Question 2.4 – Nature of consolidation adjustments (Section 2.3)
Repeating investment elimination entry when consolidating in every reporting period
The investment elimination entry is repeated in consolidation worksheets in each successive reporting period, because consolidation worksheet adjusting entries do not carry forward from one reporting period to the next, as they are not posted to the accounts of either the parent entity or its subsidiaries. At each reporting/consolidation date, the consolidation commences with the accounts of the parent entity, and its subsidiaries at that date, (which do not include the consolidation adjusting entries of previous reporting periods). Where consolidation worksheet adjusting entries from the previous reporting period are still relevant in the current reporting period, such as the investment elimination entry, they are repeated in the current period consolidation.
During an accounting period between reporting dates, each entity in the group maintains its own separate accounting records by recording all transactions it engages in, including any transactions with other entities in the group. At the end of the reporting period, each entity in the group prepares its own financial statements. The completed financial statements of each entity in the group, is the starting point for the preparation of consolidated financial statements.
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The group as a whole has no separate accounting records, and in particular has no ledger. Consolidation worksheet adjusting entries are prepared at the end of each reporting period, and posted to the consolidation worksheet, which is used to prepare consolidated financial statements.
Question 2.5 – Pre-acquisition versus post-acquisition equities (Section 2.3)
Pre-acquisition equity of a subsidiary
Pre-acquisition equity of a subsidiary is the issued capital, reserves, and retained earnings (or accumulated losses) of the subsidiary at acquisition date. Acquisition date of a subsidiary is the date the parent entity obtains control of the subsidiary
The pre-acquisition equity of a subsidiary includes:
1) the equity recorded by the subsidiary in its separate accounting records on acquisition date; and
2) the equity of the subsidiary existing on acquisition date, but not recorded by the subsidiary in its
accounting records. Unrecorded equity arises from:
a) differences between the recorded values of assets and liabilities in the subsidiary’s accounts at
acquisition date, and their fair value at acquisition date; and
b) the existence of identifiable assets and liabilities of the subsidiary, which are not recorded in
the subsidiary’s accounts at acquisition date.
Therefore, the pre-acquisition equity of the subsidiary is the equity which represents the fair value of the subsidiary’s identifiable net assets at acquisition date.
Post-acquisition equity of a subsidiary
The post-acquisition equity of a subsidiary is the change in the subsidiary’s equity after acquisition date until consolidation date. The post-acquisition equity consists of:
1) the retained profits or accumulated losses of the subsidiary, (i.e. profits and/or losses less dividends/profit distributions), from acquisition date to consolidation date; and
2) movements in reserves, (e.g. revaluations of property, plant and equipment recorded directly in the revaluation surplus), from acquisition date to consolidation date.
Significance of the distinction between pre-acquisition equity and post-acquisition equity to the consolidation process
The pre-acquisition equity of the subsidiary is eliminated upon consolidation against the parent entity’s investment in subsidiary asset, in the investment elimination entry. Any difference between the pre-acquisition equity and the cost of the investment in subsidiary is recognised as goodwill or gain on bargain purchase in the consolidated accounts. Therefore the pre-acquisition equity of the subsidiary is not part of the consolidated equity reported in the consolidated financial statements.
The post-acquisition equity of the subsidiary, after any necessary consolidation adjustments to eliminate the effect of intragroup transactions, is included in the consolidated equity reported in the consolidated financial statements. These post-acquisition profit and losses, are included in consolidated profit or loss, and consolidated equity, because these profits are earned and losses incurred by the subsidiary, while the subsidiary is part of the group. Similarly, post-acquisition movements in reserves are included in consolidated total comprehensive income, and consolidated equity, because these movements in reserves occurred, while the subsidiary is part of the group.
Question 2.6 – Cost of investment in subsidiary (Section 2.4.1)
Measuring the cost of investment in a subsidiary
The cost of a parent entity’s investment in a subsidiary is measured as the fair value at acquisition date of the consideration transferred by the parent to acquire the investment in subsidiary. The consideration is the sum of the acquisition date fair values of the assets transferred by the parent, the liabilities incurred by the parent to the former owners of the subsidiary, and the equity interests issued by the parent (AASB3.37).
Treatment of each item
The following items should be included in the cost of the acquirer company’s investment in the target company:
1) The fair value of shares in the acquirer company issued to target company shareholders
Explanation: The shares issued by the acquirer company forms part of the consideration paid by the acquirer for its investment in the target company. The shares issued by the acquirer are included in the cost of acquisition of the acquirer’s investment in the target company by measuring the shares at their fair value at acquisition date. The best evidence of the fair value of the acquirer’s shares is their quoted market price at acquisition date. If the acquirer is not listed on a stock exchange, or the quoted price is considered to be unreliable, other valuation techniques must be used to estimate the fair value of the acquirer’s shares, such as prices in recent arm’s length transactions, discounted cash flows, option pricing models;
2) The fair value of probable additional shares in the acquirer company, the acquirer is required to issue to target company shareholders two years after acquisition date, if the market value of the acquirer’s shares is below $5.50 on that date
Explanation: The contingent consideration, the additional shares the acquirer may be required to issue two years after acquisition date, forms part of the consideration paid by the acquirer for its investment in the target company (AASB3.39). The probable number of additional shares expected to be issued by the acquirer is included in the cost of acquisition of the acquirer’s investment in the target company by measuring the additional shares at their fair value at acquisition date. The fair value of the probable additional shares is measured by discounting the expected market value of the additional shares two years after acquisition date to their present value at acquisition date. [The effect of discounting should be material as the probable additional shares will be issued two years after acquisition date];
3) The fair value of debt obligations of the target company assumed by the acquirer company – only if the debt obligations are owed by the target company to the former shareholders of the target company
Explanation: The debt obligations of the target company owed to its former shareholders, which is assumed by the acquirer company, forms part of the consideration paid by the acquirer for its investment in the target company. The assumption by the acquirer of debt obligations of the target company owed to the former shareholders of the target company is part of the contract to purchase shares in the target company between the acquirer and the former shareholders of the target company. The debt obligations of the target company are included in the cost of acquisition of the acquirer’s investment in the target company by measuring the debt obligations at their fair value at acquisition date. The fair value of the debt obligations is measured by discounting the future cash payments to present value at acquisition date; and
9) The fair value of unsecured notes issued by the acquirer company to target company shareholders
Explanation: The unsecured notes issued by the acquirer company forms part of the consideration paid by the acquirer for its investment in the target company. The unsecured notes issued by the acquirer are included in the cost of acquisition of the acquirer’s investment in the target company by measuring the unsecured notes at their fair value at acquisition date. The fair value of the unsecured notes is measured by discounting the future cash payments to present value at acquisition date.
The following items should not be included in the cost of the acquirer company’s investment in the target company:
3) The fair value of debt obligations of the target company assumed by the acquirer company –
if the debt obligations of the target company are not owed to the former shareholders of the target company
Explanation: The debt obligations of the target company, which are not owed to its former shareholders, and is assumed by the acquirer company, does not form part of the consideration paid by the acquirer for its investment in the target company. The assumption by the acquirer of
debt obligations of the target company owed to other entities, does not involve the former shareholders of the target company, and therefore is not part of the contract to purchase shares in the target company between the acquirer and the former shareholders of the target company. The assumption by the acquirer of debt obligations of the target company owed to other entities is a transaction between the acquirer and the target company;
4) Stamp duty payable on acquisition of target company shares
Explanation: The stamp duty payable on acquisition of target company shares does not form part of the consideration paid by the acquirer for its investment in the target company. The stamp duty payable is an acquisition related cost, which AASB3.53 requires to be expensed in the period incurred;
5) Accounting fees for a due diligence report on the target company
Explanation: The accounting fees for a due diligence report on the target company does not form part of the consideration paid by the acquirer for its investment in the target company. The accounting fees is an acquisition related cost, which AASB3.53 requires to be expensed in the period incurred;
6) Costs incurred by a department in the parent entity formed to facilitate the acquisition of the target company
Explanation: The costs incurred by a department in the parent entity, formed to facilitate the acquisition of the target company, do not form part of the consideration paid by the acquirer for its investment in the target company. The costs incurred by the department are an acquisition related cost, which AASB3.53 requires to be expensed in the period incurred;
7) Borrowing costs incurred on debt used to finance the acquisition of the target company Explanation: The borrowing costs incurred on debt used to finance the acquisition of the target company do not form part of the consideration paid by the acquirer for its investment in the target company. The borrowing costs are a finance cost, which is required to be expensed in the period it is incurred;
8) Allocation of director’s fees for time spent on the acquisition of the target company Explanation: The portion of director’s fees attributable to the time spent by directors on the acquisition of the target company does not form part of the consideration paid by the acquirer for its investment in the target company. If additional director’s fees are incurred due to time spent on the acquisition of the target company, the additional director’s fees are an acquisition related cost, which AASB3.53 requires to be expensed in the period incurred. Alternatively, if no additional directors fees are incurred due to the acquisition of the target company, the directors fees are not an acquisition related cost, but the directors fees are still expensed in the period incurred; and
10) Redundancy costs payable to employees of the target company as part of a planned restructuring of the target company
Explanation: The redundancy costs payable to employees of the target company as part of a planned restructuring of the target company does not form part of the consideration paid by the acquirer for its investment in the target company. The redundancy costs payable to employees, does not involve the former shareholders of the target company, and therefore is not part of the contract to purchase shares in the target company between the acquirer and the former shareholders of the target company.
The redundancy costs payable should not be recognised as part of target company’s net identifiable assets purchased by the acquirer at acquisition date, because the redundancy costs the acquirer expects to incur, but is not obliged to incur, are not liabilities at acquisition date (AASB3.10 and 3.11). Subsequent to acquisition date, the acquirer must recognise a liability for redundancy costs payable in the consolidated financial statements, when the acquirer has detailed formal plan for restructuring, and the acquirer has raised a valid expectation that it will implement the restructuring plan by commencing to implement the restructuring plan, or announcing its main features to those affected by it (AASB137.72).
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