an acceptable
method of reliable measurement.
The fair value adjustment for Samsons land and buildings on
acquisition is $20m. The subsequent increase in value of $4m, in the
year to 31 March 2006, is treated as a revaluation.
As Highveldt only acquired 75% of Samson, the goodwill of $75m
would be grossed up to $100m. This is impaired by $20m, down
to $80m, but only 75% of this (ie $60m) would be shown in the
consolidated balance sheet. In effect, Highveldts goodwill is impaired by
$15m.
(2) Minority interest $m
Ordinary shares 80
Share premium 40
Retained earnings (221 - 1 URP see below) 220
Fair values at acquisition (40 + 20) 60
Post-acquisition revaluation of land and buildings 4
404 x 25%
= 101
There are $5m of goods in inventory at 31 March 2006. The URP on
these goods is $1m (5 x 25%/125%).
(3) Revaluation reserve: (40 + (75% x 4)) 43
(4) Retained earnings
Highveldt from question 350
Post acquisition Samson (101 - 1 URP see above) x 75% 75
Finance cost on deferred consideration (see below) (6)
URP in sale of plant (4)
Amortisation of brand (40/10 years) (4)
Impairment of goodwill (15)
(19)
Retained earnings in consolidated balance sheet 396
At the date of sale, there is an unrealised profit of $5m ($15m - $10m)
on the plant sold by Highveldt to Samson.
By 31 March 2006, the remaining life of the plant is four years
out of an original five years. Thus 4/5ths of the URP (ie $4m) must be
eliminated from the carrying amount of the asset, and from Highveldts
profits.
Steve Scott is examiner for Paper 2.5