Group Accounts under UK GAAP 9781526521484, 9781526521514, 9781526521507

This title provides accountants and auditors with easy to follow and well structured guidance on the preparation of grou

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English Pages [295] Year 2022

Table of contents :
Preface
Contents
Table of Statutes
Table of Statutory Instruments and Other Guidance
Table of Examples
Chapter 1. Introduction
Introduction
Interaction with other accounting standards
Purpose of consolidated financial statements
Company law requirements
Exemptions in company law
Exemptions available under FRS 102
Ineligible groups
Chapter 2. Overview of Consolidated Financial Statements and UK GAAP
Introduction
FRS 100
FRS 101
FRS 102
FRS 103
FRS 104
FRS 105
Small groups
FRS 102, Section 9 Consolidated and Separate Financial Statements
FRS 102, Section 19 Business Combinations and Goodwill
Chapter 3. Group Accounts: Introduction
Introduction
Definition and introduction to control
Loss of control
Acquisition of control
Group structures
Intra-group transactions and balances
Chapter 4. Fair Values and Deferred Tax in a Group
Introduction
Fair value of net assets acquired
Deferred tax and unremitted earnings
Chapter 5. The Consolidation Process
Introduction
Purchase method of accounting
Disclosure requirements
Chapter 6. Investments in Associates
Introduction
Scope of FRS 102 and FRS 105
Group issues
Definition of an associate and significant influence
Measurement – accounting policy election
Fair value models
Disclosure requirements
Chapter 7. Investments in Joint Ventures
Introduction
Defined terms
Types of joint venture under UK GAAP
Transactions between a venturer and a joint venture
Group issues
Investors that do not have joint control
Disclosures
Chapter 8. Acquisitions and Disposals of Interests
Introduction
Investment to associate
Associate to investment
Joint venture to associate
Subsidiary to subsidiary
Subsidiary to financial investment
Subsidiary to associate or joint venture
Partial disposal where control is retained
Deemed disposals
Chapter 9. Consolidated Cash Flow Statement
Introduction
Company law requirements
Overview of preparing the consolidated cash flow statement
Cash flows attributable to NCI
Cash received from and paid to associates
Subsidiaries
Foreign exchange gains and losses
Worked example incorporating the above technical issues
Thematic review of the cash flow statement
Chapter 10. Foreign Currency Issues
Introduction
Functional currency
Reporting foreign currency transactions in the functional currency
Presentation currency
Intra-group balances and transactions
Goodwill on acquisition of a foreign operation
Chapter 11. Group Reconstructions
Introduction
Merger accounting
Merger relief
Disclosures
Chapter 12. Auditing Groups
Introduction
Objectives of the group auditor
Acceptance
Planning the group audit
Reliance on the work of component auditors
Auditing investments in subsidiaries
Auditing the consolidation
Obtaining sufficient audit evidence
Communication with group management
Communication with those charged with governance of the group
Overseas subsidiaries
Support letters
Transnational audits
Documentation
Index

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Group Accounts under UK GAAP

ii

Group Accounts under UK GAAP Steve Collings FCCA

BLOOMSBURY PROFESSIONAL Bloomsbury Publishing Plc 50 Bedford Square, London, WC1B 3DP, UK 1385 Broadway, New York, NY 10018, USA 29 Earlsfort Terrace, Dublin 2, Ireland BLOOMSBURY and the Diana logo are trademarks of Bloomsbury Publishing Plc © Bloomsbury Professional 2022 All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage or retrieval system, without prior permission in writing from the publishers. While every care has been taken to ensure the accuracy of this work, no responsibility for loss or damage occasioned to any person acting or refraining from action as a result of any statement in it can be accepted by the authors, editors or publishers. All UK Government legislation and other public sector information used in the work is Crown Copyright ©. All House of Lords and House of Commons information used in the work is Parliamentary Copyright ©. This information is reused under the terms of the Open Government Licence v3.0 (http://www.nationalarchives.gov.uk/ doc/open-government-licence/version/3) except where otherwise stated. All Eur-lex material used in the work is © European Union, http://eur-lex.europa.eu/, 1998-2022. British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. ISBN: PB: 978 1 52652 148 4 ePDF: 978 1 52652 150 7 ePub: 978 1 52652 149 1 Typeset by Compuscript Ltd, Shannon

To find out more about our authors and books visit www.bloomsburyprofessional.com. Here you will find extracts, author information, details of forthcoming events and the option to sign up for our newsletters

Preface This is the first edition of Group Accounts Under UK GAAP published by Bloomsbury Professional, which examines the core principles involved in preparing consolidated financial statements under UK and Irish Generally Accepted Accounting Practice. The aim of this book is to provide concise and practical guidance on the application of UK GAAP and relevant company law to assist preparers of consolidated financial statements in correctly applying UK and Irish accounting standards and relevant company law. The author recognises that consolidated financial statements can be complicated, particularly when the group is diverse and has overseas entities which bring about foreign exchange complexities. In addition, some of the consolidation adjustments required to arrive at a set of consolidated financial statements can be difficult to apply in practice and so, where applicable, the book goes ‘back to basics’ and explains the reasons why certain adjustments are carried out rather than just assuming that this knowledge has been retained by the preparer. A lot of what accountants understand about technical areas such as consolidated financial statements is due to understanding why things are done in a certain way, rather than just carrying out processes because ‘… it has always been done like that in the past’. Accounting standards change over time and the way certain transactions are recorded in the consolidated financial statements, such as the acquisition of additional ownership in a pre-owned subsidiary, are not accounted for in the same way under FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland as they were under old UK GAAP. This is one of the many pitfalls that preparers need to avoid and hence a sound understanding of the requirements of UK GAAP and company law is essential when carrying out very technical work, such as the preparation of consolidated financial statements. This book is the first book published by Bloomsbury Professional on consolidated financial statements and my hope is that users will find it easy to use and informative. As a practitioner myself, I recognise the challenges faced by preparers in keeping up-to-date with developments in financial reporting and ensuring that financial statements (whether consolidated or separate) can stand up to scrutiny by the various regulators, including the professional bodies. To that end, this book goes back to basics in many areas, highlighting key concepts and explaining why things are done in a certain way. It uses examples throughout the text to highlight technical areas and reconciles various figures so that users can see exactly what is happening as the consolidation itself (or extract from the consolidation) is developed. Recalculation is a technique often used by auditors to obtain assurance that certain figures in financial statements (including consolidated financial

v

Preface statements) are correct and free from material misstatement, whether caused by fraud or error. The use of reconciliations throughout the text to highlight how figures have been derived is aimed to show auditors and accountants (including aspiring auditors and accountants) how to prove certain key figures in the consolidated financial statements. The use of ‘Focus’ boxes throughout the text aims to highlight key aspects relating to consolidated financial statements that readers must take on board to avoid the many pitfalls that can easily be fallen into when preparing a set of consolidated financial statements that aim to present a true and fair view. Many newly qualified accountants are trained in International Financial Reporting Standards (IFRS) under their relevant syllabuses by their professional body, rather than UK GAAP. There are some notable differences between IFRS and UK GAAP where consolidated financial statements are concerned, and certain chapters contain a summary of the differences between FRS 102 and IFRS at the end so that users can easily see what to look out for because the two regimes are not consistent in their requirements. For example, goodwill arising in a business combination under FRS 102 must be amortised on a systematic basis over its useful economic life; whereas under IFRS, goodwill is not amortised but is tested for impairment at each reporting date. Newly qualified accountants may not appreciate these differences (assuming that IFRS and UK GAAP are aligned in all respects) and so we felt it necessary to flag up certain key differences to avoid errors creeping into the consolidation. Another key feature of this title is the use of ‘Signposts’ at the start of each chapter. These are designed to highlight, at a glance, key aspects of a chapter. My hope is that you find this book useful and informative in your dealing with consolidated financial statements under UK GAAP. As always, comments are always welcome, via the publisher, for future editions of this book. My sincere thanks go to Diane Nichols BA FCA, who has carried out the technical review of this book and made some valuable suggestions to enhance the value of each chapter. My thanks also go to the editors, Dave Wright, Sarah Hastings and Claire Banyard for their help during the production of this book. Finally, I would like to thank all the rest of the team at Bloomsbury Professional for their help in bringing this book to market. Steve Collings FCCA April 2022

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Contents

Preface Table of Statutes Table of Statutory Instruments and Other Guidance Table of Examples

v xi xiii xxi

1 Introduction 1 Introduction1 Interaction with other accounting standards 3 Purpose of consolidated financial statements 4 Company law requirements 4 Exemptions in company law 9 Exemptions available under FRS 102 15 Ineligible groups 18 2

Overview of Consolidated Financial Statements and UK GAAP 23 Introduction23 FRS 100 25 FRS 101 25 FRS 102 32 FRS 103 34 FRS 104 35 FRS 105 36 Small groups 37 FRS 102, Section 9 Consolidated and Separate Financial Statements39 FRS 102, Section 19 Business Combinations and Goodwill40

3

Group Accounts: Introduction 43 Introduction43 Definition and introduction to control 44 Loss of control 46 Acquisition of control 46 Group structures 46 Intra-group transactions and balances 49

4

Fair Values and Deferred Tax in a Group 58 Introduction58 Fair value of net assets acquired 59 Deferred tax and unremitted earnings 62

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Contents 5

The Consolidation Process 72 Introduction72 Purchase method of accounting 91 Disclosure requirements 118

6

Investments in Associates 122 Introduction122 Scope of FRS 102 and FRS 105 123 Group issues 123 Definition of an associate and significant influence 124 Measurement – accounting policy election 127 Fair value models 133 Disclosure requirements 134

7

Investments in Joint Ventures 138 Introduction138 Defined terms 139 Types of joint venture under UK GAAP 140 Transactions between a venturer and a joint venture 145 Group issues 146 Investors that do not have joint control 147 Disclosures147

8

Acquisitions and Disposals of Interests 150 Introduction150 Investment to associate 151 Associate to investment 153 Joint venture to associate 154 Subsidiary to subsidiary 154 Subsidiary to financial investment 156 Subsidiary to associate or joint venture 158 Partial disposal where control is retained 159 Deemed disposals 160

9

Consolidated Cash Flow Statement 163 Introduction163 Company law requirements 166 Overview of preparing the consolidated cash flow statement 166 Cash flows attributable to NCI 169 Cash received from and paid to associates 171 Subsidiaries173 Foreign exchange gains and losses 175 Worked example incorporating the above technical issues 175 Thematic review of the cash flow statement 179

viii

Contents 10

Foreign Currency Issues 189 Introduction189 Functional currency 191 Reporting foreign currency transactions in the functional currency 194 Presentation currency 200 Intra-group balances and transactions 203 Goodwill on acquisition of a foreign operation 204

11

Group Reconstructions 207 Introduction207 Merger accounting 208 Merger relief 214 Disclosures215

12

Auditing Groups 217 Introduction217 Objectives of the group auditor 219 Acceptance220 Planning the group audit 220 Reliance on the work of component auditors 224 Auditing investments in subsidiaries 226 Auditing the consolidation 227 Obtaining sufficient audit evidence 231 Communication with group management 235 Communication with those charged with governance of the group 236 Overseas subsidiaries 236 Support letters 237 Transnational audits 238 Documentation239

Index243

ix

x

Table of Statutes [All references are to paragraph numbers]

Republic of Ireland

Companies Act 2006 – contd s 395(1)�� 2.34 s 399�� 1.4, 2.5 s 399–408�� 1.4 s 399(2A)�� 1.11, 2.10 s 399(2B)�� 2.10 s 400�� 1.8 s 400–402�� 2.5 s 400(1)(a), (b), (c)�� 1.8 s 400(2)�� 1.8 s 401�� 1.9, 1.11 s 401(1)(c)�� 1.11 s 401(2)(b)�� 1.9 s 402�� 1.10–1.11 s 405�� 1.10 s 405(3)�� 5.7 s 466(4)�� 1.4 s 467(2)�� 1.12 s 474�� 1.12 s 474(1)�� 1.13 s 474(a)�� 2.5 s 479A�� 1.13 s 479A(2)(a), (c)�� 1.13 s 479C�� 1.13 s 479C(1)�� 1.13 s 610�� 11.4 s 612�� 11.4, 11.5 s 615�� 11.4 s 1162�� 1.10, 5.2 s 1162(2)�� 5.2 s 1162(3)�� 5.2 s 1162(4)�� 5.2 s 1162(5)�� 5.2 s 1173�� 1.12 Sch 6 para 10�� 11.2 para 11(6)�� 11.2 Sch 6(6)(4)�� 5.10 Credit Unions Act 1979�� 2.3 European Union (Withdrawal Agreement) Act 2020 Sch 5 para 1(1)�� 1.9

Companies Act 2014�� 1.11, 2.11 s 280B�� 1.11 s 280D�� 2.9 s 293(1A)�� 1.11 s 294�� 1.7, 2.10 s 296�� 1.7, 2.10 s 299�� 1.11 s 300�� 1.11 s 301�� 1.11 s 307�� 1.7, 2.10 s 308�� 1.7, 2.10 s 309�� 1.7, 2.10 s 317�� 1.7, 2.10 s 320�� 1.7, 2.10 s 321�� 1.7, 2.10 s 323�� 1.7, 2.10 Sch 4A, para 2(1)�� 1.7, 2.10

United Kingdom Building Societies Act 1986 s 72A�� 1.4, 10.1 s 119(1)�� 2.3 Charities Act 2011 s 132�� 1.4, 10.1 Companies Act 2006�� 1.4, 1.11, 2.4, 5.1, 5.2, 6.26, 11.1, 12.4 s 382(5)�� 1.4 s 382(6)�� 1.4 s 383�� 1.11 s 383(1)�� 1.5 s 383(4)�� 1.4 s 384�� 1.11–1.12 s 384(2)�� 1.12 s 384A�� 1.5, 2.9 s 384B�� 2.9 s 390�� 5.13 s 393�� 1.6 s 394�� 1.4, 10.1

xi

Table of Statutes Financial Services and Markets Act 2000 s 55A�� 2.3 Friendly Societies Act 1974 s 7(1)(a)�� 2.3

Pension Schemes Act 2017 s 39(1)�� 1.12

xii

Table of Statutory Instruments and Other Guidance [All references are to paragraph numbers]

STATUTORY INSTRUMENTS Republic of Ireland European Communities (Accounts) Regulations 1993 (SI 396/1993)�� 2.9

United Kingdom Accounts and Reports (Amendment) (EU Exit) Regulations 2019 (SI 2019/145) reg 1(2)(b)�� 1.9 reg 2�� 1.9 reg 7(2)�� 1.9 Sch 2 para 10(c)(i)�� 1.9 Companies and Statutory Auditors etc. (Consequential Amendments) (EU Exit) Regulations 2020 (SI 2020/523) reg 1(2)�� 1.9 reg 1(10)�� 1.9 reg 1(11)�� 1.9 Companies, Partnerships and Groups (Accounts and Reports) Regulations 2015 (SI 2015/980)�� 1.7, 1.9, 1.11, 5.32, 6.1, 11.2, 11.4 Friendly Societies (Accounts and Related Provisions) Regulations 1994 (SI 1994/1983) Sch 1�� 2.3 Sch 2�� 2.3 Insurance Accounts Directive (Miscellaneous Insurance Undertakings) Regulations 2008 (SI 2008/565)�� 2.3

Insurance Contracts Directive (Lloyd’s Syndicate and Aggregate Accounts) Regulations 2008 (SI 2008/1950) Sch 1�� 2.3 Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410)�� 2.3, 2.7, 9.6 Sch 1 para 3(2)–(3)�� 5.14 para 6(2)(2)�� 5.13 para 6(3)�� 5.14 para 6(6)�� 5.10 para 19(1)�� 6.4 para 61(1)�� 2.5 Sch 4 para 19�� 6.26 Sch 6 para 2�� 11.3 para 10�� 11.2, 11.4 para 18�� 6.26 para 19�� 6.26 Limited Liability Partnerships (Accounts and Audit) (Application of Companies Act 2006) Regulations 2008 (SI 2008/1911) reg 5A�� 2.9 Small Companies and Groups (Accounts and Directors’ Report) Regulations 2008 (2008/409) Sch 6 para 1(1)�� 1.7, 2.10

xiii

Table of Statutory Instruments and Other Guidance

EUROPEAN DIRECTIVES AND REGULATIONS Directive 2004/39/EC on Markets in Financial Instruments (MiFID)�� 1.11 Directive 2006/43/EC on Statutory and Third Countries Audits�� 12.1 Directive 2006/48/EC on Banking Consolidation�� 2.10 Directive 2009/138/EC on Insurance (Solvency II)�� 2.7 Directive 2016/97/EC on Insurance�� 2.10 Regulation (EU) 575/2013 on Credit Institutions art 4(1)(1)�� 2.10 art 4(1)(2A)�� 2.10 Regulation (EU) 600/20014 on Markets in Financial Institutions (MiFID) art 2.1.13�� 1.12 art 2.1.13A�� 1.12

FINANCIAL REPORTING STANDARDS FRS 2 Accounting for Subsidiary Undertakings�� 5.4 FRS 23 Effects of Changes in Foreign Exchange Rates para 11(a)�� 10.4 FRS 100 Application of Financial Reporting Requirements�� 1.1, 2.1–2.2 FRS 101 Reduced Disclosure Framework�� 1.1, 2.1, 2.3, 2.8 Glossary�� 2.3 para 4A�� 2.3 FRS 102 The Financial Reporting Standard applicable in the UK and the Republic of Ireland�� 1.1, 2.1, 2.5, 2.6, 2.8, 3.7, 5.1, 5.4, 5.5, 5.12, 5.14, 5.22, 6.1, 9.8, 9.9, 12.15

FRS 102 The Financial Reporting Standard applicable in the UK and the Republic of Ireland – contd Glossary (See Appendix I) Section 1 (Scope)�� 2.6 para 1.12�� 2.5 Section 1A (Small Entities)�� 1.5, 2.6, 6.28 para 1A.22�� 1.7, 2.10 Appendix A Guidance on adapting the balance sheet formats�� 2.6 Appendix B Guidance on adapting the profit and loss account formats�� 2.6 Appendix C Disclosure requirements for small entities in the UK�� 2.6 Appendix D Disclosure requirements for small entities in the Republic of Ireland�� 2.6 Appendix E Additional disclosures encouraged form small entities�� 2.6 Section 2 (Concepts and Pervasive Principles)�� 2.6, 6.22, 6.24 Appendix Fair value measurement�� 1.2, 2.6, 5.7, 7.12 Section 3 (Financial Statement Presentation)�� 2.6 para 3.17(d)�� 2.5 Section 4 (Statement of Financial Position)�� 2.6 Section 5 (Statement of Comprehensive Income and Income Statement)�� 2.6 Appendix Example showing presentation of discontinued operations�� 2.6 Section 6 (Statement of Changes in Equity and Statement of Income and Retained Earnings)�� 2.6

xiv

Table of Statutory Instruments and Other Guidance FRS 102 The Financial Reporting Standard applicable in the UK and the Republic of Ireland – contd Section 7 (Statement of Cash Flows)�� 1.2, 2.6, 9.1, 9.17 para 7.2�� 9.5 para 7.4(a)–(e)�� 9.2 para 7.5(a)–(h)�� 9.3 para 7.6(a)–(e)�� 9.4 Section 8 (Notes to the Financial Statements)�� 2.6 Section 9 (Consolidated and Separate Financial Statements)�� 2.6, 2.11 para 9.3(a)�� 1.11 para 9.3(b)�� 1.11 para 9.3(bA)�� 1.8, 1.11 para 9.3(dA)�� 1.9, 1.11 para 9.3(g)�� 2.11, 5.1 para 9.5�� 3.2, 5.2 para 9.5(a)–(d)�� 3.2 para 9.6A�� 5.4 para 9.8�� 5.5 para 9.8A�� 5.6 para 9.9�� 1.10, 5.7 para 9.9A�� 5.7 para 9.9(a)�� 5.7 para 9.9B�� 5.7 para 9.9C�� 5.7 para 9.10�� 5.8 para 9.11�� 5.8, 5.9 para 9.11(a)–(d)�� 5.9 para 9.13�� 5.9 para 9.14�� 5.9 para 9.15�� 5.10 para 9.16�� 5.13 para 9.17�� 5.14 para 9.18�� 8.6 para 9.18A�� 8.6 para 9.19�� 8.7 para 9.26�� 5.7, 6.2, 7.1 para 9.26A�� 6.2, 7.1 para 9.33–9.38�� 5.8 Section 10 (Accounting Policies, Estimates and Errors)�� 1.2, 2.6, 5.28

FRS 102 The Financial Reporting Standard applicable in the UK and the Republic of Ireland – contd Section 11 (Basic Financial Instruments)�� 1.2, 2.5, 2.6, 3.2, 5.22, 6.19, 7.15, 8.2, 8.3, 8.6 para 11.13�� 3.8 para 11.42�� 2.5 para 11.43�� 6.27, 7.16 para 11.44�� 2.5, 6.27, 7.16 para 11.45�� 2.5 para 11.47�� 2.5 para 11.48A�� 6.28, 7.17 para 11.48(a)(iii)–(iv)�� 2.5 para 11.48(b)–(c)�� 2.5 para 11.48(d)–(e)�� 6.28, 7.17 Section 12 (Other Financial Instruments Issues)�� 1.2, 2.5, 2.6, 3.2, 5.22, 6.19, 7.15, 8.2, 8.3, 8.6 para 12.27–12.29(a), (b)�� 2.5 para 12.29A�� 2.5 Section 13 (Inventories)�� 2.6 Section 14 (Investments in Associates)�� 1.2, 2.6, 6.1, 6.2, 8.2 para 14.1�� 6.2 para 14.2�� 6.4 para 14.3�� 6.4 para 14.3(a)�� 6.5 para 14.3(b)�� 6.6 para 14.4�� 6.8, 6.24 para 14.4(b)�� 6.8 para 14.5�� 6.8 para 14.6�� 6.8 para 14.8�� 5.7, 6.10–6.11 para 14.8(c)�� 8.2, 8.7 para 14.8(i)�� 8.3 para 14.9�� 6.8 para 14.10�� 6.8 para 14.10A�� 6.8 para 14.12�� 6.27

xv

Table of Statutory Instruments and Other Guidance FRS 102 The Financial Reporting Standard applicable in the UK and the Republic of Ireland – contd Section 15 (Investments in Joint Ventures)�� 1.2, 2.6, 6.19, 7.1 para 15.4�� 4.7, 7.4 para 15.5�� 7.4 para 15.7�� 4.7, 7.5 para 15.13�� 8.4 para 15.15�� 7.12 para 15.16�� 7.13 para 15.17�� 7.13 para 15.18�� 7.15 para 15.19�� 7.16 para 15.20�� 7.16 para 15.21�� 7.16 para 15.21A�� 7.16 Section 16 (Investment Property)�� 2.6 Section 17 (Property, Plant and Equipment)�� 2.6 Section 18 (Intangible Assets other than Goodwill)�� 2.6, 2.12, 5.30 para 18.8�� 5.36 para 18.19�� 5.36 Section 19 (Business Combinations and Goodwill)�� 1.2, 2.6, 2.12, 5.9, 5.16, 6.19 para 19.2�� 2.12 para PBE 19.2A�� 2.12 para 19.4�� 3.6 para 19.7�� 5.15 para 19.10�� 5.16 para 19.10A�� 5.17 para 19.10(a)–(c)�� 5.16 para 19.11�� 4.2, 5.18 para 19.11(a)–(b)�� 5.18 para 19.12�� 5.23 para 19.13�� 5.23 para 19.13B�� 5.23 para 19.14�� 5.24 para 19.14A�� 5.24

FRS 102 The Financial Reporting Standard applicable in the UK and the Republic of Ireland – contd Section 19 (Business Combinations and Goodwill) – contd para 19.15�� 4.2, 5.24, 5.31 para 19.15A�� 5.24, 5.31 para 19.15(a)�� 5.24 para 19.15B�� 5.24, 5.31 para 19.15(b)�� 5.24 para 19.15C�� 5.24, 5.31 para 19.15(c)�� 5.24, 5.28 para 19.16�� 5.25 para 19.18�� 5.26, 8.6 para 19.18B�� 8.6 para 19.19�� 5.27, 8.7 para 19.19(b)�� 8.7 para 19.19D�� 8.5 para 19.21�� 5.28 para 19.21(a)–(b)�� 5.28 para 19.22�� 5.31, 8.2 para 19.22(a)�� 5.31 para 19.22(b)�� 5.31 para 19.23�� 8.2 para 19.23(a)�� 5.32 para 19.24�� 4.2, 5.35, 5.40, 8.2 para 19.24(a)–(c)�� 5.35 para 19.25�� 5.38–5.39 para 19.25A�� 5.39 para 19.25(a)�� 5.39 para 19.25(c)�� 5.39 para 19.25(d)�� 5.39 para 19.25(e)�� 5.39 para 19.25(fA)�� 5.39 para 19.25(g)�� 5.39 para 19.25(h)�� 5.39 para 19.26�� 5.38, 5.40 para 19.26A�� 5.38 paras 19.27–19.32�� 11.1 para 19.27(a)–(c)�� 11.2 para 19.30�� 11.2 para 19.33�� 11.5 Section 20 (Leases)�� 2.6

xvi

Table of Statutory Instruments and Other Guidance FRS 102 The Financial Reporting Standard applicable in the UK and the Republic of Ireland – contd Section 21 (Provisions and Contingencies)�� 2.6, 4.2, 5.23, 5.26, 5.28, 6.18 Appendix Examples of recognising and measuring provisions�� 2.6 Section 22 (Liabilities and Equity)�� 2.6, 5.22 Appendix Example of the issuer’s accounting to convertible tax�� 2.6 Section 23 (Revenue)�� 2.6, 5.28 Appendix Examples of revenue recognition�� 2.6 Section 24 (Government Grants)�� 2.6 Section 25 (Borrowing Costs)�� 2.6 Section 26 (Share-based Payment)�� 2.6, 5.24 para 26.18(b)�� 2.5 paras 26.19–26.23�� 2.5 para 26.23�� 2.5 Section 27 (Impairment of Assets)�� 1.2, 2.6, 2.12, 5.12, 6.9, 6.14 para 27.21�� 5.34 para 27.22�� 5.34 para 27.22(a)�� 5.34 para 27.23�� 5.34 para 27.24�� 5.33 para 27.26�� 5.33 Section 28 (Employee Benefits)�� 2.6, 5.8 Section 29 (Income Tax)�� 1.2, 2.6, 4.3, 4.9, 5.24 para 29.9�� 4.3 para 29.11�� 4.8 para 29.11A�� 4.8 Section 30 (Foreign Currency Translation)�� 1.2, 2.6, 8.6, 10.1 para 30.3�� 10.2 para 30.4�� 10.2 para 30.5�� 10.3–10.4

FRS 102 The Financial Reporting Standard applicable in the UK and the Republic of Ireland – contd Section 30 (Foreign Currency Translation) – contd para 30.5(a)�� 10.4 para 30.11�� 10.8 para 30.12�� 10.9 para 30.13�� 10.9 para 30.16�� 10.7 para 30.21�� 10.10 Section 31 (Hyperinflation)�� 2.6 Section 32 (Events after the End of the Reporting Period)�� 2.6 Section 33 (Related Party Disclosures)�� 1.2, 2.6 para 33.7�� 2.5 Section 34 (Specialised Activities)�� 2.6, 8.6 Appendix A Guidance on funding commitments�� 2.6 Appendix B Guidance on incoming resources from non-exchange transactions�� 2.6 Section 35 (Transition to this FRS)�� 1.2, 2.6 Appendix I Glossary�� 1.4, 2.3, 2.5, 2.6, 2.12, 3.2, 3.3, 3.4, 3.8, 5.1, 5.2, 5.7, 5.8, 5.13, 5.16, 5.17, 5.33, 6.3, 6.4, 6.10, 6.16, 7.2, 9.5, 10.1, 10.6, 11.1 Appendix II Table of equivalence form company law terminology�� 2.6 Appendix III Note on legal requirements�� 2.6 Appendix IV Republic of Ireland legal references�� 2.6 Basis for Conclusions�� 2.6 para A.2(a)–(e)�� 2.1 FRS 103 Insurance Contracts�� 1.1, 2.1, 2.7 para A4.21�� 2.7

xvii

Table of Statutory Instruments and Other Guidance FRS

104 Interim Financial Reporting�� 1.1, 2.1, 2.8 FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime�� 1.1, 2.1, 2.9, 6.29 Glossary�� 2.9 Section 7 (Subsidiaries, Associates, Jointly Controlled Entities and Intermediate Payment Arrangements)�� 6.1, 7.18 para 7.1�� 6.2, 7.1 Section 9 (Financial Instruments)�� 7.15 Section 22 (Impairment of Assets)�� 6.9, 6.14

I N T E R N AT I O N A L ACCOUNTING STANDARDS IAS 1 Presentation of Financial Statements para 10(d),(f)�� 2.5 para 10(f)�� 2.5 para 16�� 2.5 para 38�� 2.5 para 38A�� 2.5 para 38B�� 2.5 para 38C�� 2.5 para 38D�� 2.5 para 40A�� 2.5 para 40B�� 2.5 para 40C�� 2.5 para 40D�� 2.5 para 79(a)(iv)�� 2.5 para 111�� 2.5 paras 134–136�� 2.3, 2.5 IAS 7 Statement of Cash Flows�� 2.5, 9.7, 9.17, 9.22, 9.26–9.27 para 6�� 9.19 para 16�� 9.23 para 17�� 9.25 para 39�� 9.24 para 44A�� 9.25

IAS

8 Accounting Policies, Changes in Accounting estimates and Errors para 30�� 2.5 para 31�� 2.5 IAS 12 Income Taxes�� 4.3, 4.8, 4.9 IAS 16 Property, Plant and Equipment para 73(e)�� 2.5 para 74A(b)�� 2.5 IAS 21 The Effects of Changes in Foreign Exchange Rates�� 8.6, 10.10 para 21.48�� 8.6 IAS 24 Related Party Disclosures para 17�� 2.5 para 18A�� 2.5 IAS 36 Impairment of Assets para 130(f)(ii)–(iii)�� 2.5 para 134(d)–(f)�� 2.5 para 135(c), (e)�� 2.5 IAS 38 Intangible Assets�� 5.14, 5.36 para 118(e)�� 2.5 IAS 40 Investment Property para 76�� 2.5 para 79(d)�� 2.5 IAS 41 Agriculture para 50�� 2.5 IASB Discussion Paper Business Combinations under Common Control�� 11.5

INTERNATIONAL FINANCIAL REPORTING STANDARDS IFRS 1 First-time adoption of International Financial Reporting Standards para 6�� 2.5 para 21�� 2.5 IFRS 2 Share-based Payment para 45(b)�� 2.5 paras 46–52�� 2.5

xviii

Table of Statutory Instruments and Other Guidance IFRS 3 Business Combinations�� 2.9, 5.22, 5.23, 5.29, 5.32, 11.1, 12.9 para 62�� 2.5 para B6�� 3.6 para B64(d), (e), (g), (h), (j), (m), (n)(ii), (o)(ii), (p), (q)(ii)�� 2.5 para B66�� 2.5 para B67�� 2.5 IFRS 5 Non-current Assets Held for Sale and Discontinued Operations para 33(c)�� 2.5 IFRS 6 Exploration for and Evaluation of Mineral Resources�� 2.5 IFRS 7 Financial Instruments: Disclosures�� 2.3, 2.5, 9.26–9.27 para 35�� 9.29 IFRS 11 Joint Arrangements�� 7.3 IFRS 13 Fair Value Measurement�� 2.3 paras 91–99�� 2.5 IFRS 15 Revenue from Contracts with Customers para 110�� 2.5 para 113(a)�� 2.5 para 114�� 2.5 para 115�� 2.5 para 118�� 2.5 para 119(a)–(c)�� 2.5 paras 120–127�� 2.5 para 129�� 2.5 IFRS 16 Leases�� 9.28 para 52�� 2.5 para 58�� 2.5 para 89�� 2.5 para 90�� 2.5 para 91�� 2.5 para 92�� 2.5 IFRS 17 Insurance Contracts�� 2.3

INTERNATIONAL STANDARDS ON AUDITING ISA (UK) 260 Communicating Deficiencies in Internal Control to Those Charged with Governance and Management�� 12.18, 12.19 ISA (UK) 300 Planning an Audit of Financial Statements�� 12.4 ISA (UK) 320 Materiality in Planning and Performing an Audit�� 12.6 ISA (UK) 520 Analytical Procedures�� 12.11 ISA (UK) 580 Written Representations�� 12.15 ISA (UK) 600 Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors)�� 12.1, 12.2, 12.4, 12.16 para 8�� 12.2 para 9(a)�� 12.2 para 9(b)�� 12.2 para 9(m)�� 12.2

OTHER DOCUMENTS Financial Reporting Council: Amendments to UK and Republic of Ireland accounting standards – UK exit from the European Union (2020)�� 1.7 Financial Reporting Council: Staff Guidance Note 02/2018�� 12.1 Lloyd’s Syndicate Accounting Byelaw No 8 of 2005�� 2.3 TECH 02/17BL Guidance on Realised and Distributable Profits under the Companies Act 2006 (ICAEW/ICAS) (2017)�� 10.9

xix

xx

Table of Examples [All references are to paragraph numbers]

Determining the size of a group Presentation currency is Euros Micro-entity which is the parent of a group Small company is a parent of a group Subsidiary trades securities A vertical group structure A ‘D-shaped’ group Computing a measurement difference for a below market rate loan Interest allocation Loan from subsidiary to parent Loans between two subsidiaries Fair value adjustment Subsidiary has undistributed profit Subsidiary will distribute profit in the foreseeable future Parent cannot control the payment of dividends Deferred tax on unremitted earnings of an associate Dividends in a joint venture Difference in value of an asset at the date of acquisition Loss-making subsidiary Deferred tax in a business combination Group relief at normal corporation tax rates Group relief transferred at less than the applicable tax rate Assessment potential control Dissimilar activities Eliminating intra-group profit in inventory Intra-group profit on transfer of a fixed asset Non-coterminous reporting dates Creation of a new entity to effect a business combination Discounted deferred consideration Establishing the cost of a business combination Contingent consideration Provision for inventory allowance Adjustment of fair values 12-month time limit has elapsed Contingent liability at the date of acquisition Potential reduction in a contingent liability at the date of acquisition Goodwill arising on acquisition of a subsidiary Notionally adjusted goodwill Allocating an impairment loss Consolidated profit and loss account in a mid-year acquisition Equity accounting Jointly controlled operation

xxi

1.4 1.4 1.5 1.5 1.12 3.6 3.6 3.8 3.10 3.11 3.12 4.2 4.4 4.4 4.4 4.5 4.6 4.8 4.8 4.8 4.9 4.9 5.2 5.5 5.12 5.12 5.13 5.16 5.21 5.22 5.23 5.25 5.27 5.27 5.28 5.28 5.31 5.33 5.34 5.37 6.10 7.4

Table of Examples Jointly controlled asset Transaction between a venturer and a joint venture Simple investment to associate Loss of significant influence of an associate Additional investment in a subsidiary Disposal where parent retains control Deemed disposal where control is retained Dividend paid to NCI Associate’s transactions in the consolidated cash flow statement Acquisition of a subsidiary in the year Disposal of a subsidiary Disposal of a subsidiary Non-cash foreign exchange gain or loss Acquisition of a subsidiary during the period Disposal of a subsidiary Functional currency Functional currency of a foreign operation Foreign branch Non-monetary asset measured at historical cost Accounting for a change in functional currency Monetary asset translated at the year end Revaluation of a non-monetary asset Retranslation into presentation currency Intra-group loan Net investment in a foreign operation Group reconstruction: Investment has a carrying amount less than the nominal value of the shares acquired Group reconstruction: Investment has a carrying amount in excess of the nominal value of the shares acquired Shares issued when applying merger accounting New parent has a short accounting period

xxii

7.5 7.13 8.2 8.3 8.5 8.8 8.9 9.10 9.11 9.13 9.14 9.14 9.15 9.16 9.16 10.2 10.3 10.3 10.6 10.7 10.8 10.8 10.10 10.11 10.11 11.2 11.2 11.2 11.3

Chapter 1

Introduction

SIGNPOSTS ●●

Micro-entities are scoped out of FRS 105 if their financial statements are consolidated with those of a parent (see 1.1).

●●

General purpose consolidated financial statements must give a true and fair view of the group’s financial affairs at the reporting date (see 1.6).

●●

The exemption contained in CA 2006, s 401 is only available for UK intermediate parent companies whose EEA parent produces consolidated financial statements which are considered to meet the UK equivalence test following Brexit (see 1.9).

●●

When a group becomes an ‘ineligible group’, none of the exemptions available to small or medium-sized companies and groups will be available (see 1.12).

●●

There is an exemption from audit available for subsidiaries whose parent guarantees their debts under CA 2006, s 479A (see 1.13).

INTRODUCTION 1.1 This book is concerned with consolidated financial statements (also known as ‘group accounts’) which are prepared under UK Generally Accepted Accounting Practice (UK GAAP). It is designed as an essential tool for practitioners and has been written by a practitioner. At the outset it is important to emphasise that while this book does cover most aspects of consolidated financial statements, it may not cover every eventuality faced in practice. For more unusual or contentious situations, preparers should refer to the text of the relevant section of the accounting standard or company law. This book’s primary focus is that of UK GAAP (see below). However, the author recognises that currently accountants are trained under the IFRS regime when preparing for their professional examinations. There are a number of differences between UK GAAP and the IFRS regime so this book does highlight these differences, where applicable. The aim of this is to flag up where there are differences in recognition and measurement issues so that preparers avoid 1

1.1 Introduction the many pitfalls that exist during the preparation of consolidated financial statements. To that end, a ‘Summary of differences: FRS 102 v IFRS’ is provided at the end of some chapters for ease of reference. UK GAAP consists of the following standards: ●●

FRS 100 Application of Financial Reporting Requirements

●●

FRS 101 Reduced Disclosure Framework

●●

FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland

●●

FRS 103 Insurance Contracts

●●

FRS 104 Interim Financial Reporting1

●●

FRS 105 The Financial Reporting Standard applicable to the Microentities Regime

Focus For more detailed narrative on the concepts involved in each FRS noted above, readers are directed to Financial Reporting for Unlisted Companies in the UK and Republic of Ireland (third edition, Bloomsbury Professional) or A Practical Guide to Accounting and Auditing Standards (second edition, Bloomsbury Professional).

It should be noted that the FRC issued updated editions of the above FRSs (except FRS 100 which is expected to be reissued later in 2022) so the latest editions are the January 2022 editions. The January 2022 editions consolidate all amendments made to the standards since March 2018. In the context of consolidated financial statements, this book will be concerned with the requirements of FRS 102 and UK company law. Chapter 2 provides a more detailed overview of UK GAAP and consolidated financial statements. It is also worth emphasising that micro-entities cannot use FRS 105 if their financial statements are consolidated with those of a parent. This is because groups are beyond the scope of FRS 105. As a minimum, the micro-entity would have to report under FRS 102 and apply the presentation and disclosure requirements of Section 1A Small Entities if it wishes.

1

FRS 104 is not an accounting standard as there is no mandatory requirement for entities to prepare interim financial reports under UK GAAP. It has been included in this list for completeness.

2

Introduction 1.2

INTERACTION WITH OTHER ACCOUNTING STANDARDS 1.2 FRS 102 is divided into sections and each section of the standard specifies the recognition, measurement and disclosure requirements for a particular topic. FRS 102 defines the concept of ‘control’ in the context of groups and contains the presentation and disclosure requirements that financial statements (both individual and consolidated) must contain. The standard reflects the requirements of company law in terms of formats. When preparing consolidated financial statements, an entity will need to have regard to the following sections of FRS 102: Relevant section of FRS 102

Why the section is relevant

Appendix to Section 2 Concepts and The Appendix to Section 2 provides Pervasive Principles guidance on arriving at fair values which are used in business combinations Section 11 Basic Financial Instruments and Section 12 Other Financial Instruments Issues

These sections cover the accounting treatment of investments in companies which qualify as financial assets

Section 14 Investments in Associates This section deals with the accounting treatment of investments in associates including outlining the equity method of accounting which is relevant to the consolidated financial statements Section 15 Investments in Joint Ventures

This includes the general principles relating to joint ventures and overlaps with the equity method of accounting in Section 14

Section 19 Business Combinations and Goodwill

This covers the accounting requirements concerning the acquisition and disposal of group entities

Section 27 Impairment of Assets

This deals with the carrying value of financial assets which should not be held at a value above recoverable amount, at parent (investments in group entities) and group level (goodwill on consolidation)

Section 30 Foreign Currency Translation

This deals with the translation of investments in foreign operations

The above sections of FRS 102 act as ‘building blocks’ where the consolidated financial statements are concerned and include all the principles and guidance which are necessary to correctly account for the group. They are supported by other sections of FRS 102 as follows: ●●

Section 7 Statement of Cash Flows

●●

Section 10 Accounting Policies, Estimates and Errors

3

1.3 Introduction ●●

Section 29 Income Tax

●●

Section 33 Related Party Disclosures

●●

Section 35 Transition to this FRS

Taken together, this should ensure the consolidated financial statements are prepared correctly and disclosures are complete.

PURPOSE OF CONSOLIDATED FINANCIAL STATEMENTS 1.3 At the outset it is worthwhile understanding why consolidated financial statements are prepared. The purpose of consolidated financial statements is to present the results of the group in line with its economic substance, which is that of a single reporting entity. Financial statements, including consolidated financial statements must report the substance of arrangements and transactions. UK GAAP does not specifically define ‘substance over form’ but the concept has been enshrined in financial reporting for decades. When an entity correctly applies substance over form, the financial statements will convey the financial reality of a transaction (ie, the substance) as opposed to simply recording legal form. Essentially, economic substance reports the ‘commercial reality’ of a transaction. Hence, for consolidated financial statements, the economic substance is that the group structure does not exist and that the consolidated financial statements present those financial statements as a single reporting entity. Therefore, during the consolidation process, any and all intra-group trading and balances will be eliminated. This is examined in more detail in Chapter 5.

COMPANY LAW REQUIREMENTS 1.4 ●●

At the outset, it is worth noting some relevant definitions: Act ‘The Companies Act 2006’2

●●

Consolidated financial statements ‘The financial statements of a parent and its subsidiaries presented as those of a single economic entity.’3

2 3

FRS 102 Glossary Act. FRS 102 Glossary consolidated financial statements.

4

Introduction 1.4 ●●

Individual financial statements ‘The accounts that are required to be prepared by an entity in accordance with the Act or relevant legislation, for example: (a)

“individual accounts”, as set out in CA 2006, s 394;

(b)

“statement of accounts” as set out in the Charities Act 2011, s 132; or

(c)

“individual accounts” as set out in the Building Societies Act 1986, s 72A.

Separate financial statements are included in the meaning of this term.’4 ●●

Parent ‘An entity that has one or more subsidiaries.’5

●●

Separate financial statements ‘Those presented by a parent in which the investments in subsidiaries, associates or jointly controlled entities are accounted for either at cost or fair value rather than on the basis of the reported results and net assets of the investees. Separate financial statements are included within the meaning of individual financial statements.’6

Group accounts and their preparation are dealt with in the Companies Act 2006 (CA 2006), Part 15, Chapter 4 Annual accounts, ss 399–408. Under CA 2006, s 399, a company is required to prepare consolidated financial statements if, at the end of the financial year, that company is a parent entity and cannot claim any exemptions from this requirement. One exemption from this requirement to prepare consolidated financial statements is if the group is small and so it is essential to determine the size of the parent and group correctly. A group is classified as small, medium-sized or large having regard to size thresholds outlined in CA 2006. Understandably, it follows that larger groups will have to make more disclosure than, say, a small or medium-sized group. The thresholds relevant to groups according to CA 2006 are as follows: Size of group

Turnover

Small group

Not more than £10.2m Not more than £5.1m net or £12.2m gross7 net or £6.1m gross

Not more than 50

Medium-sized group

Not more than £36m net or £43.2m gross8

Not more than £18m net or £21.6m gross

Not more than 250

Large group

More than £36m net or £43.2m gross

More than £18m net or £21.6m gross

More than 250

4 5 6 7 8

Balance sheet total

FRS 102 Glossary individual financial statements. FRS 102 Glossary parent. FRS 102 Glossary separate financial statements. CA 2006, s 383(4). CA 2006, s 466(4).

5

No. of employees

1.4 Introduction The group must meet two out of the three criteria for two consecutive years above in order to be classed as small, medium-sized or large. With regards to the above table, there are some important points to emphasise: (a) The term ‘balance sheet total’ is fixed assets plus current assets (CA 2006, s 382(5)). It is important not to use net assets because this figure is arrived at after the deduction of the group’s liabilities. The term ‘balance sheet total’ is also referred to as ‘gross assets’. (b) The average number of employees is the average number employed by the group throughout the year, ie it is not the actual number of employees in employment by the group at the reporting date. CA 2006, s 382(6) sets out the required calculation as follows (note the section refers to ‘company’ rather than ‘group’ but as individual companies will be included within a consolidation, this requirement is relevant): (i)

find for each month in the financial year the number of persons employed under contracts of service by the company in that month (whether throughout the month or not);

(ii) add together the monthly totals; and (iii) divide by the number of months in the financial year. (c)

References to ‘gross’ in the table mean the effects of intra-group trading have not been eliminated; whereas references to ‘net’ mean the effects of intra-group trading have been eliminated.

(d) A subsidiary whose financial statements are consolidated with those of a parent cannot qualify as a micro-entity (charities are also unable to qualify as micro-entities). Example 1.1 – Determining the size of a group Extracts from the accounting records of the Sunnie Group Ltd for its first year of trading show the following: Gross turnover

£14m

Net turnover

£10m

Total assets (gross)

£5.7m

Total assets (net)

£5.5m

Number of employees

61

Based on size criteria, the group would qualify as small on the grounds that net turnover is below £10.2m and total assets are below the gross value of £6.1m. The group does, however, exceed the employee headcount threshold but two out of the three qualifying criteria have been met hence the group can be classed as small.

6

Introduction 1.5 If, say, turnover was £17.1m gross and £14.3m net then the group would not qualify as a small group because it breaches two out of the three criteria (on both turnover and employee headcount). Therefore, in this case the group would be classed as medium-sized. Example 1.2 – Presentation currency is Euros Molbert Ltd, a company based in the UK, has prepared its first set of financial statements in Euros. The finance director is unsure whether the company can be classed as small. In situations where a company has a different presentation currency from GBP, the turnover figure is translated using the average rate and the balance sheet total is translated using the closing rate. This method of translation should also be used in a group context.

Individual companies that are parent companies 1.5 Individual parent companies must meet the size criteria shown above to qualify as micro, small or medium-sized on an individual company basis. A parent company will only qualify as a small company in relation to a financial year if the group headed by it qualifies as a small group. Example 1.3 – Micro-entity which is the parent of a group Microco Ltd has a 100% ownership interest in Subco Ltd and is seeking to prepare its financial statements under FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime. Not only does Microco Ltd have to consider whether it meets the criteria to prepare its individual financial statements under the micro-entities regime, it must also consider the size of the group that it heads up. In this example, the group only needs to be a small group in order for Microco Ltd to be able to prepare its financial statements under the micro-entities regime. This is possible because a small group does not have to prepare group accounts and there is no concept of a ‘micro group’ under CA 2006, s 384A. Example 1.4 – Small company is a parent of a group Smallco Ltd has a 100% ownership interest in Subco Ltd and is seeking to prepare its financial statements under FRS 102 including applying the presentation and disclosure requirements of Section 1A Small Entities. CA 2006, s 383(1) states that a parent company can only qualify as a small company in a financial year if the group headed up by it qualifies as a small group.

7

1.6 Introduction If Smallco Ltd would qualify as a small company but Subco Ltd qualifies as a medium-sized company, Smallco would only be entitled to the exemptions available to a medium-sized company when preparing its individual financial statements. In terms of group accounts, it would only be necessary for Smallco to consider the size of the group it heads up. This would be the case even if the group is small (hence not preparing group accounts) on the basis that it may be part of a larger group.

True and fair requirements 1.6 Consolidated financial statements, like individual financial statements, must present a true and fair view of the group’s financial performance, position and cash flows as at the reporting date. The true and fair concept has been enshrined in company law for decades and CA 2006, s 393 makes it a criminal offence for directors to approve financial statements which do not give a true and fair view. Surprisingly, there has never been any statutory definition attributed to ‘true and fair’ by the courts. The most authoritative statements as to the meaning of true and fair are legal opinions written by Lord Hoffmann and Dame Mary Arden in 1983 and 1984 and again by Dame Mary Arden in 1993. Lord Hoffmann said that true and fair was ‘… an abstraction or philosophical concept expressed in simple English’. Lord Hoffmann then went on to say that it was considered wise for the courts not to offer to define true and fair in a legal context. Clearly, a significant amount of time has elapsed since Lord Hoffmann’s and Dame Mary Arden’s opinions were expressed and, during that time, there has been a significant amount of change in financial reporting and company law. These changes do beg the question as to whether those opinions remain applicable in the modern accounting profession. The term ‘true and fair’ is pivotal in auditing as well and consolidated financial statements will usually be subject to audit. Chapter 11 of this book examines the provisions of auditing consolidated financial statements in more detail. In his independent review into the quality and effectiveness of audit in 2019, Sir Donald Brydon CBE suggested that the ‘true and fair’ concept should be replaced by the phrase ‘present fairly, in all material respects’. His rationale is that this will bolster transparency in auditing and accounting and shore up the responsibility of company directors when preparing reliable financial statements. Brydon suggests that ‘true and fair’ contributes to the ‘expectations gap’ where auditing is concerned. The ‘expectations gap’ is the gap that exists between what the general public think auditors do and what the auditor is

8

Introduction 1.7 actually required to do under standards, legislation and regulations. Brydon states in his report that replacing ‘true and fair’ with ‘present fairly, in all material respects’ would strengthen the value of the audit opinion, and recognises that accounting ‘… increasingly involves the use of estimates and judgments’ as well as the fact that the objective of an audit is to provide reasonable assurance that the financial statements are ‘free of material misstatements.’ The true and fair debate has raged on for years and, more recently, the concept was challenged where the use of IFRS is concerned. The Financial Reporting Council (which will eventually be replaced by the Audit, Reporting and Governance Authority (expected in 2023)) commissioned a legal opinion from Martin Moore QC who confirmed that the true and fair requirement underpins the preparation of financial statements in the UK, regardless of whether the reporting entity prepares its financial statements under UK GAAP or IFRS. Indeed, for companies, HM Revenue and Customs (HMRC) require financial statements to be prepared under one of these regimes. The correct application of accounting standards and company law should enable the financial statements (whether individual or consolidated) to give a true and fair view.

EXEMPTIONS IN COMPANY LAW 1.7 At the outset, it is worth noting that small groups are exempt from the requirement to prepare consolidated financial statements. However, if a small group voluntarily chooses to prepare consolidated financial statements, FRS 102, para 1A.22 will apply which states: ‘If a small entity that is a parent voluntarily chooses to prepare consolidated financial statements it: (a) shall apply the consolidation procedures set out in Section 9 Consolidated and Separate Financial Statements; (b) is encouraged to provide the disclosures set out in paragraph 9.239 (c) shall comply so far as practicable with the requirements of Section 1A as if it were a single entity (Schedule 6 of the Small Companies Regulations, paragraph 1(1)10 (d) shall provide any disclosures required by Schedule 6 of the Small Companies Regulations.11,12 9

10 11

12

Irish small entities are required to provide certain of these disclosures. Irish small entities shall refer to CA 2014, Sch 4A, para 2(1). Irish small entities shall refer to CA 2014, Sch 4A and ss 294, 296, 307 to 309, 317, 320, 321 and 323. FRS 102, para 1A.22.

9

1.8 Introduction In addition, The Companies, Partnerships and Groups (Accounts and Reports) Regulations 2015 (SI 2015/980) extended the scope exemption to include a company which is a public limited company (PLC) provided that it would otherwise qualify as small and the company is not a traded company. A company is a traded company if it has securities traded on a regulated market such as the London Stock Exchange. The Alternative Investment Market (AIM) is not currently defined as a regulated market for this purpose. Focus In December 2020, the FRC issued Amendments to UK and Republic of Ireland accounting standards – UK exit from the European Union. These amendments reflected changes in company law following the end of the transition period. The majority of the amendments merely changed references to ‘EU’ to ‘UK’ and ‘EU-adopted IFRS’ to ‘UK-adopted IFRS’ or ‘adopted IFRS’. The amendments take mandatory effect for accounting periods beginning on or after 1 January 2021. Early application is permissible in some circumstances to provide UK entities with the option to use IAS that are adopted for use within the UK after 31 December 2020, in addition to IFRS that have been adopted in the EU as at this date. The amendments document confirms that this is consistent with the transitional arrangements provided in UK company law for entities preparing ‘IAS accounts’.

CA 2006, s 400 exemption 1.8 CA 2006, s 400 provides exemption from preparing consolidated financial statements for a company which is included in the group accounts of a larger group. The company will be exempt if it is itself a subsidiary undertaking and its immediate parent is established under the law of any part of the UK provided the following conditions in s 400(1)(a)–(c) are met: (a)

the company is a wholly owned subsidiary of that parent undertaking;

(b) the parent undertaking holds 90% or more of the allotted shares in the company and the remaining shareholders have approved the exemption; and (c)

the parent undertaking holds more than 50% (but less than 90%) of the allotted shares in the subsidiary and notice requesting the preparation of consolidated financial statements has not been served on the company by shareholders which hold in aggregate at least 5% of the allotted shares in the company. The notice must be served at least six months prior to the end of the financial year to which it relates.

10

Introduction 1.8 Focus In (b) and (c) above, shares held by a wholly owned subsidiary of the parent undertaking, or held on behalf of the parent undertaking or a wholly owned subsidiary, must be attributed to the parent. In addition, the exemption does not apply to a company which is a traded company. Shares which are held by directors of a company for the purpose of complying with any share qualification requirement must be disregarded in determining whether the company is a wholly owned subsidiary for the purposes of CA 2006, s 400.

The above points are the first hurdles to get over. Once the subsidiary meets the above, there are further conditions that must be met under s 400(2) which are as follows: ‘Exemption is conditional upon compliance with all of the following conditions— (a) the company must be included in consolidated accounts for a larger group drawn up to the same date, or to an earlier date in the same financial year, by a parent undertaking established under the law of any part of the United Kingdom; (b) those accounts must be drawn up and audited, and that parent undertaking’s annual report must be drawn up— (i) if the undertaking is a company, in accordance with the requirements of this Part of this Act, or, if the undertaking is not a company, the legal requirements which apply to the drawing up of consolidated accounts for that undertaking, or (ii) in accordance with UK-adopted international accounting standards; (c)

the company must disclose in the notes to its individual accounts that it is exempt from the obligation to prepare and deliver group accounts;

(d) the company must state in its individual accounts the name of the parent undertaking that draws up the group accounts referred to above and— (i) the address of the undertaking’s registered office, or (ii) if it is unincorporated, the address of its principal place of business; (e)

the company must deliver to the registrar, within the period for filing its accounts and reports for the financial year in question, copies of— (i) those group accounts, and (ii) the parent undertaking’s annual report, together with the auditor’s report on them; 11

1.9 Introduction (f) any requirement of Part 35 of this Act as to the delivery to the registrar of a certified translation into English must be met in relation to any document comprised in the accounts and reports delivered in accordance with paragraph (e).’13 The CA 2006, s 400 exemption will only apply when the UK parent is either wholly owned, or majority-owned (ie, more than 50% of the allotted shares) by the immediate parent as per FRS 102, para 9.3(bA). Focus It should be noted that for financial years commencing on or after 1 January 2021, the exemption under CA 2006, s 400 for a UK intermediate parent company with an EEA parent no longer applies. However, the CA 2006, s 401 exemption will be available where the EEA parent produces consolidated financial statements under EU-adopted IFRS or produces consolidated financial statements which are equivalent to those required by UK company law. If the EEA parent does not produce consolidated financial statements which meet the equivalence test, and nobody further up the group does, the UK intermediate parent will need to produce consolidated financial statements at UK sub-group level.

CA 2006, s 401 exemption 1.9 As noted in 1.8 above, for UK intermediate parent companies whose EEA parent produces consolidated financial statements which are considered to meet the UK equivalence test, CA 2006, s 401 provides an exemption for the UK intermediate parent from producing consolidated financial statements. CA 2006, s 401 states: ‘(1) A company is exempt from the requirement to prepare group accounts if itself is a subsidiary undertaking and its parent undertaking is not established under the law of any part of the United Kingdom, in the following cases— (a) where the company is a wholly-owned subsidiary of that parent undertaking; (b) where that parent undertaking holds 90% or more of the allotted shares in the company and the remaining shareholders have approved the exemption; or (c) where the parent undertaking holds more than 50% (but less than 90%) of the allotted shares in the company and notice requesting 13

CA 2006, s 400(2).

12

Introduction 1.9 the preparation of group accounts has not been served on the company by the shareholders holding in aggregate at least 5% of the allotted shares in the company.

Such notice must be served at least six months before the end of the financial year to which it relates.

(2) Exemption is conditional upon compliance with all of the following conditions— (a) the company and all of its subsidiary undertakings must be included in consolidated accounts for a larger group drawn up to the same date, or to an earlier date in the same financial year, by a parent undertaking; (b) those accounts and, where appropriate, the group’s annual report, must be drawn up— (i) ……..14 (ii) in a manner equivalent to consolidated accounts and consolidated reports drawn up in accordance with the requirements of this Part of this Act, (iii) in accordance with UK-adopted international accounting standards, or (iv) in accordance with accounting standards which are equivalent to such international accounting standards, as determined pursuant to Commission Regulation (EC) No. 1569/2007 of 21 December 2007 establishing a mechanism for the determination of equivalence of accounting standards applied by third country issuers of securities pursuant to Directives 2003/71/EC and 2004/109/EC of the European Parliament and of the Council; (c) the group accounts must be audited by one or more persons authorised to audit accounts under the law under which the parent undertaking which draws them up is established; (d) the company must disclose in its individual accounts that it is exempt from the obligation to prepare and deliver group accounts; (e) the company must state in its individual accounts the name of the parent undertaking which draws up the group accounts referred to above and— (i) the address of the undertaking’s registered office (whether in or outside the United Kingdom, or;

14

CA 2006, s 401(2)(b) omitted (31.12.20 with effect in relation to financial years beginning on or after IP completion day) by virtue of The Accounts and Reports (Amendment) (EU Exit) Regulations 2019 (SI 2019/145), regs 12(b), 2, Sch 2, para 10(c)(i) (with reg 7(2)) (as amended by SI 2020/523, regs 1(2), 10, 11); 2020 c 1, Sch 5, para 1(1).

13

1.10 Introduction (ii) if it is unincorporated, the address of its principal place of business; (f) the company must deliver to the registrar, within the period for filing its accounts and reports for the financial year in question, copies of— (i) the group accounts, and (ii) where appropriate, the consolidated annual report,

together with the auditor’s report on them;

(g) any requirement of part 35 of this Act as to the delivery to the registrar of a certified translation into English must be met in relation to any document comprised in the accounts and reports delivered in accordance with paragraph (f). (3)

For the purposes of subsection (1)(b) and (c), shares held by a whollyowned subsidiary of the parent undertaking, or held on behalf of the parent undertaking or a wholly-owned subsidiary, are attributed to the parent undertaking.

(4) The exemption does not apply to a company which is a traded company. (5) Shares held by directors of a company for the purpose of complying with any share qualification requirement shall be disregarded in determining for the purpose of this section whether the company is a wholly-owned subsidiary.’15 FRS 102, para 9.3(dA) was included by virtue of the amendments brought about by The Companies, Partnerships and Groups (Accounts and Reports) Regulations 2015 (SI 2015/980). The revisions to the Act now distinguish between a UK parent where 90%, or more, of its allotted shares are owned by an immediate parent and one where the immediate parent holds more than 50%, but less than 90%, of the allotted shares. If the immediate parent owns 90% or more of the UK parent, the remaining shareholders must all approve the exemption. If the immediate parent owns more than 50%, but less than 90%, the exemption will not be available if minority shareholders which hold 5% of the total allotted shares, have requested consolidated financial statements be prepared. The minority shareholders must serve this notice no later than six months prior to the end of the financial year to which it relates.

CA 2006, s 402 exemption 1.10 CA 2006, s 402 Exemption if no subsidiary undertakings need be included in the consolidation states that a parent company is exempt from the 15

CA 2006, s 401 Exemption for company included in non-UK group accounts of larger group.

14

Introduction 1.11 requirement to prepare group accounts if, under s 405, all of its subsidiary undertakings could be excluded from consolidation in Companies Act group accounts. Focus Under CA 2006, s 405 Companies Act group accounts: subsidiary undertakings included in the consolidation, all subsidiary undertakings must be included in the consolidation, except for where as follows: ●●

its inclusion is not material for the purposes of giving a true and fair view (but two or more undertakings may be excluded only if they are not material taken together);

●●

severe long-term restrictions substantially hinder the exercise of the rights of the parent company over the assets or management of that undertaking;

●●

extremely rare circumstances mean that the information necessary for the preparation of consolidated financial statements cannot be obtained without disproportionate expense or undue delay; or

●●

the interest of the parent company is held exclusively with a view to resale.

References to the rights of the parent company and the interest of the parent company are, respectively, to the rights and interests held by or attributed to the company for the purpose of the definition of ‘parent undertaking’ (see CA 2006, s 1162) in the absence of which it would not be a parent company. The final two sub-list points above are similar to the wording in FRS 102, para 9.9. However, FRS 102, para 9.9 expands the final sub-list point by requiring that the subsidiary has not previously been consolidated in the consolidated financial statements prepared in accordance with FRS 102.

EXEMPTIONS AVAILABLE UNDER FRS 102 1.11 FRS 102, para 9.3 sets out various exemptions from preparing consolidated financial statements as follows: ‘A parent is exempt from the requirement to prepare consolidated financial statements on any one of the following grounds: For an entity reporting under the Act, when its immediate parent is established under the law of any part of the UK16 or for an entity reporting

16

CA 2006, s 400.

15

1.11 Introduction under the Companies Act 2014, when its immediate parent is established under the law of an EEA State:17 (a)

The parent is a wholly-owned subsidiary. Exemption is conditional on compliance with certain further conditions set out in company law.

(b) The immediate parent holds 90% or more of the allotted shares in the entity and the remaining shareholders have approved the exemption. Exemption is conditional on compliance with certain further conditions set out in company law. (bA) The immediate parent holds more than 50% (but less than 90%) of the allotted shares in the entity, and notice requesting the preparation of consolidated financial statements has not been served on the entity by shareholders holding in aggregate at least 5% of the allotted shares in the entity. Exemption is conditional on compliance with certain further conditions set out in company law. For an entity reporting under the Act, when its parent is not established under the law of any part of the UK18 or for an entity reporting under the Companies Act 2014, when its parent is not established under the law of an EEA State:19 (c)

The parent is a wholly-owned subsidiary. Exemption is conditional on compliance with certain further conditions set out in company law.

(d) The parent holds 90% or more of the allotted shares in the entity and the remaining shareholders have approved the exemption. Exemption is conditional on compliance with certain further conditions set out in company law. (dA) The parent holds more than 50% (but less than 90%) of the allotted shares in the entity, and notice requesting the preparation of consolidated financial statements has not been served on the entity by shareholders holding in aggregate at least 5% of the allotted shares in the entity. Exemption is conditional on compliance with certain further conditions set out in company law. Other situations (e) The parent, and the group headed by it, qualify as small20 and the parent and the group are considered eligible for the exemption.21 (f) All of the parent’s subsidiaries are required to be excluded from consolidation by paragraph 9.9.22 17 18 19 20 21

22

CA 2014, s 299. CA 2006, s 401. CA 2014, s 300. UK entities shall refer to CA 2006, s 383. Irish entities shall refer to CA 2014, s 280B. UK entities shall refer to CA 2006, ss 384 and 399(2A). Irish entities shall refer to CA 2014, ss 280B and 293(1A). UK entities shall refer to CA 2006, s 402. Irish entities shall refer to CA 2014, s 301.

16

Introduction 1.11 (g) For a parent not reporting under the Act, if its statutory framework does not require the preparation of consolidated financial statements. In sub-paragraphs (a) to (dA), for an entity reporting under the Act, the parent is not exempt if any of its transferable securities are admitted to trading on a UK regulated market and for an entity reporting under the Companies Act 2014, the parent is not exempt if any of its transferable securities are admitted to trading on a regulated market of any EEA State within the meaning of Directive 2004/39/EC.’23 To recap the history of FRS 102, para 9.3 for technical completeness purposes. This particular paragraph was amended in July 2015 due to The Companies, Partnerships and Groups (Accounts and Reports) Regulations 2015 (SI 2015/980) by inserting paragraph 9.3(bA) (see above). Prior to the amendments, CA 2006 did not distinguish between a majority-owned UK parent where more than 90% of the allotted shares are owned by the immediate parent and one where more than 50%, but less than 90%, are so owned. Prior to the July 2015 amendments, the exemption was not available if minority shareholders, holding in total more than 50% of the remaining allotted shares, or 5% of the total allotted shares, requested the parent to prepare consolidated financial statements. This request (ie, the notice) had to be served no later than six months after the end of the previous financial year. Prior to the July 2015 revisions to CA 2006, if the immediate parent owned 90% or more of the allotted shares, unanimous agreement by the remaining 10% was not required. Following the July 2015 revisions to CA 2006, unanimous agreement is required. If the immediate parent owns more than 50%, but less than 90% of the allotted shares, the exemption is not available when the minority shareholders holding in aggregate 5% of the total allotted shares have requested consolidated financial statements to be prepared. The notice must be received by the parent from the minority shareholders no later than six months before the end of the financial year to which it relates (CA 2006, s 400(1)(c)). Focus There are several exemptions from preparing consolidated financial statements available in company law and groups may be able to take advantage of them. However, care must be taken because groups can be complex in terms of identifying parents and intermediate parents as well as subsidiaries because it is easy to fall into one of the many pitfalls where the exemptions are concerned (especially given some of the complex changes to company law as a result of Brexit). In complex cases, it is always advisable to seek technical advice to ensure correct application of company law and/ or UK GAAP.

23

FRS 102, para 9.3.

17

1.12 Introduction

INELIGIBLE GROUPS 1.12 The term ‘ineligible’ means the group is unable to take for any exemptions that apply to small or medium-sized companies and groups. In practice, the effect of being an ineligible group means that exemptions for small and medium-sized companies are unavailable where a group member has shares admitted to trading on a UK regulated market (or for periods commencing before 1 January 2021, a regulated market rather than a UK regulated market). CA 2006, s 384 Companies excluded from the small companies regime, states that a company cannot qualify as small if it was, any time within the financial year to which the accounts relate: ‘(a) a public company, (b) a company that— (i) is an authorised insurance company, a banking company, an e-money issuer, a MiFID investment firm or a UCITS management company, or (ii) carries on insurance market activity, or (iii) is a scheme funder of a Master Trust scheme within the meanings given by section 39(1) of the Pension Schemes Act 2017 (interpretation of Part 1), or (c)

a member of an ineligible group.’

Where an ineligible group is concerned, (ie, in (c) above), the test of whether a small company is a member of an ineligible group is in a two-way direction (ie, up and down). It will therefore be necessary to look at the largest group of which the company is a member and consider whether it is ineligible. Focus This is not the same as the tests described earlier in this chapter. In the size tests above, it is only necessary to consider the size of the company and, where relevant, any subsidiaries. For ineligible group purposes, a group comprises its parent and its subsidiary undertakings but excludes investments in associates and joint ventures as well as investors which account for the reporting entity as an associate or joint venture.

According to the CA 2006, s 384(2) and s 467(2), a group becomes an ineligible group if any of its members is: ‘(a) a traded company, (b)

[For periods commencing on or after 1 January 2021] a body corporate (other than a company) whose shares are admitted to trading on a UK

18

Introduction 1.12 regulated market, or [For periods commencing before 1 January 2021] a body corporate (other than a company) whose shares are admitted to trading on a regulated market in an EEA State, (c)

a person (other than a small company) who has permission under Part 4A of the Financial Services and Markets Act 2000 (c. 8) to carry on a regulated activity,

(cA) an e-money issuer; (d) a small company that is an authorised insurance company, a banking company, a MiFID investment firm or a UCITS management company, or (e)

a person who carries on insurance market activity, or

(f)

a scheme funder of a Master Trust scheme within the meanings given by section 39(1) of the Pension Schemes Act 2017 (interpretation of Part 1).’24

(a) above refers to a ‘traded company’. This was changed from ‘a public company’ by virtue of The Companies, Partnerships and Groups (Accounts and Reports) Regulations 2015 (SI 2015/980). A ‘traded company’ is defined as: ‘[For periods commencing on or after 1 January 2021] … unless the context otherwise requires, means a company any of whose transferable securities are admitted to trading on a UK regulated market …’ [For periods commencing before 1 January 2021] … unless the context otherwise requires, means a company any of whose transferable securities are admitted to trading on a regulated market …’.25 Note, the reference to ‘UK’ was inserted for periods commencing on or after 1 January 2021. A ‘UK regulated market’ would be, for example, the London Stock Exchange. However, it would not include the Alternative Investment Market (AIM). For periods commencing on or after 1 January 2021, CA 2006, s 1173 goes on to define a ‘UK regulated market as follows: ‘“UK regulated market” has the meaning given in Article 2.1.13A of Regulation (EU) No. 600/20014 of the European Parliament and of the Council of 15 May 2014 and amending Regulation (EU) No. 648/2012.’

24 25

CA 2006, s 384(2) and s 467(2). CA 2006, s 474.

19

1.13 Introduction For periods commencing before 1 January 2021, CA 2006, s 1173 goes on to define ‘regulated market’ as follows: ‘“regulated market” has the meaning given in Article 2.1.13 of Regulation (EU) No. 600/2014 of the European Parliament and of the Council of 15 May 2014 and amending Regulation (EU) No. 648/2012.’ The amendments to CA 2006 by virtue of SI 2015/980 narrowed the definition of an ineligible group. In practice, it would mean that a private company which individually meets the qualifying conditions for exemptions will not be excluded if it is a member of a group which includes a PLC unless that company, or another entity in the group, has transferable securities admitted to trading on a UK regulated market (or for periods commencing before 1 January 2021, a regulated market rather than a UK regulated market). Example 1.5 – Subsidiary trades securities Laggon Ltd is a wholly-owned subsidiary of the Caledonian Group. Laggon trades its shares on AIM. AIM is not a UK regulated market and hence Laggon will not be ineligible for exemptions regardless of the size of the group. If Laggon Ltd were to be trading its shares on the London Stock Exchange (which is a UK regulated market), then this would mean the entire group would be ineligible. It must be borne in mind that where ineligible groups are concerned, a ‘group’ comprises a parent and its subsidiary undertakings. Where the member is an associate or joint venture of a company that is either an ineligible company or forms part of an ineligible group, the associate or joint venture entity is not, in itself, part of that group.

CA 2006, s 479A audit exemption 1.13 In terms of audit exemption, a subsidiary may be able to claim exemption from audit at subsidiary level under CA 2006, s 479A Subsidiary companies: conditions for exemptions from audit. For periods commencing on or after 1 January 2021, CA 2006, s 479A provides audit exemption for companies which are subsidiaries whose parent undertaking is established under the law of any part of the UK. There are strict conditions that must be met where the s 479A exemption is concerned which often means that, in practice, the subsidiary does not take advantage of the audit exemption. The conditions are as follows: ‘(a) all members of the company must agree to the exemption in respect of the financial year in question,

20

Introduction 1.13 (b) the parent undertaking must give a guarantee under section 479C in respect of that year, (c)

the company must be included in the consolidated accounts drawn up for that year or to an earlier date in that year by the parent undertaking in accordance with— (i) if the undertaking is a company, the requirements of Part 15 of this Act, or, if the undertaking is not a company, the legal requirements which apply to the drawing up of consolidated accounts for that undertaking, or (ii) UK-adopted international accounting standards (within the meaning given by section 474(1)),

(d) the parent undertaking must disclose in the notes to the consolidated accounts that the company is exempt from the requirements of this Act relating to the audit of individual accounts by virtue of this section, and (e)

the directors of the company must deliver to the registrar on or before the date that they file the accounts for that year— (i) a written notice of the agreement referred to in subsection (2)(a), (ii) the statement referred to in section 479C(1), (iii) a copy of the consolidated accounts referred to in subsection (2)(c), (iv) a copy of the auditor’s report on those accounts, and (v) a copy of the consolidated annual report drawn up by parent undertaking.’26

In practice, it is the guarantee under CA 2006, s 479C Subsidiary companies audit exemption: parent undertaking declaration of guarantee which is the ‘sting in the tail’. The guarantee is that the parent will guarantee the subsidiary’s debts until they are satisfied in full. This guarantee will be enforceable against the parent undertaking by any person to whom the subsidiary is liable in respect of those liabilities. Many parent companies are unwilling to guarantee the debts of their subsidiary and hence audit exemption cannot be taken under CA 2006, s 479A. However, where the parent is willing to guarantee the subsidiary’s liabilities and complies with the other protocol outlined in s 479A, audit exemption can be claimed. In such cases, a statement must be made on the face of the subsidiary’s balance sheet that audit exemption under CA 2006, s 479A has been claimed. For periods commencing before 1 January 2021, the s 479A audit exemption was wider in scope and, with similar criteria, was available where a UK or EEA parent prepared the consolidated financial statements and provided the guarantee.

26

CA 2006, s 479A (extract).

21

1.13 Introduction

CHAPTER ROUNDUP ●●

There are six FRSs in the suite of UK GAAP (FRS 100 to FRS 105). FRS 104 is not, however, an accounting standard.

●●

Consolidated financial statements involve the interaction of several sections of FRS 102.

●●

Groups are scoped out of the requirements of FRS 105.

●●

The objective of consolidated financial statements is to show the results of the group in line with its economic substance, which is that of a single reporting entity.

●●

Small groups are exempt from preparing consolidated financial statements and further exemptions exist in company law which may not require consolidated financial statements.

●●

Exemptions are contained in FRS 102 which are largely based on the exemptions contained in company law.

22

Chapter 2

Overview of Consolidated Financial Statements and UK GAAP

SIGNPOSTS ●●

The Financial Reporting Council carry out periodic reviews of UK GAAP every four or five years to ensure it remains up-to-date and proportionate, although important emerging issues may be dealt with outside of this review cycle (see 2.1).

●●

There are reduced disclosure frameworks available in both FRS 101 and FRS 102 for subsidiaries and ultimate parents, but strict protocol must be followed prior to their application (see 2.5).

●●

A micro-entity which is a parent and prepares consolidated financial statements cannot apply FRS 105. They must apply FRS 102 as a minimum (see 2.9).

INTRODUCTION 2.1 UK Generally Accepted Accounting Practice (UK GAAP) consists of the following: ●●

FRS 100 Application of Financial Reporting Requirements

●●

FRS 101 Reduced Disclosure Framework

●●

FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland

●●

FRS 103 Insurance Contracts

●●

FRS 104 Interim Financial Reporting1

●●

FRS 105 The Financial Reporting Standard applicable to the Microentities Regime

UK GAAP is maintained by the Financial Reporting Council (FRC) who are due to transition to the Audit, Reporting and Governance Authority (ARGA) in 2023.2 1

2

FRS 104 is not an accounting standard – see 2.8 below. On 18 January 2022, the FRC published a three-year plan and budget to prepare for the transition to ARGA.

23

2.1 Overview of Consolidated Financial Statements and UK GAAP This transition to ARGA is unlikely to have a significant impact on preparers and is in response to the review of the FRC carried out by Sir John Kingman in 2018. The FRC carry out regular reviews of UK GAAP to ensure that it remains proportionate and up-to-date. At the time of writing the FRC had started the process for the next periodic review of UK GAAP which aims to make changes to the accounting standards to ensure they are fit for purpose and proportionate as well as reflecting stakeholder feedback. While the periodic review will primarily be focussed on FRS 102, all other FRSs in the suite of UK GAAP will see some changes as well. The FRC have indicated that an Exposure Draft of the proposed changes is expected to be issued in the second half of 2022, although this planned date could change over time. At the time of writing, the amendments arising from the periodic review are expected to apply for accounting periods commencing on or after 1 January 2025. Again, this date could also change hence it is always advisable to regularly check the FRC’s website (frc.org.uk) for updates. Focus It should be borne in mind that it may not necessarily be the case that all agreed amendments are effective for accounting periods commencing on or after 1 January 2025 (or whichever date the FRC finally agree upon). The FRC could bring forward, or defer, certain changes depending on feedback received and other issues which influence the standard-setting process. It may also be the case that some, or all, of the amendments are available for early adoption.

The FRC have said that they intend to carry out periodic reviews of UK GAAP every four or five years. This was a change in direction from the first Triennial Review of UK GAAP which was finalised in 2017. Carrying out periodic reviews every four or five years will not only allow the most recent editions of the standards to become firmly established, but it will also provide an opportunity for the FRC/ARGA to receive more constructive and detailed feedback as to how the latest edition of the standards have been applied in practice. This is also consistent with the FRC’s objective which is to provide succinct financial reporting standards that: ‘(a) have consistency with global accounting standards through the application of an IFRS-based solution unless an alternative clearly better meets the overriding objective; (b) balance improvement, through reflecting up-to-date thinking and developments in the way businesses operate and the transactions they undertake, with stability;

24

Overview of Consolidated Financial Statements and UK GAAP 2.3 (c)

balance consistent principles for accounting by all UK and Republic of Ireland entities with proportionate and practical solutions, based on size, complexity, public interest and users’ information needs;

(d) promote efficiency within groups; and (e)

are cost-effective to apply.’3

While the FRC have confirmed periodic reviews will be carried out every four or five years, if there are any issues that come to light which the FRC consider to be important, they will deal with the issue(s) outside of the periodic review cycle. This was the case with the amendments made to UK GAAP in respect of multi-employer defined benefit pension plans and COVID-19-related rent concessions. Essentially, the FRC will deal with important issues outside of the periodic review cycle to ensure diversity in practice is kept to a minimum. Comment periods on Exposure Drafts of proposed changes to UK GAAP are usually (but not always) open for a period of three months. These periods can be shorter depending on the urgency of the matter(s) at hand. In some cases, a comment period can be very short, as was the case when the FRC made changes to FRS 102 and FRS 105 in respect of COVID-19-related rent concessions.

FRS 100 2.2 FRS 100 Application of Financial Reporting Requirements outlines the applicable financial reporting framework for entities which prepare financial statements in accordance with legislation, regulation or accounting standards applicable in the UK and Republic of Ireland. FRS 100 also requires that where an entity is subject to a Statement of Recommended Practice (SORP), the relevant SORP will apply in the circumstances set out in the FRS. In addition, if the entity (other than a small entity) follows a SORP, then it must state in its financial statements the title of the relevant SORP followed and whether the financial statements have been prepared in accordance with the SORP’s provisions which are currently in effect. FRS 100 applies to financial statements that are intended to give a true and fair view.

FRS 101 2.3 FRS 101 Reduced Disclosure Framework sets out disclosure exemptions available to certain qualifying entities, ie UK qualifying subsidiaries and parent companies that otherwise apply the recognition, measurement and disclosure requirements of IFRS. 3

FRS 102, Basis for Conclusions, para A.2(a)–(e).

25

2.3 Overview of Consolidated Financial Statements and UK GAAP The term ‘qualifying entity (for the purposes of this FRS)’ is defined as: ‘A member of a group where the parent of that group prepares publicly available consolidated financial statements which are intended to give a true and fair view (of the assets, liabilities, financial position and profit or loss) and that member is included in the consolidation. The following are not qualifying entities: (a) charities; (b) entities that are both required to apply Schedule 3 to the Regulations and have contracts that are within the scope of IFRS 17 Insurance Contracts; and (c) entities that are not companies but are both required to apply requirements similar to those in Schedule 3 to the Regulations4 and have contracts that are within the scope of IFRS 17.’5 The definition above means that the qualifying entity’s financial statements must be included in the consolidated financial statements prepared by the parent. In some cases, a parent company may not include a subsidiary in its consolidated financial statements because the subsidiary is immaterial to the group, or other exceptions or exemptions from consolidation apply. Where this is the case, the subsidiary would not meet the definition of a qualifying entity and hence would not be able to apply FRS 101. As mentioned above, the qualifying entity must also prepare its financial statements under the IFRS regime. There is, however, a reduced disclosure framework within FRS 102 which allows qualifying entities certain disclosure exemptions under that standard (see 2.5 below). Focus It should be noted that while both reduced disclosure frameworks in FRS 101 and FRS 102 allow qualifying entities to take advantage of certain disclosure exemptions in the individual financial statements, the exemptions do not apply to the consolidated financial statements. This prohibition also extends to small groups which voluntarily prepare consolidated financial statements. Entities meeting the definition of a ‘financial institution’ are also unable to apply the exemption from the disclosure requirements in IFRS 7 Financial Instruments: Disclosures, IFRS 13 Fair Value Measurement (to the extent that they apply to financial instruments) and the disclosure requirements in 4

5

Requirements that are similar to those in Schedule 3 to the Regulations include: (a) The Friendly Societies (Accounts and Related Provisions) Regulations 1994 (SI 1994/1983), Schs 1 and 2; (b) the Insurance Contracts Directive (Lloyd’s Syndicate and Aggregate Accounts) Regulations 2008 (SI 2008/1950), Sch 1; (c) Syndicate Accounting Byelaw No 8 of 2005; and (d) The Insurance Accounts Directive (Miscellaneous Insurance Undertakings) Regulations 2008 (SI 2008/565). FRS 101 Glossary qualifying entity (for the purposes of this FRS).

26

Overview of Consolidated Financial Statements and UK GAAP 2.3 IAS 1 Presentation of Financial Statements, paras 134–136 which outline the disclosure requirements in respect of the entity’s capital. A ‘financial institution’ is defined in FRS 102 as: ‘Any of the following: (a)

a bank which is: (i) a firm with a Part 4A permission6 which includes accepting deposits and: (a) which is a credit institution, or (b) whose Part 4A permission includes a requirement that it complies with the rules in the General Prudential sourcebook and the Prudential sourcebook for Banks, Building Societies and Investment Firms relating to banks, but which is not a building society, a friendly society or a credit union; (ii) an EEA bank which is a full credit institution;

(b) a building society which is defined in section 119(1) of the Building Societies Act 1986 as a building society incorporated (or deemed to be incorporated) under that act; (c) a credit union, being a body corporate registered under the Co-operative and Community Benefit Societies Act 2014 as a credit union in accordance with the Credit Unions Act 1979, which is an authorised person; (d) custodian bank or broker-dealer; (e)

an entity that undertakes the business of effecting or carrying out insurance contracts, including general and life assurance entities;

(f)

an incorporated friendly society incorporated under the Friendly Societies Act 1992 or a registered friendly society registered under section 7(1)(a) of the Friendly Societies Act 1974 or any enactment which it replaced, including any registered branches;

(g) an investment trust, Irish investment company, venture capital trust, mutual fund, exchange traded fund, unit trust, open-ended investment company (OEIC); or (h) [deleted] (i)

any other entity whose principal activity is similar to those listed above but is not specifically included in that list.

A parent entity whose sole activity is to hold investments in other group entities is not a financial institution.’7 6 7

As defined in the Financial Services and Markets Act 2000, s 55A or references to equivalent provisions of any successor legislation. FRS 102 Glossary financial institution.

27

2.4 Overview of Consolidated Financial Statements and UK GAAP FRS 101 acknowledges that financial statements prepared by qualifying entities under FRS 101 are not financial statements prepared in accordance with IFRS. Consequently, a qualifying entity must also ensure that it complies with any other legal requirements that may apply. FRS 101, para 4A provides an example of an individual set of financial statements prepared under FRS 101 and acknowledges that these are Companies Act accounts, not IAS accounts as set out in CA 2006, s 395(1). Hence, such accounts must comply with the requirements of CA 2006 together with any applicable Regulations, such as The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410).

FRS 101 protocol 2.4 In order to apply the reduced disclosure framework, a qualifying entity must ensure that it has followed correct protocol. The following conditions must be met to apply the reduced disclosure framework: (a)

The financial statements must be prepared under the IFRS regime. This includes the recognition, measurement and disclosure requirements but amended to comply with CA 2006 and associated Regulations. This is to ensure that the financial statements prepared by the qualifying entity comply with legislative requirements.

(b) The financial statements of the qualifying entity must disclose the following: (i)

a brief summary of the disclosure exemptions adopted; and

(ii) the name of the parent of the group in whose consolidated financial statements its financial statements are consolidated, and from where those financial statements can be obtained.

Disclosure exemptions available 2.5 FRS 101 currently provides the following disclosure exemptions (because a change to an IFRS can bring about a change to this list): Relevant IFRS

Disclosure exemption available

IFRS 1 First-time adoption of International Financial Reporting Standards

Paragraphs 6 and 21 which require an entity to present an opening statement of financial position at the date of transition.

IFRS 2 Share-based Payment

Requirements of paragraph 45(b) and 46 to 52, provided that: ●● if the qualifying entity is a subsidiary, the sharebased payment arrangement concerns equity instruments of another group entity; or

28

Overview of Consolidated Financial Statements and UK GAAP 2.5 Relevant IFRS

Disclosure exemption available ●● if the qualifying entity is an ultimate parent, the share-based payment arrangement is in relation to its own equity instruments and the ultimate parent’s own financial statements are presented alongside the consolidated financial statements. In both of the above cases, the equivalent disclosures must be made in the consolidated financial statements of the group in which the entity is consolidated.

IFRS 3 Business Combinations

The requirements in paragraphs 62, B64(d), B64(e), B64(g), B64(h), B64(j) to B64(m), B64(n)(ii), B64(o)(ii), B64(p), B64(q)(ii), B66 and B67. Again, equivalent disclosures must be included in the consolidated financial statements of the group in which the entity is consolidated.

IFRS 5 Non-current Assets Held for Sale and Discontinued Operations

The requirements of paragraph 33(c).

IFRS 6 Exploration for and Evaluation of Mineral Resources

Exemption from disclosing the operating and investing cash flows arising from the exploration for and evaluation of mineral resources.

IFRS 7 Financial Instruments: Disclosures

Exemption is available to qualifying entities in respect of all disclosure requirements, provided that the equivalent disclosures are made in the consolidated financial statements of the group in which the entity is consolidated. A qualifying entity which is a financial institution cannot take advantage of this disclosure exemption.

IFRS 13 Fair Value Measurement

The requirements of paragraphs 91 to 99 provided that equivalent disclosures are made in the consolidated financial statements of the group in which the entity is consolidated.

IFRS 15 Revenue from Contracts with Customers

The requirements of the second sentence of paragraph 110 and paragraphs 113(a), 114, 115, 118, 119(a) to (c), 120 to 127 and 129.

IFRS 16 Leases

The requirements of paragraph 52, the second sentence of paragraph 89, and paragraphs 90, 91 and 93. The requirements of paragraph 58, provided that the disclosure of details of indebtedness required by paragraph 61(1) of Schedule 1 to The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410) is presented separately for lease liabilities and other liabilities, and in total

29

2.5 Overview of Consolidated Financial Statements and UK GAAP Relevant IFRS

Disclosure exemption available

IAS 1 Presentation of Financial Statements

The requirement in paragraph 38 of IAS 1 to present comparative information in respect of: ●● paragraph 79(a)(iv) of IAS 1; ●● paragraph 73(e) of IAS 16 Property, Plant and Equipment; ●● paragraph 118(e) of IAS 38 Intangible Assets; ●● paragraphs 76 and 79(d) of IAS 40 Investment Property; and ●● paragraph 50 of IAS 41 Agriculture. The requirements of paragraphs 10(d), 10(f), 16, 38A, 38B, 38C, 38D, 40A, 40B, 40C, 40D, 111 and 134 to 136.

IAS 7 Statement of Cash Flows

Full exemption available.

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors

Paragraphs 30 and 31.

IAS 16 Property, Plant and The requirements of paragraph 74A(b). Equipment IAS 24 Related Party Disclosures

The requirements of paragraphs 17 and 18A and the requirements to disclose related party transactions entered into between two or more members of a group, provided that any subsidiary which is a party to the transaction is wholly owned by such a member.

IAS 36 Impairment of Assets

Paragraphs 130(f)(ii), 130(f)(iii), 134(d) to 134(f) and 135(c) to 135(e) provided that equivalent disclosures are included in the consolidated financial statements of the group in which the entity is consolidated.

There is a reduced disclosure framework contained in FRS 102, para 1.12. However, there are some important considerations which need to be understood where this is concerned.

Focus A qualifying entity (for the purposes of FRS 102) is defined differently than that in FRS 101. FRS 102 defines a ‘qualifying entity (for the purposes of this FRS)’ as: ‘A member of a group where the parent of that group prepares publicly available consolidated financial statements which are intended to give

30

Overview of Consolidated Financial Statements and UK GAAP 2.5 a true and fair view (of the assets, liabilities, financial position and profit or loss) and that member is included in the consolidation.8,9 A qualifying entity for the purposes of FRS 102 which meets the definition of a financial institution may take advantage of the disclosure exemptions contained in FRS 102, para 1.12 (except for the disclosure exemptions from Section 11 Basic Financial Instruments and Section 12 Other Financial Instruments Issues). In addition, a qualifying entity for the purposes of FRS 102 which is required to prepare consolidated financial statements (eg, if the entity is required by CA 2006, s 399 to prepare consolidated financial statements and is not entitled to any of the exemptions in CA 2006, ss 400–402), or is a parent which voluntarily prepares consolidated financial statements, may not take advantage of the disclosure exemptions in FRS 102, para 1.12 in the consolidated financial statements.

A qualifying entity for the purposes of FRS 102 can take advantage of the disclosure exemptions contained in FRS 102, para 1.12 provided that: ●●

It applies the recognition, measurement and disclosure requirements of FRS 102.

●●

It discloses in the notes to the financial statements: ––

a brief narrative summary of the disclosure exemptions adopted; and

––

the name of the parent of the group in whose consolidated financial statements its own financial statements are consolidated and from where those financial statements may be obtained.

The disclosure exemptions are as follows: Relevant section

Disclosure exemption available

Section 7 Statement of Cash Flows

Full exemption available including FRS 102, para 3.17(d).

Section 11 Basic Financial Instruments and Section 12 Other Financial Instruments Issues

The requirements of paragraphs 11.42, 11.44, 11.45, 11.47, 11.48(a)(iii), 11.48(a) (iv), 11.48(b), 11.48(c), 12.26 (in relation to those cross-referenced paragraphs from which a disclosure exemption is available), 12.27 to 12.29(a), 12.29(b), 12.29A and 12.30 provided disclosures equivalent to those required by FRS 102 are included in the consolidated financial statements of the group in which the entity is consolidated.

8 9

As set out in CA 2006, s 474(a). FRS 102 Glossary qualifying entity (for the purposes of this FRS).

31

2.6 Overview of Consolidated Financial Statements and UK GAAP Relevant section

Disclosure exemption available

Section 26 Share-based Payment

The requirements of paragraphs 26.18(b), 26.19 to 26.21 and 26.23, provided that for a qualifying entity that is: ●● a subsidiary, the share-based payment arrangement concerns equity instruments of another group entity; ●● an ultimate parent, the share-based payment arrangement concerns its own equity instruments and its separate financial statements are presented alongside the consolidated financial statements of the group; and, in both cases, provided that equivalent disclosures required by FRS 102 are included in the consolidated financial statements of the group in which the entity is consolidated. Paragraph 33.7.

Section 33 Related Party Disclosures

There is also an exemption from the requirements of paragraph 24(b) to IFRS 6 to disclose the operating and investing cash flows arising from the exploration for and evaluation of mineral resources (when an entity applies IFRS 6 in accordance with FRS 102, para 34.11).

FRS 102 2.6 FRS 102 can be considered to be the ‘backbone’ of UK GAAP and outlines the recognition, measurement and disclosure requirements for financial statements. FRS 102 has its ‘roots’ based on the principles found in IFRS for SMEs® which is issued by the International Accounting Standards Board, although it is incorrect to say it is completely aligned to IFRS for SMEs. For example, IFRS for SMEs recognises the concept of ‘public accountability’ which is not defined in UK company law and hence FRS 102 does not follow that concept. In addition, FRS 102, Section 29 Income Tax is notably very different to Section 29 of IFRS for SMEs given that the UK and Republic of Ireland recognise deferred tax on a timing difference, rather than a temporary difference, basis. The structure of FRS 102 is as follows: Section Overview 1 1A

Contents Scope Small Entities Appendix A: Guidance on adapting the balance sheet formats Appendix B: Guidance on adapting the profit and loss account formats

32

Overview of Consolidated Financial Statements and UK GAAP 2.6 Section

Contents Appendix C: Disclosure requirements for small entities in the UK Appendix D: Disclosure requirements for small entities in the Republic of Ireland Appendix E: Additional disclosures encouraged for small entities

2

Concepts and Pervasive Principles Appendix: Fair value measurement

3

Financial Statement Presentation

4

Statement of Financial Position

5

Statement of Comprehensive Income and Income Statement Appendix: Example showing presentation of discontinued operations

6

Statement of Changes in Equity and Statement of Income and Retained Earnings

7

Statement of Cash Flows

8

Notes to the Financial Statements

9

Consolidated and Separate Financial Statements

10

Accounting Policies, Estimates and Errors

11

Basic Financial Instruments

12

Other Financial Instruments Issues Appendix: Examples of hedge accounting

13

Inventories

14

Investments in Associates

15

Investments in Joint Ventures

16

Investment Property

17

Property, Plant and Equipment

18

Intangible Assets other than Goodwill

19

Business Combinations and Goodwill

20

Leases

21

Provisions and Contingencies Appendix: Examples of recognising and measuring provisions

22

Liabilities and Equity Appendix: Example of the issuer’s accounting for convertible debt

23

Revenue Appendix: Examples of revenue recognition

24

Government Grants

25

Borrowing Costs

26

Share-based Payment

27

Impairment of Assets

33

2.7 Overview of Consolidated Financial Statements and UK GAAP Section

Contents

28

Employee Benefits

29 30 31 32 33 34

Income Tax Foreign Currency Translation Hyperinflation Events after the End of the Reporting Period Related Party Disclosures Specialised Activities ●● Agriculture ●● Extractive Activities ●● Service Concession Arrangements ●● Financial Institutions ●● Retirement Benefit Plans: Financial Statements ●● Heritage Assets ●● Funding Commitments ●● Incoming Resources from Non-exchange Transactions ●● Public Benefit Entity Combinations ●● Public Benefit Entity Concessionary Loans ●● Appendix A: Guidance on funding commitments ●● Appendix B: Guidance on incoming resources from non-exchange transactions 35 Transition to this FRS Appendices: I Glossary II Table of equivalence for company law terminology III Note on legal requirements IV Republic of Ireland legal references Approval by the FRC Basis for Conclusions FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland

FRS 103 2.7 FRS 103 is a very industry-specific standard which outlines the reporting requirements for entities that apply FRS 102 in the preparation of their financial statements who issue insurance contracts or reinsurance

34

Overview of Consolidated Financial Statements and UK GAAP 2.8 contracts. As a result, FRS 103 is beyond the scope of this book, however, a brief overview is as follows: A revised edition of FRS 103 was issued in February 2017 which incorporated the amendments arising as a result of the introduction of Solvency II in May 2016. The latest edition of FRS 103 is the January 2022 edition. FRS 103, para A4.2A clarifies a legal requirement regarding a reference to the Solvency II Directive in The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410) on which the Department for Business, Energy and Industrial Strategy wrote to the Financial Reporting Council confirming that there is no requirement to change the accounting basis to one consistent with Solvency II. Essentially, FRS 103 allows an entity that writes insurance contracts and reinsurance contracts to continue with their existing accounting policies, including the appropriate measurement of long-term insurance business. FRS 103 requires disclosures which: (a) identify and explain the amount in an insurer’s financial statements arising from the insurance contracts (including reinsurance contracts) which the entity issues and reinsurance contracts which it holds; (b)

relate to the financial strength of entities carrying on long-term insurance business; and

(c)

help the users of the financial statements to understand the amount, timing and uncertainty of future cash flows from those insurance contracts.

FRS 104 2.8 FRS 104 outlines the reporting requirements for entities applying UK and Irish GAAP and who prepare interim financial statements.

Focus FRS 104 does not require an entity to prepare an interim report; nor does it change the extent to which laws and regulations require the preparation of such a report and hence this is the reason why FRS 104 is not considered to be an accounting standard. Where the entity is subject to the requirements of the Disclosure and Transparency Rules, the entity is required to prepare a half-yearly financial report which must include a condensed set of financial statements. FRS 104 is intended for use in the preparation of interim reports by entities applying FRS 102. In addition, a qualifying entity applying FRS 101 may also use FRS 104 as a basis for its interim financial report.

35

2.9 Overview of Consolidated Financial Statements and UK GAAP An important point to emphasise is that while FRS 104 does not make any obligation for entities to produce interim financial reports, where the entity does prepare such a report and makes a statement of compliance with FRS 104, the entity must ensure that it applies all the provisions of FRS 104. As a minimum, an interim financial report must comprise: (a)

a condensed statement of financial position (balance sheet);

(b) a single condensed statement of comprehensive income or a separate condensed income statement (profit and loss account) and a separate condensed statement of comprehensive income; (c)

a condensed statement of changes in equity;

(d) a condensed statement of cash flows; and (e)

selected explanatory notes.

Focus It is important that the single condensed statement of comprehensive income or single condensed income statement is consistent with the basis of presentation applied in the entity’s most recent annual financial statements.

FRS 105 2.9 FRS 105 applies to micro-entities. A ‘micro-entity’ is defined in FRS 105 as follows: ‘A micro-entity is: (a) a company meeting the definition of a micro-entity as set out in section 384A of the Act,10 and not prevented from applying the micro-entity provisions by section 384B of the Act; (b) an LLP which qualifies as a micro-entity and is not prevented from applying the micro-entity provisions in accordance with Regulation 5A of the Limited Liability Partnerships (Accounts and Audit) (Application of Companies Act 2006) Regulations 2008 (SI 2008/1911); or (c)

10

11

a qualifying partnership that would meet the definition of a microentity as set out in section 384A of the Act, and not be prevented from applying the micro-entity provisions by section 384B of the Act, if the partnership were a company.’11

Irish micro-entities (including partnerships that are required to comply with Part 6 of CA 2014, by virtue of the European Communities (Accounts) Regulations 1993 (as amended)) shall refer to CA 2014, s 280D. FRS 105 Glossary micro-entity.

36

Overview of Consolidated Financial Statements and UK GAAP 2.10 FRS 105 is restrictive in its application and the eligibility criteria must be carefully considered at the outset. For example, a charitable company cannot apply FRS 105. In addition, a parent company that is required, or chooses, to prepare consolidated financial statements is excluded from the micro-entity regime and hence cannot apply FRS 105. Focus If a micro-entity that is a parent wishes to prepare consolidated financial statements, then it must report under FRS 102 as a minimum. In practice, very few groups which would be classed as small in the eyes of company law prepare consolidated financial statements due to the costs involved of preparing such statements; however, some small groups do voluntarily prepare consolidated financial statements. If the micro-entity is a parent but does not prepare consolidated financial statements then it may be eligible to report under FRS 105, provided other eligibility criteria are met.

SMALL GROUPS 2.10 A group will be classed as small in the eyes of company law if it does not breach two of the following three criteria for two consecutive years: Turnover

Balance sheet total (gross assets)

Average employee headcount

Net

£10.2m

£5.1m

50

Gross

£12.2m

£6.1m

50

Keep in mind that references to ‘net’ mean that the effects of intra-group trading have been eliminated; whereas ‘gross’ means that they have not. Focus A group qualifies as small in relation to the parent company’s first financial year if the qualifying conditions are met in that year. There are some groups which will never be eligible to qualify as small due to the nature of their business and this includes groups where any entity within the group is: ●●

a MiFID investment firm;

●●

a UCITS management company; 37

2.10 Overview of Consolidated Financial Statements and UK GAAP ●●

an entity authorised under the Banking Consolidation Directive or the Insurance Directives;

●●

an e-money issuer;

●●

an entity listed on a UK stock market (eg the London Stock Exchange).

CA 2006, s 399(2A) states: ‘A company is exempt from the requirement to prepare group accounts if— (a)

at the end of the financial year, the company— (i) is subject to the small companies regime, or (ii) would be subject to the small companies regime but for being a public company, and

(b)

is not a member of a group which, at any time during the financial year, has an undertaking falling within subsection (2B) as a member.’12

CA 2006, s 399(2B) states: ‘An undertaking falls within this subsection if— (a)

it is established under the law of any part of the United Kingdom,

(b) it has to prepare accounts in accordance with the requirements of this Part of this Act, and (c) it— (i) is an undertaking whose transferable securities are admitted to trading on a UK regulated market, (ii) is a credit institution within the meaning given by Article 4(1)(1) of Regulation (EU) No. 575/2013 of the European Parliament and of the Council, which is a CRR firm within the meaning of Article 4(1)(2A) of that Regulation, or (iii) would be an insurance undertaking within the meaning given by Article 2(1) of Council Directive 91/674/EEC of the European Parliament and of the Council on the annual accounts of insurance undertakings were the United Kingdom a member State.’13 As noted earlier in this chapter, many small groups tend not to prepare consolidated financial statements because they claim exemption from such under CA 2006, s 399(2A). However, where the parent of a small group wishes to prepare consolidated financial statements on a voluntary basis, FRS 102, para 1A.22 states: ‘If a small entity that is a parent voluntarily chooses to prepare consolidated financial statements it: (a) shall apply the consolidation procedures set out in Section 9 Consolidated and Separate Financial Statements; 12 13

CA 2006, s 399(2A). CA 2005, s 399(2B).

38

Overview of Consolidated Financial Statements and UK GAAP 2.11 (b) is encouraged to provide the disclosures set out in paragraph 9.23;14 (c) shall comply so far as practicable with the requirements of Section 1A as if it were a single entity (Schedule 6 of the Small Companies Regulations, paragraph 1(1)15 (d) shall provide any disclosures required by Schedule 6 of the Small Companies Regulations.16’17

FRS 102, SECTION 9 CONSOLIDATED AND SEPARATE FINANCIAL STATEMENTS 2.11 FRS 102, Section 9 applies to parent entities which prepare consolidated financial statements in accordance with CA 2006 or, for Irish entities, Companies Act 2014 (CA 2014). The consolidated financial statements that are prepared by the parent entity must intend to present a true and fair view of the financial position and profit or loss (or income and expenditure) of the group, regardless as to whether, or not, they report under the Act. When a parent entity does not report under company law, but prepares consolidated financial statements, they must still prepare those consolidated financial statements in accordance with the requirements of FRS 102, Section 9 and of the Act referred to in that section. The exception to this rule would be where consolidated financial statements are not required and except to the extent that the requirements of FRS 102, Section 9 are not permitted by any statutory framework under which the entity reports. There is an apparent contradiction between the scope of FRS 102, Section 9 and FRS 102, para 9.3(g). In practice, an entity that is a parent which is located overseas may not be required to prepare consolidated financial statements under UK company law except to the extent that the requirements are not permitted by any statutory framework under which the entity reports. FRS 102, para 9.3 provides some exemptions from the requirement to prepare consolidated financial statements and FRS 102 para 9.3(g) states: ‘For a parent not reporting under the Act, if its statutory framework does not require the preparation of consolidated financial statements.’18 Hence it would appear that FRS 102, para 9.3(g) would be more commonly applied in practice.

14 15 16

17 18

Irish small entities are required to provide certain of these disclosures. Irish small entities shall refer to CA 2014, Sch 4A, para 2(1). Irish small entities shall refer to CA 2014, Sch 4A and ss 294, 296, 307 to 309, 317, 320, 321 and 323. FRS 102, para 1A.22. FRS 102, para 9.3(g).

39

2.12 Overview of Consolidated Financial Statements and UK GAAP

FRS 102, SECTION 19 BUSINESS COMBINATIONS AND GOODWILL 2.12 FRS 102, Section 19 applies when a parent entity acquires a subsidiary during the reporting period. The term ‘business combination’ is defined in FRS 102 as: ‘The bringing together of separate entities or businesses into one reporting entity.’19 FRS 102, Section 19 applies to all business combinations, however, the scope section at FRS 102, para 19.2 states that Section 19 does not apply to: (a)

the formation of a joint venture; and

(b) the acquisition of a group of assets that does not constitute a business. For clarity, the term ‘business’ is defined as: ‘An integrated set of activities and assets conducted and managed for the purpose of providing: (a)

a return to investors; or

(b)

lower costs or other economic benefits directly and proportionately to policyholders or participants.

A business generally consists of inputs, processes applied to those inputs, and resulting output that are, or will be, used to generate revenues. If goodwill is present in a transferred set of activities and assets, the transferred set shall be presumed to be a business.’20 FRS 102, para PBE19.2A also states that: ‘In addition, public benefit entities shall consider the requirements of Section 34 Specialised Activities in accounting for public benefit entity combinations.’21 An acquisition of a group of assets which does not constitute a business cannot be a business combination so would not fall within the scope of FRS 102, Section 19. Hence, it follows that when a group of assets is acquired which does not constitute a business, no goodwill is recognised in the consolidated financial statements and the purchase consideration is simply allocated to the assets acquired.

19 20 21

FRS 102 Glossary business combination. FRS 102 Glossary business. FRS 102, para PBE19.2A.

40

Overview of Consolidated Financial Statements and UK GAAP 2.12 Focus Whether, or not, there has been a business combination will sometimes require professional judgement. It is important that the substance of the arrangement is considered rather than the arrangement’s legal form. When reference is made to the ‘substance’ of an arrangement, it means considering the commercial reality of the arrangement. Careful documentation of such judgements will often be needed, especially for audit purposes.

In a business combination when goodwill arises on acquisition (ie, where the cost of the combination exceeds the fair value of the net assets acquired) it is dealt with in FRS 102, Section 19. Chapter 5 examines goodwill in more detail, but it must be amortised on a systematic basis over its useful life. There is no option under FRS 102 to assign indefinite useful lives to goodwill. While accounting for goodwill is set out in Section 19, amortisation issues are dealt with in FRS 102, Section 18 Intangible Assets other than Goodwill. Therefore, preparers must keep in mind that there is often overlap between different sections of FRS 102. This is examined further in Chapter 1. In addition, assets acquired in a business combination will also be subject to the impairment requirements of FRS 102, Section 27 Impairment of Assets. This requires management to assess whether the group’s assets are showing indicators of impairment and, if so, to carry out an impairment test which involves establishing a recoverable amount for the asset or the cash-generating unit to which the asset belongs. Chapter 5 examines the issues relevant to impairment within a group context.

CHAPTER ROUNDUP ●●

UK GAAP consists of five accounting standards (FRS 104 Interim Financial Reporting is not an accounting standard) and is maintained by the Financial Reporting Council who will eventually transition to the Audit, Reporting and Governance Authority.

●●

FRS 100 Application of Financial Reporting Requirements outlines the applicable financial reporting framework for entities.

●●

FRS 101 Reduced Disclosure Framework provides a reduced disclosure framework for entities preparing their financial statements under the IFRS regime.

41

2.12 Overview of Consolidated Financial Statements and UK GAAP ●●

FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland is the ‘main’ accounting standard used by private entities in the UK and Republic of Ireland.

●●

FRS 103 Insurance Contracts is applied by entities who issue insurance or reinsurance contracts and prepare their financial statements under FRS 102.

●●

FRS 104 Interim Financial Reporting outlines the reporting requirements for entities applying UK and Irish GAAP that are required to prepare interim financial statements (eg, under the Disclosure and Transparency Rules).

●●

FRS 105 The Financial Reporting Standard applicable to the Microentities Regime is a separate standard for micro-entities. Groups are beyond the scope of FRS 105.

●●

FRS 102, Section 9 Consolidated and Separate Financial Statements applies to parent entities which prepare consolidated financial statements in accordance with company law and which are intended to give a true and fair view of the financial position and profit or loss of the group.

●●

FRS 102, Section 19 Business Combinations and Goodwill applies when one entity (the parent) acquires a controlling ownership interest in another entity (the subsidiary).

42

Chapter 3

Group Accounts: Introduction

SIGNPOSTS ●●

Control is the power to govern the financial and operating policies of an entity (see 3.2).

●●

Group structures can be complex, and it is therefore critical that a sound understanding of the group structure is obtained to enable correct preparation of the consolidated financial statements (see 3.6).

●●

There are specific issues that must be considered at individual group member level when intra-group loans are entered into to ensure these are correctly reflected in the separate financial statements of the transacting members (see 3.8).

INTRODUCTION 3.1 Consolidated financial statements (or ‘group accounts’ as they are often called) can be tricky to prepare. There is a lot more technical detail to consider when carrying out a consolidation to ensure that it is carried out correctly and in compliance with UK GAAP and company law requirements. In practice, there are often hurdles to overcome when preparing consolidated financial statements, such as agreeing and/or reconciling intra-group balances. Indeed, many accountants who work for companies that are involved in preparing monthly, quarterly or annual consolidated financial statements will tell you that in real life, agreeing intra-group balances alone can be an arduous exercise in itself. The preparation of consolidated financial statements becomes even more complicated when a group has a complex structure or subsidiaries which are located overseas. Overseas subsidiaries alone present logistical difficulties, such as translating the subsidiary’s individual financial statements into the group’s presentation currency. Due to the complex nature of group accounts, preparing and auditing consolidated financial statements requires particular skills and a high level of technical competence. While professional examinations will introduce students to the technical requirements of producing consolidated financial statements

43

3.2 Group Accounts: Introduction (indeed, the higher level papers may bring in some rather advanced issues), practical experience in preparing consolidated financial statements is essential. In addition to the usual audit considerations for a single entity, group audits can bring additional challenges, particularly with more complex group structures. Auditing of groups is considered in Chapter 12. The aim of this chapter is to introduce some important concepts where consolidated financial statements are concerned. In addition, there are some important points that are worthy of consideration where intra-group loans (in the individual financial statements of each transacting group member) are concerned as these have proven to be quite contentious since the introduction of FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland. These are covered from section 3.8 onwards in this chapter.

DEFINITION AND INTRODUCTION TO CONTROL 3.2

A group is defined as:

‘A parent and all its subsidiaries.’1 In the broadest sense of the term, a ‘parent’ is essentially the investor, and the subsidiary is the investee. In order for there to be a parent-subsidiary relationship, the parent has to have the ability to control the subsidiary. The concept of control is examined further in Chapter 5, but FRS 102 defines the term ‘control (of an entity)’ as: ‘The power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.’2 In practice, control is usually (but not always) obtained when a parent entity acquires an ownership interest of more than 50% in the net assets or voting rights of the subsidiary. Hence, even if the parent acquires an ownership interest of 50.01% this will usually demonstrate that control exists unless there is clear evidence to the contrary. An ownership interest of 50% or less will generally mean that the investor does not have control over the investee, again, unless there is clear evidence to the contrary. An ownership interest of 20 to 50% will usually indicate ‘significant influence’ exists and hence there is an investorassociate relationship (associates are examined in Chapter 6). Ownership interest of less than 20% is usually treated as an investment and hence is accounted for under the provisions of FRS 102, Section 11 Basic Financial Instruments or Section 12 Other Financial Instruments Issues as appropriate. While control is generally obtained through an ownership interest of more than 50%, this is not always the case. The substance of the arrangement needs to be carefully considered and this takes precedence over legal form. When we talk

1 2

FRS 102 Glossary group. FRS 102 Glossary control (of an entity).

44

Group Accounts: Introduction 3.3 about the ‘substance’ of an arrangement, we are referring to the ‘commercial reality’ of a transaction or event rather than its strict legal composition. According to FRS 102, para 9.5, control is presumed to exist when the parent owns more than half (ie, 50%), either directly or indirectly through subsidiaries, of the voting power of an entity. Therefore, while numeric benchmarks will usually give a good indicator that a control relationship exists, they are not always absolute. Indeed, control can still be obtained by a parent even with an ownership interest of 50% or less, for example if the parent has: ‘(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.’3 These examples are considered in more detail in Chapter 5.

Joint control 3.3 It is important to correctly distinguish between ‘control (of an entity)’ and ‘joint control’, both of which are defined terms in the Glossary to FRS 102. The term ‘joint control’ is defined as: ‘The contractually agreed sharing of control over an economic activity. It exists only when the strategic financial and operating decisions relating to the activity require the unanimous consent of the parties sharing control (the venturers).’4 The above definition relates to joint ventures and not to the acquisition of a subsidiary. It is easy to see why this could cause confusion given the fact the word ‘control’ appears in both definitions. For the purposes of consolidated financial statements, control only applies to the parent’s ability to control the financial and operating policies of the subsidiary. There can only be one parent in such a situation; whereas in a joint venture, there will be two or more parties exerting joint control. Joint ventures are examined in Chapter 7 of this book.

3 4

FRS 102, para 9.5(a)–(d). FRS 102 Glossary joint control.

45

3.4 Group Accounts: Introduction

LOSS OF CONTROL 3.4 As discussed earlier in this chapter, control arises when the parent owns more than half of the voting rights or net assets of the subsidiary; or there are other clear indicators that control exists even with an ownership interest of half or less than half of the voting rights or net assets. When a parent-subsidiary relationship is created, the results of the subsidiary are consolidated with those of the parent from the acquisition date. The ‘acquisition date’ is defined as: ‘The date on which the acquirer obtains control of the acquiree.’5 Where consolidated financial statements are required, the results of the subsidiary are included in the consolidation up to the date on which control is lost. Control can be lost when the parent disposes of its ownership interest in the subsidiary (either in full or in part) or external parties subscribe to shares in the subsidiary – for example, a convertible loan note holder may decide to receive settlement of the principal amount of the loan note in shares rather than in cash. This will dilute the parent’s shareholding such that control may be lost. The acquisition and disposal of interests is examined further in Chapter 8.

ACQUISITION OF CONTROL 3.5 Control can be acquired by a parent in a one-off transaction (ie, at the date of acquisition when consideration is paid); or it can be achieved in stages. You may also see acquisitions of control in stages called ‘piecemeal acquisitions’, ‘step acquisitions’ or ‘acquisitions on the step’. It means that the parent has obtained control by way of a series of transactions rather than in one single transaction. Step acquisitions have become increasingly common over the years. Indeed, some simple investments have eventually turned out to be wholly owned subsidiaries over time as the investor invests more in the investee. Step acquisitions are also examined in Chapter 8, and it is important that a sound understanding of these sorts of transactions is obtained because they are a common occurrence in practice and lend themselves to many pitfalls which must be avoided if the consolidated financial statements are to present a true and fair view.

GROUP STRUCTURES 3.6 FRS 102, para 19.4 acknowledges that a business combination (ie, a group) may be structured in a variety of ways for legal, taxation or other reasons. The paragraph goes on to confirm that the combination itself may involve one entity acquiring the equity of another entity, the purchase of all the net assets of another entity, the assumption of liabilities of another entity or the purchase of some of the net assets of another entity. 5

FRS 102 Glossary acquisition date.

46

Group Accounts: Introduction 3.6 This book is concerned with UK GAAP. However, there is often material in IFRS that can be usefully applied to UK GAAP to elaborate on the requirements contained in FRS 102. The Application Guidance in IFRS 3 Business Combinations, paragraph B6 provides further detail on the different types of business combination and provides examples as follows: (a)

one or more entities become subsidiaries of the acquirer, or the net assets of one or more entities are legally merged into the acquirer;

(b) one entity which is a party to the combination transfers its net assets to another combining entity; or the shareholders transfer their equity interests to another combining entity; (c)

all entities which are a party to the combination transfer their net assets to a newly formed business, or the shareholders transfer their equity interests to the newly formed business; and

(d) a group of former shareholders of one of the businesses which is a party to the combination obtains control of the combined entity. Group structures can be straightforward; for example, a parent company may acquire 80% of the voting rights or net assets of a subsidiary and hence this sort of structure would not be considered complex. However, group structures can be (and often are, nowadays) complex, for example, where there is a vertical group or a ‘D-shaped’ group. Example 3.1 – A vertical group structure Consider the following group structure:

Hill 60% Ratchford 75% Harrison In this group structure, Hill owns 60% of Ratchford and hence Ratchford is a subsidiary of Hill due to the ownership interest. Ratchford owns 75% of Harrison and hence Harrison is a subsidiary of Ratchford. This seems straightforward so far, but groups often have inherent complexities, and this example demonstrates one of these. The question arises as to whether Hill controls Harrison? In such structures, Harrison will be a subsidiary of Hill on the grounds that Hill controls Harrison through its control of Ratchford and hence Harrison is a

47

3.6 Group Accounts: Introduction subsidiary of Hill. Hill’s effective ownership interest in Harrison is calculated as 60% × 75% = 45% of Harrison. This calculation is a useful tool to use when it comes to the consolidation exercise but is irrelevant in determining the status of the investment because status is always based on control. All three companies form a group. Hill is the parent company and both Ratchford and Harrison are its subsidiaries and hence the subsidiaries’ individual financial statements will be consolidated with those of Hill to form the group accounts. Example 3.2 – A ‘D-shaped’ group Consider the following group structure:

Hall 70% Whitaker

5%

60% Heaton In this example, Hall’s indirect and direct ownership interest will need to be calculated. Clearly, as Hall owns 70% of Whitaker, Whitaker becomes Hall’s subsidiary. As Whitaker owns 60% of Heaton, Heaton becomes Whitaker’s subsidiary. The question arises as to the ownership interest of Hall in Heaton. This is calculated as follows: Indirect ownership interest 70% × 60% Direct ownership interest

42%

Per group structure Hall’s ownership interest Non-controlling interest

5% 47% 53%

The key to identifying a subsidiary in a complex group structure is based on establishing control. To establish control, the holdings of the parent and of other companies within the group must be considered in aggregate. In addition, the date of acquisition must be carefully considered because this is the date on which the parent effectively obtains control over a subsidiary.

48

Group Accounts: Introduction 3.7

INTRA-GROUP TRANSACTIONS AND BALANCES 3.7 As you will see in Chapter 5, all intra-group transactions and balances (including unrealised profits and losses) must be eliminated at group level. This is to enable the consolidated financial statements to present the results of the group in line with its economic substance, which is that of a single reporting entity.

Focus The economic substance of a transaction or event is pivotal in financial reporting. Financial statements (whether individual or consolidated) must reflect the substance of transactions and not a transaction’s legal form. When reference is made to ‘economic substance’ it can be interpreted as the transaction’s ‘commercial reality’.

In almost all cases, members of a group will often trade with each other. This trading is not ‘real’ trading until the goods in the transaction have been sold to parties which are external to the group. For example, a parent entity may sell goods to its subsidiary at a 25% profit. The parent’s individual financial statements will record the sale and the subsidiary will record the purchase in cost of sales/inventory. In the group accounts the transaction must be eliminated because it is not a true sale – it is merely a transfer of goods from one group member to another. If any of the goods are still held in the inventory of the subsidiary at the reporting date, the unrealised profit must also be removed on consolidation. This is all pretty straightforward. When accountants were studying their professional financial reporting exams, they would have come across the requirement to eliminate intra-group transactions and balances when preparing consolidated financial statements and this is exactly the same in practice. What has become a ‘bone of contention’ however under UK GAAP is the treatment of intra-group loans. When FRS 102 was first introduced, it became apparent that the treatment of intra-group loans was notably different under FRS 102 than was the case under old UK GAAP.

Focus References to old UK GAAP are being kept to an absolute minimum in this book because the old standards have been redundant for several years. Therefore, introducing comparisons to old UK standards unless considered necessary may confuse the issue at hand.

49

3.8 Group Accounts: Introduction

Financing transactions 3.8 The Glossary to FRS 102 does not define the term ‘financing transaction’ but a definition is contained within FRS 102, para 11.13 which clarifies how a financing transaction may arise as follows: ‘… An arrangement constitutes a financing transaction if payment is deferred beyond normal business terms or is financed at a rate of interest that is not a market rate, for example, providing interest-free credit to a buyer for the sale of goods or an interest-free or below market interest rate loan made to an employee.’6 One common type of financing transaction that arises in a group context is the provision of a loan by one group member to another where that loan is either at a rate of interest which is below market rate; or is provided at a zero rate of interest (ie, interest-free). In practice, many intra-group loans are usually unstructured (in other words, they do not have formal loan terms attached to them). Therefore, FRS 102 would regard these types of loans as being repayable on demand. As such, the borrowing group member would recognise the loan within current liabilities in its individual financial statements; and the lending group member would recognise the loan as a current asset. As the loan contains no formal loan terms, it is recognised at the amount repayable on demand and hence no discounting to present value using an imputed market rate of interest would be necessary. Where a loan is formalised (ie, it is covered by formal terms) and attracts a rate of interest which is below market rate, or the loan is interest-free, this will constitute a financing transaction. In a group situation, the group must measure the financial asset (in the lending group member’s books) and the financial liability (in the borrowing group member’s books) at present value using a rate of interest for a similar debt instrument; for example, a rate of interest which the bank would charge on an equivalent loan to the group member. The difference between the present value of the loan and the transaction price is known as a ‘measurement difference’. Focus The issues concerning intra-group financing transactions only affect the individual financial statements of the borrowing and lending group member. At group level, the intra-group financing transaction would be eliminated and hence becomes irrelevant for the consolidated financial statements.

6

FRS 102, para 11.13 (extract).

50

Group Accounts: Introduction 3.8

Example 3.3 – Computing a measurement difference for a below market rate loan On 1 January 2020, Sunnie Ltd lends £350,000 to its subsidiary. The loan is covered by formal loan terms and repayment is due in two years’ time. The interest on the loan is at 5%, but if the subsidiary were to obtain a similar loan from its bank, the bank would charge 10%. As the loan has been entered into at below market rates of interest, the arrangement constitutes a financing transaction. There are terms in place and hence the loan is not repayable on demand. The equivalent interest rate is 10% and the present value of the loan is calculated as follows: Year

Cash flow Discount factor7 (10%)

Present value

2020

17,500

0.90909

15,909

2021

367,500

0.82645

303,720 319,629

The measurement difference is calculated as the difference between the transaction price of the loan (£350,000) and the present value (£319,629) which is £30,371 and must be reflected in the individual financial statements of each group member. The entries in the individual accounts of the parent and subsidiary are as follows: In Sunnie’s books: £ Dr Loan debtor

319,629

Dr Cost of investment Cr Cash at bank

30,371 350,000

In the subsidiary’s books: £ Dr Cash at bank

350,000

Cr Loan creditor

319,629

Cr Capital contribution

7

30,371

As a reminder, to calculate the discount factor for a cash flow one year in the future, you simply divide 1 by (interest rate plus 1). For year 2, it is 1 divided by the square of (interest rate plus 1), etc. Hence, at 10%: in year 1 the discount factor = 1/(1+10%) = 0.90909; in year 2, the discount factor is 1/(1+10%)2 = 0.82645.

51

3.9 Group Accounts: Introduction In the above example, the measurement difference represents the value of the benefit which the borrowing group member is receiving because the parent company is providing its subsidiary with a loan at a below market rate of interest. In other words, the measurement difference represents a transfer of value from the parent to its subsidiary because if the subsidiary were to take an equivalent loan out with its bank, it would pay more cash out in the form of interest, which it is saving by entering into a loan with its parent. Hence, there is an increase in the cost of the investment by the parent and a corresponding capital contribution in the equity section of the subsidiary’s individual balance sheet to represent this transfer of value. It also reflects the substance of the arrangement which is that the parent is providing the company with implicit financing as well as the underlying loan through its reduced rate of interest. The above example focussed on a loan from the parent to the subsidiary. However, loans could be provided by the subsidiary to the parent, or from subsidiary to subsidiary. Focus Keep in mind that a measurement difference would only arise if the intragroup loan is covered by formal loan terms and is below market rates of interest. If the loan is not covered by formal loan terms, the loan is repayable on demand and is recognised as current in both the lending and borrowing group member’s financial statements. On-demand loans must not be recognised as non-current under any circumstances.

Subsequent measurement of a measurement difference 3.9 FRS 102 is silent on the subsequent measurement of the measurement difference. In practice, the additional cost of the investment would remain on the parent’s balance sheet and would be dealt with via an impairment test at a subsequent reporting date. The capital contribution reserve in the subsidiary could be reduced by the value of the finance cost as the discount in the loan unwinds.

Allocating the interest 3.10 After initial recognition, the interest element of the loan will have to be allocated to profit or loss over the life of the loan. The amount of interest which is credited/charged to profit or loss is the effective interest rate, not the coupon rate of interest paid to the parent (ie, the interest charge in the profit and loss account at 5%, not 2%).

52

Group Accounts: Introduction 3.10

Example 3.4 – Interest allocation Continuing with the example of Sunnie Ltd above, the rate of interest on the loan physically paid is 5% and this amounts to £17,500 in 2020 and 2021 (ie 5% × £350,000) but the interest charge in the subsidiary’s profit and loss account (and the corresponding finance income in Sunnie’s individual financial statements) is to be recorded at 10% as this is the market rate of the loan. The loan is profiled as follows: Year

Opening balance

Interest at 10%

£

£

Cash flow

Closing balance

£

£

2020

319,629

31,963

(17,500)

334,092

2021

334,092

33,408

(367,500)

-

In Sunnie’s books

£

2020 Dr Cash at bank

17,500

Dr Intra-group loan receivable

14,463

Cr Interest income

31,963

Being coupon interest received and adjustment for the effective interest 2021 Dr Cash at bank

17,500

Dr Intra-group loan receivable

15,908

Cr Interest income

33,408

Dr Cash at bank

350,000

Cr Intra-group loan receivable

350,000

Being coupon interest received, adjustment for effective interest and loan redemption In the subsidiary’s books

£

2020 Dr Interest expense

31,963

Cr Cash at bank

17,500

Cr Intra-group loan payable

14,463

Being coupon interest paid and adjustment for effective interest 2021 Dr Interest expense

33,408

Cr Cash at bank

17,500

Cr Intra-group loan payable

15,908

Dr Intra-group loan payable

350,000

Cr Cash at bank

350,000

Being coupon interest paid, adjustment for effective interest and redemption of loan

53

3.11 Group Accounts: Introduction

Loan from subsidiary to parent 3.11 It is not uncommon for a subsidiary company to provide a loan to its parent and the rates of interest charged are sometimes at below market rate. In a situation where the subsidiary provides a loan to the parent, a measurement difference will also arise where rates of interest are charged at below market rates. The substance of this arrangement is that the subsidiary has contributed to the parent by providing the parent with a loan at below market rates of interest (hence essentially a dividend has been paid up to the parent). Example 3.5 – Loan from subsidiary to parent Using the example above in the reverse scenario (ie, the subsidiary makes a £350,000 loan to its parent), the journals are as follows: In the subsidiary’s books

£

Dr Intra-group loan receivable

319,629

Dr Distribution (equity)

30,371

Cr Cash at bank

350,000

In the parents’ books

£

Dr Cash at bank

350,000

Cr Dividend income

30,371

Cr Intra-group payable

319,629

Focus Care needs to be taken in this scenario if the subsidiary does not have any distributable reserves because the above accounting treatment will draw attention to the fact that the subsidiary has effectively paid a dividend out of non-distributable reserves. The distribution in the subsidiary’s books is not necessarily a distribution for legal purposes and hence it may be advisable to seek legal advice in this regard.

Loans between subsidiaries 3.12 Two subsidiaries of the same parent might also enter into loans with each other. When this situation presents itself, the accounting treatment will depend on whether the loan has been made at the parent’s behest or not. If the loan has been authorised by the parent, it is accounted for as if the loan had been received by the parent and paid by the parent, even though the individual financial statements of the parent are not affected by the transaction.

54

Group Accounts: Introduction 3.12

Example 3.6 – Loans between two subsidiaries Sunnie Ltd (the lender and a subsidiary of the Morley Group) is to make a loan to Dexter Ltd (the borrower and a fellow subsidiary of the Morley Group) of £350,000 and charges interest at a rate of 5% with market rates being at 10%. The loan has been formalised with loan terms which require repayment in two years’ time. As we are using the same figures as in the previous examples, the measurement difference, again, is £30,371. The substance of the arrangement is that the parent has agreed that the loan can take place and hence is accounted for as if the loan has been made, and received, by the parent as follows: In Sunnie’s books

£

Dr Intra-group receivable

319,629

Dr Distribution (equity)

30,371

Cr Cash at bank

350,000

In Dexter’s books

£

Dr Cash at bank

350,000

Cr Intra-group loan payable

319,629

Cr Capital contribution (equity)

30,371

The interest income and expense will be allocated in the same way as above with Sunnie recognising the interest income and Dexter recognising the interest expense. If the loan had not been made at the parent’s behest (which is quite rare in practice because in general the assumption would be that the parent, as controlling shareholder, has the right to decide on intra-group transactions), the debit to distribution (equity) would instead go to finance cost (profit and loss) in Sunnie’s books; and the credit to capital contribution in Dexter’s books would go to finance income (profit and loss). The table below provides a summary as to how the measurement difference is accounted for depending on the direction of the loan: Relationship

In the lender’s books (Dr)

In the borrower’s books (Cr)

Parent lends to subsidiary

Cost of investment

Capital contribution

Subsidiary lends to parent

Distribution

Income from subsidiary

Subsidiary to subsidiary (at the parent’s behest)

Distribution

Capital contribution

Subsidiary to subsidiary (not at the parent’s behest)

Finance cost

Finance income

55

3.13 Group Accounts: Introduction

Avoiding measurement differences 3.13 The issue of measurement differences can cause additional complexities in the individual financial statements of the group members. There are three potential ways of avoiding such measurement differences. ●●

First, the lending subsidiary could charge a market rate of interest to the borrowing subsidiary and hence no measurement differences will arise because the loan is being entered into at market rates.

●●

Secondly, the loan could be classified as ‘on demand’. Where a loan does not have formal loan terms in place (as is often the case for loans among related parties) then the presumption is that it is automatically repayable on demand and hence is treated as current. This may cause an issue where a subsidiary previously classified the loan as long-term liabilities under its previous financial reporting framework, because under FRS 102 it will have to be reallocated to current liabilities which will affect the value of reported net current assets/liabilities. (Though the lender will most likely still classify it as non-current based on expectations rather than contractual rights).

●●

Thirdly, the loan terms could be renegotiated so they are a 53-week loan term. The 53rd week, technically, should be discounted to present value because this is the element of the loan which is long-term; however, it may be the case that the effect of discounting is immaterial and hence the measurement difference may not need to be accounted for. Deliberate manipulation of loan terms is not advised, and auditors will undoubtedly question any ‘rolling’ 53-week terms.

CHAPTER ROUNDUP ●●

Consolidated financial statements must be prepared when there is a parent-subsidiary relationship (unless any exceptions or exemptions from preparing such can be claimed by the parent). A parent-subsidiary relationship is created when the parent controls the subsidiary.

●●

Control is the power to govern the financial and operating policies of the entity.

●●

Joint control is irrelevant to a parent-subsidiary relationship. Joint control can only exist in a joint venture which is subject to a separate section of FRS 102.

56

Group Accounts: Introduction 3.13

●●

Control can be lost through disposal or dilution of ownership interest. Control can also be acquired in stages.

●●

Group structures can be complex and hence a sound understanding of the structure is required to enable the correct preparation of consolidated financial statements.

●●

Intra-group transactions and balances must be eliminated on consolidation.

●●

There are specific issues that must be considered in the individual financial statements of group members where intra-group financing transactions are entered into.

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Chapter 4

Fair Values and Deferred Tax in a Group

SIGNPOSTS ●●

The fair value of a subsidiary’s net assets will invariably be different from book values at the date of acquisition (see 4.2).

●●

Fair value adjustments will need to be reflected by way of a consolidation adjustment in most cases as the subsidiary will not record fair values in its own financial statements (see 4.2).

●●

Deferred tax is calculated using the timing difference ‘plus’ approach under FRS 102 whereas the temporary difference approach is used under the IFRS regime (see 4.3).

●●

The requirement to recognise deferred tax in a business combination is supplementary to the timing difference approach under FRS 102 to maintain consistency with the IFRS regime (see 4.8).

●●

Careful consideration must be given to situations when one group member transfers unutilised tax losses to another group member by way of group relief as this could cause legal issues if the transferring group member does not have distributable reserves available (see 4.9).

INTRODUCTION 4.1 As has already been examined in the first chapters of this book, the objective of consolidated financial statements is to show the financial position, performance and cash flows of the group in line with its economic substance, which is that of a single reporting entity. Company law (both UK and Irish law) requires the consolidated financial statements to present a true and fair view. In practice, there are groups whose structure is quite basic, merely consisting of a parent and a single subsidiary. In other, more diverse and larger groups, the group structure can be extremely complex and a whole range of challenges can present themselves when it comes to preparing the consolidated financial statements of the group, particularly where there have been a large number of acquisitions and disposals during the year.

58

Fair Values and Deferred Tax in a Group 4.2

FAIR VALUE OF NET ASSETS ACQUIRED 4.2

FRS 102, para 19.11 states:

‘The acquirer shall measure the cost of a business combination as the aggregate of: (a) the fair values, at the acquisition date, of assets given, liabilities incurred or assumed, and equity instruments issued by the acquirer, in exchange for control of the acquiree; plus (b) any costs directly attributable to the business combination.’1 When a parent entity acquires control of a subsidiary, it is necessary to carry out a fair value exercise on the net assets that have been acquired in the business combination. The fair value of the subsidiary’s net assets at the date of acquisition will invariably be different from the equivalent book values recorded in the subsidiary’s individual financial statements.

Focus Preparers must also keep in mind the requirements of FRS 102, para 19.15 which requires a contingent liability to be recognised in business combination only if its fair value can be measured reliably. FRS 102, para 19.20 states that if its fair value cannot be measured reliably: (a) there is a resulting effect on the amount recognised as goodwill or the amount accounted for in accordance with paragraph 19.24 (which refers to negative goodwill on an acquisition); and (b)

the acquirer must disclose information about that contingent liability in accordance with FRS 102, Section 21 Provisions and Contingencies.

When a fair value exercise is carried out, it is likely to be the case that the net assets of the subsidiary increase; for example, a property that is measured under the cost model in the subsidiary’s individual financial statements may show a carrying amount of £100,000 in the balance sheet, but the fair value of the property may be £150,000. In the consolidated financial statements, the property is brought into the consolidation at cost to the group, ie at £150,000. This will also mean that a fair value adjustment to depreciation must be made in the consolidated financial statements by way of a consolidation adjustment because the depreciation expense in the consolidated financial statements will be based on a higher cost to the group.

1

FRS 102, para 19.11.

59

4.2 Fair Values and Deferred Tax in a Group

Example 4.1 – Fair value adjustment On 1 January 2022, Harper Ltd acquired 90% of Tennyson Ltd when the net assets were £680,000. The following are the summarised balance sheets of the two companies for the year ended 31 December 2022: Harper Ltd

Tennyson Ltd

£’000

£’000

Investment in Tennyson

900

Total assets

Total liabilities Net assets

1,985

1,550

2,885

1,550

760

280

2,125

1,270

Equity: Ordinary shares Retained earnings

100

100

2,025

1,170

2,125

1,270

●●

Included in Tennyson’s total assets figure is a bespoke piece of machinery which had a fair value of £45,000 in excess of its carrying amount at the date of acquisition. The depreciation policy of the group for plant and machinery is to depreciate them on a straight-line basis over the assets’ useful economic life. This piece of machinery had a remaining useful life of five years. Tennyson has not recorded the fair value of this machine as its policy is to measure such assets under the cost model (ie, cost less depreciation less impairment).

●●

Goodwill is to be amortised on a straight-line basis over five years.

The consolidated financial statements are as follows:

Goodwill Total assets

W2

Harper Group £’000 198 3,571 3,769

Total liabilities

1,040

Net assets

2,729

60

Fair Values and Deferred Tax in a Group 4.2 Harper Group Equity: Ordinary shares

Harper only

100

Retained earnings

W3

2,499

Non-controlling interest

W4

130 2,729

W1 Net assets of Tennyson At acquisition £’000 Share capital Retained earnings Fair value adjustment Additional depreciation

100 580 45 725

At reporting date £’000 100 1,170 45 (9) 1,306

W2 Goodwill Cost of investment Net assets acquired (£725k × 90%) Unamortised goodwill Amortisation (£247k / 5 years) Per consolidated balance sheet

£’000 900 (653) 247 (49) 198

W3 Group retained earnings Harper’s retained earnings Plus share of Tennyson profit (£581k × 90%) Goodwill amortisation

£’000 2,025 523 (49) 2,499

W4 Non-controlling interest At acquisition (£725k × 10%) Share of post-acquisition profit (10% × £581k)

£’000 72 58 130

For clarity, the increase in the net assets of Tennyson since its acquisition is £581,000 (£1,306,000 less £725,000). This represents the profit that Tennyson has made since it was first acquired. 90% of this belongs to Harper as the parent hence is taken to the group retained earnings, whilst the other 10% belongs to the non-controlling interest. The post-acquisition profit of £581,000 includes the fair value adjustment for the machine of £45,000 uplift 61

4.3 Fair Values and Deferred Tax in a Group in fair value less the increase in depreciation on this adjustment of £9,000 (£45,000/5 years). Auditors will often want to reperform such calculations to ensure that the acquisition has been correctly included in the consolidation so these basic ‘control’ calculations are useful for audit purposes. They can also be useful for accounts working papers so that reviewers can see exactly how the figures have been derived and included in the consolidation. In addition, the increase in the net assets of the subsidiary can be looked at as the increase in the unadjusted profit of the subsidiary since acquisition £1,170,000 less £580,000 = £590,000 less the additional depreciation of £9,000 arising from the fair value adjustment equals £581,000. It should also be noted that under IFRS 3 Business Combinations, a parent can recognise the non-controlling interests’ share of goodwill at fair value. This is not permitted under FRS 102 and only the proportionate method is allowed.

DEFERRED TAX AND UNREMITTED EARNINGS 4.3 Deferred tax is dealt with in FRS 102 in Section 29 Income Tax. FRS 102, para 29.9 requires deferred tax to be recognised when income or expenses from a subsidiary, associate, branch or joint venture has been recognised in the financial statements in one accounting period but these items will not be assessed to, or allowed for, tax until a later period (timing difference), except where: (a)

the reporting entity is able to control the reversal of the timing difference; and

(b)

it is probable (ie, more likely than not) that the timing difference will not reverse in the foreseeable future.

Timing differences will arise, for example, where a subsidiary, associate, branch or joint venture has undistributed profits. Focus There is a notable difference between the deferred tax requirements under FRS 102, Section 29 and IAS 12. Under UK and Irish GAAP, deferred tax is calculated using a timing difference approach. This approach focuses on the inherent differences between accounting profit and taxable profit, hence the focus is on the profit and loss account. Under IAS 12, deferred tax is calculated using a temporary difference approach which focuses on the differences inherent between the book values of assets and liabilities and the tax written down values (or ‘tax bases’) of those assets and liabilities. Hence, under the temporary difference approach, the focus is on the balance sheet.

62

Fair Values and Deferred Tax in a Group 4.4 When an entity (the investor) has an ownership interest in a subsidiary, associate, branch or joint venture, the investor will be entitled to a share of those profits. In the consolidated financial statements, the group’s share will be recognised either by way of consolidation (ie, for a subsidiary) or by way of equity accounting (eg, for an associate). The timing difference that arises at group level, ie for the consolidated financial statements, may be different to the timing difference which arises in the parent’s individual financial statements if the parent measures the investment at cost or fair value.

Subsidiaries 4.4 Where a parent is required to prepare consolidated financial statements and none of the exceptions or exemptions from preparing consolidated financial statements apply, a subsidiary’s individual results will be consolidated with the parent entity’s financial statements to form the group accounts. In practice, a parent will more often than not have authority over a subsidiary and hence will be able to direct what happens to a subsidiary’s undistributed profit and decide that the timing difference will not reverse in the foreseeable future. Quite often, this is because the subsidiary will reinvest undistributed profits back into the business for the purposes of growth. This means that no deferred tax is recognised on the unremitted earnings of the subsidiaries, or other similar items that may trigger a tax charge or credit. However, there may be cases where legal restrictions may limit the ability to control the reversal of the timing difference, or there is an intention to distribute the profits in the foreseeable future. In such cases, deferred tax will need to be recognised on the unremitted earnings or other items of income and expense. Example 4.2 – Subsidiary has undistributed profit Topco Ltd owns 100% of Subco Ltd and is able to direct the distributions of dividends by Subco. Topco is a successful business in its own right and does not have the financial need for any dividends from Subco and requires Subco to reinvest undistributed profit back into its business to continue with its growth plans. In this situation, Topco would not need to recognise a deferred tax liability in respect of its share of the unremitted earnings of Subco in the consolidated financial statements. This is because Topco controls the reversal of the timing difference and it is not expected to reverse in the foreseeable future. Example 4.3 – Subsidiary will distribute profit in the foreseeable future Topco Ltd owns 100% of Subco Ltd and is able to direct the distribution of dividends by Subco. One of Topco’s main customers went into liquidation last week owing an amount of £125,000. The liquidator has confirmed that unsecured creditors 63

4.5 Fair Values and Deferred Tax in a Group (of which Topco is one) are unlikely to receive any payment once all the customer’s assets are realised and secured creditors paid off. This has placed considerable strain on Topco’s cash flow and so to help overcome the problems, it plans to extract a dividend from Subco in the next three months. Next month, however, is the group’s financial year end. Topco should recognise a deferred tax liability in the consolidated financial statements for the earnings which are going to be remitted from the subsidiary. Deferred tax will be required regardless of the fact that Topco can direct the distribution of dividends by Subco because it is probable that the timing difference will reverse in the foreseeable future. Example 4.4 – Parent cannot control the payment of dividends Topco Ltd owns 51% of Subco Ltd. As part of the purchase, Topco agreed that it would not be able to direct the distribution of dividends by Subco on the basis that other investors would view this as detrimental to them. Topco Ltd can have a say on the distribution of dividends but cannot unilaterally dictate the payment of a dividend. In this situation, Topco Ltd should recognise a deferred tax liability for all unremitted earnings of Subco in the consolidated financial statements. This is because it is unable to control the timing of the reversal of the timing difference.

Associates 4.5 In the consolidated financial statements, associates are equity accounted (see Chapter 6). Tax arising on the investee’s profit or loss and other comprehensive income is recognised in the investee’s financial statements and hence in the consolidated financial statements, the investor accounts for its share of the associate’s profit net of tax. Dividends which have been received from the associate will be reflected in the investor’s individual financial statements. Where an associate is concerned, a control relationship does not arise, and hence deferred tax should normally be recognised relating to the undistributed profits of the associate. The exception would be where there is strong evidence that profits will not be distributed in the foreseeable future. Example 4.5 – Deferred tax on unremitted earnings of an associate The Mayoh Group (the group) has an overseas associate based in Farland. The consolidated financial statements of the group equity accounts its associate and recognised its £42,500 share of the profit of the associate. Dividends have also been received from the associate of £6,000. Tax legislation in Farland requires tax of 20% to be paid on distributions which is not recoverable.

64

Fair Values and Deferred Tax in a Group 4.7 As the group is unable to control the timing of the reversal of the timing difference, the consolidated financial statements must also reflect the deferred tax consequences if the associate were to remit the group its share of the company’s current year profits of £36,500 (£42,500 less £6,000). A deferred tax liability will arise of £7,300 (£36,500 × 20%) and should be recognised in the consolidated financial statements in addition to the tax consequences of the £6,000 dividend.

Joint ventures 4.6 As with associates, where the venturer is a parent and prepares consolidated financial statements, investments in joint ventures are accounted for using the equity method of accounting (see Chapter 7). The difficulty with joint ventures is that there must be a contractually agreed sharing of control, hence no one venturer in the arrangement can exercise unilateral control. It will often be unclear, therefore, as to who controls the timing of the reversal of the timing differences in a jointly controlled entity. In practice, distributions in a jointly controlled entity will be dealt with via the contract between the venturers. Example 4.6 – Dividends in a joint venture Les and Lisa are both venturers in L&L Associates Limited. The terms of the contract stipulate that no one party in the venture can have unilateral control and that all financial and operating decisions of the venture must be made unanimously and this includes the payment of the dividends. In this scenario, each venturer has the ability to prevent the payment of dividends or other forms of distributions and hence prevent the reversal of the timing difference. Where this is the case, no deferred tax is recognised if the venturer considers that any distributions will not be authorised in the foreseeable future.

Interests in unincorporated entities 4.7 Investees may have interests in unincorporated entities, such as a partnership. Where such ownership interests exist, ordinarily the investor may only recognise its drawings from the investee which do not appear in the profit and loss account. Where this is the case, the investor may only need to recognise a deferred tax asset in respect of the tax that has been paid on the partnership’s profits which have not yet been recognised in the profit and loss account. The recognition criteria for a deferred tax asset must be considered before recognising it (ie, the deferred tax asset must be capable of recovery).

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4.8 Fair Values and Deferred Tax in a Group Focus The above will not apply to jointly controlled operations or jointly controlled assets because FRS 102, paras 15.4 and 15.7 effectively require the reporting entity to include its share of all jointly controlled assets and liabilities. Consequently, the results of the jointly controlled operation or jointly controlled asset will be included in the profit and loss account and be subject to current tax in the normal way which may also give rise to timing differences on which deferred tax should be recognised.

Business combinations 4.8 At the outset it is worth noting that the requirement to recognise deferred tax on business combinations is supplementary to the timing difference approach. Differences between the amount recognised on a business combination for assets and liabilities (other than goodwill) and the amount which will be allowed for, or assessed to, tax in respect of such assets and liabilities are not timing differences. The FRC wished to maintain consistency in FRS 102 with IAS 12 Income Taxes with a requirement to recognise deferred tax on a business combination. This was primarily because the objective of deferred tax under the UK and Irish ‘timing difference plus’ approach is so that the result of deferred tax calculated under this approach is consistent with the same result that would be arrived at under IAS 12. When a parent acquires a subsidiary, it must apply the purchase method of accounting. This method requires the acquirer to allocate the cost of the business combination by recognising the acquiree’s identifiable assets, liabilities and contingent liabilities at their fair value at the date of acquisition and any residue is accounted for as goodwill. While FRS 102 is not absolutely specific about this issue, deferred tax would only arise in a business combination where the purchase method of accounting has been used, ie where a parent has acquired a subsidiary. It would not be relevant where group reconstructions are accounted for using the merger method of accounting (Chapter 11 examines group reconstructions in more detail). Under the purchase method of accounting, fair values of assets and liabilities are used; whereas under the merger method of accounting book values are used and hence the book values of deferred tax balances would apply under the merger accounting method. Under FRS 102, a deferred tax balance will need to be recognised, where the carrying value of an asset or liability differs from its tax written down value. FRS 102, para 29.11 states that when the amount that can be deducted for tax for an asset (excluding goodwill) that is recognised in a business combination accounted for through the purchase method of accounting is less (more) than the value at which it is recognised, a deferred tax liability (asset) shall

66

Fair Values and Deferred Tax in a Group 4.8 be recognised for the additional tax that will be paid (avoided) in respect of that difference. Similarly, a deferred tax asset (liability) shall be recognised for the additional tax that will be avoided (paid) because of a difference between the value at which a liability is recognised in a business combination accounted for by applying the purchase method of accounting and the amount that will be assessed for tax. The amount attributed to goodwill (or negative goodwill, as the case may be) shall be adjusted by the amount of deferred tax recognised. FRS 102, para 29.11A requires the entity to consider the manner in which the entity expects, at the balance sheet date, to recover or settle the carrying amount of the asset or liability. For example, are assets going to be used up over time before being scrapped, or is the plan to sell them? This is important because for some assets there will be different tax rates or allowances, depending on the manner of recovery. The most common being indexation allowance which is available for certain capital items which are recovered through sale. In practice, business combinations can either be an acquisition of shares or an acquisition of net assets. In the former, the amounts allowable for tax are usually unaffected. Fair value adjustments will often be necessary as the subsidiary must fair value its assets, liabilities and contingent liabilities at the date of acquisition (which is the date on which control is obtained by the parent). Differences will often arise between the fair value of the subsidiary’s net assets and the amounts allowable for tax. It is these timing differences which trigger deferred tax consequences under FRS 102. Example 4.7 – Difference in value of an asset at the date of acquisition The Howard Group (the group) has acquired a 90% ownership interest in Holmes Ltd on 1 March 2021, which is the date of acquisition and is the date on which the group obtained control over Holmes. On that date, the fair value exercise revealed that an asset had a carrying value of £125,000 and a tax written down value of £75,000. The difference had arisen due to enhanced capital allowances that had been claimed by Holmes. In the consolidated financial statements, the group will recognise the asset at its higher value of £125,000 as this will be the asset’s fair value at the date of acquisition. The tax written down value of the asset will be unaffected and hence a timing difference arises because of the acquisition for which deferred tax should be recognised in the consolidated financial statements. If it is assumed that for the purposes of this example, the tax rate for the group would be 25%, the deferred tax liability recognised in the consolidated financial statements is £12,500 ((£125,000 – £75,000) × 25%). Example 4.8 – Loss-making subsidiary The Adams Group Ltd (the group) acquires a 100% ownership interest in Cahill Limited on 1 January 2022. Cahill has been sustaining losses for the last three years and has not previously recognised deferred tax in respect of 67

4.8 Fair Values and Deferred Tax in a Group unutilised corporation tax losses in its individual financial statements because the directors did not consider the tax losses to be recoverable. The group has several subsidiaries and has plans to turn the business of Cahill around so that it is profit-making. However, the group is also able to transfer some of the unutilised tax losses to other group members by way of group relief. Consequently, the unutilised tax losses are now capable of recovery and hence a deferred tax asset should be recognised at the date of acquisition of Cahill. Example 4.9 – Deferred tax in a business combination On 1 January 2022, the Breary Group (the group) acquired 100% of Byrne Ltd for £900,000. Extracts from Byrne’s financial statements at the date of acquisition are as follows: Book value

Tax Fair written value down value

£’000

£’000

£’000

Property

300

400

210

Plant and machinery

200

250

75

Other current assets

100

100

100

Liabilities

(40)

(40)

(40)

560

710

345

Byrne has unutilised tax losses amounting to £35,000 and the group intends to utilise these losses among other group members in its portfolio by way of group relief. Byrne has not previously recognised any deferred tax asset in respect of these tax losses as the directors were unsure as to whether they were capable of recovery. The group calculates deferred tax at a rate of 25%. Goodwill arising on the acquisition of Byrne Ltd is calculated as follows: Deferred tax (rounded

Book value

Fair value

Tax written down value

Timing difference

£’000

£’000

£’000

£’000

Property

300

400

210

190

25%

48

Plant and machinery

200

250

75

175

25%

44

Other current assets

100

100

100

-

-

-

Liabilities

(40)

(40)

(40)

-

-

-

-

N/A

N/A

(35)

25%

(9)

560

710

345

330

Tax losses c/f

68

Tax rate

£’000

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Fair Values and Deferred Tax in a Group 4.9 Goodwill:

£’000

Cost of investment

900

Net assets acquired

(710)

Deferred tax liability Goodwill

83 273

In this example, the deferred tax liability is recorded as: ●●

Dr Goodwill

●●

Cr Deferred tax provision

Group relief 4.9 In some groups, a group member may sustain a loss in the year which may give rise to a taxable loss in the tax computation once the various disallowable expenditure and tax reliefs/allowances have been calculated. Certain qualifying UK groups are eligible for group relief which allows a loss to be offset against the profits of another group member in the same accounting period. Example 4.10 – Group relief at normal corporation tax rates The Polaris Group is resident in the UK and has four subsidiaries. The group is eligible to claim group relief. One of its subsidiaries, Sunnie Ltd, has made a loss in the year which has given rise to a taxable loss of £24,720. This taxable loss is transferred to another group member, Bamber Ltd. All companies pay tax at 25%. The finance director has questioned how this group relief should be accounted for at group level. FRS 102, Section 29 does not provide any guidance on accounting for group relief (nor does IAS 12 Income Taxes). In practice, the generally accepted treatment is to record such payments and receipts of group relief as part of the tax charge or credit and make separate disclosure in the notes to the financial statements of group relief transferred and received. Example 4.11 – Group relief transferred at less than the applicable tax rate Weaver Ltd is a wholly owned subsidiary of Banbury Ltd. During the year to 31 December 2021, Weaver incurs taxable losses of £20,000 which it passes up to its parent to offset against Banbury’s profit by way of group relief. No payment is made by Banbury to Weaver for these losses. The question arises as to whether these losses potentially have value to the subsidiary. If the losses are considered to have value to the subsidiary and 69

4.9 Fair Values and Deferred Tax in a Group the subsidiary passes these up to the parent for nil consideration, in substance the subsidiary has given its parent a distribution and hence the transaction should be recorded as such in both the subsidiary’s books and the parent’s books. In practice, such transactions are common and often no accounting entries are made. In any case, if the losses have no value to the subsidiary, there will be no accounting entries needed. The issue of group relief is not always as straightforward as it first appears. Careful consideration should be given to whether the surrender of group relief is a distribution for legal purposes. Where group relief is transferred at applicable tax rates, there will not be any issues. However, where group relief is transferred for no payment (as in Example 4.11 above), such a transfer may be regarded as a distribution for legal purposes. In Example 4.11, the subsidiary would only be allowed to make a distribution where it has distributable reserves at least equal to any book value of the tax asset. If the tax asset has no book value, the distribution is only permitted if the subsidiary would have a positive balance on distributable reserves immediately following the transaction. Most groups would argue that tax losses have no value, and in the majority of cases group members transferring losses to another group member will invariably have distributable reserves available. However, whether such a transaction is a distribution for legal purposes will be a matter for the courts to decide, and hence it is always advisable to seek legal advice in the event of any contentious issues as well as carefully documenting any advice and any judgments made.

SUMMARY OF DIFFERENCES: FRS 102 v IFRS ●●

Under FRS 102 only the proportionate method of goodwill can be used (ie, the amount of goodwill attributable to the parent). There is no option to record the non-controlling interests’ share of their goodwill at fair value as there is under IFRS 3.

●●

Under FRS 102, Section 29, the ‘timing difference plus’ approach is used to calculate deferred tax. The focus of this approach is on the differences between accounting profit and taxable profit (ie, the profit and loss account). Under IAS 12, the temporary difference approach is used which focusses on the differences between the book value of assets and liabilities versus the tax written down values of those assets, hence the focus is on the balance sheet.

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Fair Values and Deferred Tax in a Group 4.9

CHAPTER ROUNDUP ●●

At the date of acquisition, a fair value exercise must be carried out on the net assets that have been acquired in the business combination. The fair value exercise will usually reveal differences between fair values and book values.

●●

In the consolidated financial statements, the parent will usually have to record a consolidation adjustment to take account of fair value adjustments, such as increased depreciation charges on items of property, plant and equipment acquired in the business combination as these will be based on the cost to the group (and not the cost to the subsidiary).

●●

Deferred tax in the UK and Republic of Ireland is calculated using the ‘timing difference plus’ approach. This requires deferred tax to be considered for unremitted earnings of subsidiaries, associates, branches or joint ventures in certain situations.

●●

The requirement to recognise deferred tax on business combinations is supplementary to the requirement to recognise deferred tax in respect of timing differences. This is because differences between the amount recognised on a business combination for assets and liabilities (excluding goodwill) and the amount which will be allowed for, or assessed to, tax in respect of such assets are not considered to be timing differences. This supplementary requirement was included in FRS 102, Section 29 to maintain consistency with the IFRS regime.

●●

Deferred tax recognised in a business combination will be recorded within the goodwill figure with a corresponding provision for deferred tax in the consolidated financial statements.

●●

Where group members transfer unutilised losses to each other by way of group relief, careful consideration will have to be given as to whether these tax losses have value attached to them as this may cause legal issues if the transferring subsidiary does not have distributable reserves available.

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Chapter 5

The Consolidation Process

SIGNPOSTS ●●

A parent-subsidiary relationship is created when the parent achieves control over a subsidiary (see 5.2).

●●

The default in company law is that consolidated financial statements must be prepared where there is a group, but there are certain exclusions from consolidation (see 5.7).

●●

The basic mechanics of consolidation have remained the same over the years (see 5.9).

●●

The purchase method of accounting should be used for business combinations and this requires certain steps to be applied (see 5.15).

●●

There is a 12-month window post acquisition to deal with incomplete accounting issues when a business combination takes place. Once this 12-month window has passed, the only adjustments to fair values that can be made are the correction of material errors (see 5.27).

●●

Goodwill must be amortised on a systematic basis over its useful life and an indefinite useful life cannot be assigned to goodwill (see 5.32).

●●

There are extensive disclosure requirements in respect of business combinations that have taken place during the reporting period and for all business combinations (see 5.38).

INTRODUCTION 5.1 Consolidated financial statements will be prepared by a parent company that has one or more subsidiaries. FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland defines a ‘subsidiary’ as: ‘An entity, including an unincorporated entity such as a partnership, that is controlled by another entity (known as the parent).’1

1

FRS 102 Glossary subsidiary.

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The Consolidation Process 5.2 Together, the parent and the subsidiary form a group. The objective of consolidated financial statements is to aggregate the financial statements of the parent and the subsidiary in line with the group’s economic substance, which is that of a single reporting entity. In other words, as if the group structure did not exist. In practice, preparing consolidated financial statements can be complex – especially where there is a complex group structure. As seen in Chapter 1, the company law requirements can also be particularly difficult to interpret so, in some cases, it may be advisable to seek technical advice to ensure the company law and UK GAAP requirements are correctly applied. In order for there to be a parent/subsidiary relationship, the parent must have control over the subsidiary. The term ‘control (of an entity)’ is defined as: ‘The power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.’2 A ‘parent’ is defined as: ‘An entity that has one or more subsidiaries.’3 CA 2006 only applies to companies and the Act only requires parent companies to prepare consolidated financial statements. However, FRS 102 is wider in scope and extends the requirement to all parent entities which have subsidiaries and which prepare financial statements that are intended to give a true and fair view. FRS 102, para 9.3(g) exempts a parent which does not report under CA 2006 from preparing consolidated financial statements if its statutory framework does not require the preparation of such accounts.

Control 5.2 The definition of ‘control (of an entity)’ per FRS 102 is shown above and is critical to the definition of a subsidiary. Keep in mind that the definition of a subsidiary is focussed on the concept of control rather than legal ownership or the legal nature of the entity. To have control, the parent will be able to exercise a dominant influence over the subsidiary’s operating and financial policies. This means that the subsidiary must carry out the wishes of the parent. FRS 102, para 9.5 states: ‘Control is presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity. That presumption may be overcome in exceptional circumstances if it can be clearly demonstrated that such ownership does not constitute control.

2 3

FRS 102 Glossary control. FRS 102 Glossary parent.

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5.2 The Consolidation Process Control also exists when the parent owns half or less of the voting power of an entity but it has: (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.’4 ‘Operating’ and ‘financial policies’ are not defined in either FRS 102 or Companies Act 2006 (CA 2006). In practice, such policies are not just confined to the day-to-day running of the business but would encompass areas such as the acquisition and disposal of investments, dividend policies, financing requirements and approval of budgets and forecasts. The right to exercise ‘dominant influence’ means that the owner has the right to direct the financial and operating policies of the undertaking and the directors of that undertaking are required to comply with those directions. In terms of when an entity ‘actually exercises’ dominant influence, FRS 102 does not provide a definition of such a statement and the actual exercising of dominant influence would be identified by the effect it has and the way in which it is exercised. The concept of control per FRS 102, para 9.5 is broadly consistent with CA 2006, s 1162 Parent and subsidiary undertakings. CA 2006, s 1162(2) states that: ‘An undertaking is a parent undertaking in relation to another undertaking, a subsidiary undertaking, if— (a)

it holds a majority of the voting rights in the undertaking, or

(b) it is a member of the undertaking and has the right to appoint or remove a majority of its board of directors, or (c)

it has the right to exercise a dominant influence over the undertaking— (i) by virtue of provisions contained in the undertaking’s articles, or (ii) by virtue of a control contract, or

(d) it is a member of the undertaking and controls along, pursuant to an agreement with other shareholders or members, a majority of the voting rights in the undertaking.’5 4 5

FRS 102, para 9.5. CA 2006, s 1162(2).

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The Consolidation Process 5.2 CA 2006, s 1162 then goes on to clarify that: ‘For the purposes of subsection (2) an undertaking shall be treated as a member of another undertaking— (a)

if any of its subsidiary undertakings is a member of that undertaking, or

(b) if any shares in that other undertaking are held by a person acting on behalf of the undertaking or any of its subsidiary undertakings.’6 ‘An undertaking is also a parent undertaking in relation to another undertaking, a subsidiary undertaking, if— (a)

it has the power to exercise, or actually exercises, dominant influence or control over it, or

(b) it and the subsidiary undertaking are managed on a unified basis.’7 ‘A parent undertaking shall be treated as the parent undertaking of undertakings in relation to which any of its subsidiary undertakings are, or are to be treated as, parent undertakings; and references to its subsidiary undertakings shall be construed accordingly.’8 References to ‘voting rights’ means the rights conferred on shareholders in respect of their shares or, in the case of an undertaking not having share capital, on members, to vote at general meetings of the undertaking on all, or substantially all, matters.

Focus Where an entity does not hold general meetings, a ‘majority of voting rights’ means the right under the constitution of the undertaking to direct the overall policy of the undertaking or to alter its constitution. The voting rights in an undertaking are to be reduced by any rights held by the undertaking itself.

There are instruments which an investor may hold that could give rise to potential voting rights such as convertible debt, share call options and warrants which could impact on control of the entity. However, in respect of convertible debt, where the potential voting rights are not exercisable or convertible until a future date or until an event occurs, they are not considered in making the assessment of control. Potential voting rights must be considered if these rights are substantive and such rights can be based on contractual agreements with other investors. It is important that the nature, purpose and design of these rights are considered. 6 7 8

CA 2006, s 1162(3). CA 2006, s 1162(4). CA 2006, s 1162(5).

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5.3 The Consolidation Process Substantive rights are those rights which are exercisable at any time at the discretion of the investor. An entity is said to have control over another entity when it owns more than 50% of the voting power of the entity. Control could, therefore, be achieved with an ownership interest of 50.01%. Only in exceptional cases would it be possible to demonstrate that control has not been obtained with an ownership interest of more than 50%. In all cases, the substance of the arrangement must be considered. Conversely, it may be the case that an entity has an ownership interest of less than 50.01% but still has de facto control. In practice, the circumstances giving rise to de facto control will be rare and careful judgement will need to be applied in assessing whether, or not, de facto control actually exists. In practice, de facto control could exist in a trust arrangement where trustee owners take action when prompted to do so by the controlling party. Example 5.1 – Assessment potential control Topco Ltd has acquired a 40% ownership interest in Subco Ltd. Topco Ltd can appoint, or remove, the majority of the board of directors. The Topco Group is a medium-sized group and cannot claim any exemption from preparing consolidated financial statements. Topco Ltd has not obtained control via its ownership interest of 40% because it owns less than 50.01% of the net assets of Subco Ltd. However, because Topco Ltd can appoint, or remove, the majority of the board of directors, this gives rise to control and hence a parent/subsidiary relationship is created. Topco Ltd will consolidate the results of Subco in its financial statements.

Loss of control 5.3 The lifecycle of a subsidiary follows most types of investments and will usually comprise of four stages:

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The Consolidation Process 5.4 Control may be achieved in one go, or in stages (ie a ‘piecemeal’ acquisition or a ‘step’ acquisition which are discussed in more detail in Chapter 8). Once control has been obtained, the activities of the subsidiary are integrated with those of the group and the parent will continue to govern the financial and operating activities of the subsidiary during the performance stage. Disposal is the final stage of the lifecycle when the parent will dispose of all, or some, of its ownership interest. The extent of the disposal may result in the parent no longer having control of the undertaking. When control is lost, it first needs to be established whether the loss is permanent or temporary. A loss of control could be at the parent level or at the group level. At parent level, a loss of control would require a change in the investment status of an entity and this would assume that the parent has disposed of interests in the subsidiary to such an extent that it can no longer direct the financial and operating activities of the entity. At group level, a loss of control would assume no changes at parent level. Hence, a loss of control can only arise if changes in the investor structure, contractual agreement or similar changes take place. A loss of control can arise for a variety of reasons, but in practice the following are the most common reasons for a loss of control: ●●

The subsidiary is sold by the parent.

●●

The subsidiary enters liquidation or insolvency.

●●

Local government intervenes and seizes assets or operations.

●●

There are contractual agreements in place which transfer control.

Managed on a unified basis 5.4 FRS 102, para 9.6A states that control can also exist when the parent has the power to exercise, or actually exercises, dominant influence or control over the undertaking or it and the undertaking are managed on a unified basis. FRS 102 does not define the term ‘managed on a unified basis’. Under old UK GAAP, FRS 2 defined the concept as: ‘Two or more undertakings are managed on a unified basis if the whole of the operations of the undertakings are integrated and they are managed as a single unit. Unified management does not arise solely because one undertaking manages another.’ In practice, it is unlikely that there are widespread instances of unified management and so there is little impact and the existence of control could be determined on the basis of dominant influence. Again, FRS 102 does not define the term ‘dominant influence’, but it should be taken to mean that the entity can dictate how the subsidiary is to operate.

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5.5 The Consolidation Process

Dissimilar activities 5.5 FRS 102, para 9.8 does not allow a subsidiary to be excluded from consolidation just because its activities are dissimilar from those of the parent. Indeed, for many groups, there will be subsidiaries whose activities are significantly dissimilar to those of the parent. The paragraph requires relevant information to be provided in the consolidated financial statements about the different business activities of the subsidiaries. Example 5.2 – Dissimilar activities The principal activity of Sunnie Ltd is the manufacture of disposable clothing. During the year to 31 July 2021, Sunnie Ltd acquired a 100% ownership interest in Morley Ltd. The principal activity of Morley Ltd is a retailer of adult clothing. The fact that Morley Ltd has a dissimilar principal activity to that of its parent does not preclude Morley’s financial statements from being consolidated with those of its parent. Morley’s financial statements will be fully consolidated and additional disclosure information will be provided in the consolidated financial statements which will explain the different nature of its operations, results and financial position. FRS 102 does not require information to be provided by class of business activity, except where segment information is required for entities with publicly traded securities. However, it may be the case that the group decides that this is the best way of disclosing such information for the purposes of giving a true and fair view.

Materiality considerations 5.6 FRS 102, para 9.8A confirms that a subsidiary cannot be excluded from consolidation just because the information necessary for the preparation of the consolidated financial statements cannot be obtained without disproportionate expense or undue delay. However, the paragraph then goes on to clarify that the subsidiary can be excluded from the consolidation if its inclusion is not material for the purposes of giving a true and fair view within the context of the group.

Focus When considering the materiality of the subsidiary, it is important that the group considers materiality both individually and in the aggregate for more than one subsidiary. For example, two subsidiaries in isolation may be immaterial to the group; but when taken together they may be material and hence will need to be included in the consolidation. This is a very important consideration and one which lends itself to a pitfall which must be avoided.

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The Consolidation Process 5.7

Exclusion from consolidation 5.7 FRS 102, paras 9.9 to 9.9C provide certain exclusions from consolidation as follows: ‘A subsidiary shall be excluded from consolidation where: (a) severe long-term restrictions substantially hinder the exercise of the rights of the parent over the assets or management of the subsidiary; or (b) the interest in the subsidiary is held exclusively with a view to subsequent resale; and the subsidiary has not previously been consolidated in the consolidated financial statements prepared in accordance with this FRS.’9 ‘A subsidiary may be excluded from consolidation when its inclusion is not material for the purpose of giving a true and fair view (but two or more subsidiaries may be excluded only if they are not material taken together).’10 ‘A subsidiary excluded from consolidation on the grounds set out in paragraph 9.9(a) shall be measured using an accounting policy selected by the parent in accordance with paragraph 9.26, except where the parent still exercises a significant influence over the subsidiary. If this is the case, the parent should treat the subsidiary as an associate using the equity method set out in paragraph 14.8.’11 ‘A subsidiary excluded from consolidation on the grounds set out in paragraph 9.9(b) which is: (a)

held as part of an investment portfolio shall be measured at fair value with changes in fair value recognised in profit or loss;12 or

(b)

not held as part of an investment portfolio shall be measured using an accounting policy selected by the parent in accordance with paragraph 9.26.’13

The requirements of FRS 102, para 9.9 are broadly similar to those of CA 2006, s 405(3) which states: ‘A subsidiary undertaking may be excluded from consolidation where— (a) severe long-term restrictions substantially hinder the exercise of the rights of the parent company over the assets or management of that undertaking, or

9

FRS 102, para 9.9. FRS 102, para 9.9A. 11 FRS 102, para 9.9B. 12 Additional disclosures may need to be provided in accordance with company law (see FRS 102, Appendix III, para A3.17). 13 FRS 102, para 9.9C. 10

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5.7 The Consolidation Process (b) extremely rare circumstances mean that the information necessary for the preparation of group accounts cannot be obtained without disproportionate expense or undue delay, or (c)

the interest of the parent company is held exclusively with a view to subsequent resale.’

While FRS 102 is broadly consistent with the requirements above, para 9.9A clarifies that the subsidiary can only be excluded from the consolidation if its inclusion is immaterial (both individually and in the aggregate). Where severe long-term restrictions are concerned, the subsidiary should be consolidated up to the date that the restrictions came into effect. This, of course, assumes that control was acquired before the severe long-term restrictions came into effect. There is no guidance in FRS 102 as to how long the restrictions would have to be in place for, although it would be expected that the restrictions would continue beyond a period of 12 months. Control may pass to a liquidator when the subsidiary goes into liquidation and hence consolidation would still take place up to the point at which control is transferred to the liquidator. In the event of a Company Voluntary Arrangement (CVA), the directors continue to control the business; the CVA itself is controlled by the Insolvency Practitioner and hence in a CVA situation, the parent will not necessarily lose control. The term ‘held exclusively with a view to subsequent resale’ is defined in the Glossary to FRS 102 as: ‘An interest: (a) for which a purchaser has been identified or is being sought, and which is reasonably expected to be disposed of within approximately one year of its date of acquisition; or (b) that was acquired as a result of the enforcement of a security, unless the interest has become part of the continuing activities of the group or the holder acts as if it intends the interest to become so; or (c)

which is held as part of an investment portfolio.’14

FRS 102, para 9.9C states that when a subsidiary is excluded from consolidation because it is held exclusively with a view to subsequent resale, it is accounted for as follows: (a)

if the subsidiary is held as part of an investment portfolio, it is measured at fair value through profit or loss; or

(b) if the subsidiary is not held as part of an investment portfolio, it is measured using an accounting policy selected by the parent in accordance with FRS 102, para 9.26.

14

FRS 102 Glossary held exclusively with a view to subsequent resale.

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The Consolidation Process 5.8 In (b), FRS 102, para 9.26 permits the following accounting policy choices: ●●

cost less impairment;

●●

fair value through other comprehensive income; or

●●

fair value through profit or loss.

FRS 102, para 9.26 points preparers to the Appendix to Section 2 Concepts and Pervasive Principles which provides guidance on determining fair value. Whichever accounting policy choice is selected, the entity must apply the same accounting policy for all investments in a single class, but the entity is permitted to apply different accounting policy choices to different classes.

Special purpose entities 5.8 FRS 102 requires consolidated financial statements to include, on a usual line-by-line basis, any special purpose entities (SPEs) which are controlled by the entity. FRS 102 requires that the SPE is consolidated when the substance (ie, the commercial reality) of the relationship between the reporting entity and the SPE suggests that the SPE is controlled by the reporting entity. This is the same concept as the control concept discussed earlier in this chapter. An entity may be created to accomplish a narrow objective, such as undertaking research and development activities or facilitating employee shareholders. Such an SPE may take the form of a company, trust, partnership or unincorporated entity. This is a complex area and is dealt with only briefly in FRS 102, para 9.11 which lists the following as circumstances which may indicate that an entity controls an SPE, including: ‘(a) the activities of the SPE are being conducted on behalf of the entity according to its specific business needs; (b) the entity has the ultimate decision-making powers over the activities of the SPE, even if the day-to-day decisions have been delegated; (c)

the entity has rights to obtain the majority of the benefits of the SPE and therefore may be exposed to risks incidental to the activities of the SPE; and

(d) the entity retains the majority of the residual or ownership risks related to the SPE or its assets.’15 It should be noted that the list above is not exhaustive.

15

FRS 102, para 9.11(a)–(d).

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5.9 The Consolidation Process SPEs are not defined in the Glossary to FRS 102. FRS 102 acknowledges that it is common for SPEs to be created with legal arrangements which impose strict requirements over the operation of the SPE.

Focus It should be noted that FRS 102, paras 9.10 and 9.11 which deal with SPEs do not apply to post-employment benefit plans (eg, pension plans) or other long-term employee benefit plans which are accounted for under the provisions of FRS 102, Section 28 Employee Benefits. If the SPE is an intermediate payment arrangement (eg, an employee share ownership plan and employee benefit trust which are used to facilitate employee shareholders under remuneration schemes), it is accounted for in accordance with FRS 102, paras 9.33 to 9.38 which deal with intermediate payment arrangements.

Consolidation procedures: basic elements 5.9 Keep in mind the objective of consolidated financial statements which is to present the results of the group in line with its economic substance, which is that of a single reporting entity. In other words, as if the group structure does not exist. FRS 102, para 9.13 requires the following key procedures to be followed: ‘(a) combine the financial statements of the parent and its subsidiaries line by line by adding together like items of assets, liabilities, equity, income and expenses;

Focus Even when the parent does not own 100% of the subsidiary, the subsidiary’s assets and liabilities are consolidated at 100% because this reflects the assets under the control of the parent and the liabilities of the group. The consolidated balance sheet is not time-apportioned when a mid-year acquisition takes place. In terms of the consolidated profit and loss account/statement of comprehensive income, the results of the subsidiary are time-apportioned for the effect of a mid-year acquisition and this is done from the date that control passes to the parent.

(b) eliminate the carrying amount of the parent’s investment in each subsidiary and the parent’s portion of equity of each subsidiary;

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The Consolidation Process 5.9 Focus The carrying amount of the parent’s investment in each subsidiary is eliminated as this is included in the goodwill calculation presented in the consolidated balance sheet.

(c)

measure and present non-controlling interest in the profit or loss of consolidated subsidiaries for the reporting period separately from the interest of the owners of the parent; and

Focus The consolidated profit and loss account/statement of comprehensive income must show the profit attributable to both the parent and the noncontrolling interest at the foot of the consolidated profit and loss account/ statement of comprehensive income.

(d) measure and present non-controlling interest in the net assets of the consolidated subsidiaries separately from the parent shareholders’ equity in them. Non-controlling interest in the net assets consist of: (i) the non-controlling interest’s share in the identifiable net assets (consisting of the identifiable assets, liabilities and contingent liabilities as recognised and measured in accordance with Section 19 Business Combinations and Goodwill, if any) at the date of the original combination; and (ii) the non-controlling interest’s share of changes in equity since the date of the combination or other acquisition.’16

Focus The equity section of the consolidated balance sheet shows the ownership split between the parent and the non-controlling interest. This will not, of course, be the case where a subsidiary is wholly owned by the parent. In addition, FRS 102, para 9.14 requires profit or loss and changes in equity attributable to the owners of the parent and the non-controlling interest to be determined on the basis of existing ownership interest. The allocation at the reporting date does not reflect the potential exercise or conversion of options or convertible instruments (eg, convertible debt).

16

FRS 102, para 9.13.

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5.9 The Consolidation Process A summary of the above consolidation procedure for the consolidated balance sheet is shown in the following table: Area

Method of consolidation

Assets

Amalgamate on a line by line basis

Liabilities

Amalgamate on a line by line basis

Share capital

Parent’s share capital only

Reserves

Group reserves comprise: ●●

Parent’s reserves b/f plus (profit) or minus (loss) for the period, and

●●

Share of subsidiary’s post-acquisition profit or loss

Goodwill

Capitalise and amortise

Non-controlling interest

Their share of the subsidiary’s net assets at the balance sheet date

In practice, preparing the consolidated profit and loss account is more straightforward than the consolidated balance sheet because the results of the subsidiary are simply consolidated line by line up to the profit after tax line. At the foot of the consolidated profit and loss account, the profit (or loss) is presented as the amount due to the parent of the group and the amount due to the non-controlling interest as seen in the following illustration:

Illustration – Consolidated profit and loss account Sunnie Group Ltd Consolidated profit and loss account For the year ended 31 December 2021 31.12.21

31.12.20

£'000

£'000

Turnover

13,100

14,200

Cost of sales

(7,120)

(7,970)

Distribution costs

(1,141)

(1,320)

Administrative expenses

(2,020)

(2,130)

Interest payable and similar expenses

(950)

(980)

Profit before tax

1,869

1,800

Tax on profit

(355)

(342)

Profit for the year

1,514

1,458

1,211

1,166

303

292

1,514

1,458

Profit attributable to: Owners of the parent Non-controlling interest

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The Consolidation Process 5.10

Intra-group balances and transactions 5.10 The requirement to prepare consolidated financial statements which show the results of the group as a single reporting entity means that intra-group balances and transactions must be eliminated. Intra-group balances and transactions and profits and losses arising from intragroup transactions recognised in assets such as inventory and property, plant and equipment must be eliminated in full on consolidation. If such items are not eliminated, the consolidated financial statements will not present a true and fair view and hence would be misleading. In addition, FRS 102, para 9.15 (see also Chapter 4) requires deferred tax issues to be considered where timing difference arise from the elimination of profits and losses resulting from intragroup transactions. In practice, agreeing intra-group balances can be an arduous process for some groups – particularly large groups. If intra-group balances do not immediately contra, it is more than likely due to cash or in-transit items.

Focus Intra-group losses may indicate an impairment that requires recognition in the consolidated financial statements.

The issue of eliminating transactions and balances is also outlined in Schedule 6 Companies Act Group Accounts to The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410). These Regulations require the following: ‘(1) Debts and claims between undertakings included in the consolidation, and income and expenditure relating to transactions between such undertakings, must be eliminated in preparing the group accounts. (2) Where profits and losses resulting from transactions between undertakings included in the consolidation are included in the book value of assets, they must be eliminated in preparing the group accounts. (3) The elimination required by sub-paragraph (2) may be effected in proportion to the group’s interest in the shares of the undertakings. (4) Sub-paragraphs (1) and (2) need not be complied with if the amounts concerned are not material for the purpose of giving a true and fair view.’17 Interestingly, the elimination process only applies to subsidiaries which are included within the consolidated financial statements. Where, for example, a 17

SI 2008/410, Sch 6(6).

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5.11 The Consolidation Process subsidiary is not included due to it being immaterial, the elimination process would also be immaterial. In addition, CA 2006, Sch 6(6)(4) does not require items to be eliminated from the consolidation if the amounts concerned are immaterial.

Intra-group finance costs and dividends 5.11 It is common for groups to make loans to other members of the group – for example, a parent may make a loan to its subsidiary. The effect of such loans in the individual financial statements of both the lending group member and the borrowing group member are examined in Chapter 3 (see 3.8) as there are specific issues that need to be considered where the loan is at a below market rate of interest. If there is a loan outstanding between group members, the effect of any finance costs (loan interest) received and paid must be eliminated from the consolidated profit and loss account. The relevant amount of interest must be deducted from group investment income and group finance costs. A payment of a dividend paid by the subsidiary to its parent will need to be cancelled. The effect on the consolidated financial statements is as follows: (a) only dividends paid by the parent to its own shareholders appear in the consolidated financial statements. These are presented in the consolidated statement of changes in equity; and (b) any dividend income shown in the consolidated profit and loss account/ statement of comprehensive income must arise from investments other than those in subsidiaries.

Unrealised profits and losses 5.12 Group members often trade with each other and in such situations, the selling entity may recognise a profit element in a sale. Where such intra-group sales and purchases arise and some, or all, of the goods are still in the entity’s inventory valuation at the reporting date, the cost to the buying member will often include the selling member’s profit element. From a group perspective, such profits are not realised until the goods are sold outside of the group and hence must be removed during the consolidation process. When goods are sold between group members in a group with a noncontrolling interest, there are two possible approaches which the parent could take in showing the profit attributable to the non-controlling interest in the consolidated financial statements: ●●

Allocate the non-controlling interest’s proportionate share of the unrealised profit. This has the effect of eliminating the profit in the selling group member’s financial statements. 86

The Consolidation Process 5.12 ●●

Allocate no part of the unrealised profit to the non-controlling interest. This reflects the non-controlling interest’s entitlement to their full share of the profit arising on the intra-group sale.

FRS 102 does not specify either approach and, in practice, both methods are equally acceptable. Example 5.3 – Eliminating intra-group profit in inventory The Arlo Group consists of a parent and one wholly owned subsidiary. During the year to 31 December 2021, the parent sold goods costing £10,000 to the subsidiary for £15,000. At the year end 31 December 2021, the subsidiary had half of these goods left in inventory. Intra-group sale and purchase The intra-group sale and purchase must be eliminated on consolidation as follows: Dr Revenue

£15,000

Cr Cost of sales

£15,000

Elimination of intra-group sale Intra-group profit in inventory At the year end, the subsidiary had half of the goods sold through the intragroup sale in inventory. This means that the subsidiary’s inventory includes £7,500 worth of inventory at cost to the subsidiary. However, the parent sold the goods at a profit of £5,000 but the subsidiary had only sold half the goods on to third parties by the year end, and so the subsidiary’s inventory valuation will include an element of profit (an unrealised profit). To comply with the principles of FRS 102, Section 13 Inventory, the consolidated inventory balance must be reduced by £2,500 (£5,000 profit × 50%) to bring the group inventory back down to cost to the group. If this unrealised profit were not eliminated, the consolidated inventory valuation would be overstated. To eliminate the unrealised profit in inventory, the consolidation adjustment is recorded as follows: Dr Cost of sales

£2,500

Cr Inventory

£2,500

Being elimination of unrealised profit in inventory at the reporting date

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5.12 The Consolidation Process

Example 5.4 – Intra-group profit on transfer of a fixed asset Manchester Ltd owns 80% of the net assets of City Ltd. The group has an accounting reference date of 31 December. On 1 January 2019, City purchased an item of machinery for use in its production facility. The cost of the machine was £75,000 and the machine had a useful life of ten years at acquisition. On 1 January 2021, City sold the machine to Manchester for £65,000. At 31 December 2021, the carrying amount in Manchester’s books (assuming it will write the cost of the machine of £65,000 over its remaining useful life of eight years) is £56,875 (£65,000 – (£65,000/8) £8,125). City will have recorded a profit on disposal in its individual financial statements of £5,000 (£75,000 cost less two years depreciation at £7,500 less £65,000 proceeds). Had no transfer been made, the machine would be recognised in City’s balance sheet at £52,500 including a depreciation charge of £7,500 for the year ended 31 December 2021. The consolidation adjustments in respect of this intragroup transfer are as follows: £ Dr Consolidated profit and loss

5,000 (to remove profit on sale)

Dr Property, plant and equipment

10,000 (to restore original cost of machine)

Cr Consolidated profit and loss

625 (to remove excess depreciation charge for the year)

Cr Accumulated depreciation

14,375 (to restore depreciation based on original acquisition date)

Being removal of intra-group transfer In the above example, a machine was transferred intra-group at a profit. Had the reverse scenario occurred, and the machine was transferred at a loss, this would have triggered impairment considerations. In such situations, additional factors need to be considered. If management conclude that the previous carrying value of the asset is unable to be recovered, the impairment loss is recognised in accordance with FRS 102, Section 27 Impairment of Assets. However, if it is concluded that the original carrying amount can be recovered (ie, the loss has arisen through transfer of the

88

The Consolidation Process 5.13 asset at a discount which would not otherwise be provided to an unconnected party), the entries would be recorded as follows: Dr Consolidated profit and loss

£X (additional depreciation charge)

Dr Property, plant and equipment

£X (to restore original cost of machine)

Cr Consolidated profit and loss

£X (to remove loss on sale)

Cr Accumulated depreciation

£X (to restore depreciation based on original acquisition date)

Uniform reporting date 5.13 The financial statements of the parent and its subsidiaries should be prepared to the same reporting date unless it is impracticable to do so. The term ‘impracticable’ is defined in the Glossary to FRS 102 as follows: ‘Applying a requirement is impracticable when the entity cannot apply it after making ever reasonable effort to do so.’18 In addition, CA 2006, s 390 A company’s financial year states: ‘The directors of a parent company must secure that, except where in their opinion there are good reasons against it, the financial year of each of its subsidiary undertakings coincides with the company’s own financial year.’19 This section of CA 2006 imposes an obligation on the directors of a parent to ensure coterminous accounting reference dates rather than imposing obligations over the preparation of the consolidated financial statements. There may be ‘good reasons’ that a subsidiary undertaking has a different accounting reference date to that of its parent, including: ●●

a subsidiary located overseas may be legally required to have a certain accounting reference date;

●●

seasonal trends; or

●●

tax reasons.

FRS 102 is consistent with the requirements of The Large and Mediumsized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410), Sch 6(2)(2) which outlines the position when a subsidiary’s accounting reference date is not coterminous with the parent’s. In practice, it is not difficult to change a company’s accounting reference date. This is done easily by submitting form AA01 to Companies House; hence, it will be uncommon for subsidiaries to have a different accounting reference date from their parent on the grounds of impracticability.

18 19

FRS 102 Glossary impracticable. CA 2006, s 390.

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5.13 The Consolidation Process Focus Accounting reference dates can be shortened as often as the entity wishes (although this is likely to be prohibited in the future in the Companies House reforms). However, an accounting period cannot be lengthened more than once in a five-year timescale. Following Brexit, UK subsidiaries can no longer routinely extend their accounting reference date to align with an EEA parent and the five-year rule will apply.

In situations where the reporting date and reporting period of a subsidiary are not the same as those of the parent, the consolidated financial statements are made up in one of two ways: ●●

by combining the financial statements of the subsidiary made up to an earlier date than that of the parent and adjusting for the effect of significant transactions or events between the two reporting dates – provided that the reporting date of the subsidiary is no more than three months before that of the parent; or

●●

using interim financial statements prepared by the subsidiary and made up to the parent’s reporting date.

FRS 102, para 9.16 refers to ‘significant transactions or events’ but does not go on to define them. This is, therefore, down to professional judgement but typical examples may be a significant bad debt, loss of significant assets due to catastrophe or significant restructuring. Where a subsidiary’s accounting reference date is different from that of its parent, disclosure of the difference should be made in the consolidated financial statements. Example 5.5 – Non-coterminous reporting dates The Revere Group Ltd is preparing consolidated financial statements for the year ended 31 December 2021. One of its subsidiaries makes up its individual financial statements to 30 September 2021. The group has two options: ●●

the preferred option is to include nine months of the results of the subsidiary for the period from 1 January 2021 to 30 September 2021 and three months of the unaudited results based on interim management accounts for the period 1 October 2021 to 31 December 2021; or

●●

the less ideal option would be to consolidate the full year accounts for the year to 30 September 2021 and make adjustments for any significant transactions of the subsidiary between 1 October 2021 and 31 December 2021.

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The Consolidation Process 5.15

Uniform accounting policies 5.14 FRS 102, para 9.17 states that the consolidated financial statements of a group are to be prepared using uniform accounting policies for like transactions and other events and conditions in similar circumstances. Where a member of a group uses accounting policies other than those adopted in the consolidated financial statements for like transactions, appropriate adjustments should be made when preparing the consolidated financial statements. This may apply, for example, in the case of a UK group reporting under FRS 102 which has a US-based subsidiary that prepares its individual financial statements under US GAAP. In practice, some groups which adopt different accounting policies or report under different GAAPs often require a reconciliation of the subsidiary’s financial statements to what would be reported had the subsidiary prepared their financial statements in accordance with the parent’s GAAP and applied the parent’s accounting policies. For example, a parent reporting under UK-adopted IFRS is required to capitalise development expenditure that meets the recognition criteria in IAS 38 Intangible Assets; whereas a subsidiary reporting under FRS 102 may choose to write off such expenditure as an accounting policy choice under FRS 102 for commercial reasons. The Large and Medium Sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410), Sch 6(3) makes provision for different accounting policies applied by a subsidiary and specifically requires adjustments to be made in the consolidated financial statements. However, there are two exceptions to this rule in the Regulations (SI 2008/410), Sch 6, para 3(2) and (3)): ●●

●●

where, in the opinion of the directors, there are special reasons for the application of different accounting policies and disclosure is made of the fact that different policies have been used, together with the reasons and the effects of the differing policies; and where any consolidation adjustments would be immaterial for the purpose of giving a true and fair view.

FRS 102 does not refer to ‘special reasons’ or the situation where the directors may consider it appropriate to adopt differing accounting policies for like transactions and events in similar circumstances. Therefore, it would be appropriate to make consolidation adjustments in the consolidated financial statements to align the policies to those of the group.

PURCHASE METHOD OF ACCOUNTING 5.15 FRS 102 requires all business combinations to be accounted for using the purchase method of accounting. This method of accounting is outlined in FRS 102, para 19.7 as follows: ‘(a) identifying an acquirer; (aA) determining the acquisition date; 91

5.16 The Consolidation Process (b) measuring the cost of the business combination; (c)

allocating, at the acquisition date, the cost of the business combination to the assets acquired and liabilities and provisions for contingent liabilities assumed and recognising and measuring any noncontrolling interest in the acquiree; and

(d) recognising and measuring goodwill.’20

Identify an acquirer 5.16 When a business combination takes place, an acquirer must be identified. The acquirer is the party which will obtain control of the acquiree (the target). Control is the power to govern the financial and operating policies of an entity so as to obtain economic benefits from its activities. Keep in mind that control is always based on substantive rights and is usually, but not always, achieved with an ownership interest of more than 50% in the net assets or voting rights of the acquiree. In the majority of acquisitions, it will usually be straightforward who the acquirer is and when control has been obtained. However, in some group structures, the identity of the acquirer may not be so straightforward and FRS 102, para 19.10 offers some indicators of which party in the transaction is the acquirer as follows: ‘(a) If the fair value of one of the combining entities is significantly greater than that of the other combining entity, the entity with the greater fair value is likely to be the acquirer. (b)

If the business combination is effected through an exchange of voting ordinary equity instruments for cash or other assets, the entity giving up cash or other assets is likely to be the acquirer.

(c) If the business combination results in the management of one of the combining entities being able to dominate the selection of the management team of the resulting combined entity, the entity whose management is able to dominate is likely to be the acquirer.’21 The acquirer is the party in the transaction that has control over the acquiree. The ‘power to govern’ in the definition of ‘control’ per the Glossary to FRS 102 refers to the acquirer’s legal right; and ‘obtaining economic benefits’ is the reason that the acquirer will exercise control over the acquiree. It may be the case that a business combination is effected by the creation of a new entity. The new entity will not have carried out any previous business because

20 21

FRS 102, para 19.7. FRS 102, para 19.10(a)–(c).

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The Consolidation Process 5.17 it has been set up with the intention to transact the business combination. This can be illustrated as follows: Example 5.6 – Creation of a new entity to effect a business combination Arlo Ltd is taking over the entire business of Frankie Ltd. To effect this transaction, an existing dormant company (Newco Ltd) is being used which will belong to the holding company. FRS 102 would determine Arlo as the acquirer and Frankie as the acquiree. Newco Ltd is essentially the holding company and will be preparing the consolidated financial statements. Newco has not carried on any business activities and has been set up to transact the business combination. Arlo (the acquirer) will be combined with Newco under merger accounting principles (see Chapter 11) as it is essentially outside the scope of FRS 102, Section 19. This is because Newco is not a business and the substance is really that Arlo has acquired Frankie, but Arlo has just changed its ownership to go via Newco. Hence, Frankie (the acquiree) will be accounted for as a business combination under the purchase method of accounting as Arlo has purchased this entity. The consolidated financial statements of the group will be prepared as follows: ●●

Equity will be that of Newco.

●●

The rest of Arlo’s balance sheet will be aggregated using book values, not fair values as the merger method of accounting does not use fair values.

●●

Any difference between Newco and Arlo’s equity interests will be adjusted against equity.

●●

Comparative information prior to the business combination will be that of Arlo.

●●

Frankie is included under the purchase method of accounting, which uses fair values for the assets acquired and the liabilities and contingent liabilities assumed.

Determine the acquisition date 5.17 FRS 102 requires the purchase method of accounting to be applied from the acquisition date, which is defined as: ‘The date on which the acquirer obtains control of the acquiree.’22 It should be noted that FRS 102, para 19.10A does not require a transaction to be completed in law before the acquirer obtains control. This is because there could be situations, and clauses within the transaction, where the acquirer could obtain control on a date which is either earlier or later than the completion date. It will therefore be necessary to carefully scrutinise the agreement to establish 22

FRS 102 Glossary acquisition date.

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5.18 The Consolidation Process the acquisition date because this is the date on which the acquiree’s assets and liabilities are consolidated by the parent.

Measure the cost of the business combination 5.18 The cost of a business combination according to FRS 102, para 19.11 is the aggregate of: ‘(a) the fair values, at the acquisition date, of assets given, liabilities incurred or assumed, and equity instruments issued by the acquirer, in exchange for control of the acquiree; plus (b) any costs directly attributable to the business combination.’23 At the acquisition date, the target will carry out a review to determine the fair value of all of its assets, liabilities and any contingent liabilities so that these can be included in the consolidated financial statements. The goodwill calculation will usually also be carried out at this stage for inclusion in the consolidated financial statements. There are a number of points which must be carefully considered where the cost is concerned as follows:

Quoted instruments 5.19 Quoted instruments are measured at fair value at the date of acquisition. In practice, this is usually straightforward to obtain and values other than the published price at the date of acquisition should only be used when there is clear evidence that the published price is unreliable. This is likely to be rare. If the published price is unreliable, other evidence and valuation methodologies should be used where these will provide a reliable fair value at the date of acquisition.

Unquoted instruments 5.20 Unquoted instruments are also measured at fair value, which is defined as the amount for which an asset could be exchanged, a liability settled, or an equity instrument could be exchanged between knowledgeable, willing parties in an arm’s length transaction. Therefore, the unquoted instrument should be valued at the price which it could realistically fetch on the open market.

Deferred consideration 5.21 Often, when an acquirer obtains control of an acquiree, there will be clauses within the agreement which give rise to deferred consideration. For example, the acquirer obtains control and a portion of the consideration is held back to be paid to the ex-shareholders at a future date. 23

FRS 102, para 19.11(a) and (b).

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The Consolidation Process 5.21 Where deferred consideration is concerned, this should be discounted to present value where the effects of discounting are material. The rate at which the deferred consideration should be discounted should be the rate at which the acquirer would obtain a similar borrowing, such as the rate of interest the bank would charge the acquirer. Example 5.7 – Discounted deferred consideration Weaver Ltd acquired 100% of the net assets of Emery Ltd on 30 April 2021. The purchase price was £2.6 million. At the date of acquisition, Weaver transferred £1.9m to the shareholders of Emery and the balance of £700,000 is to be paid in two years’ time. The financial controller has obtained a quotation from its bank and if they were to take out a £700,000 bank loan for two years on 30 April 2021, the bank would charge interest at a rate of 6%. The deferred consideration amount should be discounted to present value using a rate of 6%, being the market rate which the bank would charge for an equivalent loan. This gives a present value of £622,998 (£700,000/1.062). The difference of £77,002 should be charged to profit or loss as interest payable and similar expenses over the two-year period. There is no adjustment to goodwill regardless of the fact that the interest rate might change prior to the deferred consideration being paid. The deferred consideration is profiled as follows: Balance b/f £ 622,998 660,378

Interest @ 6% £ 37,380 39,622

Cash flow £ (700,000)

Balance c/f £ 660,378 -

The entries in the books of Weaver Ltd will be as follows: Year 1 Dr Fixed asset investment Cr Deferred consideration Being deferred consideration on acquisition of Emery Dr Interest payable Cr Deferred consideration Being unwinding of the discount in year 1 Year 2 Dr Interest payable Cr Deferred consideration Being unwinding of the discount in year 2 Dr Deferred consideration Cr Cash at bank Being final payment to ex-shareholders of Emery Ltd

95

£ 622,998 622,998 37,380 37,380

39,622 39,622 700,000 700,000

5.22 The Consolidation Process

Costs incurred in a business combination 5.22 The directly attributable costs incurred in a business combination are likely to include legal fees and due diligence fees as well as other nonrecoverable taxes which may be payable on completion. All acquisition-related costs are included in the cost of the combination, hence will be included in the calculation of goodwill. Careful scrutiny of the costs associated with the business combination should take place to ensure that they are directly attributable. For example, if specialist contractors were engaged to carry out investigative work in connection with the acquisition, the cost of these staff could be included in the cost of the business combination. Conversely, if the staff carrying out the investigation were employed by the acquirer, the salaries of those staff would not qualify for inclusion in the cost of the business combination because the acquirer would incur those payroll costs regardless of whether the business combination goes ahead or not. Due diligence fees which are directly attributable to a specific business combination would qualify for inclusion in the cost of the combination. However, general due diligence costs, such as those involved in identifying possible targets, are expensed to profit or loss because they cannot be specifically identified with a particular acquisition.

Focus While this book is concerned with UK GAAP only, it is worth emphasising that the treatment of acquisition-related costs is different under IFRS 3 Business Combinations. This point is relevant if staff involved in dealing with the acquisition are trained under the requirements of IFRS rather than UK GAAP. They will need to understand the key differences between IFRS 3 and FRS 102, one of them being that acquisition-related costs are capitalised under UK GAAP as opposed to being written off to profit or loss. If this is not done correctly, goodwill will be understated and expenses overstated. The general principle involved under FRS 102 is that all directly attributable costs are those costs which would otherwise be avoided by the acquirer had the transaction not taken place.

Some entities which undertake several business combinations employ individuals whose role is to target suitable businesses with a view to acquiring them. Reasons for such combinations vary but are usually undertaken to gain economic benefit. Businesses which employ individuals to seek out and target other companies with a view to acquiring them are often paid bonuses if the combination is successful. The question arises as to whether such bonuses could be included in the cost of the business combination?

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The Consolidation Process 5.22 To qualify for inclusion in the cost of a business combination, the bonus plan must have been set up before negotiations commenced. In addition, the bonus scheme must be directly linked to the specific acquisition. If there is any doubt as to whether a bonus scheme relates to an acquisition or not, the presumption must be that it does not and hence the bonus is expensed to profit or loss when it becomes payable. Bonuses which can be linked to specific acquisitions and have been set up before negotiations take place can be said to be directly attributable and hence can be included in the cost of a business combination. General bonus payments would not be directly attributable and hence would be expensed to profit or loss as incurred. All costs incurred which do not relate directly to the business combination must not be included in the cost of the combination. For example, post-combination reorganisation expenditure must be expensed as they do not directly relate to the acquisition itself; the reorganisation expenditure is incurred after the combination has taken place. Where the acquirer has incurred costs of arranging and issuing financial liabilities (eg, bank loans) to acquire the target, all costs associated with this finance do not qualify for inclusion in the cost of the business combination. They are accounted for as transaction costs in accordance with FRS 102, Section 11 Basic Financial Instruments and Section 12 Other Financial Instruments Issues as appropriate. This is because such costs are associated with the finance rather than as part of the business combination. Costs incurred in issuing equity instruments are also excluded from the cost of a business combination as they are a cost of issuing equity and hence reduce the proceeds received from the share issue. Example 5.8 – Establishing the cost of a business combination Harper Ltd acquires 100% of Churchill Ltd. The terms of the combination are as follows: (a)

Harper issues 100,000 new shares to Churchill with a fair value of £4.50 per share. Transaction costs associated with this equity issue are £5,750.

(b) Harper makes an immediate cash payment of £350,000 to the outgoing shareholders of Churchill. (c) Costs of due diligence amount to £7,000 and additional fees of £1,200 were paid to an external agency to source suitable acquisitions. (d) Loan arrangement fees of £6,000 were incurred by Harper’s bank to arrange the finance to make the acquisition.

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5.23 The Consolidation Process The cost of this business combination is as follows: £ Share issue

450,000

Cash outlay at acquisition date

350,000

Due diligence fees Total cost of combination

7,000 807,000

The total costs of £5,750 incurred on the equity issue are not included as these are an issue cost and hence to go to reduce the proceeds from the equity issue as required by FRS 102, Section 22 Liabilities and Equity. The £1,200 additional fees from the external agency to source suitable acquisitions are not included as they are not directly attributable to this particular combination. The loan arrangement fee of £6,000 is not included as this is a financing issue cost accounted for under FRS 102, Section 11 or Section 12.

Contingent consideration 5.23 The sale-purchase agreement may make provision for the buyer to transfer further consideration to the ex-shareholders at a future point in time, provided certain conditions have occurred (or not occurred as the case may be). In practice, the most common type of occurrence which would trigger further consideration being paid by the purchaser is the achievement of a certain level of profit by the acquiree post-acquisition. FRS 102, para 19.12 states that when a business combination agreement makes provision for an adjustment to the cost of the combination which is based on future events, the acquirer includes an estimated amount of that adjustment in the cost of the combination at the date of acquisition. The acquirer can only make an adjustment in respect of contingent consideration where it is probable (ie, more likely than not) that the contingent consideration will be paid and the amount can be reliably measured. In addition, the time value of money must be taken into consideration, if material. If, at the date of acquisition, the acquirer concludes that it is not probable that the contingent consideration will be paid, but subsequently it does become probable, then the additional consideration is treated as an adjustment to the cost of the business combination.

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The Consolidation Process 5.23 Focus There is a notable difference between FRS 102, Section 19 and its international equivalent, IFRS 3 Business Combinations. FRS 102 uses the probability criterion for the treatment of contingent consideration, whereas IFRS 3 does not. Under IFRS 3, all contingent consideration is recognised at the date of acquisition at fair value regardless of probability of eventual payment or reliability of measurement. The fair value itself will take account of the probability of the contingent consideration being paid, so if there is a small probability the fair value will be lower than if it is more likely to be paid. FRS 102 only recognises the expected figure rather than fair value for consideration but only if it is probable.

Example 5.9 – Contingent consideration Warrington Ltd acquires 100% of Wolves Ltd. The sale-purchase agreement makes provision for the consideration as follows: (a)

an immediate payment of £2 million; and

(b)

a further payment of £0.5 million if profit before interest and tax exceeds £700,000 in the first year post-acquisition. The £0.5 million will be held in an escrow account on completion of the transaction.

The payment in (b) is contingent on Wolves Ltd achieving a benchmark profit target and hence is treated as contingent consideration. Recognition of the contingent consideration as part of the business combination would depend on whether it is probable that payment will be made and hence will require consideration of all available information, such as budgets and forecasts. This will mean that Warrington recognises either £500,000 or £nil. If budgets and forecasts indicate that the benchmark profit will be achieved, then the £500,000 is recognised; if not, it is not recognised. At the date of acquisition, Warrington did not expect that it would be probable that the £500,000 contingent consideration would be paid and hence it was not included in the cost of the business combination. However, in the third quarter of the year, it did become probable that the contingent consideration would be paid. If, subsequent to the accounting for the business combination, it becomes probable that contingent consideration will be paid, it is brought into the cost of the business combination with a corresponding adjustment to goodwill, hence: Dr Goodwill

£500,000

Cr Liability

£500,000 (usually as a current liability)

99

5.24 The Consolidation Process The above examples demonstrate the application of FRS 102, para 19.13. It should be emphasised that under FRS 102 there is no time limit where adjustments to the cost of a business combination are concerned; although there is a one-year time limit to the adjustment of fair values of assets and liabilities acquired and assumed. Therefore, goodwill could go up or down depending on the treatment of contingent consideration as and when events unfold. As part of the FRC’s triennial review in 2017, additional clarification was included in FRS 102, para 19.12 confirming that the time value of money is reflected in the cost of a business combination where discounting would be material. FRS 102, para 19.13 confirms that the time value of money must also be reflected in respect of additional consideration which is to be treated as an adjustment, if the time value of money is material. The question then arises as to what should happen in terms of accounting treatment for the unwinding of the discount (ie, the difference between the present value and the amount which will be paid). FRS 102, para 19.13B clarifies that the unwinding of any discount is to be recognised as a finance cost in profit or loss in the period in which it arises. This is consistent with the underlying principles in other areas of FRS 102 which require discounting to be applied when it is material (for example, Section 21 Provisions and Contingencies).

Allocate the cost of the business combination and recognise non-controlling interest 5.24 Once the cost of the business combination has been measured, the next step is to allocate this cost and recognise any non-controlling interest in the acquiree. The cost of the business combination is allocated to the assets acquired and liabilities and provisions for contingent liabilities assumed. All assets and liabilities are fair valued at the date of acquisition by the acquiree and are included in the calculation of goodwill. Contingent liabilities are also recognised by the acquirer where the fair value of these can be measured reliably. Contingent liabilities in a group context are examined at 5.28 below. FRS 102, para 19.14 requires the acquiree’s identifiable assets and liabilities and provisions for contingent liabilities, which satisfy the recognition criteria, to be recognised at fair value. There are some exceptions in respect of: (a) deferred tax (FRS 102, para 19.15A requires this to be accounted for under Section 29 Income Tax); (b) employee benefit arrangements (FRS 102, para 19.15B requires this to be accounted for under Section 28 Employee Benefits); and (c)

share-based payment arrangements (FRS 102, para 19.15C requires this to be accounted for under Section 26 Share-based Payment). 100

The Consolidation Process 5.25 The valuations placed on these three exceptions are to be carried out in accordance with the relevant section of FRS 102 to which they apply. A Practical Guide to UK Accounting and Auditing Standards (3rd edition, Bloomsbury Professional) and Small Company Financial Reporting (2nd edition, Bloomsbury Professional), both written by Steve Collings, provide comprehensive guidance on these areas. In 2017, the FRC included an additional paragraph 19.14A which requires a non-controlling interest (NCI) in the acquiree to be stated at the NCI’s share of the net amount of the identifiable assets, liabilities and provisions for contingent liabilities so recognised. In contrast, IFRS 3 permits the ‘gross’ method of NCI with a corresponding increase in goodwill, which would only be possible if the fair value of the NCI’s share of goodwill can be obtained. This method is not permitted under FRS 102. The recognition criteria for a business combination are outlined in FRS 102, para 19.15 which states that the acquirer must recognise the acquiree’s identifiable assets, liabilities and contingent liabilities at the date of acquisition only if they satisfy the following criteria at the date of acquisition: ‘(a) In the case of an asset, it is probable that any associated future economic benefits will flow to the acquirer, and its fair value can be measured reliably. (b)

In the case of a liability other than a contingent liability, it is probable that an outflow of resources will be required to settle the obligation, and its fair value can be measured reliably.

(c) In the case of a contingent liability, its fair value can be measured reliably.’24 FRS 102, para 19.15 refers to assets and liabilities being ‘identifiable’. This term is not defined in FRS 102, although previous editions of the standard did provide criterion which explained the identifiability concept, but this was removed during the FRC’s triennial review in 2017. The removal of this criterion followed feedback to the FRC by groups which suggested the identifiability criterion was becoming arduous to apply in practice, as ultimately it meant having to separately recognise additional intangible assets in a business combination (see 5.36 below).

Impact of the business combination on the profit and loss account 5.25 FRS 102, para 19.16 states that the acquirer’s statement of comprehensive income must incorporate the acquiree’s profits or losses after the date of acquisition by including the acquiree’s income and expenses based on the cost of the business combination to the acquirer. 24

FRS 102, paras 19.15(a)–(c).

101

5.26 The Consolidation Process Effectively, this means, for example, that depreciation expense is included in the acquirer’s consolidated profit and loss account based on the fair value of fixed assets at the date of acquisition. This may require a fair value adjustment being included in the consolidated financial statements as the subsidiary may not have reflected the result of the fair value exercise in their individual financial statements; hence depreciation expense in the subsidiary’s individual financial statements will be different to the depreciation expense recognised in respect of those fixed assets in the consolidated financial statements. Deferred tax consequences must also be borne in mind. Example 5.10 – Provision for inventory allowance On 1 January 2021, Ratchford Ltd acquired 80% of the net assets of Harrison Ltd. The fair value exercise confirmed that inventory had a value of £820,000. In the individual financial statements of Harrison, inventory is presented net of a provision and had a carrying amount of £750,000. In the consolidated financial statements of the Ratchford Group as at 31 January 2021, the inventory is still in stock and is shown at its cost to the group (ie, at fair value) of £820,000. Any provisions are reset to £nil. FRS 102, Section 19 only deals with the accounting aspects from the perspective of the acquirer; it does not address the remeasurement of assets and liabilities in the financial statements of the acquiree. Hence, in practice, the acquiree’s financial statements will continue to measure assets and liabilities at carrying amount.

Provisions for liabilities 5.26 FRS 102, para 19.18 works in more or less the same way as FRS 102, Section 21 Provisions and Contingencies. An acquirer can only recognise a provision for liabilities as part of the cost of a business combination to the extent that the acquiree has, at the date of acquisition, an existing liability. Contingent liabilities are treated differently under FRS 102, Section 19 and are examined in 5.28 below. Applying the principles of FRS 102, para 19.18 to restructuring costs; such costs can only be recognised as a liability when they meet the recognition criteria for a provision – ie an obligation as a result of a past event; probable transfer of economic benefit; and a reliable measure of cost. Liabilities in respect of future losses to be incurred as a result of the business combination cannot be recognised. Where contracts have become onerous, these are recognised as a liability in both the acquiree’s and acquirer’s financial statements. Contracts may become onerous where leases are terminated as a result of the business combination.

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The Consolidation Process 5.27

Initial accounting is incomplete at the reporting date 5.27 Business combinations can be complex and while control may have passed to the parent by the reporting date, the fair value of the acquiree’s net assets may not have been fully established at the balance sheet date. In recognition of this, FRS 102, para 19.19 permits the acquirer to recognise provisional amounts for which the accounting is incomplete by the reporting date.

Focus FRS 102 only allows a period of 12 months from the date of acquisition to retrospectively adjust the provisional amounts of assets and liabilities for actual values to reflect new information obtained. This 12-month time limit only applies to the fair value accounting and not to any contingent consideration that may, or may not, become payable. There is no time limit for contingent consideration.

Once the 12-month period has elapsed since the date of acquisition, any adjustment to fair values can only be recognised to correct a material error in accordance with FRS 102, Section 10 Accounting Policies, Estimates and Errors. Corrections of material errors under FRS 102, Section 10 are recognised retrospectively as a prior period adjustment. Example 5.11 – Adjustment of fair values Manchester Ltd is in the process of acquiring United Ltd at its reporting date of 31 October 2020. Provisional values of certain assets and liabilities were made in the consolidated financial statements of the group for the year then ended of £40,000. Actual values became known to the group during the year to 31 October 2021 resulting in an increase in net assets acquired of £15,000. As net assets acquired in the business combination have increased by adjusting the provisional values, an adjustment is also made to goodwill by reducing it by £15,000 together with an adjustment to the amortisation charged in the year to 31 October 2020. Example 5.12 – 12-month time limit has elapsed Using the facts in 5.11 above, assume that facts become known to the directors of the group after the 12-month period had elapsed. In such cases, the adjustments can only be made to goodwill if the £15,000 adjustment arises because of a material error. If this is the case, the material error is treated as a

103

5.28 The Consolidation Process prior period adjustment (hence the comparative year’s financial statements are adjusted and relevant disclosures relating to the error are provided). FRS 102 does not outline any specific disclosure requirements where provisional values are concerned. However, in practice it would be advisable to disclose the fact that provisional values have been used at the reporting date to alert the user to the fact that adjustments may need to be made at the next reporting date. Where adjustments are made to provisional values at the next reporting date, it is also advisable to make disclosure where the adjustments are concerned.

Contingent liabilities assumed in a business combination 5.28 Contingent liabilities are treated differently in a business combination than they are in the individual financial statements of a reporting entity applying FRS 102, Section 21. In the separate financial statements of an entity, FRS 102, Section 21 does not allow recognition of a contingent liability because it fails to meet the definition of a liability; instead, the contingent liability is disclosed as a note to the financial statements if it is material. FRS 102, para 19.15(c) requires an acquirer to separately recognise a provision for a contingent liability of an acquiree, but only if its fair value can be reliably measured. Such contingent liabilities are recognised because the transfer of economic benefit is reflected in the contingent liability’s fair value, rather than it being a criterion for recognition. The fair value of a contingent liability is the amount which a third party would charge to assume the contingent liability. In practice, when an acquiree has a contingent liability, the acquirer will wish to pay less for the business given the fact that there is a risk the contingent liability will crystallise, hence the acquirer will suffer an outflow of funds further down the line. The result of this is a reduction in net assets acquired and a corresponding increase in positive goodwill, or a reduction in negative goodwill. Example 5.13 – Contingent liability at the date of acquisition On 1 March 2021, Wigan Ltd acquired 100% of the net assets of Warriors Ltd. The principal activity of Warriors is that of construction of commercial buildings. At the date of acquisition, Warriors was actively defending a lawsuit brought against it by one of its contractors who is alleging breach of contract. The maximum amount of the possible payment if breach of contract is proven is judged to be £100,000. The lawyers have said there is a 60% chance Warriors will pay nothing, a 15% chance they will have to pay £90,000 and a 25% chance they will have to pay £100,000. A contingent liability of £38,500 [(60% × £nil) + (15% × £90,000) + (25% × £100,000)] is recognised in respect of the legal claim. This provision must take into account the range of probable outcomes. This would be the case even if no payment is required. 104

The Consolidation Process 5.28 If a reliable measure of fair value is unavailable for the contingent liability, it is instead disclosed under the provisions of FRS 102, Section 21. FRS 102, para 19.21 states that after initial recognition, the acquirer measures a contingent liability at the higher of: ‘(a) the amount that would be recognised in accordance with Section 21; and (b)

the amount initially recognised less amounts previously recognised as revenue in accordance with Section 23 Revenue.’25

Applying these subsequent measurement principles, if the provision at the next reporting date turns out to be higher than the amount which was initially recognised, the provision is increased, ie: Dr Profit and loss account

X

Cr Provisions for liabilities

X

On the other hand, if the provision turns out to be lower, the provision must not be reduced; instead, it continues to be measured at fair value at the date of acquisition. The exception to this rule would be where the contingency ceases to exist or, where appropriate, it has been reduced in respect of amortisation of the liability under the revenue recognition section (Section 23). The latter would only apply if the contingent liability relates to a revenue-generating activity. Example 5.14 – Potential reduction in a contingent liability at the date of acquisition Using the scenario in Example 5.13 above in respect of the breach of contract. If it is assumed that at the next reporting date the case is still ongoing, but the lawyers advise the subsidiary that there is now a 60% chance of paying nothing; a 15% chance of paying £80,000 and a 25% chance of paying £70,000 (ie, the contingent liability is now £29,500 rather than £38,500) the contingent liability is not reduced. It continues to be recognised at its fair value at the date of acquisition. However, if the lawyers now state there is a 60% chance Warriors will pay £10,000, a 15% chance they will pay £95,000 and a 25% chance they will pay £100,000, the provision is increased by £6,750, ie: £ 60% × £10,000

6,000

15% × £95,000

14,250

25% × £100,000

25,000 45,250

Less original provision

(38,500)

Increase in provision

25

6,750

FRS 102, para 19.21(a) and (b).

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5.29 The Consolidation Process

Non-controlling interest 5.29 When a subsidiary is not wholly-owned, non-controlling interest will arise. The term ‘non-controlling interest’ is often referred to by UK GAAP preparers as ‘minority interest’. Non-controlling interest (NCI) is effectively the external shareholders who own the remainder of the shares in the subsidiary, outside of the group. NCI must be recognised in the group balance sheet and their share of the profit of the subsidiary must be disclosed on the face of the group profit and loss account. This is because where NCI arises, the parent does not enjoy a 100% ownership interest in the subsidiary’s net assets. The NCI in the group balance sheet reflects an ownership interest in the group’s net assets which is not attributable to the parent company. In addition, it is also reflected because if it is not reflected, the group balance sheet would not balance. The recognition and measurement aspects of NCI is not covered under FRS 102. In contrast, IFRS 3 does outline specific measurement principles at paragraph 19 and allows a choice of either ‘full’ recognition or the proportionate method. Full recognition means the NCI’s share of goodwill is recognised at fair value and this method is not permitted under FRS 102. Under FRS 102, only the proportionate method is permitted. This means that under FRS 102, goodwill arising and any subsequent impairment loss (see 5.33 below) is attributable to the parent company. Increases or decreases in ownership interest resulting in the increase or decrease of NCI is discussed in Chapter 8.

Recognise and measure goodwill 5.30 The final stage in applying the purchase method of accounting is for the acquirer to recognise and measure goodwill. Where the cost of a business combination exceeds the net assets acquired, positive goodwill is recognised. Conversely, where the net assets acquired exceeds the consideration, this gives rise to a ‘bargain’ purchase and negative goodwill arises. Most businesses will assume there is some element of goodwill attached to it. For example, the shareholders of a long-established, profitable, business will assume that when it comes to selling, a purchaser will pay more than the business may be valued at, hence an element of goodwill is inherent in the business. Goodwill has not been without controversy over the years – largely because of its subjective nature. This subjective nature was tested in the case of Commissioner of Inland Revenue v Muller & Co Margarine [1901] AC 217. The presiding judge, Lord MacNaghten, said: ‘What is goodwill? It is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation and connection of the business. It is the attractive force which brings in custom. It is the one 106

The Consolidation Process 5.31 thing which distinguishes an old established business from a new business at its first start. Goodwill is composed as a variety of elements. It differs in its composition in different trades and in different businesses in the same trade. One element may preponderate here, and another there.’ Goodwill under FRS 102 is not included in the same section as intangible assets (Section 18 Intangible Assets other than Goodwill). This is because internally generated goodwill is never recognised on the balance sheet under any circumstances and to reinforce this principle, goodwill is dealt with in Section 19. In addition, the CA 2006 only permits goodwill to be recognised on the balance sheet to the extent that it was acquired for valuable consideration.

Initial recognition of goodwill 5.31

FRS 102, para 19.22 requires an acquirer, at the date of acquisition, to:

‘(a) recognise goodwill acquired in a business combination as an asset; and (b) initially measure that goodwill at its cost, being the excess of the cost of the business combination over the acquirer’s interest in the net amount of the identifiable assets, liabilities and contingent liabilities recognised and measured in accordance with paragraphs 19.15 to 19.15C.’26 The default ‘template’ for calculating goodwill is as follows: £ Cost of investment Less share of net assets acquired Goodwill

X (X) X

Example 5.15 – Goodwill arising on acquisition of a subsidiary Greaves Ltd acquires 80% of the net assets of McCaffery Ltd on 1 January 2021 for £75,000. At the date of acquisition, the net assets of McCaffery Ltd were as follows: £ Share capital

1,000

Share premium

1,500

Revaluation reserve

15,000

Retained earnings

65,000 82,500

26

FRS 102, para 19.22(a) and (b).

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5.32 The Consolidation Process Goodwill arising on the acquisition is calculated as follows: £ Cost of investment in McCaffery

£ 75,000

Less net assets acquires (80%): –– Share capital –– Share premium

800 1,200

–– Revaluation reserve

12,000

–– Retained earnings

52,000 (66,000)

Goodwill on acquisition

9,000

The individual financial statements of Greaves Ltd will show the cost of the investment in McCaffery of £75,000 within fixed assets as a long-term investment. In the group financial statements, this investment is removed and is cancelled against the net assets acquired and is replaced with the goodwill figure of £9,000.

Subsequent measurement of goodwill 5.32 After initial recognition, goodwill is always measured at cost less accumulated amortisation and accumulated impairment losses. FRS 102 requires all goodwill and intangible assets to be amortised on a systematic basis over their useful economic lives. There is no option under the standard to assign indefinite useful lives to goodwill or any intangible asset.

Focus The requirement to amortise goodwill (and other intangible assets) on a systematic basis over its useful economic life is different from old UK GAAP. While old UK GAAP has been withdrawn for several years, it is still apparent that some groups are assuming indefinite useful lives can be assigned to goodwill. This is not the case under FRS 102.

FRS 102, para 19.23(a) confirms that goodwill cannot have an indefinite useful life and, in exceptional cases, where management are unable to make a reliable estimate of the useful life of goodwill, the amortisation period must not exceed ten years. FRS 102, para 19.23(a) was amended in July 2015 to reflect the provisions of The Companies, Partnerships and Groups (Accounts and Reports) Regulations 108

The Consolidation Process 5.33 2015 (SI 2015/980). The change was to increase the useful life from five years to ten years where management are unable to make a reliable estimate of the useful life of goodwill, so the standard is consistent with company law.

Focus Under the provisions of IFRS 3, goodwill is not amortised. IFRS 3 requires management to undertake annual impairment reviews of goodwill; there is no option to amortise goodwill under the IFRS regime. FRS 102 is more restrictive in that it does not permit indefinite useful lives to be assigned and hence goodwill must be amortised on a systematic basis over its useful economic life. This does not preclude management from undertaking an impairment test on goodwill, which must be carried out if there is any indication that goodwill is showing signs of impairment. Prior impairment losses on goodwill can never be reversed (FRS 102, para 27.28). This means that when an impairment loss has been recognised on goodwill, it cannot be reversed in a subsequent period unlike impairment losses for other assets (see 5.33 below).

Impairment of goodwill 5.33 Impairment of assets is dealt with in FRS 102, Section 27 Impairment of Assets. FRS 102, para 27.24 recognises that goodwill, on its own, cannot be sold. Goodwill does not generate cash flows to an entity which are independent of the cash flows of other assets. Hence, the fair value of goodwill cannot be measured directly. Consequently, the fair value of goodwill must be derived from measurement of the fair value of the cash-generating unit to which it belongs. A ‘cash-generating unit’ (CGU) is defined in the Glossary to FRS 102 as: ‘The smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.’27 Examples of CGUs include: ●●

an individual hotel in a chain;

●●

an individual branch of a retailer;

●●

books published in electronic format and hard copy for a book publisher; and

●●

an individual restaurant in a chain.

Each of these individual entities or products would be classed as a CGU because they generate their own revenue for the business. 27

FRS 102 Glossary cash-generating unit.

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5.33 The Consolidation Process In a group context, a subsidiary is generally classed as a CGU. FRS 102, para 27.26 says: ‘Part of the recoverable amount of a cash-generating unit is attributable to the non-controlling interest in goodwill. For the purpose of impairment testing of a non-wholly-owned cash-generating unit with goodwill, the carrying amount of that unit is notionally adjusted, before being compared with its recoverable amount, by grossing up the carrying amount of goodwill allocated to the unit to include the goodwill attributable to the non-controlling interest. This notionally adjusted carrying amount is then compared with the recoverable amount of the unit to determine whether the cash-generating unit is impaired.’28 Therefore, where the parent does not wholly-own a subsidiary, FRS 102, para 27.26 requires the goodwill to be grossed up to include the goodwill attributable to the NCI. This grossing up calculation is done before conducting the impairment review because it is the notionally adjusted goodwill figure which is then aggregated with the other net assets of the CGU. The aggregate amount is then compared to recoverable amount to determine the value of any write down. Example 5.16 – Notionally adjusted goodwill Topco Ltd owns 80% of Subco Ltd and the group has an accounting reference date of 31 March each year. On 31 March 2022, the carrying amount of Subco’s net assets were £880,000, excluding goodwill of £120,000 (net of amortisation). Management decided to restructure the group and announced this restructuring exercise immediately prior to the reporting date. The finance director has calculated the recoverable amount of Subco’s net assets to be £950,000. FRS 102, para 27.26 requires Topco to notionally adjust the goodwill to take into account the NCI. The impairment loss is calculated as follows: £'000 120 30

Goodwill Unrecognised NCI (£120,000 × 20/80) Notionally adjusted goodwill Net assets Carrying amount Recoverable amount Impairment loss

£'000

150 880 1,030 (950) 80

80% of the impairment loss is allocated to the group so an impairment loss of £64,000 (£80,000 × 80%) is recognised in Topco’s consolidated financial statements. This impairment loss cannot be reversed in a subsequent accounting period, even if the circumstances giving rise to the original impairment loss cease to apply. 28

FRS 102, para 27.26.

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The Consolidation Process 5.34

Other considerations for impairment losses of goodwill 5.34 The order in which an impairment loss is to be allocated to a CGU is prescribed in FRS 102, para 27.21 which states: ‘An impairment loss shall be recognised for a cash-generating unit if, and only if, the recoverable amount of the unit is less than the carrying amount of the unit. The impairment loss shall be allocated to reduce the carrying amount of the assets of the unit in the following order: (a) first, to reduce the carrying amount of any goodwill allocated to the cash generating unit; and (b)

then, to the other assets of the unit pro rata on the basis of the carrying amount of each asset in the cash-generating unit.’29

Care needs to be taken when dealing with such impairment losses because there is a restriction in FRS 102, para 27.22 which states that an entity cannot reduce the carrying amount of any asset in a CGU below the highest of: (a)

its fair value less costs to sell (if determinable);

(b) its value in use (if determinable); and (c) zero. FRS 102, para 27.23 then goes on to say that any excess amount of the impairment loss which cannot be allocated to an asset because of the above restriction must be allocated to the other assets of the unit pro rata on the basis of the carrying amount of those other assets. Example 5.17 – Allocating an impairment loss The Ratchford Group is a clothing retailer. One of its subsidiaries, Jobling Clothing Ltd, suffered a fire and management have decided to close the store permanently and redeploy staff to other stores. The loss adjuster has determined that 40% of the machinery has been destroyed but the remaining 60% can be sold. The carrying amount of Jobling’s assets are as follows: £'000 Goodwill

100

Licences

250

Machinery

850

Other fixed assets

220

Vehicles

48

Building

1,500

Cash at bank

82 3,050

29

FRS 102, para 27.21.

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5.35 The Consolidation Process An independent surveyor has suggested a selling price of £1.6m could be achieved for the building. The finance director has calculated a recoverable amount for the CGU (being the subsidiary) of £2.5m. 40% of the machinery was destroyed in the fire, hence 40% of the carrying amount must be written off immediately (ie, £340,000). This leaves a carrying amount for the machinery of £510,000 (£850k – £340k). The total carrying amount of the CGU after impairment of the machinery is £2,710,000 (see below). Recoverable amount is £2.5m so a further impairment loss of £210,000 is needed. This is allocated first to goodwill and then to the other assets in the CGU on a pro rata basis (FRS 102, para 27.21). Goodwill of £100,000 is written off in full leaving £110,000 to allocate. Therefore, for example, the amount attributable to licences if £53,000 ((£250,000/(£250,000 + £220,000 + £48,000)) × £110,000). There should be no further impairment loss allocated to the machinery because these have already been written down to their recoverable amount. In addition, the impairment loss cannot be set against the building because its fair value is greater than its carrying amount (£1.6m as suggested by the independent surveyor) hence the restriction in FRS 102, para 27.22(a) applies. The monetary asset (cash at bank) is also not affected by the impairment loss because this will be realised at full value. The impairment loss is allocated as follows: Post machinery impairment

Further Post impairment impairment

£'000

£'000

£'000

Goodwill

100

(100)

-

Licences

250

(53)

197

Machinery

510

-

510

Other fixed assets

220

(47)

173

Vehicles

48

(10)

38

Building

1,500

-

1,500

82

-

82

2,710

(210)

2,500

Cash at bank

Negative goodwill 5.35 In the majority of cases, it is likely that positive goodwill will arise in the consolidated financial statements as generally the consideration paid in the business combination will be in excess of the net assets acquired. However, this is not necessarily always the case in every business combination and there 112

The Consolidation Process 5.36 may be circumstances which give rise to a ‘bargain’ purchase, ie where the consideration paid to acquire the business is less than the fair value of the net assets acquired. This usually (but not always) takes place in a distressed sale where a company is in financial distress and the outgoing shareholders agree to sell the company to an acquirer at less than the fair value of the net assets. Negative goodwill is dealt with in FRS 102, para 19.24. This paragraph takes a different approach when compared to IFRS 3, which requires negative goodwill to be immediately recognised in profit or loss. When negative goodwill appears to arise, there are three steps which take place according to FRS 102, para 19.24: ‘(a) Reassess the identification and measurement of the acquiree’s assets, liabilities and provisions for contingent liabilities and the measurement of the cost of the combination. (b) Recognise and separately disclose the resulting excess on the face of the statement of financial position on the acquisition date, immediately below goodwill, and followed by a subtotal of the net amount of goodwill and the excess. (c) Recognise subsequently the excess up to the fair value of nonmonetary assets acquired in profit or loss in the periods in which the non-monetary assets are recovered. Any excess exceeding the fair value of non-monetary assets acquired shall be recognised in profit or loss in the periods expected to be benefited.’30 Professional judgement will be needed where (b) and (c) are concerned. For example, an acquirer may decide to allocate the excess on a pro-rata basis, or to allocate the excess to specific assets where these can be identified. In practice, amounts which are allocated to, say, stock (inventory) will be eliminated quickly; whereas amounts allocated to fixed assets may take a longer period of time to eliminate depending on depreciation policies.

Intangible assets acquired in a business combination 5.36 As discussed in previous sections of this chapter, when a parent acquires a subsidiary, at the date of acquisition the subsidiary will carry out a fair value exercise of its assets, liabilities and contingent assets. These fair values are used to compute the goodwill arising in the business combination which will be recognised in the consolidated balance sheet. Intangible assets are dealt with in FRS 102, Section 18 Intangible Assets other than Goodwill. FRS 102, para 18.8 was redrafted as part of the FRC’s triennial review in 2017. The objective of this redrafting exercise was to reduce the burdens placed on businesses which undertook a business combination. Prior to the amendments, FRS 102 required separate identification of intangible 30

FRS 102, paras 19.24(a)–(c).

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5.36 The Consolidation Process assets outside of goodwill. In practice, this proved to be arduous to groups and resulted in extra costs being incurred in searching for additional intangible assets that may have been acquired as a result of a business combination. The redrafted paragraph 18.8 means that an entity can elect to recognise fewer intangible assets on the consolidated balance sheet and the excess can be subsumed within goodwill. This revised paragraph has been welcomed by groups. FRS 102, para 18.8 states that intangible assets which are acquired in a business combination shall be recognised separately from goodwill when: ‘(a) the recognition criteria set out in paragraph 18.4 are met; (b) the intangible asset arises from contractual or other legal rights; and (c) the intangible asset is separable (ie, capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged either individually or together with a related contract, asset or liability).’31 Focus FRS 102, para 18.8 does state that an entity can continue to recognise separately intangible assets from goodwill for which condition (a) and only one of (b) or (c) above is met. However, such a policy must then be applied to all intangible assets in the same asset class and be applied consistently to all business combinations.

FRS 102 does not provide examples of what it regards as classes of intangible assets, although the Illustrative Examples in the Accompanying Documents to IFRS 3 do provide a non-exhaustive list of examples which are split into categories as follows: ●●

marketing-related intangible assets;

●●

customer-related intangible assets;

●●

artistic-related intangible assets;

●●

contract-based intangible assets; and

●●

technology-based intangible assets.

31

FRS 102, para 18.18.

114

The Consolidation Process 5.36 Class Marketing-related intangible assets32 Trademarks, trade names, service marks, collective marks and certification marks Trade dress (unique colour, share or package design) Newspaper mastheads Internet domain names Non-competition agreements Customer-related intangible assets33 Customer lists Order or production backlog Customer contracts and related customer relationships Non-contractual customer relationships Artistic-related intangible assets34 Plays, operas and ballets Books, magazines, newspapers and other literary works Musical works such as compositions, song lyrics and advertising jingles Pictures and photographs Video and audiovisual material, including motion pictures or films, music videos and television programmes Contract-based intangible assets35 Licensing, royalty and standstill agreements Advertising, construction, management, service or supply contracts Construction permits Franchise agreements Operating and broadcast rights Servicing contracts, such as mortgage servicing contracts Employment contracts Use rights, such as drilling, water, air, timber, cutting and route authorities Technology-based intangible assets36 Patented technology Computer software and mask works Unpatented technology Databases, including title plants Trade secrets, such as secret formulas, processes and recipes 32 33 34 35 36

IFRS 3, IE18. IFRS 3, IE23. IFRS 3, IE32. IFRS 3, IE34. IFRS 3, IE39.

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Basis Contractual Contractual Contractual Contractual Contractual Non-contractual Contractual Contractual Non-contractual Contractual Contractual Contractual Contractual Contractual

Contractual Contractual Contractual Contractual Contractual Contractual Contractual Contractual

Contractual Contractual Non-contractual Non-contractual Contractual

5.37 The Consolidation Process Under FRS 102, any of the above type would be capitalised if they were purchased from a third party. The separability test would be passed because otherwise the transaction could not take place. Under the IFRS regime, assets of any of the above type would be capitalised where they are acquired via a business combination. Thus, under IFRS, more intangible assets qualify for recognition in a business combination than under FRS 102 because IFRS assumes that all intangible assets acquired in a business combination can be measured reliably, whereas FRS 102 is more restrictive. Some commentators argue that while the IFRS regime assumes that all intangible assets acquired in a business combination can be fair valued reliably, the bases of this fair value exercise should be introduced into FRS 102 (ie, converging the requirements of FRS 102 more with IFRS 3). The reason that FRS 102 is more restrictive where the recognition criteria for intangible assets in a business combination is concerned is because all intangible assets have finite useful lives and must be amortised over their useful economic lives (FRS 102, para 18.19). IAS 38 Intangible Assets allows intangible assets to have indefinite useful lives, although in practice most intangible assets are amortised over their estimated useful lives; whereas goodwill under IFRS 3 is never amortised (instead it is tested annually for impairment). It follows that given the fact that all intangible assets (including goodwill) must be amortised over their useful economic lives under FRS 102, the standard limits the recognition of intangible assets to only those whose cost or value can be measured reliably.

Mid-year acquisitions 5.37 In practice, it is highly unusual that the date of acquisition will be on day one of the accounting period; although that is not to say this is not impossible and, where it does happen to be the case, the accounting for the business combination will be less complex because there will be no timeapportioning needed.

Focus It is important to remember that if a subsidiary is acquired part way through the year, the subsidiary’s results must only be consolidated from the date of acquisition, which is the date on which control is obtained.

However, the reality is that most business combinations arise during the accounting period and these are referred to as ‘mid-year’ acquisitions.

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The Consolidation Process 5.37 When a parent acquires a subsidiary mid-year, the consolidated financial statements must show control by bringing in 100% of the items of the parent and the subsidiary (remember ‘control’ is the ability to direct the financial and operating activities of the subsidiary and is always based on substantive rights). There are no exceptions to this 100% amalgamation. In the consolidated profit and loss account/statement of comprehensive income, the results of the subsidiary are time-apportioned. This means that the parent is still bringing in 100% of the subsidiary’s income and expenses, but the consolidation restricts it for the period owned by the parent. So, for example, if a group has a 31 December year end and the date of acquisition of a subsidiary is 1 July, the consolidated profit and loss account will consolidate six months of the acquiree’s income and expenses. However, the subsidiary’s balance sheet is consolidated at 100% – there is no time apportioning required because the subsidiary’s balance sheet is a ‘snapshot’ of the financial position of the subsidiary as at the reporting date. Example 5.18 – Consolidated profit and loss account in a mid-year acquisition On 30 November 2021, Holdco Ltd acquired 75% ownership interest in Subco Ltd. No dividends were paid by either party during the year. Investment income shown in each company’s profit and loss account is from listed investments and has been recorded correctly in the separate financial statements of each reporting entity. The group has a 31 March 2022 reporting date. The financial statements of both companies for the year ended 31 March 2022 are as follows: Holdco

Subco

31.03.2022

31.03.2022

£'000

£'000

Turnover

153,000

110,000

Cost of sales

(72,900)

(53,400)

80,100

56,600

(37,250)

(26,304)

42,850

30,296

Gross profit Administrative expenses Operating profit Investment income

1,600

750

Profit before tax

44,450

31,046

Tax on profit

(8,446)

(5,899)

Profit for the year after tax

36,004

25,147

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5.38 The Consolidation Process Holdco Group Ltd Consolidated profit and loss account For the year ended 31 March 2022 31.03.2022 £'000 Turnover

(153,000 + (110,000 × 4/12))

189,667

Cost of sales

(72,900 + (53,400 × 4/12))

(90,700)

(37,250 + (26,304 × 4/12))

(46,018)

Gross profit Administrative expenses

98,967

Operating profit Investment income

52,949 (1,600 + (750 × 4/12))

1,850

Profit before tax Tax on profit

54,799 (8,446 + (5,899 × 4/12))

(10,412)

Profit for the year after tax

44,387

Amount attributable to: Equity holders of the parent Non-controlling interest

42,291

(25% × (25,147 × 4/12))

2,096 44,387

In a mid-year acquisition, the pre-acquisition reserves of the subsidiary will be included within the goodwill calculation (because that is what the parent is acquiring as part of the business combination). Post-acquisition reserves are included within group retained earnings. Generally, the difference between pre-acquisition reserves and post-acquisition reserves is the profit (or loss, as the case maybe) that has been generated by the subsidiary since the date of acquisition. It is important to get the pre-acquisition and post-acquisition reserves correct because otherwise the goodwill calculation and the group retained earnings figure may become materially misstated.

DISCLOSURE REQUIREMENTS 5.38 The disclosure requirements are contained in FRS 102, paras 19.25 to 19.26A and are split between disclosure requirements for business combinations that have taken place during the reporting period and all business combinations.

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The Consolidation Process 5.40

For business combinations effected during the reporting period (FRS 102, para 19.25) 5.39 For each business combination, excluding any group reconstructions, that was effected during the period, the acquirer shall disclose the following: (a)

the names and descriptions of the combining entities or businesses;

(b) the acquisition date; (c)

the percentage of voting equity instruments acquired;

(d) the cost of the combination and a description of the components of that cost (such as cash, equity instruments and debt instruments); (e) the amounts recognised at the acquisition date for each class of the acquiree’s assets, liabilities and contingent liabilities, including goodwill; (f) [deleted] (fA) a qualitative description of the nature of intangible assets included in goodwill; (g) the useful life of goodwill, and if this cannot be reliably estimated, supporting reasons for the period chosen; and (h)

the periods in which the excess recognised in accordance with paragraph 19.24 will be recognised in profit or loss.

FRS 102, para 19.25A requires the acquirer to disclose, separately for each material business combination that occurred during the reporting period, the amounts of revenue and profit or loss of the acquiree since the acquisition date included in the consolidated statement of comprehensive income for the reporting period. The disclosure may be provided in aggregate for business combinations that occurred during the reporting period which, individually, are not material. FRS 102, para 19.25(fA) was included as part of the FRC’s triennial review in 2017 in recognition of the fact that an entity may choose not to separately recognise all intangible assets in a business combination (see 5.36 above).

For all business combinations (FRS 102, para 19.26) 5.40 Disclose a reconciliation of the carrying amount of goodwill at the beginning and end of the period, showing separately: (a)

changes arising from new business combinations;

(b) amortisation; (c)

impairment losses;

(d) disposals of previously acquired businesses; and (e)

other changes.

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5.40 The Consolidation Process This reconciliation need not be presented for prior periods. An entity is also required to provide a reconciliation of the carrying amount of negative goodwill (called the ‘excess’ recognised in accordance with paragraph 19.24) at the beginning and end of the reporting period, showing separately: (a)

changes arising from new business combinations;

(b) amounts recognised in profit or loss per paragraph 19.24(c); (c)

disposals of previously acquired businesses; and

(d) other changes This reconciliation need not be presented for prior periods.

SUMMARY OF DIFFERENCES: FRS 102 V IFRS ●●

●● ●●

●●

●●

●●

●●

●●

Some group members may choose to write off development expenditure under FRS 102 as this is an accounting policy choice. Under IAS 38, an entity must capitalise such expenditure if it meets the recognition criteria so a consolidation adjustment may need to be done. Acquisition-related costs are capitalised under FRS 102 as part of the goodwill calculation. Under IFRS 3 they are written off as incurred. FRS 102 uses the probability criterion for the treatment of contingent consideration, whereas IFRS 3 does not hence all contingent consideration is recognised under IFRS 3 regardless of the probability of eventual payment or reliability of measurement. Under FRS 102 only the proportionate method can be used to measure goodwill. Under IFRS 3 goodwill can be recognised using the ‘full’ method which includes the non-controlling interest’ share of goodwill. Goodwill must be amortised under FRS 102, whereas goodwill is not amortised under IFRS; instead, it is tested for impairment at each reporting date. Negative goodwill is written off in full under IFRS 3; whereas FRS 102 requires negative goodwill to be presented immediately underneath positive goodwill and a subtotal struck. Negative goodwill is then written off to profit or loss in the periods in which the non-monetary assets are recovered. Recognition and measurement of non-controlling interest is not covered under FRS 102, whereas IFRS 3 does outline specific measurement principles. Intangible assets acquired in a business combination can only be recognised if their cost or value can be measured reliably. Under IFRS 3, the standard assumes that all intangible assets acquired in a business combination can be measured reliably hence more intangible assets are capitalised under IFRS than under FRS 102. 120

The Consolidation Process 5.40

CHAPTER ROUNDUP ●●

Control is the power to govern the financial and operating policies of an entity.

●●

Control can be achieved with an ownership interest of more than 50% but numeric benchmarks are not always an indicator that control has been achieved.

●●

There are certain exclusions in company law and FRS 102 from consolidation but these must be carefully analysed to ensure they are being correctly applied.

●●

Consolidated financial statements present the results of the group in line with its economic substance, which is that of a single reporting entity.

●●

The purchase method of accounting is used to account for a business combination.

●●

Goodwill (and other intangible assets) recognised in a business combination must be amortised on a systematic basis over their useful economic lives. There is no option under FRS 102 to assign indefinite useful lives to such assets.

●●

Mid-year acquisitions are only time-apportioned in the consolidated profit and loss account.

●●

Extensive disclosures are required in the consolidated financial statements where a business combination has taken place in the year as well as for all other business combinations.

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Chapter 6

Investments in Associates

SIGNPOSTS ●●

Entities which are parents and have investments in associates are required to equity account the associate in the consolidated financial statements (see 6.3).

●●

An investment is classed as an associate when the investor has significant influence over the entity (see 6.4).

●●

There are three accounting policy options available for investors which are not parents in respect of investments in associates (see 6.8).

●●

The equity method of accounting in the consolidated financial statements ceases to apply when the investor no longer has significant influence over the investee (see 6.19).

●●

Extensive disclosures are required depending on the financial reporting framework used and these disclosures are found in both company law and in UK GAAP (see 6.25 to 6.29).

INTRODUCTION 6.1 FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland deals with investments in associates in Section 14 Investments in Associates. FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime deals with them in Section 7 Subsidiaries, Associates, Jointly Controlled Entities and Intermediate Payment Arrangements. In 2015, amendments were made to company law by virtue of The Companies, Partnerships and Groups (Accounts and Reports) Regulations 2015 (SI 2015/980) which allow the option to use the equity method of accounting (see 6.10) in the individual financial statements of the investor. The Financial Reporting Council (FRC) decided not to introduce this option on the grounds that FRS 102 already included a number of options for accounting for investments in associates and hence this option is not available to UK GAAP reporters. However, FRS 102 does require disclosure of what the effect would 122

Investments in Associates 6.3 have been had the investments in associates been accounted for under the equity method.

SCOPE OF FRS 102 AND FRS 105 6.2 The scope section of FRS 102, Section 14 was amended by the FRC as part of the triennial review in 2017. The amendments did not change the overall scope of Section 14, but simply tidied up the wording. FRS 102, Section 14 applies to associates in: ‘(a) consolidated financial statements; and (b) the individual financial statements of an investor that is not a parent. An entity that is a parent shall account for its investments in associates in its separate financial statements in accordance with paragraphs 9.26 and 9.26A, as appropriate.’1 FRS 105, para 7.1 was also amended as part of the FRC’s triennial review in 2017 and, again, this was mainly to tidy up the wording. FRS 105, para 7.1 states that Section 7 applies to investments in subsidiaries and associates, interests in jointly controlled entities and intermediate payment arrangements.

GROUP ISSUES 6.3 When an entity is a parent (ie, it owns a subsidiary(ies) and prepares consolidated financial statements), investments in associates are accounted for using the equity method of accounting (see 6.10). The exception to the use of the equity method of accounting is where the investments are held as part of an investment portfolio. The term ‘held as part of an investment portfolio’ is defined in the Glossary to FRS 102 as follows: ‘An interest is held as part of an investment portfolio if its value to the investor is through fair value as part of a directly or indirectly held basket of investments rather than as media through which the investor carries out business. A basket of investments is indirectly held if an investment fund holds a single investment in a second investment fund which, in turn, holds a basket of investments. In some circumstances, it may be appropriate for a single investment to be considered an investment portfolio, for example when an investment fund is first being established and is expected to acquire additional investments.’2

1 2

FRS 102, para 14.1. FRS 102 Glossary held as part of an investment portfolio.

123

6.4 Investments in Associates Entities which are not parents, but have investments in associates, are required to account for those investments using an accounting policy choice of cost, fair value through other comprehensive income or fair value through profit or loss. As noted above, disclosure is also required as to the effect of equity accounting if the investments in associates had been equity accounted in the individual financial statements.

DEFINITION OF AN ASSOCIATE AND SIGNIFICANT INFLUENCE 6.4 An ‘associate’ is defined in the Glossary to FRS 102, and FRS 102, para 14.2 as: ‘An entity, including an unincorporated entity such as a partnership, over which the investor has significant influence and that is neither a subsidiary nor an interest in a joint venture.’3 It is important to clearly distinguish between an associate and a subsidiary because a parent-subsidiary relationship is created when the parent acquires control over the subsidiary. In such cases, consolidated financial statements will be required if any exceptions or exemptions from preparing consolidated financial statements cannot be claimed. In contrast, an investor has an investment in an associate when the investor has significant influence over the associate. The term ‘significant influence’ is defined as follows: ‘Significant influence is the power to participate in the financial and operating policy decisions of the associate but is not control or joint control over those policies.’4 FRS 102, para 14.3 then goes on to provide additional guidance as follows: ‘(a) If an investor holds, directly or indirectly (eg through subsidiaries), 20 per cent or more of the voting power of the associate, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case. (b) Conversely, if the investor holds, directly or indirectly (eg through subsidiaries), less than 20 per cent of the voting power of the associate, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated. (c) A substantial or majority ownership by another investor does not preclude an investor from having significant influence.’5

3 4 5

FRS 102 Glossary associate. FRS 102 Glossary significant influence. FRS 102, para 14.3.

124

Investments in Associates 6.5 The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410) (Accounting Regulations), Schedule 6.19 refers to ‘associated undertakings’ as follows: ‘(1) An “associated undertaking” means an undertaking in which an undertaking included in the consolidation has a participating interest and over whose operating and financial policy it exercises a significant influence, and which is not— (a) a subsidiary undertaking of the parent company or (b) a joint venture dealt with in accordance with paragraph 18.’6 The Accounting Regulations refer to a ‘participating interest’ which is an interest that is held in the shares of another entity on a long-term basis. Holdings of 20% or more are taken to be a participating interest unless there is evidence to the contrary. In addition, the Accounting Regulations refer to an ‘associated undertaking’. Such an undertaking can be a body corporate, a partnership or an unincorporated entity with or without a view to making a profit. Significant influence is usually achieved with an ownership interest of 20% or more in the net assets of the investee. Such numeric benchmarks are not always absolute, because there can be other indicators that significant influence has been acquired, such as: ●●

representation on the board of directors or equivalent governing body of the investee;

●●

a participation in the policy-making processes, including dividend policies and other distributions;

●●

interchange of managerial personnel;

●●

provision of essential technical information; and

●●

material transactions taking place between the investor and the investee.

Focus Where an ownership interest is below 20%, careful scrutiny of the relationship between the investor and the investee will be needed to ensure that de facto significant influence has not been created.

Ownership interest of more than 20% but the entity is not treated as an associate 6.5 FRS 102, para 14.3(a) states that an investor which holds, directly or indirectly, 20% or more of the voting power of the associate has significant influence, unless it can be clearly demonstrated that this is not the case. 6

Accounting Regulations, Sch 6, para 19(1).

125

6.6 Investments in Associates The following are non-exhaustive examples of what may give rise to an ownership interest of 20% or more not giving rise to an investment being classed as an associate: (a) Severe long-term restrictions prevent the investor from receiving funds from the investee. (b)

The investor rescinds all significant influence through an agreement with other investors.

(c)

Law or regulation prevent significant influence from being exercised by the investor (for example, in a foreign country).

(d) It is probable (ie, more likely than not) that the investee will issue additional shares to third parties which dilute the ownership interest of the investor. (e) There are adverse political and economic conditions in the foreign country which the investee is situated. Focus The above list is not comprehensive, but it is important to carefully scrutinise the substance of the relationship between the investor and the investee because significant influence may be achieved by other means (eg, participating in the policy-making process).

Ownership interest of less than 20% but the entity is treated as an associate 6.6 FRS 102, para 14.3(b) states that where an investor holds, directly or indirectly, less than 20% of the voting rights of an entity, it is presumed that significant influence does not exist unless such influence can be clearly demonstrated. Significant influence with a holding of less than 20% of the voting rights of an entity could arise, for example, where the investor’s major shareholder or parent holds additional shares in the investee or the investee is a member of the executive or finance committee.

Ceasing to have significant influence 6.7 Significant influence over an investee is lost when the investor loses the power to participate in the financial and operating policy decisions of the investee. The loss of significant influence usually arises due to disposal of the investee but it can also occur where the entity is taken over as a matter of law (eg, by a court or official receiver), or where there is a dilution in interest, due to further shares being issued to third parties. 126

Investments in Associates 6.9 Once significant influence is lost, the use of the equity method of accounting in the consolidated financial statements must cease.

MEASUREMENT – ACCOUNTING POLICY ELECTION 6.8 FRS 102, para 14.4 states that an investor which is not a parent, but has an investment in one, or more, associates shall, in its individual financial statements, account for all of its investments in associates using either: (a)

the cost model in accordance with paragraphs 14.5 to 14.6;

(b) [deleted] (c)

at fair value in accordance with paragraphs 14.9 to 14.10A; or

(d) at fair value with changes in fair value recognised in profit or loss. FRS 102, para 14.4(b) is shown as ‘[deleted]’ in FRS 102. The equivalent para 14.4(b) in the IFRS for SMEs refers to the equity method of accounting in the individual financial statements. As noted above, the FRC have not included this option in FRS 102 even though it was incorporated into company law following the transposition of the EU Accounting Directive. The equity method is only possible in the consolidated financial statements. Focus The accounting policy choices outlined in FRS 102, para 14.4 only apply to investors that are not parents; ie they do not own any subsidiaries. Where an investor is a parent (ie, they own subsidiary entities) and prepare consolidated financial statements, they must account for all of their investments in associates using the equity method of accounting. However, an exception to this rule would be where an investor which is a parent has an associate which is held as part of an investment portfolio as this would be measured at fair value with changes in fair value going through profit or loss in the consolidated financial statements.

Cost model 6.9 An investor which is not a parent and which chooses to adopt the cost model measures its investments in associates at cost less accumulated impairment losses. Impairment issues are dealt with in FRS 102, Section 27 Impairment of Assets and FRS 105, Section 22 Impairment of Assets. Dividends and other distributions which are received from the investment are recognised as income regardless of whether the distributions are received

127

6.10 Investments in Associates from accumulated profits of the associate arising before, or after, the date of acquisition. Therefore, under the cost model: ●●

investments in associates are recognised at cost (including transaction costs such as legal fees incurred in acquiring the associate);

●●

dividends and distributions are taken to the profit and loss account as income; and

●●

where there are indicators that the investment is impaired at the reporting date and recoverable amount is less than carrying amount, it is written down to recoverable amount by way of an impairment loss. Impairment losses are recognised in profit or loss.

In practice, the cost model is the most common model used due to its simplicity. However, if the investment in associate has a quoted price, obtaining fair value at the reporting date will not prove arduous. FRS 102, para 14.7 is shown as ‘[deleted]’. The equivalent paragraph in the IFRS for SMEs requires the use of the fair value model where there is a published price quotation for the associate.

Equity method of accounting 6.10

FRS 102, para 14.8 says:

‘Under the equity method of accounting, an equity investment is initially recognised at the transaction price (including transaction costs) and is subsequently adjusted to reflect the investor’s share of the profit or loss, other comprehensive income and equity of the associate.’7 Focus FRS 102, para 14.8 refers to the term ‘equity investment’, but FRS 102 does not define this term in the Glossary. Equity investments are usually investments in shares of another entity. In summary, the equity method of accounting works as follows: ●●

initial recognition at cost; plus or (minus);

●●

share of profit (loss) from associate; less

●●

dividends and other distributions received from the associate.

7

FRS 102, para 14.8.

128

Investments in Associates 6.11 Focus Dividends and other distributions received from the associate are not taken to profit or loss under the equity accounting method; they reduce the value of the investment in the consolidated balance sheet. A review of some financial statements has indicated that this accounting treatment has been incorrectly applied in the past, with some dividends and distributions being credited to the profit and loss account. This is incorrect under equity accounting.

Example 6.1 – Equity accounting On 1 January 2021, Westhead Ltd acquires a 35% interest in Heaton Ltd which cost £475,000. On this date the book value of Heaton’s assets was £900,000. During the year to 31 December 2021, Heaton made a profit of £80,000 and paid a dividend of £120,000. Under the equity method, Westhead would account for its associate as follows: Acquisition of Heaton Ltd

£

Share of Heaton’s net assets (£900,000 x 35%)

315,000

Goodwill8 (£475,000 less £315,000)

160,000

£

475,000 Share of profit (£80,000 x 35%)

28,000

Dividend received (£120,000 x 35%)

(42,000)

Carrying amount of investment at 31 December 2021

461,000

Reconciled as: Share in book value of Heaton’s net assets (£315,000 + 35% (£80,000 – £120,000))

301,000

Goodwill

160,000

Carrying amount per consolidated financial statements

461,000

There are some general points outlined in FRS 102, para 14.8 which relate to the equity method of accounting as set out in 6.11–6.15 below as follows:

Distributions from the associate 6.11 Distributions received from the associate reduce the carrying value of the investment (as they are a return on the investment); they are not taken to profit or loss. Adjustments to the carrying amount of the investment may also 8

The goodwill element is shown here for clarity purposes. Goodwill may ‘arise’ where an investment in an associate is made, but it is not shown separately in the consolidated balance sheet.

129

6.12 Investments in Associates be required due to changes in the associate’s equity arising from items of other comprehensive income. When the interest in the associate is reduced to zero, any further losses are only recognised to the extent that the investor has a legal or constructive obligation, or has made payments on behalf of the associate. FRS 102 does not provide any guidance as to what happens in the event that dividends are received to the extent that the investment is reduced to zero and further dividends or distributions are then received by the investor. In such situations, provided that the distributions are not refundable by the investor and the investor is not liable for the investor’s liabilities, then any dividends or distributions received in excess of the carrying value of the investor should be recognised in income. It would not be appropriate to have a negative balance as an investment in associate in the group balance sheet.

Potential voting rights 6.12 While potential voting rights are brought into consideration when establishing whether significant influence exists, the investor must measure its share of profit or loss and other comprehensive income (and its share of changes in the associate’s equity) on the basis of actual ownership interest at the reporting date and not include what may, or may not, happen in the future (eg, where the investor has provided convertible debt).

Implicit goodwill and fair value adjustments 6.13 On acquisition of an associate, goodwill is the difference between the cost of the acquisition and the investor’s share of the fair value of the net identifiable assets of the associate (see Example 6.1 above). The goodwill arising is not shown separately on the face of the consolidated balance sheet as would be the case where a subsidiary is concerned. The investor must adjust its share of the associate’s profit or losses after acquisition so as to account for the additional depreciation or amortisation of the depreciable or amortisable assets in the associates. This is because, at the date of acquisition, the associate’s identifiable asset and liabilities will be fair valued and the fair values may be different to book values at the time the associate is acquired giving rise to a fair value adjustment to be incorporated in the consolidated financial statements.

Impairment 6.14 Where there is evidence that an investment in an associate is impaired, the investor must test the entire carrying amount of the investment for impairment using the provisions in FRS 102, Section 27 or FRS 105, Section 22 as appropriate. The test for impairment is as a single asset. Goodwill arising on the acquisition of an associate is not tested separately, but is part of the test for impairment on the entire investment. 130

Investments in Associates 6.17

Investor’s transactions with associates 6.15 It is not uncommon for an investor to trade with its associates and vice versa. Where such trading takes place, the investor must eliminate all unrealised profits and losses in both directions (ie, ‘upstream’ which refers to trading between the associate and the investor, and ‘downstream’ which refers to trading between the investor and the associate). Care must be taken here because this is not the same as eliminating intra-group trading where a subsidiary is concerned. This is because, in the case of an associate, the investor will only eliminate unrealised profits and losses to the extent of the investor’s interest in the associate. In addition, it must be borne in mind that unrealised losses on such transactions may indicate that the asset transferred is impaired. Focus As associates are not part of an investor’s group, any inter-company balances between the group and the associates are not eliminated as they are when a subsidiary is consolidated. Normal trading balances which are unsettled at the balance sheet date are recognised as current assets or current liabilities as appropriate. In addition, any long-term loans to the associate are disclosed as due after more than one year and this will require consideration as to whether such balances are shown as fixed assets or debtors due after more than one year in the consolidated balance sheet.

Coterminous reporting date 6.16 The equity method of accounting requires the associate to use the same accounting reference date as that of its investor, unless this is impracticable to do so. The term ‘impracticable’ is defined in the Glossary to FRS 102 as follows: ‘Applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so.’9 Such impracticalities are likely to be rare, but where it does prove to be impracticable the investor should use the most recent available financial statements of the associate and make adjustments for the effects of any significant transactions or events that have taken place between the two accounting periods.

Accounting policies 6.17 Where the associate uses accounting policies which differ from those used by the investor, the investor must adjust the associate’s financial statements 9

FRS 102 Glossary impracticable.

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6.18 Investments in Associates so that they reflect the accounting policies for the purposes of applying the equity method, unless it is impracticable to do so. Again, it is likely to be rare for such impracticalities to exist in practice.

Losses in excess of the investment 6.18 As noted in 6.11, when the investor’s interest is zero, any additional losses are recognised as a provision only to the extent that the investor has incurred a legal or constructive obligation which will necessitate the recognition of a provision under the requirements of FRS 102, Section 21 Provisions and Contingencies. In addition, the investor recognises a provision where it has made payments on behalf of the associate. When the associate subsequently reports a profit, the investor can then resume recognising its share of those profits, but only where its share of the profits is equivalent to the share of losses not recognised.

Discontinuing the equity method 6.19 The equity method of accounting ceases from the date that the investor no longer has significant influence over the investment. The equity method will also no longer apply where the investor becomes a subsidiary (ie, the investor increases its ownership interest in the associate such that a parentsubsidiary relationship is created, usually by way of an ownership interest of more than 50%). Chapter 8 examines changes in ownership interest in more detail. Where control is achieved, the investor applies the provisions in Section 19 Business Combinations and Goodwill. Conversely, if the associate becomes a joint venture, the investor will also cease to use the equity method (except in the case of a jointly controlled entity in the consolidated financial statements) and accounts for the joint venture in accordance with FRS 102, Section 15. Where the equity method of accounting is discontinued, the accounting treatment is as follows: ●●

Where significant influence is lost as a result of a full or partial disposal, the associate is derecognised from the balance sheet and the difference between the disposal proceeds and the carrying value of the investment at the date of disposal is recognised in profit or loss. Any interest which the investor continues to retain following the disposal is accounted for using FRS 102, Section 11 Basic Financial Instruments or Section 12 Other Financial Instruments Issues as appropriate. The carrying value of the associate on the date of disposal is then regarded as cost on initial measurement of the financial asset.

●●

If other reasons apply for the loss of significant influence, other than a partial disposal of the investment, the investor regards the carrying value of the investment as at that date as the new cost and the investment is accounted for under FRS 102, Section 11 or Section 12 as appropriate. 132

Investments in Associates 6.22 Focus The gain or loss recognised on disposal should also include all amounts that have been recognised in other comprehensive income which relate to the associate subject to the disposal and where such amounts have to be reclassified to profit or loss on disposal. Where amounts cannot be recycled through profit or loss, they are transferred directly to retained earnings. In practice, the only items which may need to be reclassified on disposal of an associate under FRS 102 are those amounts relating to cash flow hedges that had been recognised in other comprehensive income.

FAIR VALUE MODELS 6.20 Investors which are not parents but have an investment in one, or more, associates have an accounting policy option available to them which allows them to measure their investments in associates at fair value in the individual financial statements. Both the cost model, and the fair value model, are not alternatives for equity accounting in the consolidated financial statements as they are only relevant to the individual financial statements of the investor. Focus In practice it is not expected that many investments in associates are measured at fair value, unless there is a quoted market price available, hence the cost model is expected to be the most commonly applied measurement method.

Initial recognition 6.21 On initial recognition, the investment in associate in the financial statements of an investor that is not a parent which chooses to adopt the fair value model shall measure it at transaction price. Any transaction costs which are incurred in acquiring the associate are immediately expensed; they are not recognised on the balance sheet as part of the cost of the associate.

Subsequent measurement 6.22 At each balance sheet date, an investor that is not a parent which chooses to adopt the fair value model for its investments in associates shall measure its investments in associates at fair value. Changes in fair value from the previous reporting date are recognised in other comprehensive income. Fair value guidance is provided in the Appendix to FRS 102, Section 2 Concepts and Pervasive Principles. 133

6.23 Investments in Associates

Dividends and distributions 6.23 Where the fair value model is being used to measure investments in associates, any dividends or distributions received from the associate are recognised as income in profit or loss regardless of whether the distributions are from accumulated profits of the associate which arose before or after the date of acquisition.

Fair value through profit or loss 6.24 As an accounting policy choice, FRS 102, para 14.4 allows an investor to account for its investments in associates at fair value through profit or loss. Under this model, fluctuations in fair value are taken to profit or loss, as are dividends and other distributions from the associate. Fair value is determined by the investor having regard to the relevant fair value guidance in the Appendix to FRS 102, Section 2.

DISCLOSURE REQUIREMENTS 6.25 There are extensive disclosure requirements where investments in associates are concerned. These are contained in both company law and accounting standards as follows:

Companies Act 2006 6.26 The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410), Schedule 4 Information on related undertakings required whether preparing Companies Act or IAS accounts at para 19 requires the following disclosures in respect of associated undertakings: ‘19. – (1) The following information must be given where an undertaking included in the consolidation has an interest in an associated undertaking: (2) The name of the associated undertaking must be stated. (3) There must be stated— (a) if the undertaking is incorporated outside the United Kingdom, the country in which it is incorporated, (b) the address of the undertaking’s registered office (whether in or outside the United Kingdom). (4)

The following information must be given with respect to the shares of the undertaking held— (a) by the parent company, and 134

Investments in Associates 6.27 (b) by the group, and the information under paragraphs (a) and (b) must be shown separately. (5) There must be stated— (a) the identity of each class of shares held, and (b) the proportion of the nominal value of the shares of that class represented by those shares. (6) In this paragraph “associated undertaking” has the meaning given by paragraph 19 of Schedule 6 to these Regulations; and the information required by this paragraph must be given notwithstanding that paragraph 21(3) of that Schedule (materiality) applies in relation to the accounts themselves.’10 Focus Para 19 of Schedule 6 to the Accounting Regulations states that an ‘associated undertaking’ means an undertaking in which an undertaking included in the consolidation has a participating interest and over whose operating and financial policy it exercises a significant influence, and which is not: (a)

a subsidiary undertaking of the parent company; or

(b) a joint venture dealt with in accordance with para 18 [of Schedule 6 to the Accounting Regulations].

FRS 102 6.27 FRS 102, para 14.12 requires the entity to disclose in the individual and consolidated financial statements: ●●

the accounting policy for investments in associates;

●●

the carrying amount of investments in associates; and

●●

the fair value of investments in associates accounted for using the equity method for which there are published price quotations.

Where the investor has received dividends or other distributions from the associate accounted for under the cost model, it must disclose the value of those dividends or distributions that have been recognised as income. For equity accounted associates, disclose separately the investor’s share of the profit or loss of such associates and its share of any discontinued operations of such associates.

10

Accounting Regulations, Sch 4, para 19.

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6.28 Investments in Associates Where the fair value model has been used to measure investments in associates, disclose the information required by FRS 102, paras 11.43 and 11.44 (ie, the basis for determining fair value, or if a reliable measure of fair value is no longer available for any financial instruments that would otherwise be required to be measured at fair value through profit or loss, disclose that fact). In respect of the individual financial statements of an investor that is not a parent, disclose summarised financial information concerning investments in the associates, along with the effect of including those investments as if they had been accounted for using the equity method. Investing entities that are exempt from preparing consolidated financial statements, or which would be exempt if they had subsidiaries, are exempt from this disclosure requirement.

FRS 102, Section 1A Small Entities 6.28 Small companies choosing to apply the presentation and disclosure requirements of FRS 102, Section 1A should disclose: ●●

The accounting policies adopted for investments in associates.

●●

When an investor adopts a policy of accounting for its investments in associates at fair value through other comprehensive income, disclose the items affected and the basis of valuation adopted in determining the amounts in question within the note on accounting policies.

●●

Where investments in associates are measured at fair value through profit and loss, the disclosures required by FRS 102, Section 11 are required, including FRS 102, para 11.48A: ––

If there is a difference between the fair value of a financial instrument at initial recognition and the amount determined at that date using a valuation technique, the aggregate difference yet to be recognised in profit or loss at the beginning and end of the period and a reconciliation of the changes in the balance of this difference.

––

Information that enables users of the entity’s financial statements to evaluate the nature and extent of relevant risks arising from financial instruments to which the entity is exposed at the end of the reporting period. These risks typically include, but are not limited to, credit risk, liquidity risk and market risk. The disclosure should include both the entity’s exposure to each type of risk and how it manages those risks. (FRS 102 para 11.48 (d) and (e)).

FRS 105 6.29

There are no disclosures required under FRS 105.

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Investments in Associates 6.29

CHAPTER ROUNDUP ●●

FRS 102 deals with investments in associates in Section 14. FRS 105 deals with them in Section 7.

●●

FRS 102 deals with the accounting treatment and disclosure requirements in respect of both the individual financial statements of the investor and the consolidated financial statements.

●●

Entities which are not parents have three accounting policy choices available to them in respect of investments in associates.

●●

Significant influence is usually achieved with an ownership interest of between 20% and 50%, although numeric benchmarks are not always an absolute indicator.

●●

The equity method of accounting applies to the associate in the consolidated financial statements of the parent. It cannot be used in the individual financial statements of the investor.

●●

Goodwill ‘arises’ when an entity makes an investment in an associate, but it is not shown separately in the consolidated financial statements.

●●

Where investments in associates are measured using one of the fair value models in FRS 102, they cannot be used as an alternative to equity accounting in the consolidated financial statements.

●●

Extensive disclosures are required in both the consolidated financial statements and individual financial statements to comply with the requirements of company law and UK GAAP.

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Chapter 7

Investments in Joint Ventures

SIGNPOSTS ●●

Unanimous consent must be obtained by all parties sharing control in respect of a joint venture (see 7.2).

●●

There must be a contractually agreed sharing of control and a contractual arrangement in place in order that the venture meets the definition of a joint venture under FRS 102 (see 7.2).

●●

Equity accounting must be applied in the consolidated financial statements for investments in jointly controlled entities (see 7.9).

●●

The cost model which is available to measure certain joint ventures is not an alternative to equity accounting in the consolidated financial statements (see 7.11).

●●

The fair value model is also not an alternative to equity accounting in the consolidated financial statements as the model is only relevant to the individual financial statements of the venturer (see 7.12).

●●

Transactions between a venturer and investor are eliminated in the consolidated financial statements but only to the extent of the investor’s ownership interest (the transaction is not cancelled) and this also applies to unrealised profits (see 7.14).

INTRODUCTION 7.1 FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland deals with joint ventures in Section 15 Investments in Joint Ventures. The scope of this section applies to: (a)

investments in joint ventures in: (i)

the consolidated financial statements; and

(ii) the individual financial statements of a venturer that is not a parent; and (b) investments in jointly controlled operations and jointly controlled assets in the separate financial statements of a venturer which is a parent. 138

Investments in Joint Ventures 7.2 Venturers which are parents (ie, which prepare consolidated financial statements because they control one or more subsidiaries) account for interests in jointly controlled entities in their separate financial statements in accordance with FRS 102, paras 9.26 and 9.26A (Chapter 2 deals with the issue of consolidated and separate financial statements in more detail). For micro-entities applying FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime, the provisions of Section 7 Subsidiaries, Associates, Jointly Controlled Entities and Intermediate Payment Arrangements will apply. FRS 105, para 7.1 states that Section 7 applies to investments in subsidiaries and associates, interests in jointly controlled entities and intermediate payment arrangements.

DEFINED TERMS 7.2 At the outset it is important to understand some defined terminology where joint ventures are concerned. This is because there are some technical aspects which are critical to determining whether, or not, an investment is to be classed as a joint venture or otherwise. Joint control ‘The contractually agreed sharing of control over an economic activity. It exists only when the strategic financial and operating decisions relating to the activity require the unanimous consent of the parties sharing control (the venturers).’1 Joint venture ‘A contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control. Joint ventures can take the form of jointly controlled operations, jointly controlled assets, or jointly controlled entities.’2

Focus The distinction between a joint venture and other types of investment is that there must be a contractual arrangement in place. This contractual arrangement must confirm that there is joint control between the venturers. In other words, no one party to the contract can have overall control because if this were the case, there would not be a joint venture; instead, there would be a parent-subsidiary relationship.

1 2

FRS 102 Glossary joint control. FRS 102 Glossary joint venture.

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7.3 Investments in Joint Ventures It is important to remember that regard must be had to the substance of the arrangement to determine whether joint control exists. Regard must not just be had to how the agreement is legally formed, but the mechanism of control must be considered. The definition of ‘joint control’ makes reference to the ‘unanimous consent’ having to be obtained by all parties sharing control in respect of the venture’s financial and operating decisions. In some situations, the venturers may not agree, and hence unanimous agreement may not be achieved. The contract may make provision for the joint venture to be liquidated if the unanimous agreement of all parties sharing control cannot be obtained.

Focus As you can see from the definition of ‘joint control’ and ‘joint venture’, reference is made to a ‘contractually agreed sharing of control’ and ‘a contractual arrangement’. Where there is no contract, or where a contractual arrangement does not involve joint control, a joint venture for the purpose of FRS 102 or FRS 105 does not exist and hence Section 15 (FRS 102) or Section 7 (FRS 105) will not apply.

UK GAAP does not specify the form that the contractual arrangement must take. In practice, it is usual for such contracts to be in writing and it will deal with various matters. The following list provides a non-comprehensive list of notable matters which the contract may deal with. The list below only provides some examples of the content of a joint venture agreement as there could be other venture-specific matters that need to be provided for as well: ●●

the activity, objectives and reporting obligations of the joint venture;

●●

capital contributions by the venturers;

●●

the sharing of the output of the venture including income, expenses and results; and

●●

the appointment of a board or equivalent governing body together with any applicable voting rights.

TYPES OF JOINT VENTURE UNDER UK GAAP 7.3 There are three types of joint venture which are dealt with under UK GAAP as follows: ●●

jointly controlled operations;

●●

jointly controlled assets; and

●●

jointly controlled entities. 140

Investments in Joint Ventures 7.4 It is worth noting that only two types of joint venture are dealt with under the IFRS regime in IFRS 11 Joint Arrangements. Joint arrangements under IFRS 11 are divided into: ●●

joint ventures; or

●●

joint operations.

Jointly controlled operations 7.4

FRS 102, paras 15.4 and 15.5 state:

‘The operation of some joint ventures involves the use of the assets and other resources of the venturers rather than the establishment of a corporation, partnership or other entity, or a financial structure that is separate from the venturers themselves. Each venturer uses its own property, plant and equipment and carries its own inventories. It also incurs its own expenses and liabilities and raises its own finance, which represents its own obligations. The joint venture activities may be carried out by the venturer’s employees alongside the venturer’s similar activities. The joint venture agreement usually provides a means by which the revenue from the sale of the joint product and any expenses incurred in common are shared among the venturers.’3 ‘In respect of its interest in jointly controlled operations, a venturer shall recognise in its financial statements: (a)

the assets that it controls and the liabilities that it incurs; and

(b) the expenses that it incurs and its share of the income that it earns from the sale of goods or services by the joint venture.’4 In summary, a joint venture may be set up which involves the use of assets and resources of individual venturers, as opposed to the creation of a separate vehicle to operate the joint venture through. Each venturer in the joint venture will use their own assets and carry their own inventory as well as incurring their own expenses and liabilities. This includes raising their own finances. Example 7.1 – Jointly controlled operation A & B Enterprises enters into a contractual arrangement with C & D Industries under which it will combine its operations, resources and technical expertise to manufacture, market and distribute a new type of electric car aimed at the low-cost market.

3 4

FRS 102, para 15.4. FRS 102, para 15.5.

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7.5 Investments in Joint Ventures Both entities will carry out different parts of the manufacturing process. Both entities will bear their own costs and will be entitled to a share of the revenue from the sale of the cars. The basis for allocating revenue is determined in accordance with the terms of the contractual arrangement. A & B Enterprises and C & D Industries both have joint control over the manufacturing operations and the joint venture takes the form of a jointly controlled operation. Consequently, in the separate financial statements of A & B Enterprises and C & D Industries, both will recognise the assets they control and the liabilities and expenses each entity incurs and its share of the income which it will earn from the sale of the cars.

Jointly controlled assets 7.5 A joint venture may be created whereby the venturers both control and own one, or more, assets which have been contributed to the venture. For example, a property. FRS 102, para 15.7 states that each venturer shall recognise, in its own financial statements: ‘(a) its share of the jointly controlled assets, classified according to the nature of those assets; (b) any liabilities that it has incurred; (c)

its share of any liabilities incurred jointly with the other venturers in relation to the joint venture;

(d) any income from the sale or use of its share of the output of the joint venture, together with its share of any expenses incurred by the joint venture; and (e)

any expenses that it has incurred in respect of its interest in the joint venture.’5

Example 7.2 – Jointly controlled asset E & F Properties and G & H Investments both own a residential property which is let out to a third party to earn rental income. In the individual financial statements of both entities, each venturer will recognise its share of the jointly controlled asset (being the property itself) and its own share of the income generated from the rental business. Each entity will also recognise its own liability for the mortgage repayments on the property as well as the interest charge on those borrowings.

5

FRS 102, para 15.7(a)–(e).

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Investments in Joint Ventures 7.10

Jointly controlled entities 7.6 Jointly controlled entities are more complex to account for in comparison to jointly controlled operations and jointly controlled assets. A jointly controlled entity involves the creation of a separate vehicle through which the jointly controlled entity will operate, such as an incorporated entity or partnership. The joint venture itself will operate in much the same way as other entities. However, a notable difference is that there will be a contractual arrangement in place between the venturers which will establish joint control over the economic activity of the company.

Accounting policy election 7.7 Measurement of a jointly controlled entity will all depend on whether the venturer is: (a)

not a parent; or

(b) is a parent; or (c)

is a parent that has jointly controlled entities held as part of an investment portfolio.

Venturer is not a parent 7.8 A venturer that is not a parent but has one, or more, interests in jointly controlled entities accounts for the jointly controlled entity in its individual financial statements using either: ●●

the cost model;

●●

fair value through other comprehensive income; or

●●

fair value through profit or loss.

Venturer is a parent 7.9 A venturer that is a parent must, in its consolidated financial statements, account for all investments in jointly controlled entities using the equity method of accounting. The equity method used is the same as that for investments in joint ventures (see Chapter 6). However, the term ‘significant influence’ is replaced by ‘joint control’ and ‘associate’ is replaced by ‘jointly controlled entity’.

Venturer is a parent and has jointly controlled entities held as part of an investment portfolio 7.10 A venturer that is a parent shall measure its investments in jointly controlled entities held as part of an investment portfolio at fair value through 143

7.11 Investments in Joint Ventures profit or loss in the consolidated financial statements. In practice, such portfolios are uncommon.

Cost model 7.11 Under the cost model, a venturer which is not a parent measures its investments in jointly controlled entities at cost less accumulated impairment losses. Distributions (including dividends) received from the jointly controlled entity are recognised as income regardless of whether they are made from accumulated profits of the jointly controlled entity arising before, or after, the date of acquisition. In practice, the cost model is likely to be the most common type of model and it is identical to the same cost model applied to investments in associates (see Chapter 6).

Focus The cost model is not an alternative to equity accounting in the consolidated financial statements. The cost model only applies to the individual financial statements.

Fair value model 7.12 There are two fair value models available, being fair value through other comprehensive income and fair value through profit or loss. FRS 102, para 15.15 was amended as part of the triennial review in 2017 to clarify that where a venturer elects a policy of fair value through profit or loss, fair value fluctuations are taken directly to profit or loss. In practice, it is rare for a fair value model to be used for a jointly controlled entity, unless there is a published price quotation available (ie, if the jointly controlled entity is a listed entity).

Focus As with the cost model, either fair value model is not an alternative to equity accounting in the consolidated financial statements. The fair value model is only relevant to the individual financial statements.

Under the fair value model, an investment in a jointly controlled entity is initially recognised at transaction price (ie, at cost). At each reporting date, a venturer which is not a parent, measures its investments in jointly controlled entities at fair value (using the fair value

144

Investments in Joint Ventures 7.13 guidance in the Appendix to Section 2 Concepts and Pervasive Principles). The only difference between the two fair value models is where the movements go – changes in fair value are recognised in other comprehensive income or profit or loss depending on whether the investment is measured at fair value through other comprehensive income or fair value through profit or loss. When the fair value model is adopted, any dividends or other distributions the venturer receives from the jointly controlled entity are recognised in income regardless of whether the distributions are from accumulated profits of the jointly controlled entity arising before, or after, the date of acquisition.

TRANSACTIONS BETWEEN A VENTURER AND A JOINT VENTURE 7.13

FRS 102, para 15.16 states:

‘When a venturer contributes or sells assets to a joint venture, recognition of any portion of a gain or loss from the transaction shall reflect the substance of the transaction. While the assets are retained by the joint venture, and provided the venturer has transferred the significant risks and rewards of ownership, the venturer shall recognise only that portion of the gain or loss that is attributable to the interests of the other venturers in its consolidated financial statements. The venturer shall recognise the full amount of any loss when the contribution or sale provides evidence of an impairment loss.’6 In addition, FRS 102, para 15.17 reflects the situation where an asset’s carrying amount is realised as follows: ‘When a venturer purchases an asset from a joint venture, the venturer shall not recognise its share of the profits of the joint venture from the transaction until it resells the asset to an independent party or otherwise realises its carrying amount. A venturer shall recognise its share of the losses resulting from these transactions in the same way as profits except that losses shall be recognised immediately when they represent an impairment loss.’7 The treatments above are consistent with the ‘upstream’ and ‘downstream’ transactions that arise in an investor-associate relationship (see Chapter 6). Example 7.3 – Transaction between a venturer and a joint venture Leyla is one of the venturers in Westhead Ltd which is a jointly controlled entity. On 31 December 2021, she purchased goods from the venture for onward sale in her own company.

6 7

FRS 102, para 15.16. FRS 102, para 15.17.

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7.14 Investments in Joint Ventures When a venturer purchases goods or other forms of assets from a joint venture, they must not recognise any share of the profits of the joint venture from the purchase until the goods or assets are then resold to an unconnected party. However, Leyla would recognise her share of the losses from any such transactions where these provide evidence of impairment.

GROUP ISSUES 7.14 There will have to be a consolidation adjustment in respect of unrealised profits at the reporting date that have arisen because of transactions between the joint venture and other members of the group. It should be emphasised that, unlike when consolidating a subsidiary in the parent’s financial statements, there is no cancellation of the transaction itself with a joint venture. The unrealised profit adjustment is calculated in the normal way, but only the investor’s percentage of the ownership interest in the joint venture is cancelled. As is the case with any provision for unrealised profit, there is a reduction in profit and assets. Joint venture sells to the group ●●

Where the joint venture sells goods to the group, then it will have recorded the profit and hence the parent or subsidiary will hold the inventory. In the group balance sheet, deduct the percentage of the unrealised profit from both retained earnings and from inventory.

●●

In the group profit and loss account/statement of comprehensive income, the percentage of the unrealised profit is deducted from the income of the joint venture as it is the joint venture that has reported the unrealised profit.

Group sells to the joint venture ●●

Where the parent or subsidiary sells to the joint venture, the parent/ subsidiary will record the unrealised profit and the joint venture will hold the inventory.

●●

In the group balance sheet, the percentage of the unrealised profit is deducted from the parent/subsidiary’s retained earnings and from the investment in the joint venture. It is not deducted from inventory because inventory of the joint venture is not consolidated, therefore the consolidation adjustment is recorded in the investment in the joint venture itself as this is where the unsold inventory is recorded.

●●

In the group profit and loss account/statement of comprehensive income, the percentage of the unrealised profit is added to group cost of sales to reduce group profit. If the selling company is the subsidiary, a further adjustment is required to the profit attributable to any non-controlling interest.

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Investments in Joint Ventures 7.16 A summary of the above is shown in the table below: Group balance sheet

Group profit or loss

Joint venture Deduct percentage of unrealised sells to parent or profit from inventory and from subsidiary retained earnings

Deduct percentage of unrealised profit from income from joint venture

Parent or subsidiary sells to joint venture

Add percentage of unrealised profit to cost of sales. If the subsidiary is the seller, deduct from profit attributable to the non-controlling interest

Deduct percentage of unrealised profit from investment in the joint venture. If parent is the seller, deduct from retained earnings or if subsidiary is the seller deduct from net assets of the subsidiary

INVESTORS THAT DO NOT HAVE JOINT CONTROL 7.15 Where an investor does not have joint control, FRS 102, para 15.18 states that the entity accounts for that investment in accordance with FRS 102, Section 11 Basic Financial Instruments or Section 12 Other Financial Instruments Issues or FRS 105, Section 9 Financial Instruments as appropriate. If the venturer has significant influence over the venture, it accounts for it in accordance with FRS 102, Section 14, or FRS 105, Section 7. FRS 102, para 15.18 places emphasis on the fact that joint control must exist for a venture to be classed as a joint venture. For example, where two parties hold 45% each of the venture and the remaining third only holds 10%, it is quite likely that the 10% holder does not have joint control and hence may be required to account for their 10% share under FRS 102, Section 11 or 12, or FRS 105, Section 9 as appropriate.

DISCLOSURES 7.16 The disclosure requirements are contained in FRS 102, paras 15.19 to 15.21A and the disclosures cover those required in both the individual and consolidated financial statements as follows: (a)

the accounting policy for recognising investments in jointly controlled entities;

(b) the carrying amount of investments in jointly controlled entities; (c) the fair value of investments in jointly controlled entities accounted for using the equity method of accounting for which there are published price quotations; and (d) the total amount of commitments relating to joint ventures, including its share in the capital commitments which have been incurred jointly with other venturers, as well as its share of the capital commitments of the joint ventures themselves. 147

7.17 Investments in Joint Ventures In addition disclose the following: (a)

For jointly controlled entities accounted for in accordance with the equity method, the venturer must disclose separately its share of the profit or loss of such investments together with its share of any discontinued operations of such jointly controlled entities.

(b) For jointly controlled entities measured at fair value, the venturer must make the disclosures required by FRS 102, paras 11.43 and 11.44 (see below). (c)

In the individual financial statements of a venturer which is not a parent, summarised financial information must be disclosed concerning the investments in the jointly controlled entities, along with the effect of including those investments as if they had been accounted for using the equity method. FRS 102, para 15.21A confirms that investing entities which are exempt from preparing consolidated financial statements (or would be exempt if they had subsidiaries) need not comply with this disclosure requirement.

FRS 102, paras 11.43 and 11.44 require disclosure of the basis for determining fair value, or if a reliable measure of fair value is no longer available for financial instruments that would otherwise be required to be measured at fair value through profit or loss, disclosure of that fact.

FRS 102, Section 1A 7.17 For small entities choosing to apply the presentation and disclosure requirements of FRS 102, Section 1A, the small entity should disclose: (a)

the accounting policy for investments in joint ventures;

(b)

the aggregate amount of commitments relating to joint ventures, including its share in the capital commitments which have been incurred jointly with other venturers, as well as its share of the capital commitment of the joint ventures themselves;

(c) Where investments in joint ventures are measured at fair value through profit or loss, the disclosures required by FRS 102, Section 11 are required, including FRS 102, para 11.48A: (i) if there is a difference between the fair value of a financial instrument at initial recognition and the amount determined at that date using a valuation technique, the aggregate difference yet to be recognised in profit or loss at the beginning and end of the period and a reconciliation of the changes in the balance of this difference is disclosed; and (ii) information that enables users of the entity’s financial statements to evaluate the nature and extent of relevant risks arising from

148

Investments in Joint Ventures 7.18 financial instruments to which the entity is exposed at the end of the reporting period. These risks typically include, but are not limited to, credit risk, liquidity risk and market risk. The disclosure should include both the entity’s exposure to each type of risk and how it manages those risks. See FRS 102, paras 11.48(d) and (e).

FRS 105 7.18

There are no disclosure requirements under FRS 105, Section 7.

CHAPTER ROUNDUP ●●

A joint venture must have a contractually agreed sharing of control in order for it to meet the definition of such under UK GAAP.

●●

There are three categories of joint venture under FRS 102: jointly controlled operations, jointly controlled assets and jointly controlled entities.

●●

Joint ventures can be measured under the cost model or a fair value model under FRS 102. Fair value models are outlawed under FRS 105.

●●

Unrealised profits must be eliminated to the extent of the investor’s ownership interest in the joint venture. The transactions are not cancelled as the joint venture does not belong to the group.

●●

Extensive disclosures are required in both the individual and consolidated financial statements where joint ventures are concerned.

SUMMARY OF DIFFERENCES: FRS 102 v IFRS ●●

Under FRS 102, joint ventures are classified into three categories: jointly controlled operations, jointly controlled assets and jointly controlled entities. Under IFRS 11 Joint Arrangements, there are only two categories: joint ventures or joint operations.

●●

The equity method of accounting can only be used in the consolidated financial statements of the group due to restrictions imposed by company law. Under IFRS, the equity method of accounting can be applied in the separate financial statements.

●●

Fewer disclosures are required under FRS 102 than under IFRS. Under IFRS 12 Disclosure of Interests in Other Entities, more detailed disclosures are required in respect of joint arrangements which are material to the entity.

149

Chapter 8

Acquisitions and Disposals of Interests

SIGNPOSTS ●●

Consolidation must begin from the date on which the parent obtains control over a subsidiary and must cease when the parent loses control of the subsidiary (see 8.1).

●●

FRS 102 does not address the situation when an associate is acquired in stages (ie, a piecemeal acquisition resulting in eventual associate status) (see 8.2).

●●

Equity accounting in the consolidated financial statements for an associate must cease when significant influence is lost (see 8.3).

●●

Exchange differences relating to the retranslation of a net investment in a foreign operation which have been reported in other comprehensive income are not recycled into profit or loss on disposal of that subsidiary which is a notable difference in comparison to the IFRS regime (see 8.6).

●●

Where a disposal results in reclassification as an associate, joint venture or simple investment, the carrying amount at the date the entity ceases to be a subsidiary is regarded as deemed cost on the initial measurement of the financial asset, investment in associate or jointly controlled entity as appropriate. No remeasurement to fair value is carried out (see 8.7).

●●

Partial disposals of subsidiaries where control is retained are accounted for as a transaction among equity holders in their capacity as equity holders (see 8.8).

●●

Deemed disposals are accounted for in the same way as other types of disposals (see 8.9).

INTRODUCTION 8.1 In many cases, a parent will acquire ownership interest in a subsidiary by way of a single transaction, although some portion of the consideration may be deferred or contingent depending on the terms of the 150

Acquisitions and Disposals of Interests 8.2 agreement between the buyer and the seller (Chapter 5 examines deferred and contingent consideration in more detail). In other cases, things may not be as straightforward and what may start off being a simple investment may eventually turn out to be a subsidiary. Conversely, what may start out as a subsidiary may end up being just a simple investment. This chapter examines the more advanced issue of acquisitions and disposals of interests. This is an important chapter because it must be borne in mind that consolidation must start from the date of acquisition which is the date on which the parent achieves control. Conversely, consolidation ceases when the parent loses control of the subsidiary. Careful scrutiny of the contractual terms of the acquisition and disposal must be carried out (especially when the group is audited) to ensure that consolidation has begun or ceased at the correct date. Any misinterpretation may result in the consolidated financial statements failing to present a true and fair view.

Focus Transactions such as piecemeal acquisitions (or ‘step acquisitions’ as they are often referred to) can be complex and it is important that a sound understanding of the accounting treatment under UK GAAP is obtained if the consolidated financial statements are to present a true and fair view. Similarly, disposals of ownership interest in a subsidiary need to be fully understood in order that the accounting treatment is applied correctly. Any misunderstanding in the accounting treatment may result in misleading consolidated financial statements, which must be avoided at all costs.

INVESTMENT TO ASSOCIATE 8.2 Investments in associates are examined in more detail in Chapter 6 of this book. Remember that associate status is usually achieved when the investor holds between 20 and 50% of the net assets or voting rights of the investee, which in turn gives rise to ‘significant influence’. While numeric benchmarks are not always an absolute indicator of significant influence, (because the substance of the arrangement must be considered which may suggest significant influence even with an ownership interest of less than 20%), they are often a clear indicator of the status of the investment. FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland deals with investments in associates in Section 14 Investments in Associates. An ownership interest of less than 20% is deemed to have no influence and hence is accounted for as an investment. Therefore, the provisions in FRS 102, Section 11 Basic Financial Instruments or Section 12 Other Financial

151

8.2 Acquisitions and Disposals of Interests Instruments Issues will be relevant. For simple investments, these will be classed as basic and hence Section 11 will apply; whereas more complex investments will generally fall to be classed as non-basic, meaning Section 12 will apply which will usually involve the investment being remeasured to fair value at each reporting date. An investor may make a further investment in an investee such that significant influence is achieved. As noted above, FRS 102 deals with investments in associates in Section 14. Section 14 does not address the situation when an associate is acquired in stages. However, FRS 102, para 14.8(c) states that goodwill is to be calculated in the same way as that for a subsidiary and cross-references to FRS 102, paras 19.22 to 19.24. Consequently, it will be necessary to follow the requirements for piecemeal acquisitions which are addressed in FRS 102, Section 9 Consolidated and Separate Financial Statements. Example 8.1 – Simple investment to associate On 1 April 2020, The Sunnie Group (Sunnie) obtained a 15% ownership interest in Bart Ltd (Bart) for a consideration of £150,000. The investment was measured at cost and there has been no impairment of the investment since its acquisition. Both entities have a 31 March accounting reference date and Sunnie is the parent of a group and is required to prepare consolidated financial statements. At 31 March 2021 year end, the investment in Bart is treated as a simple investment by Sunnie. It is neither consolidated nor equity accounted because there is no control nor significant influence due to the ownership interest only being 15%. For simplicity, it can be assumed that as at 31 March 2021 the investment was accounted for under the provisions of FRS 102, Section 11. On 1 April 2021, Sunnie agreed to provide a further investment in Bart to assist with its rapid expansion plans. The additional investment was for £100,000 and in return Sunnie received an additional 10% ownership interest. After the second investment, Sunnie has a 25% ownership interest in Bart and hence has significant influence. Bart is no longer regarded as a simple investment but has moved up to associate status where Sunnie is concerned. As Sunnie is required to prepare consolidated financial statements, the results of Bart must be included in those consolidated financial statements for the year ended 31 March 2022, by equity accounting, to comply with the requirements of FRS 102, Section 14. The consolidated financial statements will recognise the investment in Bart at a cost of £250,000 (£150,000 [investment 1] plus £100,000 [investment 2]) and this amount is used as a starting point for equity accounting.

152

Acquisitions and Disposals of Interests 8.3 Focus There is no requirement under FRS 102 to retrospectively fair value the investee’s net assets – in other words the first investment need not be revalued to fair value at the date that equity accounting starts, which is a requirement under the IFRS regime. The treatment under UK GAAP is inherently simpler than that under IFRS.

ASSOCIATE TO INVESTMENT 8.3 An investor may lose significant influence over an associate. This can occur through an outright disposal of ownership interest in the associate, or it can occur through a deemed disposal (ie, where the associate may issue shares to a third party thus diluting the ownership interest). Deemed disposals are examined in section 8.9 of this chapter. Significant influence can also be lost due to a contractual agreement or through liquidation. Significant influence is said to be lost when the investor loses the power to participate in the financial and operating policy decisions of the investee. When significant influence of an associate is lost, equity accounting in the consolidated financial statements must cease from the date that significant influence is lost. FRS 102, para 14.8(i) states that if the investor loses significant influence over an associate due to a full or partial disposal, it derecognises that associate and recognises a gain or loss on disposal. The gain or loss on disposal is the difference between the sales proceeds received and the carrying amount of the investment in the associate relating to the proportion disposed of, or lost, at the date significant influence is lost. Example 8.2 – Loss of significant influence of an associate On 1 April 2018, Churchill acquired a 45% ownership interest in Revere Ltd. Churchill has an accounting reference date of 31 March and on 10 December 2021, Churchill disposed of 30% of its ownership interest in Revere hence retaining 15% ownership interest following the disposal. Churchill is the parent of a group and is required to produce consolidated financial statements. Equity accounting in the consolidated financial statements must cease from the date on which significant influence is lost (ie, 10 December 2021). On the date of disposal, Churchill derecognises part of its investment in Revere and recognises a gain or loss on disposal. FRS 102, para 14.8(i) requires the retained interest in Revere (ie, the 15%) to be accounted for under Section 11 Basic Financial Instruments or Section 12

153

8.4 Acquisitions and Disposals of Interests Other Financial Instruments Issues, as appropriate. In other words, Churchill accounts for its retained interest in Revere as a simple investment. The carrying amount of Revere as at 10 December 2021 becomes the deemed cost for accounting under FRS 102, Section 11 or Section 12. No revaluation to fair value of the retained ownership is necessary. FRS 102, para 14.8(i) also clarifies that if an investor loses significant influence for reasons other than a partial disposal of its investment (as in Example 8.2 above), the investor must regard the carrying amount of the investment at that date as a new cost basis and account for the investment under Section 11 or Section 12 as appropriate. FRS 102, para 14.8(i) states that a gain or loss arising on disposal must also include those amounts which have been recognised in other comprehensive income in relation to that associate, where those amounts are required to be reclassified to profit or loss on disposal in accordance with other sections of FRS 102. Amounts which are not required to be reclassified to profit or loss on disposal must be transferred directly to retained earnings (ie, as a movement on reserves). In practice, the only items that may need to be reclassified on disposal of an associate are amounts that have been recognised in other comprehensive income for cash flow hedges which had not been reclassified to profit or loss on disposal of the associate.

JOINT VENTURE TO ASSOCIATE 8.4 Joint ventures are dealt with in FRS 102, Section 15 Investments in Joint Ventures and in Chapter 7 of this book. Where the venturer is a parent (hence produces consolidated financial statements), FRS 102, para 15.13 requires the venturer to measure its investments in jointly controlled entities using the equity method of accounting (see Chapter 6). This is the same method of accounting used for investments in associates in the consolidated financial statements. Where a jointly controlled entity is reclassified to an associate because joint control is lost but significant influence is gained, there is no difference in the accounting treatment. The entity continues to apply the equity method of accounting in the consolidated financial statements. The retained ownership interest is not remeasured.

SUBSIDIARY TO SUBSIDIARY 8.5 It may be the case that a parent company, owning more than 50% of the net assets of a subsidiary, will obtain further ownership interest in the subsidiary. 154

Acquisitions and Disposals of Interests 8.5 Under FRS 102, the net assets of the subsidiary are not revalued, and no additional goodwill is recognised at the date of acquisition of the additional investment in the subsidiary. This is because FRS 102, para 9.19D regards this transaction as one among equity holders in their capacity as equity holders. Example 8.3 – Additional investment in a subsidiary On 1 June 2021, Topco Ltd acquired 70% of the net assets in Subco Ltd for a purchase price of £500,000. On the date of acquisition, the fair value exercise revealed the net assets of Subco to be £380,000, which was also equivalent to book values. On 1 June 2022, Topco agreed to invest an additional £75,000 in Subco in exchange for a further 10% of the net assets and on this date Subco’s net assets had a book value of £435,000 and a fair value of £485,000. The group’s accounting reference date is 31 May. Accounting for the subsidiary at the date of acquisition (1 June 2021) At the date of acquisition, Topco has acquired control of Subco because it has acquired an ownership interest of 70% of the net assets. As a result, the identifiable assets and liabilities of Subco are consolidated at their fair value of £380,000. Positive goodwill is recognised in the consolidated financial statements of £234,000, calculated as follows: £ Cost of investment

500,000

Less net assets acquired: (70% x £380,000)

(266,000)

Positive goodwill

234,000

At the date of acquisition, the non-controlling interest (NCI) is £114,000 (or 30% x £380,000). Year end 31 May 2022 The increase in Subco’s net assets amounts to £55,000 (£435,000 less £380,000) which has arisen is due to the profit yielded by Subco during the year to 31 May 2022. This profit is split £38,500 to Topco (being 70% x £55,000) and £16,500 to the NCI. The NCI share is now £130,500 (£114,000 plus £16,500). Further acquisition on 1 June 2022 On 1 June 2022, Topco acquired a further 10% of Subco which means that the NCI share of Subco’s net assets drops from 30% to 20%. NCI’s share in Subco decreases by £43,500 ((30% – 20%) x £435,000) and their share will now equal £87,000 (£130,500 less £43,500) or 20% x £435,000. This further acquisition is accounted for as a transaction among equity holders and the resulting change in NCI is accounted for under FRS 102, para 22.19. In this example, FRS 102, para 22.19 would require the NCI to be adjusted to reflect the parent’s additional ownership interest in the subsidiary. 155

8.6 Acquisitions and Disposals of Interests Any difference between the value of the NCI adjustment and the consideration paid to acquire the additional 10% interest is recognised in equity and attributed to the equity holders of the parent. Therefore, the accounting would be as follows: £ Dr Non-controlling interests

43,500

Dr Equity attributable to the parent

31,500

Cr Cash at bank

(75,000)

SUBSIDIARY TO FINANCIAL INVESTMENT 8.6

FRS 102, para 9.18 states:

‘The income and expenses of a subsidiary are included in the consolidated financial statements from the acquisition date, except when a business combination is accounted for by using the merger accounting method under Section 19 or, for certain public benefit entity combinations, Section 34 Specialised Activities. The income and expense of a subsidiary are included in the consolidated financial statements until the date on which the parent ceases to control the subsidiary. A parent may cease to control a subsidiary with or without a change in absolute or relative ownership levels. This could occur, for example, when a subsidiary becomes subject to the control of a government, court, administrator or regulator.’1 A parent loses control of a subsidiary when its ownership interest falls to 50% or below. Significant influence is usually gained if ownership interest lies between 20% and 50% (see 8.7 below) but anything below 20% is regarded as a financial investment to which the provisions of FRS 102, Section 11 Basic Financial Instruments or Section 12 Other Financial Instruments Issues will apply. Where control is lost, FRS 102, para 9.18A will apply, which states: ‘Where a parent ceases to control a subsidiary, a gain or loss is recognised in the consolidated statement of comprehensive income (or in the income statement, if presented) calculated as the difference between: (a)

the proceeds from the disposal (or the event that resulted in the loss of control); and

(b) the proportion of the carrying amount of the subsidiary’s net assets, including any related goodwill, disposed of (or lost) as at the date of disposal (or date control is lost). The cumulative amount of any exchange differences that relate to a foreign subsidiary recognised in equity in accordance with Section 30 Foreign 1

FRS 102, para 9.18.

156

Acquisitions and Disposals of Interests 8.6 Currency Translation is not recognised in profit or loss as part of the gain or loss on disposal of the subsidiary and shall be transferred directly to retained earnings.’2 There is a notable difference between the requirements of FRS 102, para 9.18A and the same treatment under the IFRS regime. FRS 102, para 9.18A clarifies that exchange differences relating to the retranslation of a net investment in a foreign operation that have been reported in other comprehensive income are not recycled into profit or loss on disposal of that subsidiary. Under FRS 102, such cumulative exchange differences may have already been recognised directly in retained earnings because there is no specific requirement to recognise them in a separate component of equity. Under the IFRS regime, IAS 21 The Effects of Changes in Foreign Exchange Rates exchange differences arising on a monetary item that forms part of a reporting entity’s net investment in a foreign operation are recognised in profit or loss in the individual financial statements but are recognised in other comprehensive income in the consolidated financial statements. Under IAS 21, para 21.48, the cumulative amount of the exchange differences relating to the disposal of a foreign operation that have been recognised in other comprehensive income and accumulated in a separate component of equity are reclassified from equity to profit or loss when a gain or loss on disposal on the foreign operation is recognised. While this book’s focus is on UK GAAP, there are many notable differences between UK GAAP and the IFRS regime. As many newly qualified accountants will have been trained under the requirements of IFRS, it is considered useful to highlight the key differences to avoid errors when preparing financial statements under UK GAAP.

Focus It is important to carefully consider the substance of an arrangement on apparent disposal of a subsidiary. This is because there may be situations that, on the face of it, may suggest that a disposal has taken place but, in fact, there may not be. For example, the parent entity may dispose of ownership interest but retains the risks and rewards of ownership meaning control may not have been transferred. Or, there may be a contractual clause which requires the buyer to sell the subsidiary back to the seller at fair value, or the seller may have significant voting power on the board even after the transaction has completed. Professional judgement will invariably need to be exercised to determine whether, or not, a sale has, in fact, taken place. The facts and circumstances will also need to be verifiable, particularly by auditors so supporting documentation must be retained to demonstrate the conclusions drawn. 2

FRS 102, para 9.18A.

157

8.7 Acquisitions and Disposals of Interests FRS 102, para 9.18B states: ‘The gain or loss arising on the disposal shall also include those amounts that have been recognised in other comprehensive income in relation to that subsidiary, where those amounts are required to be reclassified to profit or loss upon disposal in accordance with other sections of this FRS. Amounts that are not required to be reclassified to profit or loss upon disposal of the related assets or liabilities in accordance with other sections of this FRS shall be transferred directly to retained earnings.’3 In practice, the only items which may have to be reclassified from other comprehensive income are amounts recognised in respect of cash flow hedges which had not been recognised in profit or loss at the date of disposal.

SUBSIDIARY TO ASSOCIATE OR JOINT VENTURE 8.7

FRS 102, para 9.19 states:

‘If an entity ceases to be a subsidiary but the investor (former parent) continues to hold: (a) an investment that is not an associate (see paragraph 9.19(b)) or a jointly controlled entity (see paragraph 9.19(c)), that investment shall be accounted for as a financial asset in accordance with Section 11 Basic Financial Instruments or Section 12 Other Financial Instruments Issues from the date the entity ceases to be a subsidiary; (b) an associate, that associate shall be accounted for in accordance with Section 14 Investments in Associates; or (c) a jointly controlled entity, that jointly controlled entity shall be accounted for in accordance with Section 15 Investments in Joint Ventures. The carrying amount of the net assets (and goodwill) attributable to the investment at the date that the entity ceases to be a subsidiary shall be regarded as the cost on initial measurement of the financial asset, investment in associate or jointly controlled entity, as appropriate. In applying the equity method to investments in associate or jointly controlled entities as required in sub-paragraphs (b) and (c) above, paragraph 14.8(c) shall not be applied.’4 Essentially, FRS 102, para 9.19 requires the deemed cost of any retained interest to be based on book values (not fair values) at the date the parent loses control. This is notably different to the IFRS regime which would require the retained interest to be remeasured to fair value at the date control is lost and for this to be reflected in the financial statements when dealing with the gain 3 4

FRS 102, para 9.18B. FRS 102, para 9.19.

158

Acquisitions and Disposals of Interests 8.8 or loss on disposal. The treatment under FRS 102 is inherently simpler than that under IFRS.

PARTIAL DISPOSAL WHERE CONTROL IS RETAINED 8.8 There may be situations when a parent may dispose of some, but not all, of its ownership interest in a subsidiary and continue to retain control following the disposal (ie, the parent still owns more than 50% of the net assets following the partial disposal). When this happens, the change in the parent’s controlling interest is accounted for as a transaction among equity holders in their capacity as equity holders. In other words, the carrying amount of the non-controlling interest is increased to reflect the parent’s diluted ownership interest. Any difference between the consideration received by the parent and the amount of the non-controlling interest’s adjustment is recognised directly in equity.

Focus This treatment is considerably different to what was the case under old UK GAAP. Under FRS 102, no gain or loss is recognised on disposal and no adjustment to goodwill is made. A major pitfall to avoid is to assume that the accounting treatment under FRS 102 is the same as that under old UK GAAP which would invariably result in the consolidated financial statements presenting a misleading position. This, in turn, could result in the group auditor expressing an incorrect opinion on the consolidated financial statements as the error could be material.

Example 8.4 – Disposal where parent retains control On 31 March 2022, The Sunnie Group (the group) disposed of a 20% ownership interest in a subsidiary for £300,000. This reduced the group’s holding from 80% to 60%. On this date, the carrying amount of the identifiable net assets in the subsidiary was £500,000 and the carrying amount of goodwill was £30,000. Under FRS 102, no gain or loss on disposal is recognised as the transaction is treated as one between equity holders in their capacity as equity holders. This is because the group still retains control of the subsidiary. The non-controlling interest will increase from 20% to 40% and hence the non-controlling interest’s share of the subsidiary’s net assets will increase from £100,000 (£500,000 x 20%) to £200,000 (£500,000 x 40%), ie by £100,000. No goodwill is attributable to the non-controlling interest. As the group has retained control following the partial disposal, FRS 102, para 22.19 will apply. The carrying amount of the non-controlling interest will 159

8.9 Acquisitions and Disposals of Interests be adjusted to reflect the change in the parent’s ownership of the subsidiary’s net assets. The difference between the non-controlling interest’s adjustment and the fair value of the consideration received is recognised directly in equity and attributed to the equity holders of the parent. The journals to record the transaction are as follows: £ Dr Cash at bank

300,000

Cr Non-controlling interest

100,000

Cr Equity attributable to parent

200,000

Illustrative statement of changes in equity showing change in ownership interest Group

At 1 April 2020

Called-up Retained Total Non- Total share earnings shareholders’ controlling equity capital equity interest £’000

£’000

£’000

£’000

£’000

10

240

250

60

310

30

Profit for the year

120

120

Equity dividend

(50)

(50)

310

320

90 10

At 31 March 2021

10

Profit for the year Equity dividend Change in ownership At 31 March 2022

10

150 (50) 410

40

40

(10)

(10)

50

200

200

100

300

540

550

200

750

(10)

DEEMED DISPOSALS 8.9 An entity may cease to be a subsidiary of a parent, or the group may reduce its ownership interest, as a result of a deemed disposal. This is where a parent’s ownership interest is diluted but no cash consideration has been exchanged with the parent. A deemed disposal might arise where: (a)

the group does not take up its full allocation of rights in a rights issue;

(b) the group does not take up its full share of a scrip dividend; (c)

another party exercises its options or warrants; or

(d) the subsidiary issues shares to other non-group parties (non-controlling interest).

160

Acquisitions and Disposals of Interests 8.9 A typical transaction where a deemed disposal may occur is if a lender exercises a conversion right in a convertible loan. Rather than receive cash in settlement of the loan upon maturity, the lender may decide it is more beneficial to them to receive shares in the subsidiary. On issuance of the shares, the parent’s ownership interest becomes diluted due to the exercise of the lender’s conversion option. Deemed disposals have the same effect as changes in ownership by disposal and are accounted for in the same way. If a parent retains control of a subsidiary following the deemed disposal, the transaction is accounted for as a transaction between shareholders. No gain or loss is recognised in the consolidated financial statements. If control is lost, a gain or loss is recognised in the consolidated statement of comprehensive income (or income statement, if presented). This is the difference between: ●●

the proceeds from the disposal; and

●●

the proportion of the carrying amount of the subsidiary’s net assets, including any related goodwill, disposed of (or lost) at the date on which control is lost.

Example 8.5 – Deemed disposal where control is retained Ratchford Ltd acquires 600,000 of the 1 million shares in Greaves Ltd which results in Ratchford obtaining a 60% ownership interest in Greaves when Greaves’ net assets were £100m. A year later, Greaves issues a further 90,909 shares to a third party for £17m. Following the issuance of the shares, Ratchford’s interest in Greaves becomes diluted from 60% to 55% (600,000/1,090,909). Ratchford still retains control of Greaves because its ownership interest is more than 50% of the net assets, hence Greaves is still a subsidiary of Ratchford. This deemed disposal is accounted for as a transaction among equity holders. Ratchford does not recognise any gain or loss and does not adjust any goodwill that was previously recognised on acquisition of Greaves. All Ratchford does in the consolidated financial statements is: Dr Cash at bank

£17m

Cr Non-controlling interest

£12.65m*

Cr Equity

£4.35m

* Previously, the non-controlling interest in Greaves was 40% of net assets of £100m, hence 40% x £100m = £40m. The non-controlling interest is now 45% and hence 45% x £117m (£100m net assets plus £17m proceeds from the share issue) = £52.65m. Therefore, £52.65m less £40m is an increase of £12.65m.

161

8.9 Acquisitions and Disposals of Interests

SUMMARY OF DIFFERENCES: FRS 102 V IFRS ●●

There is no requirement under FRS 102 to retrospectively fair value the investee’s net assets when a simple investment moves to associate status, which is a requirement under the IFRS regime.

●●

Exchange differences relating to the retranslation of a net investment in a foreign operation that have not been reported in other comprehensive income are not recycled into profit or loss on disposal of that subsidiary. Under IAS 21, these are recycled.

●●

When a parent loses control of a subsidiary, but retains some ownership interest, the investment is accounted for as an associate, joint venture or simple investment as appropriate under FRS 102. The deemed cost of any retained interest is based on book values. Under the IFRS regime, any retained interest would be remeasured to fair value at the date control is lost and would be reflected in the financial statements when dealing with the gain or loss on disposal.

CHAPTER ROUNDUP ●●

Simple investments can end up being accounted for as subsidiaries through ‘step acquisitions’ or ‘piecemeal acquisitions’ which is where one entity will make multiple investments in another entity and each increase in ownership interest may change the status of the investment from investment to associate to subsidiary.

●●

Significant influence over an associate is lost through an outright disposal or a deemed disposal. Significant influence is lost when the investor loses the power to participate in the financial and operating policy decisions of the investee.

●●

Jointly controlled entities may be reclassified as associates when a change in ownership interest arises. In the consolidated financial statements there will be no change in how this entity is accounted for as jointly controlled entities are equity accounted in the consolidated financial statements in the same way as associates are.

●●

When a parent disposes of ownership interest in a subsidiary such that control is lost, a gain or loss on disposal is recorded and any retained interest is accounted for as an associate, joint venture or simple investment accordingly.

●●

For partial disposals where control is retained, the transaction is accounted for as one between equity holders in their capacity as equity holders.

●●

Deemed disposals are accounted for in the same way as other disposals.

162

Chapter 9

Consolidated Cash Flow Statement

SIGNPOSTS ●●

The consolidated cash flow statement is prepared using three cash flow classifications: operating activities, investing activities and financing activities (see 9.1).

●●

There are some additional factors that need to be taken into consideration when preparing the consolidated cash flow statement in comparison to a cash flow statement for a standalone entity (see 9.10 to 9.14).

●●

The Financial Reporting Council have noted some deficiencies in entities’ cash flow statements when they have carried out a thematic review. While this review is focussed on entities preparing financial statements under IFRS, much of the content of the thematic review can be applied by UK GAAP preparers as IAS 7 Statement of Cash Flows and FRS 102, Section 7 Statement of Cash Flows are both broadly consistent (see 9.17).

INTRODUCTION 9.1 Cash flow statements are dealt with in FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland in Section 7 Statement of Cash Flows. Broadly, a consolidated cash flow statement (or ‘group cash flow statement’ as it is often referred to) is prepared in much the same way as a cash flow statement for a standalone entity. Consolidated cash flows are classified into three distinct types of cash flow headings: ●●

Operating activities

●●

Investing activities

●●

Financing activities

163

9.2 Consolidated Cash Flow Statement

Operating activities 9.2 These are the day-to-day revenue-producing activities of the group and this is essentially the ‘default’ category. In other words, if the cash flows are not investing or financing cash flows, they will be classed as operating cash flows. Helpfully, FRS 102, para 7.4 provides examples of such activities which include: ‘(a) cash receipts from the sale of goods and the rendering of services; (b) cash receipts from royalties, fees, commissions, and other revenue; (c)

cash payments to suppliers for goods and services;

(d) cash payments to and on behalf of employees; (e) cash payments or refunds of income tax, unless they can be specifically identified with financing and investing activities; (f) cash receipts and payments from investments, loans and other contracts held for dealing or trading purposes, which are similar to inventory acquired specifically for resale; and (g) cash advances and loans made to other parties by financial institutions.’1

Investing activities 9.3 These are cash flows that arise from the acquisition and disposal of long-term assets and other investments which are not included in cash equivalents (‘cash equivalents’ are described in more detail at 9.5 below). Examples of such according to FRS 102, para 7.5 include: ‘(a) cash payments to acquire property, plant and equipment (including self-constructed property, plant and equipment), intangible assets and other long-term assets. These payments include those relating to capitalised development costs and self-constructed property, plant and equipment;

1

(b)

cash receipts from sales of property, plant and equipment, intangibles and other long-term assets;

(c)

cash payments to acquire equity or debt instruments of other entities and interests in joint ventures, including the net cash flows arising from obtaining control of subsidiaries or other businesses (other than payments for those instruments classified as cash equivalents or held for dealing or trading);

(d)

cash receipts from sales of equity or debt instruments of other entities and interests in joint ventures, including the net cash flows arising from losing control of subsidiaries or other businesses (other than

FRS 102, para 7.4(a)–(g).

164

Consolidated Cash Flow Statement 9.5 receipts for those instruments classified as cash equivalents or held for dealing or trading); (e)

cash advances and loans made to other parties (except those made by financial institutions – see paragraph 7.4(g));

(f)

cash receipts from the repayment of advances and loans made to other parties;

(g) cash payments for futures contracts, forward contracts, option contracts and swap contracts, except when the contracts are held for dealing or trading, or the payments are classified as financing activities; and (h)

cash receipts from future contracts, forward contracts, option contracts and swap contracts, except when the contracts are held for dealing or trading, or the receipts are classified as financing activities.’2

Financing activities 9.4 These are cash flows which result in changes in the borrowing and equity composition of the consolidated balance sheet. According to FRS 102, para 7.6, examples of cash flows arising from financing activities include: ‘(a) cash proceeds from issuing shares or other equity instruments; (b) cash payments to owners to acquire or redeem the entity’s shares; (c)

cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short-term or long-term borrowings;

(d) cash repayment of amounts borrowed; and (e)

cash payments by a lessee for the reduction of the outstanding liability relating to a finance lease.’3

Cash and cash equivalents 9.5

The term ‘cash’ is defined as:

‘Cash on hand and demand deposits.’4 ‘Cash equivalents’ are defined as: ‘Short-term, highly liquid investments that are readily convertible into known amounts of cash and that are subject to an insignificant risk of changes in value.’5 2 3 4 5

FRS 102, para 7.5(a)–(h). FRS 102, para 7.6(a)–(e). FRS 102 Glossary cash. FRS 102 Glossary cash equivalents.

165

9.6 Consolidated Cash Flow Statement FRS 102, para 7.2 clarifies that an investment will normally qualify as a cash equivalent only if it has a maturity of, say, three months or less from the date of acquisition. In practice, professional judgement is required to determine whether such an investment (or other transaction) would be a cash equivalent, and this was one of the issues raised in a thematic review by the Financial Reporting Council in November 2020 (see 9.17 below). FRS 102 does not define the term ‘readily convertible’ in the definition of cash equivalents but the time condition of three months or less should be taken to mean that anything within this timeframe is likely to be readily convertible. Equity investments would normally be excluded from classification as cash equivalents because there is a significant risk of change in value. Preference shares, on the other hand, may be caught under the definition of cash equivalents where there is a short period to maturity through a specified redemption date.

COMPANY LAW REQUIREMENTS 9.6 It should be noted that there are no specific requirements in The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410) where cash flow statements are concerned and hence all the requirements are contained within accounting standards. In addition, there is no title specified for the cash flow statement in SI 2008/410, hence any title that adequately describes the group cash flow statement is permissible. In practice, most groups head up the statement ‘Consolidated cash flow statement’ or ‘Group statement of cash flows’. Alternative titles can be used provided these are not misleading. Generally, in practice automated accounts production software will generate titles in line with accounting standards and these are usually compliant.

OVERVIEW OF PREPARING THE CONSOLIDATED CASH FLOW STATEMENT 9.7 In today’s modern accounting world, cash flow statements, whether they are for standalone entities or groups, are prepared using accounts production software systems. However, it is important to check the output of accounts production software systems to ensure the cash flow statement is in balance and that all items have been correctly treated. In practice, manual adjustments will often be required. To that end, it is worthwhile recapping on some of the basic theory which is involved in correctly preparing a group cash flow statement.

166

Consolidated Cash Flow Statement 9.8 Focus In November 2020, the Financial Reporting Council (FRC) issued a thematic review of the cash flow statement. This report looked at a number of companies’ cash flow statements and in many cases the FRC found discrepancies or errors within the cash flow statement. While this thematic review focussed on listed entities preparing financial statements under IAS 7 Statement of Cash Flows, some of the recommendations to address deficiencies can be applied to UK GAAP preparers as the same deficiencies could be being repeated under UK GAAP, hence UK GAAP preparers can learn from the mistakes of IFRS reporters. A summary of the FRC’s thematic review of the cash flow statement is included in section 9.17 of this chapter.

The consolidated cash flow statement is prepared under the same principle as the rest of the group accounts. Therefore, the consolidated cash flow statement must only show the cash flows which are external to the group. This means that all intra-group cash flows must be eliminated on consolidation. FRS 102 allows two methods of presenting the consolidated cash flow statement: ●●

the indirect method; and

●●

the direct method.

Indirect method 9.8 Under the indirect method, the group will present a reconciliation from a specific measure of profit to net cash flows from operating activities. FRS 102 does not stipulate which profit (or loss, as the case may be) should be used, but many groups tend to use profit before tax. Some groups present an operating profit line item in the consolidated profit and loss account and while FRS 102 does not specifically require operating profit to be shown separately on the face of the consolidated profit and loss account, presenting operating profit as a separate line item is permissible.

Focus Whichever measure of profit is used to arrive at net cash flows from operating activities, this measure of profit should be used consistently from one reporting period to the next to aid consistency and comparability.

167

9.9 Consolidated Cash Flow Statement The measure of profit is adjusted for the non-cash effects of transactions, such as depreciation and a gain or loss on disposal of assets as well as increases and decreases in the group’s working capital (namely increases or decreases in inventory and work in progress, receivables and payables). The indirect method of preparing the consolidated cash flow statement is more common in the UK and Republic of Ireland, primarily because of its ease of use. Illustration – The indirect method 31.12.21 31.12.20 £’000

£’000

6,261

6,063

539

475

Loss on disposal of property, plant and equipment

−

62

Gain on disposal of property, plant and equipment

(125)

−

Group operating profit Depreciation charges

Equity-settled share-based payment expense Decrease (increase) in trade and other debtors Decrease (increase) in stock and work in progress (Decrease) increase in trade and other creditors Cash generated from operations Interest paid Interest received Tax paid Cash flow from operating activities

156

208

(140)

139

27

(14)

222

149

6,940

7,082

(1,650)

(1,110)

12

14

(1,254)

(1,657)

4,048

4,329

Direct method 9.9 The ‘direct method’ of presenting the consolidated cash flow statement is less common in the UK and Republic of Ireland. Some commentators suggest that the direct method is the most preferred method by accounting standards, but there is no suggestion in FRS 102 that this is the case. Entities are free to choose either the indirect or the direct method provided they are consistent with the method of presentation from one reporting period to the next. Under the direct method, the net cash flow from operating activities figure is presented by disclosing information about major classes of gross receipts and gross cash payments as can be seen in the following illustration:

168

Consolidated Cash Flow Statement 9.10 Illustration – The direct method 31.12.2021 31.12.2020 £’000 Collections from trade debtors Payments to suppliers Payments to employees Payments of corporation tax

£’000

4,217

4,420

(2,142)

(2,162)

(657)

(569)

(64)

(138)

Payments relating to retirement benefits

(235)

(252)

Cash flows from operating activities

1,119

1,299

Early in the introduction, it was mentioned that ‘broadly, a group cash flow statement is prepared in much the same way as a cash flow statement for a standalone entity.’ While this is true, there are some additional factors that must be taken into consideration when producing a consolidated cash flow statement in dealing with: ●●

Cash flows attributable to non-controlling interests (NCI)

●●

Cash received from associates

●●

Payments to acquire subsidiaries

●●

Receipts from the disposal of subsidiaries

CASH FLOWS ATTRIBUTABLE TO NCI 9.10 The equity section of the consolidated balance sheet will show the NCI’s share of the net assets of any of the group’s subsidiaries which are not wholly owned. The consolidated statement of comprehensive income (or consolidated income statement, if presented) will show the resulting profit or loss which is attributable to the NCI. Any cash paid to the NCI will usually be in the form of a dividend. The nonwholly owned subsidiary will, of course, pay a dividend to the parent company which will be eliminated at consolidation level in the normal way; however, the dividend paid to the NCI must be recorded in the consolidated cash flow statement because it has been paid to shareholders which are external to the group. Such dividends are usually presented in the ‘Financing activities’ section of the consolidated cash flow statement.

169

9.10 Consolidated Cash Flow Statement Focus The consolidated cash flow statement will still need to present 100% of the dividend paid by the parent entity because that will always be treated as a cash flow which is external to the group. In addition, the NCI’s share of the dividend paid by a subsidiary will also need to be included.

Example 9.1 – Dividend paid to NCI Extracts from the consolidated financial statements of Byrne Group Ltd are shown below: Consolidated balance sheet (extract) as at 31 December 2021 31.12.21

31.12.20

£’000

£’000

1,000

1,000

450

320

Retained earnings

4,685

4,120

Total reserves

6,135

5,440

Ordinary share capital Non-controlling interest

Consolidated statement of comprehensive income for the year ended 31 December 2021 31.12.21

31.12.20

£’000

£’000

Total comprehensive income attributable to equity shareholder of the parent

565

473

Non-controlling interest

100

110

665

583

The dividend paid to the NCI can be calculated as follows: £’000 Balance per NCI at 31.12.20

320

Plus profit attributable to NCI at 31.12.21

100 420

Balance per NCI at 31.12.21

(450)

Dividend paid to NCI in year to 31.12.21.

170

30

Consolidated Cash Flow Statement 9.11 While the figures in the above would generally be calculated automatically from an accounts production software package, it is often worthwhile recapping how the figures are derived in the event of any technical problems with the consolidated cash flow statement (keep in mind that, often, over-reliance on accounts production software can lead to mistakes creeping into the financial statements, so sense checks are usually advisable). In addition, for audit purposes, auditors may decide that recalculation of the dividend is needed to ensure its correct presentation in the consolidated cash flow statement when auditing the statement.

CASH RECEIVED FROM AND PAID TO ASSOCIATES 9.11 At the outset it is worth noting that associates are not part of the group even though the investor has significant influence over the associate. To that end, cash flows between the group and the associate must be reported in the consolidated cash flow statement.

Focus In practice, cash flows among associated entities should be disclosed separately where they are material. Such cash flows would ordinarily be distinguished between: ●●

Dividends received from an associate

●●

Cash payments to acquire an associate

●●

Cash receipts from disposal of an associate

●●

Loans made to associates

These sorts of cash flows should be classified as cash flows from investing activities.

In the consolidated financial statements, associates are accounted for using the equity method of accounting (see Chapter 6). The group records its share of profit from the associate which, of course, is a non-cash transaction and hence is shown as a deduction from group profit and cash generated from operating activities.

171

9.11 Consolidated Cash Flow Statement

Example 9.2 – Associate’s transactions in the consolidated cash flow statement Extracts from the consolidated financial statements of Harper Group Ltd are as follows: Consolidated balance sheet as at 31 December 2021 (extract) 31.12.21

31.12.20

£’000

£’000

950

940

750

450

Fixed assets Investment in associate Current assets Loan to associate

Consolidated statement of comprehensive income for the year ended 31 December 2021 (extract)

Operating profit Share of profit from associate

31.12.21

31.12.20

£’000

£’000

980

920

65

78

Profit before tax

1,045

998

Tax on profit

(199)

(190)

846

808

Profit for the year

Extracts from the consolidated statement of cash flows showing the associate’s figures are as follows: Cash flows from operating activities

£’000

Profit before tax

1,045

Share of profit from associate

(65) 980

Investing activities Dividend received from associate*

55

Loan to associate (£750k – £450k)

(300)

*Dividend from associate: £’000 Opening balance of investment in associate Share of profit from associate

940 65 1,005

Closing balance of investment in associate Balance = dividend paid

(950) 55

172

Consolidated Cash Flow Statement 9.14

SUBSIDIARIES 9.12 The acquisition and disposal of subsidiaries will need to be presented separately in the consolidated financial statements so that the user is fully aware as to how the transaction has impacted the group’s cash flows.

Acquisition of a subsidiary 9.13 During the reporting period, a group may acquire a subsidiary. In the consolidated statement of cash flows, this transaction must be recorded but net of any cash held by the subsidiary which is now controlled by the group. Example 9.3 – Acquisition of a subsidiary in the year The McCaffery Group Ltd acquires 70% of the net assets of Naylor Ltd for £2.3m in cash. At the date of acquisition, Naylor Ltd had £125,000 held in two bank accounts. No bank accounts were overdrawn at the date of acquisition. While the McCaffery Group has acquired control of Naylor for a consideration of £2.3m, at that date it also acquired control of Naylor’s £125,000 positive bank balances. Hence, in the consolidated cash flow statement, this transaction would be recorded as follows: £’000 Cash flows from investing activities Acquisition of subsidiary (net of cash acquired)

2,175 (£2.3m less £125k cash acquired)

Disposal of a subsidiary 9.14 The consolidated cash flow statement must show the cash proceeds received from the sale of the subsidiary net of any cash held by the subsidiary which it has lost control over. Disposals also have an inherent added complication because the assets and liabilities of the subsidiary which the group has disposed of must also be included in the calculations when dealing with the cash movement for an item during the year. Example 9.4 – Disposal of a subsidiary The Byrne Group owned 80% of the net assets of Breary Ltd. During the year, this investment was disposed of for £750,000 in cash. At the date of disposal, Breary had positive bank balances amounting to £110,000.

173

9.14 Consolidated Cash Flow Statement The group has fully disposed of its investment in Breary Ltd and hence has lost control over that subsidiary. It has also lost control over its positive cash balances and hence this is presented as follows in the consolidated cash flow statement: £,000 Cash flows from investing activities Disposal of subsidiary, net of cash disposed

640 (£750k less £110k)

Example 9.5 – Disposal of a subsidiary Extracts from The Arlo Group’s consolidated balance sheet are as follows: 31.12.2021

31.12.2020

£’000

£’000

Inventory

62,863

61,080

Trade receivables

89,076

71,234

Trade payables

77,023

51,432

During 2021, Arlo acquired Frankie Ltd and disposed of Morley Ltd. Extracts from the individual financial statements of Frankie and Morley are shown below: Frankie as at acquisition date Morley as at disposal date £’000

£’000

Inventory

11,209

8,312

Trade receivables

15,010

7,213

9,033

4,200

Trade payables

In the consolidated financial statements of the group, Frankie’s net assets were not included at the start of the year (as the subsidiary was not part of the group until part-way through 2021) and Morley’s will not be included at the end of the year (as this subsidiary was sold part-way through 2021). In order to achieve comparability, the movement between the opening and closing balances is calculated. The group will then: (a)

deduct Frankie’s opening balances at the date of acquisition; and

(b) add Morley’s closing balances at the date of disposal.

174

Consolidated Cash Flow Statement 9.16 Group

Inventories

Trade receivables Trade payables

£’000

£’000

£’000

Balance at 31.12.2021

62,863

89,076

77,023

Balance at 01.01.2021

(61,080)

(71,234)

(51,432)

1,783

17,842

25,591

Less: Frankie acquisition

(11,209)

(15,010)

(9,033)

Add: Morley disposal

8,312

7,213

4,200

Movement in the year

(1,114)

10,045

20,758

Cash flow impact

Inflow

Outflow

Outflow

FOREIGN EXCHANGE GAINS AND LOSSES 9.15 Assets and liabilities which are denominated in a foreign currency will fluctuate depending on the movement in the foreign exchange rate. Example 9.6 – Non-cash foreign exchange gain or loss The Revere Group Ltd is based in the UK and has a subsidiary based in the US. During the year the parent lent £150,000 to the subsidiary. At the start of the financial year the subsidiary’s loan balance was £62,000. An exchange loss of £31,000 arose on translation of the loan into the group’s presentation currency of GBP. A foreign exchange gain or loss is not a cash flow and hence must be taken into consideration when preparing the consolidated cash flow statement. An exchange loss will reduce the debtor balance. £’000 Opening balance at start of year

62

Exchange loss

(31)

Closing balance at end of year

150

Cash received (balancing figure)

181

WORKED EXAMPLE INCORPORATING THE ABOVE TECHNICAL ISSUES 9.16 Using the theory above in respect of the consolidated cash flow statement, the following worked examples show how this theory can be put into practice.

175

9.16 Consolidated Cash Flow Statement

Example 9.7 – Acquisition of a subsidiary during the period Lucas Ltd acquired Gabriella Ltd for £22m during the year to 31 December 2021. Consideration comprised 3m 25p shares with a market value of £4 each and the balance was paid in cash. At the date of acquisition, the net assets of Gabriella were as follows: £’000 Tangible fixed assets 13,000 Stock 8,995 Trade and other debtors 14,280 Cash at bank 2,830 Trade and other creditors (23,224) Overdraft (5,182) Non-controlling interest (5) 10,694 An extract of the group cash flow statement will show: Investing activities £’000 Purchase of subsidiary (cash element of subsidiary – (10,000) see below) Overdraft acquired on acquisition (net of cash in hand) 2,352 (£5,182 – £2,830) The notes to the group cash flow statement will show: Net assets acquired £’000 Tangible fixed assets 13,000 Stock 8,995 Trade and other debtors 14,280 Cash at bank 2,830 Trade and other creditors (23,224) Overdraft (5,182) Non-controlling interest (5) 10,694 Goodwill (balancing figure) 11,306 22,000 Satisfied by: Shares allotted (3m x £4) 12,000 Cash 10,000 22,000

176

Consolidated Cash Flow Statement 9.16 Assume that pre-tax profit of the Lucas Group for the year was £20m. Included in the pre-tax profit are depreciation charges of £3.2m and in the year the group sold an item of machinery with a net book value of £1.1m for £1m. The balance sheet extracts are as follows: 2021 2020 £’000 £’000 Tangible fixed assets 165,110 143,228 Stock 92,113 60,142 Trade and other debtors 45,687 23,164 Trade and other creditors 75,897 41,231 The impact on the group statement of cash flows is as follows: £’000 £’000 Profit before tax 20,000 Loss on disposal of fixed assets (£1,000 – £1,100) 100 Depreciation 3,200 Increase in stock (92,113 – (60,142 + 8,995)) (22,976) Increase in debtors (45,687 – (23,164 + 14,280)) (8,243) Increase in creditors (75,897 – (41,231 + 23,224)) 11,442 3,523 Investing activities Purchase of tangible fixed assets Note 1 (13,182) Sale of tangible fixed assets 1,000 (12,182) Purchase of subsidiary (see above) (10,000) Overdraft acquired with subsidiary (net of cash in hand) (2,352) (12,352) Note 1: Opening balance b/f 143,228 Subsidiary fixed assets acquired 13,000 Depreciation charges (3,200) Disposals (1,100) Balance c/f (165,110) Additions = balancing figure 13,182

In practice accounts production software may often generate the above figures, however in some systems it is not usually as straightforward as the accounts system doing this and hence the above shows how the figures can be arrived at in the case that manual intervention in an automated accounts production software is needed (especially for audit purposes or for the purposes of doing a ‘sense check’).

177

9.16 Consolidated Cash Flow Statement The above example concentrated on the acquisition of a subsidiary during the accounting period. However, it is not uncommon for a parent company to dispose of a subsidiary and the cash effects of such disposals will affect the group cash flow statement. Example 9.8 – Disposal of a subsidiary Topco Ltd has held a 75% investment in Subco Ltd for several years. On 31 December 2021, Topco disposed of the investment in its entirety for £1.5m in cash. Extracts from the financial statements of Subco are as follows: Balance sheet (extract) Subco Ltd Stock Debtors Cash at bank Topco Group Consolidated balance sheet (extract)

£’000 489 525 110

2021 2020 £’000 £’000 Stock 1,645 1,983 Debtors 4,385 4,662 Cash at bank 410 165 The impact of the disposal on the Topco Group cash flow statement for the year ended 31 December 2021 is as follows: £’000 Profit before tax X Increase in stock (1,645 + 489 – 1,983) (151) Increase in debtors (4,385 + 525 – 4,662) (248) Net cash disposed of in subsidiary X Investing activities Disposal of subsidiary Net cash disposed of in subsidiary Notes to the group cash flow statement (extract) Net assets disposed of: Stock Debtors Cash Non-controlling interest Profit (loss) on disposal Satisfied by: Cash

1,500 (110) £’000 489 525 110 (X) X X 1,500 1,500

178

Consolidated Cash Flow Statement 9.17 Again, automated accounts production software systems may generate some of the required figures in the group cash flow statement but the above demonstrates some of the mechanics of arriving at the figures.

THEMATIC REVIEW OF THE CASH FLOW STATEMENT 9.17 On 17 November 2020, the Financial Reporting Council (FRC) issued a notice in which it stated that the cash flow statement needs to improve. During the Corporate Reporting Review 2019/20, the FRC challenged companies where they found deficiencies in their cash flow statements. Most notably, the FRC challenged: ●●

material inconsistencies between items in the cash flow statement and the notes;

●●

missing or incorrectly classified cash flows; and

●●

inconsistencies between financing cash flows and the reconciliation of changes in liabilities arising from activities within the notes to the financial statements.

Focus While this book is focussed on UK GAAP, the FRC’s review was focussed on IFRS reporters, (specifically IAS 7 Statement of Cash Flows). The FRC’s feedback via the thematic review can be taken on board by UK GAAP reporters because both FRS 102, Section 7 and IAS 7 are broadly consistent in their requirements so some of the pitfalls and ‘better disclosure suggestions’ can be taken on board by preparers of consolidated financial statements under UK GAAP.

While the FRC also remain concerned about ‘boilerplate’ disclosures in respect of liquidity risk and associated disclosures, they have commented that they have noted improvements in going concern, viability and liquidity disclosures. According to the FRC’s Thematic review: Cash flow and liquidity disclosures (Nov 2020), the cash flow statement has featured in the top ten most frequently raised topics by the FRC so there are still a number of challenges faced by preparers where the cash flow statement is concerned. The FRC originally planned to review the full-year accounts of a sample of 20 entities (12 with December year ends). Due to the impact of the global pandemic, the FRC decided to extend their sample to 30 to allow inclusion of more companies reporting from April onwards.

179

9.18 Consolidated Cash Flow Statement The sample was allocated across a number of different industries and sectors as follows: Sector

%

Travel and leisure

20

Industrial goods and services

13

Retail

13

Personal and household goods

10

Construction and materials

6

Food and beverage

7

Media

7

Real estate

7

Technology

7

Other

10

FRC findings 9.18 The findings from the November 2020 thematic review are somewhat consistent with the findings from previous reviews. Five companies were required to restate their cash flow statements as a result of the FRC’s enquiries. Some of these were due to basic errors which became evident from the FRC’s desktop review of the accounts. The FRC recommend that companies strengthen their pre-issuance review that is built into the financial statement close process in order to avoid these basic errors. The FRC confirm that the most frequent questions they raised related to: ●●

investing activities;

●●

the definition of cash and cash equivalents;

●●

the reconciliation of profit to net cash flows from operating activities;

●●

the acquisition or disposal of subsidiaries; and

●●

the incorrect classification of cash flows.

The FRC confirmed that most companies presented a cash flow statement which did comply with the requirements of IAS 7. However, in some cases they found that the cash flow statement did not comply, and as a result wrote to three companies out of the sample of 30 companies with substantive questions concerning their cash flow statement.

180

Consolidated Cash Flow Statement 9.20

Cash and cash equivalents 9.19

IAS 7, para 6 states that:

‘Cash comprises cash on hand and demand deposits’.6 IAS 7, para 6 also states that cash equivalents are: ‘Short-term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of change in value.’7 A reporting entity is also required to provide a reconciliation of the amounts shown as cash and cash equivalents in the cash flow statement with the equivalent items shown in the balance sheet. The FRC’s thematic review confirms that judgement may have to be exercised in determining what comprises cash and cash equivalents. IAS 7 states that investments will normally qualify as cash equivalents only if the maturity, at acquisition, is less than three months. In some cases, bank overdrafts may be included within cash equivalents in the cash flow statement. If this is the case, the FRC expects to see disclosure of the basis for including overdrafts within cash equivalents together with a reconciliation between cash and cash equivalents per the cash flow statement and the corresponding items in the balance sheet.

Composition of cash and cash equivalents 9.20 The FRC refer to the IFRS Interpretation’s Committee’s decision concerning the types of borrowings that can be included as a component of cash and cash equivalents in the cash flow statement. The fact pattern considered short-term loans and credit facilities that have a short contractual notice period (eg, 14 days). The agenda decision confirms that if the balance of a banking arrangement does not often fluctuate from negative to positive, this indicates that the arrangement does not form an integral part of the entity’s cash management and, hence, represents a form of financing. The FRC include the following examples of better disclosures: ●●

An accounting policy detailing what constitutes cash and cash equivalents.

●●

Analysis of the components of cash and cash equivalents, for example, cash at bank, short-term deposits and money market funds.

●●

Description of the terms of deposits, such as maturity, break clauses and interest rates.

6 7

IAS 7, para 6. IAS 7, para 6.

181

9.21 Consolidated Cash Flow Statement ●●

Whether overdrafts are included within cash and cash equivalents and, if so, the terms of such arrangements.

●●

Disclosure of the amount of restricted cash and the nature of the restrictions.

The FRC noted one company which had treated an invoice discounting facility as part of cash and cash equivalents in the cash flow statement, despite appearing not to fluctuate between an asset and liability position.

Cash flows from operating activities 9.21 All companies in the FRC’s sample used the indirect method which adjusts profit or loss for the effects of non-cash items. According to the FRC, examples of better disclosures include: ●●

A reconciliation to explain the cash flow impact of working capital movements, where this was not apparent from the balance sheet.

●●

A logical ordering of the items presented, for example, grouping similar items together such as working capital movements and non-cash items.

●●

References to relevant notes.

Problems identified by the FRC in respect of operating cash flows included: ●●

Changes in cash flows from working capital which were inconsistent with movements in the balance sheet.

●●

Material and unexplained variances in impairment and depreciation charges between the cash flow statement reconciliation and the notes to the accounts.

Treatment of interest and dividends 9.22 There is an accounting policy choice in IAS 7 for the presentation of interest and dividends. Interest paid and interest and dividends received may be treated as operating cash flows because they are included in the determination of profit or loss. Alternatively, interest paid and interest and dividends received can be classed as financing cash flows and investing cash flows respectively because they are costs of obtaining financial resources or represent returns on investments. The FRC expects companies to select an appropriate accounting policy for the presentation of interest, including interest relating to leases, and dividends and to apply this policy consistently from one period to another.

182

Consolidated Cash Flow Statement 9.24 The FRC identified several companies which did not apply a consistent, IAS 7-compliant, accounting policy for the presentation of interest and dividends.

Investing cash flows 9.23 IAS 7, para 16 states that only expenditure which results in a recognised asset in the balance sheet can be classed as investing activities. If there are material differences in the cash flows from investing activities to the amounts presented in the notes, the FRC suggest it is helpful to provide an explanation. Better disclosures include: ●●

References to notes which agree to the amounts presented in the cash flow statement.

●●

A reconciliation between the cash flows in the cash flow statement and notes where the reason for the difference is not apparent.

The FRC noted the following areas of concern: ●●

Material and unexplained differences in additions to property, plant and equipment between the cash flow statement and the property, plant and equipment notes.

●●

Settlements of provisions and other liabilities which were presented as investing cash flows.

Acquisition and disposal of subsidiaries 9.24 IAS 7, para 39 states that the aggregate cash flows arising from obtaining or losing control of a subsidiary or other businesses should be presented separately and classified as investing activities. The FRC also expect the notes to provide a breakdown of the impact on the cash flow statement where the impact of acquiring or disposing of a subsidiary or business is material. Better disclosures according to the FRC are as follows: ●●

References to notes which agree to the amounts presented in the cash flow statement.

●●

A breakdown of the cash flows resulting from the acquisition or disposal of subsidiaries and other businesses.

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9.25 Consolidated Cash Flow Statement

Cash flows from financing activities 9.25 IAS 7, para 17 provides three examples of cash flows from financing activities: ●●

proceeds from a share issue;

●●

cash repayments to owners to redeem shares; and

●●

proceeds and repayment of loans and cash payments in respect of an outstanding liability relating to a lease.

IAS 7, para 44A requires an entity to provide disclosures which enable users to evaluate changes in liabilities arising from financing activities, including both changes arising from cash flows and non-cash changes. The FRC confirm that while IAS 7 is not prescriptive, the most common way of meeting the disclosure requirement in paragraph 44A is to provide a reconciliation. The FRC note potential concerns in respect of the disclosure of changes in liabilities arising from financing activities. For example, some incorrectly included derivative assets which were not hedging risks relating to borrowings. Hence, they should not have been presented as part of liabilities from financing activities. Also, while companies can include cash and cash equivalents to present a net debt reconciliation, care should be taken to ensure the requirements of the standard are met; for example, by providing a subtotal of liabilities arising from financing activities. The FRC noted several cases where inconsistencies existed between amounts presented in the cash flow statement and the disclosure of changes in liabilities arising from financing activities. The FRC wrote to companies about the following: ●●

Settlement of liabilities shown as a cash flow in the disclosure of changes in liabilities arising from financing activities, but which was not included in the cash flow statement.

●●

Settlement of financing liabilities in the cash flow statement appeared inconsistent with movements in the balance sheet and notes.

●●

Non-cash amounts, such as assets purchased under finance leases and non-cash finance charges, incorrectly presented as cash flows.

IFRS 7 liquidity risk disclosures 9.26 The FRC examined various liquidity risk disclosures in their sample of reporting entities’ cash flow statements. This is because IFRS 7 Financial Instruments: Disclosures requires both quantitative and qualitative disclosures of the exposure to liquidity risk and how it arises, as well as disclosure of the entity’s objectives, policies and processes for managing the risk and the methods used to measure it. 184

Consolidated Cash Flow Statement 9.27 The FRC note that many companies in their sample provided relatively brief qualitative disclosures of liquidity risk in the financial risk management notes, with more detailed information provided elsewhere (for example, in going concern disclosures, viability statement and governance and liquidity policies included in the strategic report). The FRC note that better disclosures include: ●●

Entity-specific policies on managing liquidity risk.

●●

Details of liquid resources and uncommitted facilities.

●●

References to liquidity information contained in other notes.

●●

Information about any changes to liquidity risk management.

Maturity analysis 9.27 IFRS 7 requires an entity to provide a maturity analysis of all financial liabilities which includes leases and issued financial guarantees. The maturity analysis should include undiscounted, contractual cash flows, including principal and interest payments. The time bands disclosed must be consistent with the information provided internally to key management personnel. The FRC note that while all companies in their sample provided a maturity analysis, the quality varied. The FRC acknowledge that while the level of disaggregation of time bands may differ across reporting entities, they do expect companies to consider whether a greater degree of disaggregation than reported previously is required in the current circumstances. In addition, companies should also consider if it is clearer to present liquidity information together in one location as opposed to using separately maturity tables. The FRC notes better disclosures in their sample included: ●●

Clear explanations of what the maturity analysis represented.

●●

Information presented in such a way which could easily be compared to items in the balance sheet (such as showing the carrying value next to the total of undiscounted contractual cash flows).

●●

All relevant liabilities, including lease liabilities, presented together for easy analysis.

●●

Sufficient granularity in the time bands chosen.

Areas where the FRC note improvements are required include the following: ●●

Some companies in the FRC’s sample failed to clearly distinguish the maturity analysis presented on an undiscounted basis from that presented on a discounted basis. For example, by having the same titles for both.

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9.28 Consolidated Cash Flow Statement ●●

Several companies excluded contractual interest cash flows from the contractual undiscounted cash flows.

●●

Several companies presented the maturity disclosures in separate notes, which made it hard to understand the aggregate position.

Compliance with banking covenants 9.28 In times of economic distress (especially in a COVID-19 climate), the FRC expects companies to disclose details of their banking covenants. This applies, regardless of the fact that a company may have complied with them and there is sufficient headroom. Any judgements made in assessing compliance should also be disclosed. The vast majority of companies in the FRC’s sample did provide information concerning their compliance with the terms of covenants and waivers. The FRC also state that where a company had multiple covenants, or covenants levels changing over time, they found tabular disclosures to be helpful. The FRC note that better disclosures explained: ●●

How calculated covenant ratios compare with the requirements of lending arrangements.

●●

The available headroom.

●●

Whether adoption of IFRS 16 Leases had any impact on covenants.

●●

Any waivers agreed with debt providers.

●●

Any changes post-year end as a result of further measures taken (such as an equity raise).

●●

The impact on covenants of new borrowing facilities and government support.

●●

How often covenants are tested.

●●

How covenant levels will change over time.

●●

Any restrictions on the company, such as over shareholder distributions or acquisitions.

Seasonality 9.29 IFRS 7, para 35 says that if the qualitative data disclosed as at the end of the reporting period are unrepresentative of an entity’s exposure to risk during the period, an entity must provide further information which is representative.

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Consolidated Cash Flow Statement 9.30 The FRC noted that in their sample, several companies provided additional disclosures of the exposure during the year. The FRC note that better disclosures include: ●● ●● ●●

Disclosure of the maximum drawdown of revolving credit facilities during the year. An explanation of the impact of seasonality on liquidity and working capital in comparison to seasonality in the business operations. Use of metrics which considered average exposures in the reporting period, such as average daily net cash, in addition to the position at the reporting date.

Working capital and supplier financing arrangements 9.30 At the outset it is worth noting that the FRC’s thematic review confirms that supply chain financing arrangements, including reverse factoring transactions, are currently an area of focus for the FRC. Where companies are using material supplier financing arrangements, the FRC expects disclosure of: ●●

the amount of the facility and usage;

●●

the accounting policy applied, including the basis on which the company recognised the liability to suppliers;

●●

whether the liability is included within the determination of key performance indicators such as net debt;

●●

the cash flows generated by such arrangements; and

●●

the impact on liquidity risk which could arise from losing access to the facility, for example, acceleration of payments to suppliers leading to demands on cash and working capital.

The FRC noted three companies in their sample which disclosed material supplier financing arrangements. A further four companies disclosed immaterial arrangements or stated explicitly that no supplier financing arrangements were used. The FRC note that better disclosures include: ●●

A description of the supplier financing arrangements used including the purpose of the arrangement.

●●

How amounts relating to the arrangement are presented in the balance sheet and cash flow statement.

●●

Details of interest or fees payable.

●●

The impact on the timing of the company’s cash flows.

●●

How liquidity risk is managed in relation to the risk of losing access to the facility. 187

9.30 Consolidated Cash Flow Statement

CHAPTER ROUNDUP ●●

The consolidated cash flow statement is prepared using three cash flow classifications, being operating activities, investing activities and financing activities.

●●

Consolidated cash flow statements can be prepared using the indirect method (which is the most common) or the direct method.

●●

The consolidated cash flow statement is prepared in much the same way as a cash flow statement for a single entity, but there are some additional factors to consider.

●●

The FRC’s thematic review of the cash flow statement has highlighted a number of reporting issues that entities reporting under IFRS need to take on board. Some of these issues may also apply to groups preparing a consolidated cash flow statement under FRS 102 as both IAS 7 and FRS 102, Section 7 are broadly consistent.

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Chapter 10

Foreign Currency Issues

SIGNPOSTS ●●

Financial statements are generally prepared using the functional currency of the reporting entity. An entity’s functional currency is a matter of fact, not a choice (see 10.2).

●●

Care must be taken when establishing an entity’s functional currency to ensure correct application of UK GAAP as the case of Ball Holdings v HMRC illustrates (see 10.4).

●●

There are four initial recognition and subsequent measurement rules that must be followed when it comes to translating foreign currency transactions in the financial statements (see 10.5).

●●

Foreign exchange differences arising on the disposal of a net investment in a foreign operation are not subsequently recycled to profit or loss under FRS 102, they are transferred from other comprehensive income directly into retained earnings which is a notable difference from the treatment under IFRS (see 10.9).

●●

When consolidating the results of a foreign operation, the normal consolidation procedures apply and all intra-group balances and transactions must be eliminated (see 10.11).

INTRODUCTION 10.1 Many groups nowadays have diverse operations and some of the group’s subsidiaries may be located overseas. This means that there will be an interaction with FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland, Section 30 Foreign Currency Translation. Not only will day-to-day trading transactions need to be converted from the subsidiary’s foreign currency into the functional currency, but the individual financial statements of the foreign subsidiary may also need to be translated into the group’s presentation currency.

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10.1 Foreign Currency Issues At the outset, it is worth understanding some key definitions where foreign currency translation is concerned: Foreign operation ‘An entity that is a subsidiary, associate, joint venture or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity.’1 Functional currency ‘The currency of the primary economic environment in which the entity operates.’2 Individual financial statements ‘The accounts that are required to be prepared by an entity in accordance with the Act or relevant legislation, for example: (a)

‘individual accounts’, as set out in section 394 of the Act;

(b) ‘statement of accounts’, as set out in section 132 of the Charities Act 2011; or (c) ‘individual accounts’, as set out in section 72A of the Building Societies Act 1986. Separate financial statements are included in the meaning of this term.’3 Net investment in a foreign operation ‘The amount of the reporting entity’s interest in the net assets of that operation.’4 Presentation currency ‘The currency in which the financial statements are presented.’5

Focus While this chapter does not necessarily consider consolidated financial statements in isolation, it is an essential chapter where a UK-based parent has an overseas subsidiary (or multiple overseas subsidiaries). This is because the likelihood is that the overseas subsidiary will prepare its financial statements in a different currency to that of the parent and there are translation rules contained in FRS 102, Section 30 that must be followed.

1 2 3 4 5

FRS 102 Glossary foreign operation. FRS 102 Glossary functional currency. FRS 102 Glossary individual financial statements. FRS 102 Glossary net investment in a foreign operation. FRS 102 Glossary presentation currency.

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Foreign Currency Issues 10.2

FUNCTIONAL CURRENCY 10.2 Financial statements are usually prepared in the functional currency of the reporting entity. Every entity is required to identify and disclose its functional currency, even if the financial statements are not prepared in the functional currency. An entity’s functional currency is a matter of fact, not a choice. It follows, therefore, that where there is a change in functional currency, this change has arisen because there has been a change in the primary economic environment in which the entity operates. The ‘primary economic environment’ of an entity is the environment in which the entity operates and is usually the one in which it primarily generates and spends cash. FRS 102, para 30.3 provides some primary factors which an entity must consider when determining it functional currency: ‘(a) the currency: (i) that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); and (ii) of the country whose competitive forces and regulations mainly determine the sales price of its goods and services; and (b)

the currency that mainly influences labour, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled).’6

The factors in (a) and (b) above are those which FRS 102 states are the ‘most important factors’ an entity must take into account when determining its functional currency. FRS 102, para 30.4 then goes on to provide some secondary factors which are taken into consideration when the primary indicators of functional currency do not provide clear evidence as to the entity’s functional currency: ‘(a) the currency in which funds from financing activities (issuing debt and equity instruments) are generated; and (b) the currency in which receipts from operating activities are usually retained.’7 These secondary factors are used, for example, when the functional currency decision is unclear due to more than one dominant currency influencing the transactions of the entity. In most cases, the primary indicators will be sufficient, and it is a requirement that management give priority to the primary indicators. However, for some entities which may, perhaps, exist to provide finance to other parts of the 6 7

FRS 102, para 30.3. FRS 102, para 30.4.

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10.3 Foreign Currency Issues group, the entity’s operations may be regarded as an extension of the parent’s operations. Example 10.1 – Functional currency Greaves Ltd is a subsidiary which is located in the UK and has a large number of transactions in Euros (EUR), due to the fact that many of the items it sells are purchased from Spain. Consequently, EUR prices have a strong influence on the sales price of the goods which Greaves sells in the UK and elsewhere. However, Greaves has a UK-based workforce which it pays in GBP as well as premises in the UK, which are also paid for in GBP. Greaves considers the factors in FRS 102, para 30.3 regarding its primary economic environment and concludes that EUR is the main influence on sales prices, but the competitive forces and regulations are strongly influenced by GBP. Salaries and premises costs are mainly influenced by GBP, but costs of goods are partly influenced by EUR. As the functional currency is still unclear, Greaves considers the secondary factors and determines that its financing activities are funded entirely in GBP and the currency in which it retains receipts from operating activities is also GBP. Hence, because the primary indicators were not conclusive, Greaves uses the secondary factors as well and concludes that its functional currency is GBP.

Functional currency of a foreign operation 10.3 A foreign operation may be an extension of an entity. For example, an operation located in Spain may be an extension of an entity located in the UK and in such cases the functional currency of the Spanish entity will be the same as the English one. When the functional currency of a foreign operation is unclear, FRS 102, para 30.5 provides additional factors which must be considered. These factors establish whether the foreign operation’s functional currency is the same as that of the reporting entity. The reporting entity in the context of FRS 102, para 30.5 is the entity which has the foreign operation as its subsidiary, branch, associate or joint venture: ‘(a) Whether the activities of the foreign operation are carried out as an extension of the reporting entity, rather than being carried out with a significant degree of autonomy. An example of the former is when the foreign operation only sells goods imported from the reporting entity and remits the proceeds to it. An example of the latter is when the operation accumulates cash and other monetary items, incurs expenses, generates income and arranges borrowings, all substantially in its local currency. (b) Whether transactions with the reporting entity are a high or a low proportion of the foreign operation’s activities. 192

Foreign Currency Issues 10.4 (c) Whether cash flows from the activities of the foreign operation directly affect the cash flows of the reporting entity and are readily available for remittance to it. (d) Whether cash flows from the activities of the foreign operation are sufficient to service existing and normally expected debt obligations without funds being made available by the reporting entity.’8 Example 10.2 – Functional currency of a foreign operation Topco Ltd, a UK-based company whose functional currency is GBP, has a subsidiary (Subco Inc) located in Spain. Subco obtains products from Topco and sells them to its local customers. Invoices are raised from Topco and the Spanish customers pay Topco directly. Proceeds from cash sales are remitted into Subco’s bank account which Topco manages and controls. In this example, it is clear that Subco is operating as an extension of Topco and hence Subco’s functional currency will be the same as Topco (ie, GBP). Example 10.3 – Foreign branch Sunnie Ltd has a foreign branch (Farland Enterprises Inc). Farland is responsible for selling Sunnie’s products in its country. The transfer price of the products is similar to normal transfer prices which apply to third parties which sell Sunnie’s products in other countries. Farland is responsible for its own bank accounts and funds itself from loans obtained from its own bank and cash flows from its operations in its foreign currency. In this example, Farland operates independently from Sunnie and hence determines its functional currency independently from Sunnie.

Ball Holdings v HMRC 10.4 In Ball Holdings v HMRC, the functional currency used to prepare Ball Holdings’ statutory accounts was changed from Sterling to US Dollars. This resulted in the recognition of a large foreign exchange loss which the company claimed against UK corporation tax as an allowable expense. HMRC rejected the claim, stating the functional currency of the entity should have been Sterling and not US Dollars. Ball Holdings argued that they had entered into a derivative contract, triggering the requirements of (the now defunct) FRS 23. It was the application of FRS 23 which triggered the change in functional currency and the First-Tier Tribunal (FTT) had to decide whether the requirements of FRS 23 had been correctly applied when the entity changed its functional currency from Sterling to US Dollars. 8

FRS 102, para 30.5.

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10.5 Foreign Currency Issues The key test in FRS 23 was whether the activities of the foreign operation were being carried out as an extension of the reporting entity, rather than being carried out with a significant degree of autonomy. This test was featured in FRS 23, para 11(a), as follows: ‘(a) whether the activities of the foreign operation are carried out as an extension of the reporting entity, rather than being carried out with a significant degree of autonomy. An example of the former is when the foreign operation only sells goods imported from the reporting entity and remits the proceeds to it. An example of the latter is when the operation accumulates cash and other monetary items, incurs expenses, generates income and arranges borrowings, all substantially in the local currency.’9 The equivalent test is in FRS 102, para 30.5(a). The fundamentals of this case hinged on the autonomy of Ball Holdings. If Ball Holdings did not have autonomy, its functional currency would have been US Dollars; conversely, if it did have autonomy, its functional currency would be Sterling and no translation loss would arise. The FTT concluded that Ball Holdings had misinterpreted the word ‘autonomy’ in paragraph 11(a) of FRS 23. HMRC argued successfully that ‘autonomy’ would not be confined to decision-making power but be much wider. Therefore, HMRC dismissed the appeal and concluded that the entity had incorrectly interpreted the standard stating that the financial statements must be prepared to UK GAAP and any interpretation of accounting standards does not necessarily mean that the financial statements have been prepared under UK GAAP, especially if that interpretation is incorrect.

Focus This case highlights the importance of not only determining functional currency correctly, but also correctly interpreting accounting standards. A misinterpretation means that the entity has not applied GAAP and HMRC require financial statements in the UK to be prepared to UK GAAP principles.

REPORTING FOREIGN CURRENCY TRANSACTIONS IN THE FUNCTIONAL CURRENCY 10.5 When an entity enters into a foreign currency transaction, there is exposure to the cash flow effects of changes in value of foreign currency. These changes can be adverse or favourable, depending on what happens 9

FRS 23, para 11(a).

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Foreign Currency Issues 10.6 with the foreign exchange rate. Regardless of the impact of foreign exchange rates, reporting entities which undertake foreign currency transactions must convert foreign currency items into the entity’s functional currency in order to recognise the transactions correctly in the accounting records. This will usually give rise to exchange differences where changes in exchange rates affect the carrying amounts to be recognised in the financial statements.

Initial recognition and subsequent measurement 10.6 There are four recognition and measurement rules that need to be followed when it comes to foreign currency translation which are shown in the following table: Transaction

How to translate

On initial recognition: Transactions denoted in a foreign Translate such transactions into the functional currency currency of the entity using the exchange rate ruling at the date of the transaction (ie, the ‘spot’ rate). In practice average rates can be used (eg, monthly or weekly rates) provided there has not been any significant fluctuation in the rates Subsequent measurement: Year end foreign currency monetary amounts

Translate year end foreign currency monetary amounts using the closing rate at the reporting date

Year end foreign currency nonmonetary amounts

Translate year end foreign currency nonmonetary amounts that are measured in terms of historical cost in a foreign currency at the exchange rate ruling at the date of the transaction

Non-monetary items measured at fair value

Translate non-monetary items measured at fair value in a foreign currency using the exchange rate ruling at the date fair value was determined

Focus The date of the transaction is the date on which the transaction first qualifies for recognition under UK GAAP. In most cases, average rates will be used, but it must be borne in mind that if there have been significant fluctuations in exchange rates, an average rate will be inappropriate. Professional judgement will be needed when deriving an average rate for periods of weeks, months or quarters, as the end result must be materially correct, compared to using actual rates for each transaction.

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10.7 Foreign Currency Issues The term ‘monetary’ item is defined in the Glossary to FRS 102 as: ‘Units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency.’ Some examples of each are shown in the table below: Monetary

Non-monetary

Cash and bank balances

Property, plant and equipment

Bank loans and overdrafts

Intangible assets

Refundable deposits

Goodwill

Trade debtors and trade creditors

Investments in associates

Debt securities

Inventories

Bad debt provisions

Provisions to be settled by way of a nonmonetary assets

Holiday pay provisions

Equity securities

Deferred tax assets and liabilities, corporation tax assets and liabilities and VAT assets and liabilities

Shareholders’ equity

Finance lease obligations

Deferred income or prepayments (this is non-monetary because the cash flow has already taken place)

Example 10.4 – Non-monetary asset measured at historical cost Cahill Limited, whose functional currency is GBP, has an investment in an American entity which is accounted for at cost because the investee is not publicly traded, and a reliable measure of fair value cannot be obtained. The cost of the investment at the date of acquisition, and translated at the date of the transaction, was £700,000. The financial statements for the year ended 30 April 2022 are being prepared and if the investment was to be translated at the closing rate, it would equate to £1.2m. As the asset is carried at historical cost, it is translated using the exchange rate at the date of acquisition. Hence, the investment will continue to be recognised at a cost of £700,000.

Changes in functional currency 10.7 Care must be taken when changing an entity’s functional currency and this was highlighted in the Ball Holdings case (see 10.4 above). A change to an entity’s functional currency can only arise where there is a change to the underlying transactions, events and conditions, such as if the entity relocates to another country. It is uncommon for an entity to change its functional currency and there must be clear and justifiable reasons for doing so. 196

Foreign Currency Issues 10.8 When a change in functional currency arises, the entity applies the translation procedures applicable to the new functional currency prospectively (ie, from the date of change). No retrospective restatement is carried out. For nonmonetary items, the resulting translated amounts are treated as their historical cost. A change in functional currency is reported as of the date it is determined that there has been a change in the entity’s underlying events and circumstances. This can happen at any time during the year. An entity translates all items into the new functional currency using the exchange rate at the date of the change (FRS 102, para 30.16). Example 10.5 – Accounting for a change in functional currency Harper Inc, a company located in Austria, has an accounting reference date of 31 August each year and has previously identified its functional currency as the Euro. Harper is a wholly owned subsidiary of Tennyson Ltd, a company registered in the UK with a functional currency of GBP. During the year, a significant restructuring exercise was undertaken and the functional currency of Harper changed from the Euro to GBP on 1 February 2022. The change in functional currency is accounted for as follows: Period

Translation process

1 September 2021 to 31 January 2022

Apply the functional currency of the Euro

1 February 2022

The balance sheet is translated from Euro to GBP using the rate on 1 February 2022

1 February 2022 onwards

Apply GBP as the functional currency

Gains and losses on translation 10.8 Exchange gains and losses on retranslation of foreign currency amounts are generally recognised in profit or loss under the line item ‘Exchange (gains) losses’ (although this line item descriptor is not prescriptive, but is usually automatically generated by automated accounts production software systems). Exchange differences arising on settlement of monetary items, or on translating monetary items at different rates from those which were used in translating them on initial recognition are also recognised in profit or loss. Example 10.6 – Monetary asset translated at the year end Polaris Industries Ltd has an accounting reference date of 31 December. On 1 December 2021, it sells goods to a customer based in the US for $50,000 when the exchange rate was £1:$1.50. Payment is expected to be received in mid-January 2022 under normal payment terms. On 31 December 2021, the 197

10.8 Foreign Currency Issues exchange rate is £1:$1.55. VAT is ignored for the purposes of this example and it is assumed that Polaris Industries does not use cash flow hedge accounting. The sale is recognised at an amount of £33,333 ($50,000/$1.50) with a corresponding increase in trade debtors. At the year end 31 December 2021, the closing debtor is translated at the closing rate as it is a monetary item, hence the trade debtor becomes £32,258 ($50,000/$1.55). This results in a foreign exchange loss of £1,075 (£33,333 – £32,258) and is recognised in profit or loss in the year end financial statements. Exchange differences on non-monetary items are also recognised in profit or loss. Such exchange differences could arise, for example, where an entity sells a fixed asset accounted for under the historical cost accounting rules. Some entities choose to recognise exchange gains and losses in cost of sales, whereas others recognise them in administrative expenses. There is no specific guidance in UK GAAP as to where such gains or losses are recognised and hence it is for the entity to determine how best to present any exchange differences and to apply the chosen presentation consistently. For example, in a manufacturing company, if the exchange difference arises on office rental expense, it may not be appropriate to recognise the exchange difference in cost of sales. However, if the exchange difference arises on purchases, then it would be appropriate to recognise them in cost of sales.

Focus A change in where exchange gains and losses are presented in the profit and loss account may make comparisons with prior periods difficult and so the change in presentation would be applied retrospectively, if material, to the earliest period presented in the financial statements, which is usually just the comparative year, with an explanatory note.

FRS 102, para 30.11 states that when another section of FRS 102 requires a gain or loss on a non-monetary item to be recognised in other comprehensive income, any exchange component of that gain or loss is also recognised in other comprehensive income. Conversely, when a gain or loss on a non-monetary item is recognised in profit or loss, any exchange component is also recognised in profit or loss. A rate that approximates the foreign currency exchange rates at the dates of the transactions can be used to translate income and expenditure, provided that the foreign currency exchange rates have not fluctuated significantly. The average could be an average rate for the year, month, or week. In practice, it is common to use the average rate for the year.

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Foreign Currency Issues 10.9

Example 10.7 – Revaluation of a non-monetary asset Ratchford Ltd, whose functional currency is GBP, has a foreign subsidiary, Greaves Inc. On 31 January 2022, Greaves revalued its freehold land and buildings which resulted in a revaluation gain of €40,000 when the exchange rate was €0.876:£1. On consolidation, the gain is translated to GBP at £45,662 (€40,000/0.876) and is recorded in other comprehensive income, ie: Dr Property, plant and equipment

£45,662

Cr Revaluation reserve

£45,662

Net investment in a foreign operation 10.9 Foreign operations are translated for the purposes of consolidation, equity accounting or fair value purposes by translating all assets and liabilities (but not equity) at the foreign currency exchange rates prevailing at the balance sheet date. FRS 102, para 30.12 recognises that an entity may have a monetary item that is receivable from, or payable to, a foreign operation. Where settlement is neither planned, nor likely to occur in the foreseeable future, the item is, in substance, part of the entity’s net investment in that foreign operation. Such monetary items are likely to include long-term debtor balances or loans, but they would not include trade debtor or trade creditor balances. Determining whether settlement of a monetary item is planned or not, or likely to occur in the foreseeable future or not, may require professional judgement; particularly if there is no documentary evidence to support such a conclusion. Where the entity is an audit client, the auditor would be advised to seek a written representation from management in such a case. FRS 102, para 30.13 states: ‘Exchange differences arising on a monetary item that forms part of a reporting entity’s net investment in a foreign operation shall be recognised in profit or loss in the separate financial statements of the reporting entity or the individual financial statements of the foreign operation, as appropriate, except that any unrealised gain shall be recognised in other comprehensive income. In the financial statements that include the foreign operation and the reporting entity (eg the consolidated financial statements when the foreign operation is a subsidiary), such exchange differences shall be recognised in other comprehensive income and accumulated in equity. They shall not be recognised in profit or loss on disposal of the net investment.’10 10

FRS 102, para 30.13.

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10.10 Foreign Currency Issues While long-term debtors and loans may, in substance, be classified as part of the entity’s net investment in the foreign operation, FRS 102, para 30.13 clearly states that in the separate financial statements of the parent, exchange differences arising on monetary items which form a reporting entity’s net investment in a foreign operation are recognised in profit and loss. When it comes to the consolidated financial statements, exchange differences on monetary items which form part of the reporting entity’s net investment in a foreign operation are recognised in other comprehensive income and are not subsequently recognised within the profit and loss on disposal when the parent sells the subsidiary. It is important that preparers fully understand these accounting treatments because there is scope for incorrect treatments to be applied in the consolidated and separate financial statements of a group entity that has a foreign operation. Profits arising on the retranslation of monetary items are realised profits in the eyes of company law (ie, they are distributable to the shareholders). However, where the underlying transaction fails to meet the definition of ‘qualifying consideration’, it follows that any profits on retranslation will then not be realised profits. Unrealised gains are not distributable (as they are not readily convertible into cash) and hence should be recognised within other comprehensive income rather than taken to the profit and loss account. Some reporting entities choose to ring-fence non-distributable reserves in a separate reserve within equity to prevent them from being distributed inappropriately (although there is nothing in company law which requires this).

Focus The term ‘qualifying consideration’ refers to cash, assets which are readily convertible into cash and the writing off of a liability by a creditor. It can also refer to where a company can sell a debtor within a reasonable period of time where there is reasonable certainty that the debtor is capable of settling the debt when called upon to do so and there is an expectation that the debtor will settle. Qualifying consideration also relates to amounts receivable from shareholders. TECH 02/17BL Guidance on Realised and Distributable Profits under the Companies Act 2006 which was issued by the ICAEW and ICAS in April 2017 provides the guidance which preparers should consult when establishing whether profits are distributable or non-distributable.

PRESENTATION CURRENCY 10.10 UK GAAP allows a group (or individual company) to present its financial statements in any currency (or currencies). This may happen, for

200

Foreign Currency Issues 10.10 example, because the currency which mainly influences sales prices for goods and services may not be the domestic currency of the country in which the entity operates. Although an entity can choose to use any presentation currency, due regard must be had to the applicable laws and other requirements of the jurisdiction in which the entity operates. A UK entity could have a nonGBP functional currency and may want to present their financial statements in that same currency, which it could do. In addition, a group may consist of several entities each with a different functional currency and these entities need to be translated into a common currency in the consolidated financial statements. Where an entity’s functional currency is not the currency of a hyperinflationary economy (hyperinflation is inflation that is out of control), FRS 102, para 30.21 states that the following procedures are to be applied to translate the entity’s results and financial position into a different presentation currency: (a) all amounts (ie assets, liabilities, equity items, income and expenses, including comparatives) shall be translated at the closing rate at the date of the most recent statement of financial position, except that (b)

when amounts are translated into the currency of a non-hyperinflationary economy, comparative amounts shall be those that are presented as current period amounts in the relevant prior period financial statements.

FRS 102 does not prohibit the retranslation of amounts in respect of share capital and equity reserves. In practice, the translation of such equity amounts at closing rate would be meaningless because any differences would never be reclassified to profit or loss as a difference in equity pretranslation to equity post-translation would simply mean the difference is merely recognised in another component of equity. Accordingly, from a practical point of view, share capital and other components of equity should be translated using historical rate (ie, the rate at the date each amount of share capital was issued or the date of the transaction for equity reserves – eg, the revaluation reserve). The effect of this is that if share capital has been issued on multiple dates, more than one historical rate will apply in translating share capital to the presentation currency. This applies equally to other reserves, such as the revaluation reserve; if revaluations have taken place at more than one date, the rate at the date of each separate revaluation should be used for each. Using this approach, the balance on profit and loss reserves (retained earnings) will be a balancing figure due to the retranslation of assets and liabilities at closing rate and other equity items at historical rates. FRS 102 does not contain any requirement to take such differences to a foreign currency reserve to allow for subsequent recycling, unlike IAS 21.

201

10.10 Foreign Currency Issues

Example 10.8 – Retranslation into presentation currency The financial statements of Weaver Co are prepared using US Dollars as the functional currency. The parent company is located in the UK and prepares consolidated financial statements using GBP as its presentation currency. Summary financial statements for Weaver Co as at 31 March 2022 (when the exchange rate was £1:$1.50) are as follows: $’000

Net assets

Historical exchange rate

300

Equity and reserves Share capital (issued 1.7.19)

20

1.60

Share capital (issued 1.10.19)

50

1.65

Share capital (issued 1.12.19)

30

1.70

100 Revaluation reserve (1.8.19)

40

1.62

Revaluation reserve (31.3.20)

20

1.50

60 Retained earnings

140

Equity and reserves

300

The financial statements are translated into the presentation currency as follows: $’000

£’000

300

200

Share capital (issued 1.7.19)

20

12.5

Share capital (issued 1.10.19)

50

30.3

Net assets Equity and reserves

Share capital (issued 1.12.19)

30

17.6

100

60.4

Revaluation reserve (1.8.19)

40

24.7

Revaluation reserve (31.3.20)

20

13.3

60 Retained earnings

140

Equity and reserves

300

202

38.0 101.6 (balancing figure) 200

Foreign Currency Issues 10.11 Assume for the purposes of this example that opening net assets had been translated into GBP at a value of £100,000 and profit for the year was $200,000, translated at an average rate of 1.65 (giving £121,200). The difference of £21,200 is a foreign exchange adjustment which, together with the adjustments above, would pass through the consolidated statement of comprehensive income. A notable difference between FRS 102 and IAS 21 is that IAS 21 requires recycling of accumulated exchange differences on disposal of a foreign operation, whereas FRS 102, para 9.18A prohibits this and instead requires them to be transferred directly to retained earnings. This is the reason why FRS 102 does not specifically require such exchange differences to be accumulated in a separate foreign currency reserve.

INTRA-GROUP BALANCES AND TRANSACTIONS 10.11 The normal consolidation procedures apply when consolidating the results of a foreign operation with those of a parent – ie elimination of intragroup balances and transactions. Intra-group monetary assets or liabilities, regardless of whether they are long- or short-term, cannot be eliminated against the corresponding intra-group liability (or asset) without showing the results of currency fluctuations in the consolidated financial statements. This is because the monetary item represents a commitment to convert one currency into another and exposes the reporting entity to a gain or loss through changes in the exchange rate. Hence, in the consolidated financial statements, the reporting entity continues to recognise such an exchange difference within profit or loss. Where the exchange difference arises on a monetary item forming part of a reporting entity’s net investment in a foreign operation, it is recognised in other comprehensive income. Example 10.9 – Intra-group loan Belfry Co Ltd has a wholly owned subsidiary based in Austria. Belfry Co’s functional currency is the GBP, and the functional currency of the subsidiary is the Euro. The group has an accounting reference date of 30 April. On 1 May 2021, when the exchange rate was £1:€1.1 Belfry Co provided a GBP 50,000 loan to its Austrian subsidiary which is repayable in two years’ time and hence does not form part of the net investment in the Austrian subsidiary. On receipt the Austrian subsidiary will translate the loan at the transaction date rate to give €45,455 in its individual financial statements. No exchange difference will arise in Belfry Co’s financial statements because the loan is denominated in the entity’s functional currency. In the Austrian subsidiary’s financial statements, exchange differences will arise on translation at closing rate because the loan is a monetary item. Exchange differences on translation of this loan as at the year end 30 April 2022 are taken to profit

203

10.12 Foreign Currency Issues and loss. At the year end 30 April 2022, the exchange rate is now £1:€1.2, so as the loan is a monetary item the Austrian subsidiary will retranslate it to €41,667 (50,000/1.2). This creates a gain on translation in the Austrian subsidiary’s financial statements of €3,788, as the liability has got smaller due to the strengthening pound. On consolidation, all of the Austrian subsidiary’s assets and liabilities will be retranslated at the closing rate, in order to convert the figures into the presentation currency of GBP for the purpose of the consolidated financial statements. This means the €41,667 loan is multiplied back up by the year end rate of 1.2 to give a £50,000 liability in the accounts of the Austrian subsidiary. This intra-group loan will be eliminated from the consolidated balance sheet, with the £50,000 receivable in Belfry’s accounts. However, the exchange gain which has been recognised in the Austrian subsidiary’s profit and loss account remains within profit or loss, albeit it will be translated from the Euro figure into GBP to allow consolidation. This was the gain or loss is also recognised in the consolidated profit and loss account, as it reflects the impact on the group of foreign currency movements. Example 10.10 – Net investment in a foreign operation Belfry Co Ltd has a wholly owned subsidiary based in Austria. Belfry Co’s functional currency is the GBP, and the functional currency of the subsidiary is the Euro. The group has an accounting reference date of 30 April. On 1 May 2021, Belfry Co provided a GBP loan to its Austrian subsidiary which is regarded as forming part of the net investment in the Austrian subsidiary. Classification as ‘net investment in the foreign operation’ is because settlement of the loan is neither planned nor likely to occur in the foreseeable future. No exchange difference will arise in Belfry Co’s financial statements because the loan is denominated in the entity’s functional currency. In the Austrian subsidiary’s financial statements, exchange differences will arise on translation at closing rate because the loan is a monetary item. Exchange differences on translation of this loan on 30 April 2022 are taken to other comprehensive income. Using the information in the above example, the €3,788, once translated into GBP at the average rate, will be recognised in other comprehensive income, rather than profit or loss. This is because there is no intention to recover this money, so the fact that an exchange difference arises is not felt to be relevant for profit and loss for the year, hence FRS 102 requires it to be recognised in other comprehensive income.

GOODWILL ON ACQUISITION OF A FOREIGN OPERATION 10.12 Goodwill arising on the acquisition of a foreign operation, together with any fair value adjustments to the carrying amounts of assets and liabilities arising on the acquisition of that foreign operation are treated as assets and 204

Foreign Currency Issues 10.12 liabilities of the foreign operation. Therefore, they are expressed in the functional currency of the foreign operation and translated at closing rate as part of the normal translation procedures.

SUMMARY OF DIFFERENCES: FRS 102 V IFRS ●●

In the financial statements that include the foreign operation, such as the consolidated financial statements when a foreign operation is a subsidiary, exchange differences are recognised initially in other comprehensive income. This is the same treatment under both FRS 102 and IAS 21 The Effects of Changes in Foreign Exchange Rates. However, on disposal of the foreign operation, IAS 21 requires the gain or loss on disposal to be adjusted by the amount of the exchange differences that have been recognised in other comprehensive income (ie, the historical exchange rates are ‘recycled’ via profit or loss). FRS 102 prohibits this recycling, instead requiring a movement transferring the historical exchange rates directly into retained earnings.

CHAPTER SUMMARY ●●

Groups may have subsidiaries (or the parent) located overseas and hence the consolidated financial statements may include foreign currency transactions that will need to be translated into the parent’s functional currency for consolidation purposes.

●●

An entity’s functional currency is a matter of fact, not a choice. It is important that the entity correctly applies its functional currency having regard to primary and secondary indicators in FRS 102. Incorrect application of UK GAAP can result in significant issues arising as was the case in Ball Holdings v HMRC.

●●

There are four recognition and measurement rules which need to be followed when it comes to dealing with foreign currency transactions which include initial recognition and subsequent measurement. Monetary and non-monetary items need to be clearly understood.

●●

A change to an entity’s functional currency can only arise where there has been a change to the underlying transactions, events and conditions. It is generally uncommon to change an entity’s functional currency and there must be justifiable reasons for doing so.

●●

Exchange gains and losses are usually recognised in profit or loss, although there are occasions when they are recognised in other comprehensive income.

205

10.12 Foreign Currency Issues ●●

Average exchange rates can be used to translate income and expenditure, provided there has been no significant fluctuation in exchange rates.

●●

A net investment in a foreign operation is the amount of the reporting entity’s interest in the net assets of that operation and can include long-term loans which are not expected to be settled.

●●

An entity is free to choose its presentation currency and a UK-based entity could have a non-GBP functional currency but, in practice, this would need to be justified.

●●

Intra-group balances and transactions must be eliminated when consolidating the results of a foreign operation in the same way that such balances and transactions are eliminated in a non-foreign operation.

●●

Goodwill arising on the acquisition of a foreign operation is treated as an asset of the foreign operation.

206

Chapter 11

Group Reconstructions

SIGNPOSTS ●●

When a group reconstruction takes place, it is merely a rearrangement of the group as opposed to an acquisition or disposal of a group member (see 11.1).

●●

The merger method of accounting is a UK-specific concept and strict criteria exist in both FRS 102 and company law which must be met prior to it being applied (see 11.1).

●●

The merger method of accounting uses book values rather than fair values (see 11.2).

●●

Where non-controlling interests exist within a group, merger accounting would only be appropriate where the non-controlling interest in the net assets does not change (see 11.2).

●●

Specific disclosures must be made where a group reconstruction takes place (see 11.5).

INTRODUCTION 11.1 Group reconstructions are dealt with in FRS 102, paras 19.27 to 19.32 with the disclosure requirements for a group reconstruction being dealt with in paragraph 19.33 (see 11.5 below). A group reconstruction will usually arise when a company or business is moved around within the group. This can happen for a variety of reasons but is usually done to make the group more efficient, or there may be tax reasons for a reconstruction. When a group reconstruction takes place, it is merely a ‘rearrangement’ of the group rather than the acquisition or disposal of a group member(s). When certain conditions are met, FRS 102 allows the use of the ‘merger method’ of accounting. The merger method of accounting is UK-specific, hence is not found in IFRS 3, although similar principles will essentially be used under IFRS, as such transactions will be outside the scope of IFRS 3. The criteria to use the merger method of accounting is restrictive and CA 2006 also 207

11.2 Group Reconstructions outlines certain requirements which must be met before merger accounting is used. The term ‘group reconstruction’ is defined in the Glossary to FRS 102 as: ‘Any one of the following arrangements: (a) the transfer of an equity holding in a subsidiary from one group entity to another; (b) the addition of a new parent entity to a group; (c)

the transfer of equity holdings in one or more subsidiaries of a group to a new entity that is not a group entity but whose equity holders are the same as those of the group’s parent;

(d) the combination in a group of two or more entities that before the combination had the same equity holders; (e)

the transfer of the business of one group entity to another; or

(f)

the transfer of the business of one group entity to a new entity that is not a group entity but those equity holders are the same as those of the group’s parent.’1

MERGER ACCOUNTING 11.2 Merger accounting is a method of accounting for group reconstructions which involves the transfer of entire companies which primarily affects the consolidated financial statements. Separate financial statements may be affected by merger accounting; for example, where hybrid accounting is used when an unincorporated business has been transferred into another entity. The use of merger accounting means that book values, rather than fair values, are used which is a considerable difference when compared to acquisition/ purchase method of accounting (which uses fair values).

Focus The differences between the merger method and the purchase method mean that it is crucial a correct interpretation of whether a group reconstruction or business combination has taken place is made.

Merger accounting avoids the need to fair value transferred assets and liabilities and hence there is no recognition of goodwill because there is no purchaser, and no acquisition has taken place.

1

FRS 102 Glossary group reconstruction.

208

Group Reconstructions 11.2 Merger accounting in a group reconstruction can be used when the conditions in FRS 102, para 19.27 are met, which are as follows: ‘(a) the use of the merger accounting method is not prohibited by company law or other relevant legislation; (b) the ultimate equity holders remain the same, and the rights of each equity holder, relative to the others, are unchanged; and (c)

no non-controlling interest in the net assets of the group is altered by the transfer.’2

The Companies, Partnerships and Groups (Accounts and Reports) Regulations 2015 (SI 2015/980) amended the criteria for merger accounting so as to remove some of the conflicts between those criteria; although the amendments introduced new conflicts. Para 10 of Schedule 6 to The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410) states: ‘The conditions for accounting for an acquisition as a merger are— (a)

that the undertaking whose shares are acquired is ultimately controlled by the same party both before and after the acquisition,

(b) that the control referred to in paragraph (a) is not transitory, and (c) that adoption of the merger method accords with generally accepted accounting principles or practice.’3 Amendments to the Regulations in July 2015 did not trigger the Financial Reporting Council (FRC) to amend FRS 102, para 19.27. The FRC note in Appendix IV Note on legal requirements in the September 2015 edition of FRS 102 states that while the amended Regulations are generally consistent with the requirements of FRS 102, if an entity considers that, for the overriding purpose of a true and fair view, merger accounting should be applied in circumstances other than those in CA 2006, para 10 of Schedule 6 the entity may do so provided relevant disclosures are made in the notes to the financial statements.

Focus The legal requirements would only apply to consolidated financial statements and in situations where, for example, a hive-up or hive-down of trade or assets takes place, the true and fair override would not be necessary.

2 3

FRS 102, para 19.27(a)–(c). CA 2006, Sch 6, para 10.

209

11.2 Group Reconstructions Neither FRS 102, nor CA 2006, strictly prohibit the application of the acquisition/purchase method of accounting for a group reconstruction. However, where a group reconstruction takes place, the use of the merger method of accounting would be preferable because book values are used to consolidate the assets and liabilities which avoids the need to carry out a fair value exercise to determine the fair values of assets and liabilities. In practice, this is not only more cost effective but it is also more likely to enable the financial statements to give a true and fair view. Care must be taken in using acquisition accounting for a group reconstruction because the financial statements will almost certainly not give a true and fair view; particularly where it is not possible to apply all the requirements of FRS 102. It is always beneficial to carry out a careful assessment of whether merger or acquisition accounting is required by the law or standards or necessary to give a true and fair view. Merger accounting for a group reconstruction often takes a considerable amount of time and expertise to complete and so the task should not be underestimated. Where non-controlling interest (NCI) exists in a group, merger accounting would only be appropriate where the NCI in the net assets does not change. Therefore, where a group reconstruction takes place, the transfer of a subsidiary within a sub-group which contains NCI may qualify for merger accounting, but acquisition accounting must be applied to the transfer of a subsidiary into or out of a sub-group. Similarly, where NCI has increased or decreased (ie NCI have disposed of or acquired additional shares), the use of acquisition accounting is to be used. While merger accounting does not require the assets and liabilities to be fair valued, appropriate adjustments must be made to achieve uniformity of accounting policies with the combining entities. FRS 102, para 19.30 requires the results and cash flows of all the combining entities to be brought into the financial statements of the combined entity from the beginning of the financial year in which the business combination took place, adjusted so as to achieve uniformity of accounting policies. In addition, comparative information must be restated as if the entities which are a party to the combination had been combined throughout the previous accounting period and at the previous balance sheet date. The application of this principle is usually straightforward, although complications will often arise when dividing shareholders’ funds into called-up share capital and other classes of reserves because these essentially did not exist. A workaround to this problem could be to show only a total for shareholders’ funds with no division, subject to the relevant disclosure requirements for the type of company. If there is any difference between the nominal value of the shares issued plus the fair value of any other consideration given and the nominal value of the shares received in exchange, this difference is shown as a movement on other reserves in the consolidated financial statements which is a requirement of

210

Group Reconstructions 11.2 CA 2006 (Schedule 6, para 11(6)), although the Act does not specifically prescribe which type of reserve would be available to take this difference. Any existing balance on the share premium account or capital redemption reserve of the new subsidiary is brought into account by being shown as a movement on other reserves. All these movements must be shown in the statement of changes in equity. FRS 102, para 19.32 states that expenses incurred as a result of a merger are not included as part of the adjustments but are included in the profit or loss of the combined entity at the effective date of the group reconstruction. Example 11.1 – Group reconstruction: Investment has a carrying amount less than the nominal value of the shares acquired Sunnie Ltd acquires 100% of Morley Ltd in a group reconstruction. The value of the share capital in Morley is £300,000 and the transaction has been effected by Sunnie issuing new shares with a nominal value of £290,000. No share premium account exists. Sunnie uses merger accounting to deal with the group reconstruction and the balance sheets of each entity, and the group, post-group reconstruction, are as follows: Sunnie

Morley

Group

£’000

£’000

£’000

Investment in subsidiary Net assets

290

–

–

2,030

2,280

4,310

2,320

2,280

4,310

200

300

200

2,120

1,980

4,100

–

–

10

2,320

2,280

4,310

Share capital Retained earnings Other reserves

In this example, the carrying amount of the investment in Morley (£290,000) is less than the nominal value of the shares acquired (£300,000). Other reserves are reconciled as follows: £’000 Nominal value of shares acquired Nominal value of shares issued Difference

300 290 10

211

11.2 Group Reconstructions The group will treat the difference on consolidation as an ‘other reserve’ because the nominal value of the shares issued and the investment’s carrying amount is less than the nominal value of the shares acquired. If Morley Ltd had a balance on the share premium account or another reserve (eg, a capital redemption reserve), these would also be shown as a movement on other reserves. Example 11.2 – Group reconstruction: Investment has a carrying amount in excess of the nominal value of the shares acquired The facts are the same as in Example 11.1 above, but now consider that the nominal value of the shares acquired in Morley is £300,000 and the nominal value of the shares issued by Sunnie are £350,000. Again, no share premium account exists.

Investment in subsidiary Net assets Share capital Retained earnings Other reserves

Sunnie

Morley

Group

£’000

£’000

£’000

350

–

–

2,030

2,280

4,310

2,380

2,280

4,310

260

300

260

2,120

1,980

4,100

–

–

(50)

2,380

2,280

4,310

In this example, the carrying amount of the investment in Morley (£350,000) is more than the nominal value of the shares acquired (£300,000). Other reserves are reconciled as follows: £’000 Nominal value of shares acquired Nominal value of shares issued Difference

300 350 (50)

Example 11.3 – Shares issued when applying merger accounting Greaves Limited is acquired by Ratchford Limited in 2022. To effect this transaction, Ratchford issued shares to its parent in exchange for Greaves. Ratchford is using merger accounting in its consolidated financial statements to deal with the group reconstruction. Prior to the group reconstruction, Ratchford’s issued equity share capital is £150,000 consisting of 150,000 ordinary £1 shares issued at par. Greaves’ 212

Group Reconstructions 11.3 issued equity share capital consists of 300,000 ordinary shares at a par value of £0.75 per share. At the date of the transfer of Greaves, Ratchford issues 100,000 equity shares at par to its parent. The retained profits of both entities are as follows: Ratchford Retained profit

Greaves

2022

2021

2022

2021

£475,000

£323,000

£110,000

£98,000

No adjustments were needed in respect of uniformity of accounting policies. The consolidated profit and loss account is presented as if Ratchford and Greaves had always been combined, hence the consolidated profit and loss account for 2022 will show £585,000 (£475,000 + £110,000) and for 2021 £421,000 (£323,000 + £98,000). Ratchford’s ordinary share capital is adjusted to record the share issue as if it had been in existence at the start of 2021, hence Ratchford’s ordinary share capital is £250,000. There are no adjustments to other reserves because the number of shares issued is equivalent to the number of shares acquired.

Accounting periods 11.3 Often in a group reconstruction, a new entity is formed to effect a group reconstruction. Care must be taken when this route is taken because accounting complexities can arise if the length of the new parent’s accounting period is not the same as that of the other combining entities. Example 11.4 – New parent has a short accounting period Topco Limited was formed on 1 October 2021 to effect a group reconstruction by acquiring Subco Limited. The transaction was effected by Topco Limited issuing shares in exchange for Subco. Subco Limited has been trading for several years and has an accounting reference date of 31 March. Topco prepares consolidated financial statements and is accounting for the group reconstruction by applying merger accounting. The group finance director is unsure as to what figures should be used in the consolidated financial statements. Possible solutions The first potential solution would be to include Subco’s results for the period 1 October 2021 to 31 March 2022. However, the issue with this is that it omits

213

11.4 Group Reconstructions the first six months of trading and hence may not be ideal as the financial statements will effectively be incomplete in the group accounts. This is also not consistent with company law (see the second option below). The second (and, in the author’s opinion, better) solution would be to include the results of Topco Ltd for the period 1 October 2021 to 31 March 2022 and the full year’s trading results of Subco for the year 1 April 2021 to 31 March 2022. This second option is consistent with the requirements of The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410), Sch 6, para 2, which states: ‘The consolidated balance sheet and profit and loss account must incorporate in full the information contained in the individual accounts of the undertakings included in the consolidation, subject to the adjustments authorised or required by the following provisions of this Schedule and to such other adjustments (if any) as may be appropriate in accordance with generally accepted accounting principles or practice.’ Hence, the consolidated financial statements of the new parent for the period ended 31 March 2022 will include the new parent’s trading results for the six months and Subco’s results for the full year ended 31 March 2022. The comparative information presented would include Subco’s profit and loss account, statement of changes in equity, cash flow statement and balance sheet for the year ended 31 March 2021.

MERGER RELIEF 11.4 CA 2006, s 610 requires an entity which issues shares at a premium to recognise the premium in a share premium account. The share premium account can be used to make a bonus issue of shares. Section 612 Merger relief provides relief from creating a share premium account if the issuing company has secured at least a 90% equity holding in another company. As noted in 11.3 above, SI 2015/980 made amendments to para 10 of Schedule 6 to the Regulations, which now states that: ‘10. The conditions for accounting for an acquisition as a merger are— (a)

that the undertaking whose shares are acquired is ultimately controlled by the same party both before and after the acquisition,

(b) that the control referred to in (a) is not transitory, and (c) that adoption of the merger method accords with generally accepted accounting principles or practice.’ Prior to the amendments through SI 2015/980, para 10(a) referred to a holding of at least 90% of the nominal value of the relevant shares in the undertaking acquired being held by, or behalf of, the parent and its subsidiary undertakings. 214

Group Reconstructions 11.5 This 90% limited was repealed by SI 2015/980. The amended law also does not require at least a 90% holding to be achieved. Instead, the amended law focuses on the concept of control being maintained by the same party both before and after the combination and that control must not be transitory. Note, therefore, that the availability of merger relief does not necessarily mean that merger accounting is available, or appropriate, for the business combination in question. Merger relief is available potentially in many more situations than merger accounting, as in essence, it just requires more than 90% of the equity of a company to be purchased via the issue of equity shares. CA 2006, s 615 also relates to amounts in respect of share premiums not included in the share premium account due to the relief in s 612. Section 615 states that such amounts may also be disregarded in determining the amount at which any shares or other consideration provided for the shares issued is to be included in the company’s balance sheet.

Focus Notwithstanding the amended law not requiring at least a 90% holding being achieved, the threshold is still relevant to s 612 Merger relief. Hence, a conflict arises between paragraph 10 of Schedule 6 to the Accounting Regulations and s 612.

DISCLOSURES 11.5 FRS 102, para 19.33 requires the following to be disclosed in respect of group reconstructions: (a)

the names of the combining entities (other than the reporting entity);

(b) whether the combination has been accounted for as an acquisition or a merger; and (c)

the date of the combination.

SUMMARY OF DIFFERENCES: FRS 102 V IFRS ●●

Currently there is no equivalent to merger accounting under IFRS. At the time of writing, the International Accounting Standards Board had issued a Discussion Paper Business Combinations under Common Control, but no decision had been made as to when (or if) an Exposure Draft of a new IFRS Standard was to be issued.

215

11.5 Group Reconstructions

CHAPTER ROUNDUP ●●

A group reconstruction is usually accounted for using the merger method of accounting rather than the purchase method of accounting.

●●

The merger method of accounting uses book values rather than fair values and it is crucial that a correct interpretation of whether a group reconstruction OR business combination has taken place in order to apply the appropriate method.

●●

The purchase method of accounting can be used for a group reconstruction (FRS 102 does not mandate the merger method for group reconstructions), although careful assessment of whether the purchase method or the merger method is required by law or standards will be needed together with ensuring a true and fair view is presented.

●●

There are specific requirements in company law that must be complied with before the merger method of accounting can be used.

●●

CA 2006, s 612 provides relief from creating a share premium account if the issuing company has secured at least a 90% equity holding in another company.

●●

Certain disclosures are required to be made in the financial statements where a group reconstruction takes place.

216

Chapter 12

Auditing Groups

SIGNPOSTS ●●

The same acceptance protocol as that for a standalone audit applies to groups, although there are additional factors which must also be considered prior to acceptance which are specific to groups (see 12.3).

●●

The planning phase for a group will be much wider than that of a standalone audit because additional factors must be considered such as the group-wide risk assessment and the consolidation process (see 12.5).

●●

Complete reliance on component auditors cannot be placed and some audit work will have to be done by the group engagement team in respect of each component that has been consolidated (see 12.7).

●●

A comprehensive programme of communication is required between the group auditor, group engagement team and component auditors to ensure an efficient group audit takes place (see 12.8).

●●

The group audit engagement team must carry out some substantive procedures to detect material misstatement throughout the group audit (see 12.14).

●●

The group audit engagement team must evaluate the work of the component auditor and consider whether there is sufficient appropriate audit evidence, or establish what additional procedures are necessary to obtain such evidence (see 12.17).

●●

Support letters can be obtained by the group audit engagement team, but they will rarely serve as sufficient or appropriate audit evidence at group level (see 12.21).

INTRODUCTION 12.1 Group audits are inherently difficult assignments, particularly complex and large groups and careful planning will therefore be needed. Group auditors are required to have a sound understanding of the requirements of ISA (UK) 217

12.1 Auditing Groups 600 Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors) which is a specific ISA (UK) devoted to group audits. In a significant majority of cases, a group audit will be complex because of the numerous adjustments that are necessary to the components’ financial statements to arrive at the consolidated financial statements (or ‘group accounts’ as they are often referred to in the UK and Republic of Ireland). It follows that while the planning for a group audit will be largely similar to that of a standalone entity, other complexities will have to be considered such as group-wide controls and the consolidation process itself. The auditor’s objectives in respect of business combinations and groups are to ensure that sufficient appropriate audit evidence is obtained to form an opinion as to whether: (a)

intra-group transactions and balances have been correctly eliminated;

(b) all subsidiaries have been appropriately consolidated and apply uniform accounting policies; (c)

fair values used in the calculations have been correctly established;

(d) goodwill is free from material misstatement; (e)

non-controlling interest is reported correctly;

(f)

acquisitions and disposals arising during the reporting period have been accounted for and disclosed correctly; and

(g) related party disclosures are adequate. The group audit engagement partner is solely responsible for the group audit and the opinion contained in the group auditor’s report. In other words, the group auditor is also responsible for the audit work of all subsidiaries which it may not have audited, to the extent that the component’s results are included in the consolidated financial statements. The group audit engagement partner is not responsible for the statutory financial statements of the subsidiary. To that end, ISA (UK) 600 requires the group audit engagement partner to ensure that all component auditors (collectively) have the appropriate competence and capabilities. The group audit engagement partner is also responsible for the direction, supervision and performance of the group audit engagement.

Focus ISA (UK) 600 was revised by the Financial Reporting Council (FRC) in November 2019 and the revised ISA (UK) came into effect for audits of financial statements for accounting periods commencing on or after 15 December 2019 (ie, for 31 December 2020 financial statements onwards).

218

Auditing Groups 12.2 The revisions added to the 2016 edition of the ISA (UK) in respect of various requirements arising from The Statutory and Third Countries Audit Directive. In addition, the FRC also issued Staff Guidance Note 02/2018, which sets out how ISA (UK) 600 should be interpreted in certain key areas, such as whether a component is significant or material.

OBJECTIVES OF THE GROUP AUDITOR 12.2

According to ISA (UK) 600, the objectives of the auditor are:

‘(a) To determine whether to act as auditor of the group financial statements; and (b) If acting as the auditor of the group financial statements: (i) To communicate clearly with component auditors about the scope and timing of their work on financial information related to components and their findings; and (ii) To obtain sufficient appropriate audit evidence regarding the financial information of the components and the consolidation process to express an opinion on whether the group financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework.’1 The term ‘component’ is defined as: ‘An entity or business activity for which group or component management prepares financial information that should be included in the group financial statements.’2 The term ‘component auditor’ features a lot in ISA (UK) 600 and is defined as: ‘An auditor who, at the request of the group engagement team, performs work on financial information related to a component for the group audit. A component auditor may also be a Key Audit Partner.’3 The term ‘significant component’ is defined as: ‘A component identified by the group engagement team (i) that is of individual financial significance to the group, or (ii) that, due to its specific nature or circumstances, is likely to include significant risks of material misstatements of the group financial statements.’4

1 2 3 4

ISA (UK) 600, para 8. ISA (UK) 600, para 9(a). ISA (UK) 600, para 9(b). ISA (UK) 600, para 9(m).

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12.3 Auditing Groups

ACCEPTANCE 12.3 It should be noted that the same factors to consider apply to accepting appointment as group auditor as those of a single entity, although care must be taken to consider relationships and work done with all group companies by the audit firm as well as any other network firm, ie: (a)

the ethical considerations, such as whether independence and objectivity may be compromised by accepting appointment; for example, if any threats to independence and objectivity are present; and

(b)

whether the audit firm has the necessary resources to carry out the group audit. This is particularly important where the group is large and may have subsidiaries which are geographically spread or located overseas.

In addition to the normal pre-acceptance factors to consider, some issues which are specific to groups where the acceptance of the engagement (or continuance of the engagement is concerned) are as follows: ●●

whether the group auditor will be able to obtain sufficient appropriate audit evidence concerning the consolidation itself, together with the financial statements of all the components within the group; and

●●

where component auditors are involved, whether members of the group engagement team are to be involved in the work of component auditors.

Group auditors cannot accept a group audit engagement if the group engagement partner considers that it will not be possible to obtain sufficient appropriate audit evidence. Group auditors are required to obtain an understanding of the group, the components and their environments. The objective of obtaining this understanding is to identify components which are likely to be significant components. Group auditors are responsible for engaging component auditors. The auditor of a subsidiary’s individual financial statements only becomes a component auditor where they have been engaged as such. If they have not been engaged as a component auditor, the group auditor has no right of access to their work.

PLANNING THE GROUP AUDIT 12.4 ISA (UK) 600 requires the group audit team to develop an overall group audit strategy and a group audit plan which complies with the requirements of ISA (UK) 300 Planning an Audit of Financial Statements. The responsibility for the planning phase of the audit rests with the group audit engagement partner. It must be emphasised that the planning aspect of a group will require more work than the planning of a single entity due to additional complexities that are inherent in group audits, such as auditing a consolidation

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Auditing Groups 12.5 and consideration of group-wide controls and whether reliance can (or will) be placed on such controls. Planning issues will normally consider the following: ●●

Determining the size of the group (group audits in the UK are usually (but not always) confined to medium-sized and large groups as defined in CA 2006).

●●

Consideration of group-wide controls, such as: —— —— —— —— —— ——

does the group use an internal audit function; is there adequate segregation of duties; how often do group and component management meet; what is the group’s risk assessment procedure; is there a centralised financial reporting function; and are there group-wide fraud prevention strategies.

●●

Any issues which may give rise to a limitation of scope – hence a potentially modified audit opinion.

●●

Is the accounting function centralised, or do the components operate their own finance teams?

●●

Consideration of group accounting issues, in particular: —— how effective the elimination process is in terms of intra-group transactions and balances; —— uniformity of accounting policies or the need for any consolidation adjustments due to differing accounting policies across the group; and —— uniformity of accounting reference dates.

Key internal controls will be documented at the planning phase, and this can take various forms. For example, flowcharts may be used whereby lines demonstrate the sequence of events and symbols are used to signify significant controls or documents. For recurring group engagements, key internal controls will also be documented on the permanent audit file and should be updated on an annual basis. The group audit team should also consider the results of the prior year’s audit and determine whether there were any problems encountered, such as inefficient internal controls or scope limitations (ie, insufficient evidence available). The auditor’s reports for individual components should also be reviewed to establish whether the component auditors encountered any difficulties during the previous year’s audit which may impact on the current year.

Risk assessment 12.5 The risk assessment process is a fundamental stage in the planning of any audit. Risk assessments will essentially determine the level of substantive 221

12.6 Auditing Groups procedures which the auditor will execute during the audit of the group. Where the risk of material misstatement is judged to be high, the group auditor may decide to place less reliance on internal controls and instead carry out more detailed substantive procedures (tests of detail). This, of course, will increase the time taken on the audit and this should be considered at an early stage of the group audit process. Key factors to consider in the risk assessment process are: ●●

key factors at component level which may be significant to the group;

●●

the susceptibility of the component’s financial statements to material misstatement;

●●

technical competency of the component auditors to audit the financial statements; and

●●

reviews of the risk assessments of the components to identify if there are any significant risks of material misstatement which may need to be considered by the group auditor.

The group audit team must undertake an assessment of the component auditors. This assessment is necessary to not only determine the technical competence of the component auditor (although, clearly this is an important consideration), but to also establish whether the component auditors understand, and will comply with, ethical requirements which are relevant to the group, including independence requirements. In addition, the group auditor must also consider whether the group engagement team will be involved in the work of the component auditor to the extent necessary to obtain sufficient appropriate audit evidence.

Materiality 12.6 The group engagement team is required to determine a materiality level for the group financial statements as a whole when establishing the overall group audit strategy. Ordinarily, group materiality should be higher than the materiality levels for the individual components to reduce the risk of material misstatement in the group accounts.

Focus Where a specific component contains a higher risk of material misstatement, then particular attention must be paid to the areas of the component which are considered to be high risk. Appropriate substantive procedures should be applied to particular classes of transactions and balances which may be materially misstated.

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Auditing Groups 12.6 Materiality is dealt with in ISA (UK) 320 Materiality in Planning and Performing an Audit and is a matter of judgement. There is no ‘one-size-fitsall’ where materiality is concerned and while materiality levels (including performance and triviality levels) are established at the planning stage, they should be kept under review during the audit as they may need to be revised if problems are encountered by either the group auditor or the component auditor. The reasons for changing materiality levels during the course of the group audit should also be documented by both the group audit engagement team and the component auditors. Materiality levels are driven by the group and component auditor’s assessment of risk. The risk of material misstatement is higher in the following situations: ●●

there are poor or inadequate internal controls;

●●

management take a poor attitude towards good corporate governance;

●●

the structure of the group is complex and frequently changes;

●●

there are unusual transactions with related parties;

●●

there is poor financial monitoring;

●●

there is a history of significant errors in the financial statements discovered by the group or component auditor;

●●

the group undertakes business in high-risk areas, such as those on the Financial Action Task Force’s ‘blacklist’;

●●

accounting policies and accounting reference dates are not coterminous across the group for reasons other than necessity to comply with issues such as legislation;

●●

tax planning involves the use of aggressive tax avoidance schemes;

●●

there is a frequent change of auditor;

●●

there are significant problems in agreeing intra-group balances; and

●●

there are significant cash flow difficulties among components of the group.

Whenever there is a revision to materiality levels, the reasons for the change should be documented. Where the group or component auditor has discovered an issue which warrants a reduction to materiality levels (eg, a significant accounting problem), not only will the materiality levels need to be revised, but the overall audit plan should be revisited and changed where appropriate to reflect the new facts. As with a change in materiality levels, the reasons for changes to the audit plan should also be adequately documented on the working papers file.

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12.7 Auditing Groups

RELIANCE ON THE WORK OF COMPONENT AUDITORS 12.7 The group audit engagement team cannot rely solely on the work of the component auditors without carrying out at least some evaluation work to consider the standard of the work of the component auditors, as well as considering the component auditors’ compliance with ethical standards. For components which are not significant components, ISA (UK) 600 requires the group engagement team to perform analytical procedures at group level as a minimum – although in practice, additional procedures are usually applied to ensure the group auditor has sufficient appropriate audit evidence on file on which to base the group audit opinion. Complete reliance on component auditors is not possible because the group audit engagement partner takes full responsibility for the consolidated financial statements. Where a component auditor has carried out deficient audit work which has failed to detect a material misstatement, the group auditor will be responsible as the component will be included in the group financial statements. In practice, this could result in a negligence claim being brought against the group auditor as well as sanctions from the group auditor’s professional body and/or the Financial Reporting Council (who are expected to transition to the ‘Audit, Reporting and Governance Authority’ in 2023). The group auditor has a responsibility for ensuring that component auditors: (a) are independent and objective in their work and have dealt adequately with any threats to independence and objectivity (any such threats should be brought to the attention of the group audit engagement partner as soon as practicably possible); (b) the component audit team is professionally competent to carry out the work; (c) the group audit team is able to become involved in the work of the component auditors; and (d) the component auditors are regulated by an appropriate body which will ensure compliance with ethical standards and International Standards on Auditing.

Focus In practice, technical competence is not usually a major issue because audit firms should not (from an ethical stance) take on work which they are neither competent to carry out nor have adequate resources to fulfil the requirements under the ISAs (UK). The issues in a group audit which usually cause problems are the size of the component auditor and the significance of the component to the group; the availability of audit staff (particularly at busier times in the audit firm) and any particularly tight

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Auditing Groups 12.8 deadlines imposed by the client. Where tight deadlines are imposed, it is important that the group auditor considers whether adequate procedures can be applied in the time given to gather sufficient appropriate audit evidence. Where the group auditor deems the time given to be insufficient, the group auditor must communicate such concerns with management and/ or those charged with governance. Such tight deadlines could give rise to a modified audit opinion on the basis of a limitation in audit scope. The group auditor must ensure that procedures are implemented which will allow adequate time to review the work of the component auditor. The primary purpose of this review is to ensure that sufficient appropriate audit evidence is obtained on which to base the group auditor’s opinion. If the group auditor has any concerns about the quality of the work carried out by the component auditor or has any concerns about the professional competence of the group auditor, the group audit engagement team should carry out the work or request another component auditor to carry out the work. In practice, this occurrence is rare due to the pre-acceptance procedures required by audit firms prior to agreeing to carry out the audit.

Communication with the component auditor 12.8 It is important that the group engagement team communicates, on a timely basis, with the component auditor. Such communication must include the work that is to be performed and the use to be made of that work, together with the form and content of the component auditor’s communication with the group engagement team. In addition, the following must also be communicated to the component auditor: ●●

A request that the component auditor will co-operate with the group engagement team.

●●

The ethical requirements which are relevant to the group audit; especially independence requirements.

●●

Component materiality including, where applicable, the materiality level(s) for particular classes of transactions, account balances or disclosures and the threshold above which misstatements are not to be regarded as clearly trivial to the group financial statements. Performance materiality levels are also communicated.

●●

Identified significant risks of material misstatement of the group financial statements due to fraud or error which are relevant to the work of the component auditor. The component auditor must be requested to communicate any other identified significant risks of material misstatement of the group financial statements due to fraud or error in the component together with the component auditor’s response to this/ these risk(s). 225

12.9 Auditing Groups ●●

A schedule of related parties prepared by group management, together with any other related parties of which the group audit team is aware. The group engagement team must request that the component auditor communicate any other related parties of which they were previously unaware on a timely basis. The group engagement team will then decide whether to identify any additional related parties to the other component auditors.

●●

A request that the component auditor communicates to the group audit team: —— whether the component auditor has complied with ethical requirements relevant to the group audit; in particular independence issues and professional competence; —— whether the component auditor has complied with the engagement team’s requirements; —— identification of the financial information of the component on which the component auditor is reporting; —— instances of non-compliance with laws or regulations which may give rise to a material misstatement in the group financial statements; —— a schedule of uncorrected misstatements in the component’s financial statements (the schedule need not include misstatements below the threshold for clearly trivial misstatements); —— indicators of possible management bias; —— identified significant deficiencies in internal control of the component; —— other significant matters which the component auditor has communicated, or expects to communicate, to those charged with governance of the component, including actual or suspected fraud involving component management, employees who have a significant role in internal control of the component or others where the fraud resulted in a material misstatement of the component’s financial information; —— any other matters which may be relevant to the group audit, or which the component auditor wishes to bring to the attention of the group engagement team (eg, exceptions noted in written representations received from management); and —— the component auditor’s overall findings, conclusions or opinion.

AUDITING INVESTMENTS IN SUBSIDIARIES 12.9 The cost of the investment in the subsidiary will be included in the parent’s individual financial statements within fixed assets. In the consolidated

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Auditing Groups 12.10 financial statements, the cost of the investment is replaced by the group’s share of the subsidiary’s net assets, and any associated goodwill. Procedures which the auditor may adopt to audit the investment in the subsidiary include the following (note the list below is not designed to be a comprehensive list): ●●

Obtain copies of documentation on acquisition of the subsidiary and agree the date on which the parent obtained control (ie, the date of acquisition).

●●

Where control has passed, ensure that it is the parent that has acquired the subsidiary.

●●

Determine the level of consideration and contingent consideration and ensure that all acquisition-related costs (such as legal fees) have been included in the cost of the acquisition.

●●

Obtain the schedule of fair values of assets and liabilities included in the acquisition and agree the fair valuations placed on these to supporting documentation.

●●

In respect of deferred consideration, agree this to the sale agreement and ensure that any discount rate is appropriate (ie, the discount rate is the rate which the acquirer would be expected to be charged for a similar borrowing).

●●

Obtain details of the due diligence work to assess the fair values of assets and liabilities and review the uplift of any assets, such as property to valuation reports.

●●

Compute or check the calculation of the deferred tax arising on the acquisition and agree the closing balance and the movements to the financial statements.

●●

Compute or check the calculation of the goodwill arising on acquisition and agree this to the consolidated financial statements.

●●

Where negative goodwill has arisen, ensure that this has been calculated and presented correctly in the consolidated financial statements. Note, under IFRS 3 Business Combinations, negative goodwill is written off to the income statement immediately – it should not be included in the statement of financial position (balance sheet).

●●

Review the amortisation policy of goodwill to ensure that it is in compliance with FRS 102 (note that goodwill is not amortised under IFRS 3 but is instead tested for impairment at each reporting date).

AUDITING THE CONSOLIDATION 12.10 The group engagement team must obtain an understanding of group-wide controls and the consolidation process and assess their effectiveness. 227

12.10 Auditing Groups The group audit team must then test the effectiveness of those controls where the nature, timing and extent of work performed on the consolidation process is based on an expectation that group-wide controls are operating effectively, or where substantive procedures alone would not be capable of providing sufficient appropriate audit evidence at the assertion level. The audit programme should contain comprehensive procedures to be applied which appropriately respond to the assessed levels of risk of material misstatement arising from the consolidation process. For example, if the group-wide controls are assessed as being poor, this will create a higher risk of material misstatement than if they were operating effectively. To address this risk, the group engagement team would apply more substantive procedures to the relevant controls and consolidation process rather than place reliance on the controls. Focus In practice, group audits will be carried out using software-generated audit programmes which will contain pre-determined (generic) procedures. It is important that these are tailored to be specific to the group as some procedures may not be relevant and, conversely, the audit programme may not contain certain audit procedures which become relevant to the group or component being audited. Tailoring audit programmes enables a more efficient audit to be carried out, rather than a ‘tick box’ approach being adopted.

Typical procedures the auditor will perform at group level include the following: ●●

Obtain or prepare reconciliations of intra-group transactions and balances and ensure these have been appropriately eliminated at group level. Such transactions will include: —— intra-group sales and purchases, debtors and creditors; —— fixed assets transfers; —— interest charges and interest income and associated loan receivables and payables; —— management recharges; and —— unrealised profit in stocks.

●●

Obtain or prepare reconciliations of: —— —— —— —— ——

non-controlling interests; goodwill arising on consolidation; group tax including deferred tax; reserves movements for the current accounting period; and intra-group balances at the reporting date. 228

Auditing Groups 12.12 These reconciliations should be agreed to the group financial statements to ensure no material misstatement has arisen during the consolidation process. During the audit of the consolidation process, the group auditor may test the operational effectiveness of controls by reviewing exception reports; asking the directors if there have been any significant problems encountered during the consolidation process, or using test data to assess the effectiveness of the control procedures during the consolidation. In practice, a detailed consolidation schedule will be maintained by the parent entity, and this should be reviewed in detail by the group auditor to identify any omissions or misstatements which may be present. However, the auditor must also ensure that procedures are adopted over the audit trail from the component’s financial statements into the consolidated financial statements. Sometimes, however, the client will not have performed the consolidation and will engage the audit firm to prepare it on the client’s behalf. In that case, it is essential that the auditor considers independence issues and implements appropriate safeguards to address the threat to independence.

Analytical procedures 12.11 Analytical procedures should be applied to those components which are judged by the group auditor as being insignificant. However, analytical procedures are not confined to simply insignificant components as they must be applied throughout the course of the audit to comply with the requirements of ISA (UK) 520 Analytical Procedures. Analytical procedures can be applied to: ●●

intra-group balances and transactions; and

●●

the consolidation process.

Intra-group balances and transactions 12.12

Analytical procedures which may be carried out include:

●●

Reviewing the number and size of intra-group balances, comparing these to the prior year and investigating any significant variations. The group auditor can also use their knowledge and understanding of the group to assess current year expectations.

●●

If management charges have been levied across the group, compare the value of these in the current year to the previous year or against the auditor’s knowledge of the group and investigate any significant variations.

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12.13 Auditing Groups

Consolidation process 12.13 ●●

Where unrealised profits exist (eg, in stock), assess the values against prior years and/or the auditor’s knowledge and expectations and investigate any significant variations.

●●

Perform a proof-in-total test on the amortisation charge of goodwill (for FRS 102 reporters) and identify any misstatement between the auditor’s expected charge and the charge per the consolidated financial statements. Consider whether the amortisation rate is reasonable and whether there is any indication of impairment.

●●

Review the level of non-controlling interest against expectations.

Substantive procedures 12.14 The group auditor must carry out substantive procedures which aim to detect material misstatement. Substantive procedures must be increased where the auditor concludes that the control environment is weak or where the auditor finds issues which give rise to either fraud risk factors or material misstatement. Substantive procedures which may be used include the following: ●●

Obtain intra-group balances (trade and sundry debtors and/or trade and sundry creditors) and agree these to the individual sales and purchase ledgers.

●●

If the group has intra-group loans among subsidiaries agree these to any source documentation (eg, loan terms or agreements) and agree a sample of transactions.

●●

Obtain direct confirmation from group members concerning any intragroup balances; whether these arise from direct trading or from loan transactions.

●●

If considered appropriate, contact the component auditors directly and ask for confirmation of balances from components and discuss their knowledge of related party transactions to identify any undisclosed related parties.

●●

Where intra-group loans have been entered into, ensure that amounts included in the calculation of the closing balance are applicable to the financial reporting framework (eg, use of market rates for off-rate market loans or if loan terms are not in existence, that the loan is treated as current as it will be repayable on demand).

●●

Ensure that no netting-off has taken place between intra-group debtors and creditors.

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Auditing Groups 12.15 ●●

Where group balances have been outstanding for long periods of time, assess recoverability.

●●

Inquire of management of any security pledged for intra-group loans and review any associated disclosures in the financial statements for adequacy.

●●

If management charges are incurred, agree the terms of these and determine whether they are concluded under normal market conditions (ie, on an arm’s length basis).

●●

Where there are any loss-making subsidiaries in the group, consider the carrying amount of the subsidiary in the parent’s individual financial statements (cost of investment and any debtor balances) as the fact they are making losses may indicate the need for an impairment write-down.

●●

Where a subsidiary is loss-making, consider the need for a ‘support letter’ (sometimes referred to as ‘comfort letters’ – see 12.21 below).

●●

For loss-making subsidiaries, ensure any support granted from a third party (eg, the parent) is realistic and that the supporter can provide the necessary support to enable the loss-making subsidiary to be regarded as a going concern.

●●

Review fair value adjustments carried out at the date of acquisition (eg, in respect of property, plant and equipment) and ensure these have been correctly calculated and agree the fair values to supporting documentation.

OBTAINING SUFFICIENT AUDIT EVIDENCE 12.15 Depending on the size and complexity of the group, the group audit engagement team can undertake additional procedures to obtain sufficient appropriate audit evidence as follows: ●●

For subsidiaries disposed of during the year, recalculate the profit and loss on disposal and agree to the financial statements. Agree disposal proceeds to supporting documentation and the accounting records (eg, cash book and original bank statements) and ensure any related goodwill is removed.

●●

For acquisitions of further ownership interest in existing subsidiaries, ensure that such transactions are treated as transactions among equity holders (ie, the value of the non-controlling interest is reduced and the parent’s equity increased). No adjustment to goodwill is made under FRS 102 for additional ownership interests where control was previously obtained.

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12.15 Auditing Groups ●●

For disposals of interests where the parent retains control following the disposal, ensure the transaction is accounted for as a transaction among equity holders (ie, the value of non-controlling interest is increased and the parent’s equity decreased). No gain or loss is included in the profit and loss account.

●●

Reviewing questionnaires (internal control questionnaires (which contain a list of controls given to the client to say whether, or not, those controls are in place or internal control evaluation questionnaires (a questionnaire which asks the client what controls they have in place for a given control objective)) and considering whether the responses give rise to potential risks of material misstatement at group level.

●●

Select a sample of subsidiaries’ individual financial statements and review these against budgeted information for that particular subsidiary. Inquire of management and investigate any significant variations.

●●

Where there have been any deviations from group accounting policies, enquire as to the reasons and assess if this provides evidence of potential material misstatement.

●●

Obtain details of the group structure at the reporting date and consider whether all components have been included in the consolidation. For any subsidiaries not included in the consolidation, inquire of management as to the reasons for not consolidating and confirm this is acceptable (note, subsidiaries can only be excluded from consolidation if they meet the exceptions/exemptions available in company law or accounting standards, or if they are immaterial to the group in combination as well as in isolation).

●●

Where individual components’ financial statements are prepared on a different basis than the group (eg, different accounting reference dates and different accounting policies) ensure adequate consolidation adjustments have been made in the consolidated financial statements.

●●

Obtain the working papers files for all significant components and ensure that the work is done in accordance with the instructions from the group auditor and sufficient appropriate audit evidence has been obtained on which the auditor’s opinion can be based.

●●

Ensure that all contentious matters and difficulties at component level have been resolved.

●●

Ensure that all components in the consolidated financial statements are being provided with an unqualified opinion. If this is not the case, assess the impact this will have on the group auditor’s opinion in the consolidated financial statements.

●●

Obtain the consolidation schedule and cast the schedule to confirm accuracy.

●●

Agree all eliminating journals and reconciliations in respect of intragroup trading and intra-group balances to ensure all intra-group matters 232

Auditing Groups 12.15 are eliminated from the consolidated financial statements. This will involve obtaining the consolidation schedule and agreeing the elimination process has been carried out correctly. ●●

Ensure the completeness and accuracy of current and deferred tax on consolidation adjustments is correct.

●●

Where contingent consideration has been discounted, ensure the rate used is appropriate.

●●

In respect of due diligence work for in-year acquisitions, assess the competency of those performing the due diligence work.

●●

Obtain written representations from the group that the consolidation process is complete and all applicable subsidiaries have been included in the consolidation.

Focus The requirement for written representations is outlined in ISA (UK) 580 Written Representations. Written representations cannot be used as sole audit evidence and are not a substitute for the group audit engagement team performing specific audit procedures to gather sufficient appropriate audit evidence as such representations are internally generated. The objective of written representations is to complement existing audit evidence.

●●

Perform subsequent events procedures to identify events at those components which occur between the balance sheet date and the date of the auditor’s report on the group financial statements which may require adjustment or disclosure in the group financial statements. This may necessitate extending the work done on the parent’s own or subsidiaries’ audit files, especially if there is a time lag between the signing off of the parent or subsidiaries’ own auditor’s reports and that of the group.

●●

Ensure the documentation in the group audit working papers file includes an analysis of components, indicating those which are significant, and the type of work performed on the financial information of those components, together with: —— the nature, timing and extent of the group engagement team’s involvement in the work performed by the component auditors on significant components; and —— the group engagement team’s review of relevant parts of the component auditors’ audit documentation and conclusions.

●●

Ensure that the group audit file contains documentation outlining the communications between the group engagement team and the component auditors concerning the group engagement team’s requirements.

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12.16 Auditing Groups

Evaluating the sufficiency and appropriateness of the audit evidence 12.16 In addition to evaluating the work of the component auditor, the group engagement team must also evaluate the component auditor’s communication, including: ●●

discussing significant matters that have arisen from that evaluation with the component auditor, component management or group management, as appropriate; and

●●

determining whether a review of other relevant parts of the component auditor’s audit documentation is necessary.

ISA (UK) 600 specifically requires the group engagement team to carry out a review of the work performed by the component auditor. In practice, this will often be done in conjunction with the group audit engagement partner because it is the engagement partner who is ultimately responsible for the auditor’s report on the consolidated financial statements. It would be reckless to form an opinion on the consolidated financial statements without reviewing the work of components because issues could have arisen at component level which may impact on the opinion to be expressed in the consolidated financial statements if those issues are not resolved satisfactorily. Appropriate measures, such as outsourcing audit procedures or performing them directly, must be undertaken by the group engagement team in the event that they cannot secure the agreement to review the work of the component auditor. In practice, this is likely to be rare as full co-operation will usually be granted by the component auditor to the group audit team at the outset.

Sufficiency and appropriateness of audit evidence 12.17 In the event that the group engagement team concludes that the work of the component auditor is insufficient, the group engagement team must then establish what additional procedures are to be performed to turn this situation around. In addition, the group engagement team must decide who is to perform the additional procedures; ie whether it is the component auditor or whether the group engagement team are to perform the procedures at the component. In situations where audit evidence is insufficient and the group engagement team conclude that this is due to the component auditor’s inability or lack of knowledge, it is advisable for the group engagement team to carry out the additional procedures to try and avoid any potential modification of the group auditor’s opinion. In all audits, including component audits, the auditor is required to obtain sufficient and appropriate audit evidence to reduce audit risk (the risk that the auditor forms an incorrect opinion on the financial statements) to an acceptably low level. To that end, the group engagement team must evaluate 234

Auditing Groups 12.18 whether sufficient appropriate audit evidence has been obtained from the audit procedures performed on the consolidation process as well as the work performed by both the group engagement team and the component auditors. It is the responsibility of the group engagement partner to evaluate uncorrected misstatements which have been identified during the course of the audit and to assess the impact of these uncorrected misstatements on the auditor’s report. Where there have also been limitations of scope (ie, the auditor has been unable to obtain sufficient appropriate evidence) placed on the audit team at either group level or component level, the group engagement partner must assess whether this inability to obtain sufficient appropriate audit evidence gives rise to a modification of the group auditor’s opinion.

COMMUNICATION WITH GROUP MANAGEMENT 12.18 Where the group engagement team have identified deficiencies in the internal control environment, the group engagement team must determine which deficiencies are to be communicated to group management in accordance with ISA (UK) 260 Communicating Deficiencies in Internal Control to Those Charged with Governance and Management. In some instances, group management may wish to be notified of all deficiencies identified so that remedial action can be taken; however, in other cases the auditor may only decide to notify group management of certain deficiencies and hence the group engagement team must consider: (a)

deficiencies in group-wide internal controls that have been identified by the group engagement team;

(b) deficiencies in internal control which the group engagement team have identified in internal controls at components; and (c) deficiencies in internal control which the component auditors have brought to the attention of the group engagement team. Where fraud has been identified, or information acquired by either component auditors or the group engagement team, indicates that a fraud may exist, the group engagement team must discuss this issue with an appropriate level of group management on a timely basis. Focus It is important where fraud issues are concerned that the audit engagement team exercises caution and ensures that they fully comply with their obligations under anti-money laundering legislation. It is advisable to seek the advice of a professional body/other expert where such issues are concerned to ensure that the client is not ‘tipped off’ and that the team does not place themselves in a questionable position.

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12.19 Auditing Groups Component auditors may be required to express an audit opinion on the financial statements of the component. When this is the case, the group engagement team must ask group management to inform the component’s management of any matter which the group engagement team becomes aware which may be significant to the component’s financial statements. If group management refuse to discuss such issues with component management, the group engagement team must discuss the matter with those charged with governance. When the matter remains unresolved, the group engagement team, having regard to legal and professional confidentiality considerations, must consider whether it is appropriate to advise the component auditor not to issue the auditor’s report on the financial statements of the component until the matter is resolved.

COMMUNICATION WITH THOSE CHARGED WITH GOVERNANCE OF THE GROUP 12.19 In addition to reporting to management on internal control deficiencies under ISA (UK) 260 (as mentioned in 12.18 above), the group engagement team must communicate the following matters with those charged with governance of the group: ●●

A general overview of the type of work that is to be performed on the financial information of components.

●●

An overview of the nature of the group engagement team’s planned involvement in the work to be performed by the component auditors on the financial information of components (including significant components).

●●

Instances where the group engagement team’s evaluation of the work of a component auditor gave rise to concerns about the quality of that auditor’s work.

●●

Any limitations on the group audit.

●●

Fraud, including suspected fraud, involving group management, component management, employees who have a significant role in group-wide controls or others where the fraud has resulted in a material misstatement in the group financial statements.

OVERSEAS SUBSIDIARIES 12.20 A group may have a subsidiary, or subsidiaries, located overseas, and this may cause the group auditor some logistical problems. For example: ●●

the subsidiary may be located in a jurisdiction with no requirement to have an audit under International Standards on Auditing. This may give

236

Auditing Groups 12.21 rise to the need to request the component auditor to carry out additional testing; ●●

if the financial statements of the subsidiary are prepared in a local currency, they will need to be translated into the currency of the consolidated financial statements giving rise to additional work on the translation process;

●●

where the auditor has significant doubts about the standard and quality of the financial information of the overseas subsidiary, or the audit of the subsidiary’s financial statements, the group auditor may have to express a modified opinion; and

●●

language barriers may have a detrimental impact on the ability of the group auditor to obtain sufficient appropriate audit evidence.

In practice, where a parent has an overseas subsidiary which is material to the group, the group auditor will take account of these factors during the preacceptance process when determining whether, or not, to accept the audit engagement.

SUPPORT LETTERS 12.21 In rare situations, the group auditor may conclude it necessary to obtain a ‘support letter’ (sometimes referred to as a ‘comfort letter’) from the parent where a subsidiary is, for example, loss-making or there are material uncertainties relating to the subsidiary’s ability to continue as a going concern which have been adequately disclosed. However, such letters will rarely serve as sufficient or appropriate audit evidence at group level.

Focus Support letters are relevant for the subsidiary’s individual financial statements. However, in practice, they may not be useful to the component auditor unless they are received from an individual shareholder(s) and backed up with evidence of the ability of the company or shareholder to provide the relevant support.

In practice, letters of support are generally only relevant for the subsidiary’s individual financial statements and will not usually be helpful to the group auditor as they are not being provided within any guarantee. It may be interesting to note that a support letter was provided by Taveta Group in respect of BHS, but specifically stated that support would be maintained ‘whilst the companies continued to be under the control of Taveta 2’. There was already a well-advanced plan to sell BHS, and so the support of the group

237

12.22 Auditing Groups was intended to be very short term. This is another reason to be appropriately sceptical about group support letters, as even where they are provided, they may have caveats, or there may be other factors that ultimately affect the support given. Focus Obtaining a support letter from the directors of the group is not a substitute for the auditor undertaking the relevant going concern procedures. Again, support letters are internally generated and are designed to complement existing audit work, such as the work performed by the auditor on going concern. If a modified auditor’s opinion is to be avoided, the component auditor must be satisfied that the parent has the means to continue to support the company and has a genuine underlying reason for wanting to continue to support the subsidiary. If the parent, itself, is loss-making, the auditor may conclude that neither the parent nor the subsidiary is a going concern, and this could result in an adverse or disclaimer of opinion where the financial statements are prepared on a going concern basis. The group auditor must not, therefore, simply accept the support letter as definitive and must evaluate the overall going concern ability of the parent and the going concern work performed at both group level and component level.

TRANSNATIONAL AUDITS 12.22 A ‘transnational’ audit is an audit which may be relied upon in more than one country. This will cause issues for UK auditors because there will inevitably be some significant differences in company law and regulation of the audit profession in different countries. Issues primarily faced by auditors of transnational audits include: ●●

the regulation and oversight of auditors may take different forms and the quality of the audit work may not be at the same standard as that of the UK, hence there will be inconsistency in audit practice;

●●

corporate governance requirements will be different in other jurisdictions than in the UK; this will affect listed groups in the UK which have transnational audits. Where corporate governance is weak in a certain country, this will give rise to poor oversight of directors, poor internal structures (such as a lack of internal audit) which, in turn, will create a poor internal control environment; and

●●

there may be differences in accounting requirements – although with increasing harmonisation to IFRS, this is become less of a problem for transnational audits. However, for a company reporting under, say, US GAAP, there are significant differences between that and IFRS.

238

Auditing Groups 12.23 The issues listed above are not exhaustive and transnational audits can also cause some group- or company-specific issues.

DOCUMENTATION 12.23 The group engagement team must include the following matters in their audit documentation: ●●

A schedule analysing the components, including those which are significant, and the type of work performed on the financial information of the components.

●●

The nature, timing and extent of the group engagement team’s involvement in the work carried out by component auditors on significant components and other components including, where applicable, the group engagement team’s review of relevant parts of the component auditors’ audit documentation and conclusions reached thereon.

●●

Written communications that have taken place between the group engagement team and the component auditors concerning the group engagement team’s requirements.

●●

The group engagement team must retain sufficient and appropriate audit documentation to enable the competent authority (ie, the FRC) to review the work of the auditor of the group financial statements.

Not all audit firms are reviewed by the FRC, as the FRC usually confine their inspections to firms that carry out major audits as well as focusing on key industry sectors. However, where the group engagement team is subject to a quality assurance review or investigation concerning the group audit and the FRC is unable to obtain audit documentation of the work carried out by any component auditor from outside of the UK, the FRC can request delivery of any additional documentation of the work performed by that component auditor for the purpose of the group audit. To that end, the group engagement team must properly deliver such documentation and must therefore: ●●

retain copies of the documentation of the work carried out by the relevant component auditor for the purpose of the group audit; or

●●

obtain the agreement of the relevant component auditor that the group engagement team can have unrestricted access to such documentation on request; or

●●

retain documentation to show that the group engagement team has carried out the appropriate procedures in order to gain access to the audit documentation, together with supporting evidence in the event such access is prevented; or

●●

take any other appropriate action.

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12.23 Auditing Groups

CHAPTER ROUNDUP ●●

Group audits are inherently more complex than standalone audits and hence will need careful planning due to the additional factors that have to be considered (eg, group-wide controls and the consolidation process).

●●

The same pre-acceptance procedures and ethical considerations that apply to a standalone audit also apply to a group audit.

●●

Careful risk assessment procedures will be needed which should also cover the component auditors.

●●

Group materiality must be calculated which should ordinarily be higher than the materiality levels for individual components to reduce the risk of material misstatement in the group accounts.

●●

Complete reliance on component auditors is not possible because the group auditor must take full responsibility for the audit opinion contained in the consolidated financial statements.

●●

Effective communication with component auditors is critical throughout the group audit.

●●

Specific audit procedures must be applied over the consolidation process, including a full risk assessment and consideration of groupwide controls.

●●

For insignificant components, the group auditor may carry out analytical procedures alone.

●●

As with other audits, sufficient appropriate audit evidence must be obtained during the group audit and this applies at component level also. The group engagement team must also evaluate the component auditor’s work for sufficiency and appropriateness.

●●

There must be documentation on file concerning the communication between the group audit engagement team and group management and those charged with governance.

●●

Overseas subsidiaries which are material to the group bring specific challenges in terms of whether the audit firm has the resources and expertise available to obtain sufficient appropriate audit evidence. Other factors such as language barriers will also need to be addressed.

●●

Care must be taken not to rely too much on support letters and these must not be a substitute for the auditor undertaking relevant audit procedures on areas such as going concern.

240

Auditing Groups 12.23 ●●

Transnational audits may cause specific issues for the group auditor as the regulation and oversight of auditors in different jurisdictions may be different to the UK. Corporate governance requirements may also be somewhat different and these are important factors that need to be carefully addressed.

●●

There are specific documentation requirements for group audits which must comply with the ISAs (UK).

241

242

Index [All references are to paragraph numbers] A Accounting errors consolidated cash flow statements, 9.10 disclosure requirements, 2.5 fair value measurement, and, 5.28 Accounting estimates changes in, 2.5 disclosures, 2.5 Accounting periods group reconstructions, 11.3 new parent with short accounting period, 11.3 Accounting policies choice of fair value through profit or loss, 6.24 generally, 5.7 investments in associates, 6.3, 6.17 consolidated financial statements differences between subsidiary company and parent, 5.14 immateriality exception, 5.14 special reasons exception, 5.14 subsidiary company choice of, 5.7 uniform accounting, 5.14 investments in associates adjustments, 6.17 non-parent entities, 6.3 methods of accounting see Cost method of accounting; Equity method of accounting; Merger method of accounting; Purchase method of accounting uniform accounting, 5.14 Accounting reference dates changes, 5.13 coterminous reporting dates, 5.13, 6.16 five-year rule, 5.13 interim financial reports, 5.13 non-coterminous reporting dates, 5.13

Accounting standards Brexit transition arrangements, 1.7 Acquirer definition, 5.16 identification of, 5.15, 5.16 purchase method of accounting, and, 5.15, 5.16 Acquisition date accounting consolidation from, 5.37, 8.1 contingent consideration, recognition of, 5.23, 5.28 contingent liabilities at, 5.28 control, and, 3.4, 5.17 definition, 3.4, 5.17 determination of, 5.15, 5.17 purchase method of accounting, and, 5.15, 5.17 time-apportionment, 5.9, 5.37 Acquisitions and disposals acquirer identification of, 5.15, 5.16 purchase method of accounting, and, 5.15, 5.16 acquisition date accounting consolidation from, 5.37, 8.1 contingent consideration, recognition of, 5.23, 5.28 contingent liabilities at, 5.28 control, and, 3.4, 5.17 definition, 3.4, 5.17 determination of, 5.15, 5.17 purchase method of accounting, and, 5.15, 5.17 time-apportionment, 5.9, 5.37 change of entity status, resulting in additional investment in subsidiaries, 8.5 associate to investment, 8.3 carrying amount, influences on, 8.7

243

Index Acquisitions and disposals – contd change of entity status, resulting in – contd deemed disposals, 8.9 fair value measurement, 8.7 investment to associate, 8.2 joint venture to associate, 8.4 partial disposal where control is retained, 8.8 profit or loss, reclassification of, 8.3 significant influence, loss of, 8.3 subsidiary to associate or joint venture, 8.7 subsidiary to financial investment, 8.6 subsidiary to subsidiary transactions, 8.5 substance of arrangement, analysis of, 8.6 consolidated cash flow statements, 9.12–9.14, 9.16, 9.25 consolidation from date of, 5.37, 8.1 control date of acquisition or loss of, 8.1 loss of control, book value calculation, 8.7 loss of control of subsidiary by parent, 8.6–8.7 deemed disposals, 8.9 equity method of accounting, applicability of, 8.3 foreign exchange differences, treatment of, 8.6 goodwill calculation, 8.2, 8.7, 12.9, 12.13 intangible assets, acquisition of, 5.36 introduction, 8.1 methods of acquisition, 8.1 partial disposals retention of control, 8.8 significant influence, loss of, 8.3 significant influence, loss of, 8.3 step acquisitions, 3.5, 5.3, 8.2 consolidation, challenges of, 8.2 trends, 3.5 subsidiary companies change to financial investment status, 8.6

Acquisitions and disposals – contd subsidiary companies – contd consolidated cash flow statements, 9.12–9.14, 9.16, 9.24 deemed disposals, 8.9 goodwill, 5.31, 8.6, 12.9 Alternative Investment Market (AIM) market status, 1.7, 1.12 Amortisation goodwill, 4.2, 5.32, 12.9 intangible assets, 5.32, 5.36 Anti-money laundering group audits, and, 12.18 Assets foreign currency translation foreign exchange gains and losses, recognition of, 10.8 historical costs, functional currency measurement, 10.6 net investment in foreign operation, 10.9 qualifying consideration, 10.9 revaluation of, 10.8 identifiability of, 5.24 impairment of see Impairment of Assets intangible assets see Intangible assets jointly controlled assets, 7.3, 7.5 monetary assets, examples, 10.6 non-monetary assets, examples, 10.6 seizure by local government, 5.3 Associated undertakings definition, 6.4 Associates consolidated cash flow statements cash paid to/ received from, 9.11 dividends, 9.11 deferred tax on unremitted earnings, 4.5 definition, 6.4 equity method of accounting investor transactions with, 6.15 significant influence, and, 5.7 subsidiary company treated as associate, 5.7 ineligible group, part of, 1.12 investments in see Investments in associates investor transactions with, 6.15

244

Index Associates – contd significant influence definitions, 6.4 equity method of accounting, 5.7 loss of, 8.3 subsidiaries change in status to, 8.7 differences from, 6.4 Audit exemptions parent declaration of guarantee, 1.13 subsidiary companies, 1.13 Audit, Reporting and Governance Authority, 1.6 transition from FRC, 2.1 Audit software advantages and disadvantages, 12.10 tailoring, 12.10 Auditors acceptance, 12.3 competence, 12.1, 12.3 component auditors, 12.2 objectives, 12.2 Audits exemptions, 1.13 group audits see Group audits B Balance sheet total interpretation, 1.4 negative goodwill, 5.35, 5.40 unsettled trading balances, treatment of, 6.15 Ball Holdings v HMRC functional currency, test for, 10.4 Bank overdrafts cash equivalents, treatment as, 9.19 Banking companies ineligible groups exemption, 1.12 Banking covenants consolidated cash flow statements, 9.28 Banks Prudential Sourcebook, compliance with, 2.3 Benefits in kind see Employee benefits Bonus payments business combination services, for, 5.22

Brexit accounting reference dates, 5.13 accounting standards transition arrangements, 1.7 adopted IFRS, status of, 1.7 Business definition, 2.12 Business combinations contingent liabilities costs of, 5.24, 5.26, 5.28 recognition of, 5.24, 5.26, 5.28 costs of adjustments, time limits on, 5.23 allocation of, 5.24 contingent liabilities, 5.24, 5.26, 5.28 deferred tax, 5.24 directly attributable to, 5.15, 5.22 due diligence fees, 5.22 employee benefits, 5.24 employee bonuses, 5.22 equity instruments, 5.22 excluded costs, 5.22 fair value measurement, 5.24 finance costs, 5.22 goodwill calculation, 5.18 inventory allowances, 5.24 liabilities, 5.24–5.26, 5.28 measurement of, 5.15, 5.18 purchase method of accounting, 5.15, 5.18, 5.22–5.23 restructuring costs, 5.26 share-based payments, 5.24 transaction costs, 5.22 unrelated costs, exclusion of, 5.22 deferred tax, 5.24 definition, 2.12 disclosure requirements, 5.38 aggregate disclosures, 5.39 all business combinations, 5.40 applicable provisions, 5.38 business combinations effected during reporting period, 5.39 reconciliations, 5.40 revenue, profit and loss, of, 5.39 excluded combinations, 2.12 fair value measurement assets and liabilities, 5.24 deferred tax, 4.8

245

Index Business combinations – contd fair value measurement – contd depreciation expenses, 5.25 initial accounting incomplete at reporting date, 5.27 material errors, correction of, 5.28 overview, 4.2 profit and loss adjustments, 5.25 purchase method of accounting, 4.8, 5.24–5.25, 5.27 time limit for adjustments, 5.27 goodwill acquisition of subsidiary, 5.31, 12.9 amortisation, 5.32, 12.9, 12.13 applicable provisions, 1.2, 2.12 calculation, 5.18, 5.31, 5.37, 8.6 impairment of, 5.32–5.34 initial recognition of, 5.31 negative goodwill, 5.35, 5.40, 12.9 notionally adjusted goodwill, 5.33 recognition and measurement, 5.15, 5.30–5.35 subsequent measurement, 5.32 subsidiary to financial investment status change, 8.6 group reconstructions see Group reconstructions group structures, types of, 3.6 incomplete accounting, retrospective adjustments, 5.27 intangible assets, acquisition of, 5.36 merger accounting method, 8.6 profit and loss accounts, impact on, 5.25 public benefit entities, by, 2.12 purchase method of accounting deferred tax, 4.8 requirement to use, 5.15 C Carrying amount distributions from the associate, adjustments to, 6.11 greater or less than nominal value of shares acquired in group reconstruction, 11.2 impairment losses, restrictions on, 5.34

Carrying amount – contd joint ventures disclosure, 7.16 transactions between venturer and joint venture, 7.13 parent’s investment, elimination of, 5.9 significant influence, loss of, 8.3 test for impairment applied to entire amount, 6.14 Cash equivalents bank overdrafts, 9.19 borrowing types acceptable as, 9.19–9.20 definition, 9.5, 9.19 description, 9.5 examples, 9.5 investing activities, 9.3 readily convertible, 9.5 Cash flow statements applicability, 9.1 banking covenants, compliance with, 9.28 cash flow equivalents bank overdrafts, 9.19 borrowing types acceptable as, 9.19–9.20 definition, 9.5, 9.19 description, 9.5 examples, 9.5 investing activities, 9.3 readily convertible, 9.5 characteristics, 9.1 company law provisions, 9.6 consolidated cash flow statements see Consolidated cash flow statements financing activities, 9.4, 9.10, 9.25 FRC thematic review acquisition or disposal of subsidiaries, 9.24 background, 9.7, 9.17 cash and cash equivalents, 9.19–9.20 financing cash flows, 9.25 findings, 9.18 interest and dividends, treatment of, 9.22 investing cash flows, 9.23

246

Index Cash flow statements – contd FRC thematic review – contd liquidity risk disclosures, 9.26 maturity analysis, 9.27 overview, 9.17–9.18 supplier financing arrangements, 9.30 working capital arrangements, 9.30 investing activities, 9.3, 9.23 operating activities, 9.2, 9.21–9.22 preparation boilerplate disclosures, 9.17 deficiencies, recommendations regarding, 9.7 disclosures, 2.5, 9.17, 9.20–9.21, 9.25–9.30 manual adjustments, 9.7 overview, 9.7 reconciliation, 9.19, 9.21, 9.23, 9.25 rule inconsistencies cash and cash equivalents, 9.19 generally, 9.17 Cash flows discount factor, calculation of, 3.8 Cash-generating units definition, 5.33 goodwill measurement, and, 5.33–5.34 Cash payments financing activities, and, 9.4 investing activities, and, 9.3 Cash receipts financing activities, and, 9.4 investing activities, and, 9.3 Charities micro-entities, ineligibility as, 1.4 qualifying entities, ineligibility as, 2.3 Classification of companies average number of employees, 1.4, 2.10 balance sheet total, 1.4 groups of companies, 1.4 individual companies that are parent companies, 1.5 large companies, 1.4 medium-sized companies, 1.4 parent companies, 1.5 qualifying conditions, 2.10 small companies, 1.4 small groups, 2.10

Comfort letters group audits, 12.14, 12.21 Commissioners of Inland Revenue v Muller goodwill, recognition and measurement, 5.30 Company Voluntary Arrangement (CVA) consolidated financial statements, inclusion in, 5.7 control, transfer of, 5.7 Component auditors definition, 12.2 risk assessment, 12.5 Confirmation statements group audits, 12.14 Consideration contingent consideration, 5.23, 5.28, 12.9 deferred consideration, 5.21, 12.9 discounted deferred consideration, 5.21 group audits, 12.9 qualifying consideration, 10.9 Consolidated cash flow statements acquisitions and disposals, 9.12–9.13, 9.16, 9.24 additional factors, compared with single entity statements, 9.9–9.14 applicability, 9.1 associates, cash paid to/ received from, 9.11 banking covenants, compliance with, 9.28 cash flow equivalents, 9.3, 9.5, 9.19 characteristics, 9.1 choice of method, 9.8–9.9 company law provisions, 9.6 deficiencies, recommendations regarding, 9.7 direct method, 9.9 disclosure requirements banking covenants compliance, 9.28 boilerplate disclosures, 9.17 cash and cash equivalents, 9.20–9.21 cash flows from financing activities, 9.25

247

Index Consolidated cash flow statements – contd disclosure requirements – contd exemptions, 2.5, 2.9 liquidity risk, 9.26 maturity analysis, 9.27 micro-entities, 2.5 seasonal exposure variations, 9.29 supplier financing arrangements, 9.30 thematic review, 9.17–9.18 working capital arrangements, 9.30 dividends paid to non-controlling entities, 9.10 errors, 9.10 financing activities, 9.4, 9.10, 9.25 foreign exchange gains and losses, 9.15 FRC thematic review acquisition and disposal of subsidiaries, 9.24 background, 9.7, 9.17 cash and cash equivalents, 9.19–9.20 disclosures, 9.25 financing cash flows, 9.25 findings, 9.18 interest and dividends, treatment of, 9.22 investing cash flows, 9.23 liquidity risk disclosures, 9.26 maturity analysis, 9.27 operating cash flows, 9.21–9.22 overview, 9.17–9.18 supplier financing arrangements, 9.30 working capital arrangements, 9.30 indirect method, 9.8, 9.21 intra-group cash flows, elimination, 9.7 investing activities, 9.3, 9.23 investing cash flows, 9.23 manual adjustments, 9.7 non-controlling entities, cash flows attributable to, 9.10 operating activities, 9.2, 9.21–9.22 operating cash flows, 9.21–9.22 operating profit, separation of, 9.8

Consolidated cash flow statements – contd overview, 9.7, 9.9 profit before tax approach, 9.8 reconciliation, 9.19, 9.21, 9.23, 9.25 rule inconsistencies, comparison of cash and cash equivalents, 9.19 generally, 9.17 seasonality, impacts of, 9.29 subsidiaries acquisition of, 9.12–9.13, 9.16, 9.24 disposal of, 9.12, 9.14, 9.16, 9.24 Consolidated financial statements introduction, 3.1 preparation challenges, 3.1 Consolidated financial statements accounting policies differences between subsidiary company and parent, 5.14 immateriality exception, 5.14 reconciliation, 5.14 special reasons exception, 5.14 subsidiary company choice of, 5.7 uniform accounting, 5.14 definition, 1.4 exemption criteria EEA parent companies, 1.8 financial reporting standards, 1.11 ineligible groups, 1.12 legislation regarding, 1.8–1.19 materiality considerations, 5.6, 5.7 parent company ownership of 50 to 90 percent, 1.9, 1.11 parent company ownership of 90 percent, 1.8–1.9, 1.11 traded companies, 1.8 UK equivalence test, 1.9 preparation of see Consolidation process purpose of, 1.3, 4.1, 5.1 requested by minority shareholder, 1.9, 1.11 separate financial statements, and, 2.11 single reporting entity, presentation as, 5.9 subsidiary company exemption from audit exemption, 1.13 choice of accounting policy, 5.7

248

Index Consolidated financial statements – contd subsidiary company exemption from – contd dissimilar activities, 5.5 EEA parent statements meet UK equivalence test, 1.8 generally, 1.10, 1.12 inclusion in group accounts of larger group, 1.8 information only obtained with disproportionate expense, 5.7 limitations, 5.5–5.6 long-term restrictions hinder rights of parent over assets or management, 5.7 materiality considerations, 5.6 significant influence, equity method treatment as associate, 5.7 subsidiaries as part of investment portfolio, 5.7 subsidiary interests held with view to subsequent resale, 5.7 substance over form requirement, 1.3, 3.7 Consolidated income statements non-controlling interests, cash flows attributable to, 9.10 Consolidated profit and loss accounts depreciation expenses, 5.25 preparation of, 5.9 Consolidation process accounting policies differences between subsidiary company and parent, 5.14 immateriality exception, 5.14 reconciliation, 5.14 special reasons exception, 5.14 subsidiary company choice of, 5.7 uniform accounting, 5.14 accounting reference dates changing, 5.13 coterminous reference dates, 5.13, 6.16 interim financial statements, and, 5.13

Consolidation process – contd accounting reference dates – contd non-coterminous reference dates, 5.13 subsidiary company date different from parent’s, 5.13 assets, 5.9 basic elements of carrying amount of parent’s investment, elimination of, 5.9 goodwill calculations, 5.9, 5.31 mid-year acquisitions, treatment of, 5.9, 5.37 overview, 5.9 single reporting entity, 5.9 time-apportionment, 5.9, 5.37 business combination see Business combination dissimilar activities, 5.5 equity ownership existing ownership interest basis for calculation, 5.9 ownership split, 5.9 profit and loss changes, 5.9 goodwill see Goodwill group audits, 12.13 intra-group transactions and balances dividends, 5.11 elimination of, 5.10 finance costs, 5.11 immateriality exclusions, 5.10 interest, deduction of, 5.11 intra-group losses, 5.10 intra-group profit in inventory, elimination of, 5.10 intra-group profit on transfer of fixed asset, 5.12 loans, 5.10 plant and equipment, 5.10 treatment in, 5.10 unrealised profits and losses, 5.12 introduction, 5.1 liabilities, 5.9, 5.24–5.26, 5.28 mid-year acquisitions acquisition date, consolidation from, 5.37 consolidate profit and loss account preparation, 5.37

249

Index Consolidation process – contd mid-year acquisitions – contd control, 100 percent indication of, 5.37 goodwill calculation, 5.37 pre- and post-acquisition reserves, 5.37 purchase method accounting, 5.37 time-apportionment, 5.9, 5.37 non-controlling interests allocation exceptions, 5.24 allocation of share of unrealised profits, 5.12 deferred tax, 5.24 employee benefits, 5.24 fair value measurement, 5.24–5.25, 5.29 goodwill, fair value of, 5.24, 5.29, 5.33 interpretation, 5.9, 5.29 net vs. gross methods of accounting, 5.24 purchase method of accounting, 5.15, 5.24–5.29 recognition of interests, 5.24, 5.29 separate presentation of, 5.9 share of subsidiary’s net assets at balance sheet date, 5.9 parent companies, obligations of, 5.1 principles of, 5.9 profit and loss accounts, 5.9 purchase method of accounting acquirer, identification of, 5.15, 5.16 acquisition date, determination of, 5.15, 5.17 contingent consideration, 5.23, 5.28 cost of business combination see Costs deferred consideration, 5.21 discounted deferred consideration, 5.21 goodwill, recognition and measurement of, 5.15, 5.30–5.35 non-controlling interests, recognition and measurement, 5.15, 5.24–5.29 quoted instruments, 5.19

Consolidation process – contd purchase method of accounting – contd requirement to use, 5.15 unquoted instruments, 5.20 reserves parent’s reserves, 5.9 share of subsidiary’s post-acquisition profit or loss, 5.9 share capital, 5.9 single reporting entity, presentation as, 5.9 special purpose entities, 5.8 control of, 5.8 employee benefit trusts, 5.8 employee share ownership plans, 5.8 intermediate payment arrangements, as, 5.8 post-employment benefit plans, and, 5.8 subsidiary company exemption choice of accounting policy, 5.7 dissimilar activities, 5.5 generally, 1.12 information only obtained with disproportionate expense, 5.7 limitations, 5.5–5.6 long-term restrictions hinder rights of parent over assets or management, 5.7 materiality considerations, 5.6, 5.7 significant influence, equity method treatment as associate, 5.7, 6.19 subsidiaries as part of investment portfolio, 5.7 subsidiary interests held with view to subsequent resale, 5.7 uniform reporting date, 5.13 unrealised profits and losses, 5.12 investor transactions with associates, 6.15 Contingent consideration group audits, 12.9, 12.15 purchase method of accounting, 5.23, 5.28

250

Index Contingent liabilities business combinations, and, 5.24, 5.26, 5.28 date of acquisition, at, 5.28 fair value measurement, 5.28 individual financial statements, in, 5.28 purchase method of accounting, 5.24–5.26, 5.28 recognition of, 5.24, 5.26, 5.28 reduction of, 5.28 Contracts onerous contracts, 5.26 Control acquisition date, 3.4, 5.17 acquisition of, 3.5 consolidate financial statements, treatment of, 3.4 convertible debt, influences on, 5.2 de facto control, 5.2 definitions, 3.2, 3.3, 5.1, 5.2, 5.16 dominant influence definition, 5.4 exercise of, 5.2, 5.4 indications of, 3.2, 3.4 joint control, 3.3 liquidation or insolvency, 5.3, 5.7 loss of control, 3.4, 5.3 permanent loss of control, 5.3 of subsidiary, by parent, 8.6 temporary loss of control, 5.3 potential voting rights, and, 5.2 power to appoint or remove board members, 5.2 power to cast majority of votes, 5.2 power to govern financial and operating policies, 5.2, 5.16 presumption of existence, 5.2 significant influence, 3.2, 6.4 special purpose entities, of, 5.8 step acquisitions, 3.5, 5.3, 8.2 substance of arrangement, 3.2 transaction completion, relevance of, 5.17 transfer of control, 5.3, 5.7 trust arrangements, 5.2 unified management basis, 5.4

Convertible debt voting rights, and, 5.2 Correction of errors fair value measurement, 5.28 Cost method of accounting investments in associates choice of, 6.8, 6.20 impairment of assets, 6.9, 6.14 joint ventures impairment losses, 7.11 Costs business combinations, of adjustments, time limits on, 5.23 allocation of, 5.24 contingent liabilities, 5.24, 5.26, 5.28 deferred tax, 5.24 directly attributable to, 5.22 due diligence fees, 5.22 employee benefits, 5.24 employee bonuses, 5.22 equity instruments, 5.22 excluded costs, 5.22 fair value measurement, 5.24 finance costs, 5.22 goodwill calculation, 5.18 inventory allowances, 5.24 liabilities, 5.24–5.26, 5.28 measurement of, 5.15, 5.18 purchase method of accounting, 5.15, 5.18, 5.22–5.23 restructuring costs, 5.26 share-based payments, 5.24 transaction costs, 5.22 unrelated costs, exclusion of, 5.22 intra-group loans finance costs, 5.11 Coterminous accounting reference dates equity method of accounting, 6.16 investments in associates, 6.16 parent company obligations, 5.13 Covid-19 pandemic GAAP reviews, 2.1 rent concessions, 2.1 Credit unions financial institution, as, 2.3 Custodian banks financial institution, as, 2.3

251

Index D Deemed disposals changes in ownership resulting from, 8.9 control, retention of, 8.9 transactions amounting to, 8.9 Deferred consideration discounted deferred consideration, 5.21 group audits, 12.9, 12.15 purchase method of accounting, 5.21 Deferred tax associates, 4.5 business combinations non-controlling interests, 5.24 profit and loss accounts, impact on, 5.25 differences between UK GAAP and IAS 12, 4.3, 4.9 group audits, 12.9 group relief, 4.9 non-controlling interests, 5.24 overview, 4.3 purchase method of accounting, and, 4.8 subsidiaries, 4.4 temporary difference approach, 4.3 timing difference approach, 4.3, 4.8, 4.9, 5.10 timing difference plus approach, 4.8, 4.9 unincorporated entities, interests in, 4.7 unremitted earnings, on associates, from, 4.5 business combinations, 4.8 group reconstructions, 4.8 joint ventures, from, 4.6 overview, 4.3 subsidiaries, from, 4.4 unincorporated entity assets, 4.7 Definitions acquisition date, 3.4, 5.17 associates, 6.4, 8.2 business, 2.12 business combinations, 2.12 cash, 9.5 cash equivalents, 9.5, 9.19

Definitions – contd cash-generating units, 5.33 component, 12.2 component auditor, 12.2 consolidated financial statements, 1.4 control, 3.2, 5.1, 5.2, 5.16 dominant influence, 5.2, 5.4 equity investments, 6.10 financial and operating policies, 5.2 financial institutions, 2.3 financing transactions, 3.8 functional currency, 10.1 group reconstructions, 11.1 groups of companies, 1.4, 3.2, 5.1 held exclusively with view to subsequent resale, 5.7 impracticable, 5.13, 6.16 individual accounts, 1.4, 10.1 individual financial statements, 1.4, 10.1 ineligible groups, 1.12 interests, 5.7 investments held as part of an investment portfolio, 6.3 joint control, 3.3, 7.2 joint ventures, 7.2 large group, 1.4 majority of voting rights, 5.2 managed on unified basis, 5.4 measurement difference, 3.8 medium-sized group, 1.4 micro-entities, 2.9 minority interest, 5.29 monetary, 10.6 net investment in foreign operation, 10.1 non-controlling interest, 5.29 parent companies, 1.4, 5.1 parent entities, 2.3 participating interests, 6.4 presentation currency, 10.1 primary economic environment, 10.2 qualifying considerations, 10.9 qualifying entities, 2.3, 2.5 readily convertible, 9.5 regulated markets, 1.12 separate financial statements, 1.4 significant component, 12.2

252

Index Definitions – contd significant influence, 6.4 small group, 1.4 statement of accounts, 1.4, 10.1 subsidiary companies, 5.1, 5.2 traded companies, 1.7, 1.12 true and fair, 1.6 voting rights, 5.2 Depreciation fair value of assets acquired, 4.2 Depreciation expenses fair value adjustments, 5.25 Differences between UK GAAP and IFRS/ IAS contingent consideration, 5.23 costs attributable to business combinations, 5.22 deferred tax, 4.3, 4.9 goodwill, fair value measurement, 4.9, 5.32, 5.35, 8.8 intangible assets, fair value measurement, 5.36 intra-group loans, 3.7 Disclosure requirements accounting errors, 2.5 accounting estimates, 2.5 boilerplate disclosures, 9.17 business combinations aggregate disclosures, 5.39 all business combinations, 5.40 applicable provisions, 5.38 business combinations effected during reporting period, 5.39 reconciliations, 5.40 revenue, profit and loss, of, 5.39 consolidated cash flow statements banking covenants compliance, 9.28 cash and cash equivalents, 9.20–9.21 cash flows from financing activities, 9.25 exemptions, 2.5, 2.9 liquidity risk, 9.26 maturity analysis, 9.27 micro-entities, 2.5 seasonal exposure variations, 9.29 supplier financing arrangements, 9.30

Disclosure requirements – contd consolidated cash flow statements – contd thematic review, 9.17–9.18 working capital arrangements, 9.30 equity method of accounting, 6.1, 6.27 exemptions impairment of assets, 2.5 micro-entities, 2.5, 2.9 overview, 2.5 qualifying entities, 2.5 related party disclosures, 2.5 fair value measurement, 2.5 group reconstructions, 11.5 impairment of assets, 2.5 investments in associates, 6.1, 6.27 company law obligations, 6.26 equity method of accounting, 6.1, 6.27 financial reporting obligations, 6.27–6.28 generally, 6.25 risk management, 6.28 small entities, applicable to, 6.28 joint ventures, 7.16 micro-entities, 1.1 exemptions, 2.5, 2.9 generally, 1.1 provisional values, 5.28 qualifying entities, 2.3 content, 2.4 exemptions, 2.5 related party disclosure exemptions, 2.5 subsidiaries, reductions for, 2.5 ultimate parents, 2.5 Discounted deferred consideration purchase method of accounting, 5.21 Discounts unwinding, contingent consideration, 5.23 Disposals see Acquisitions and disposals Dissimilar activities consolidation process, grounds for exemption from, 5.5 information provision, 5.5

253

Index Dividends associates, from, 4.4 cost method of accounting, 6.9 equity method of accounting, 6.11 fair value models, 6.23 impairment of losses, 6.9 consolidation process intra-group transactions and balances, 5.11 deferred tax on, 4.4 equity method of accounting distributions from associate, 6.11 generally, 6.10 parent lack of control over payment, 4.4 Dominant influence definition, 5.4 right to exercise, 5.2 unified management, 5.4 Due diligence costs attributable to business combination, as, 5.22 group audits, 12.15, 12.19 E E-money issuers ineligible groups exemption applicability, 1.5, 1.12, 2.10 Economic substance interpretation, 1.3, 3.7 EEA Parent companies exemptions under CA 2000 s 401, availability of, 1.9 subsidiary exemption from consolidated financial statement, 1.8 UK equivalence test, and, 1.8 Employee benefit trusts special purpose entities as, 5.8 Employee benefits non-controlling interests, 5.24 special purpose entities, and, 5.8 Employee share ownership plans special purpose entities as, 5.8 Employees average number of, 1.4, 2.10 small companies, 2.10 Equity instruments costs of, 5.22

Equity investments definition, 6.10 Equity method of accounting coterminous accounting reference dates, 6.16 dividends and other distributions carrying amount adjustments, 6.11 distributions from associate, 6.11, 6.18 generally, 6.10 zero value investments, 6.11 equity investments definition, 6.10 recognition, 6.10 incorrect applications, 6.10 introduction, 6.1 investments in associates, and accounting method differences, adjustment for, 6.17 coterminous reporting dates, 6.16 disclosure obligations, 6.1 discontinuance, 6.19 dividends and distributions, 6.11, 6.18 exceptions to, 6.3 fair value adjustments, 6.13 goodwill, 6.10, 6.13 investor transactions with associated, 6.15 long-term loans, 6.15 loss of significant influence, and, 6.7, 6.19 losses in excess of investment, 6.18 non-applicability to, 5.7, 6.19 potential voting rights, 6.12 provisions and contingencies, recognition of, 6.18 requirement for, 6.3 unrealised profits and losses, elimination of, 6.15 joint ventures, and deferred tax, 4.6 loss of significant influence, 6.19 venturer is a parent, 7.9 procedure, 6.10

254

Index Equity ownership consolidation process existing ownership interest basis for calculation, 5.9 ownership split, 5.9 profit and loss changes, 5.9 Exchange rates see also Foreign currency translation; Foreign exchange gains and losses acquisitions and disposals of interests cumulative amounts, classification of, 8.6 effects on, 8.6 Exchange traded funds financial institution, as, 2.3 Expectations gap true and fair requirements, 1.6 F Fair value measurement adjustments, time limits for, 5.28 associate assets acquired cost method of accounting, 6.9 deferred tax on, 4.5 business combinations assets and liabilities, 5.24 deferred tax on unremitted earnings, 4.8 depreciation expenses, 5.25 initial accounting incomplete at reporting date, 5.27 non-controlling interests, recognition of, 5.24 profit and loss adjustments, 5.25 purchase method of accounting, 4.8, 5.24–5.25, 5.27 time limit for adjustments, 5.27 contingent consideration, 5.23, 5.28 contingent liabilities, 5.28 cost to group, 4.2 date of acquisition, differences in, 4.8 deferred consideration, 5.21 deferred tax on unremitted earnings associates, 4.5 business combinations, 4.8 joint ventures, from, 4.6 overview, 4.3

Fair value measurement – contd deferred tax on unremitted earnings – contd profit and loss accounts, impact on, 5.25 subsidiaries, from, 4.4 unincorporated entity assets, 4.7 depreciation, 4.2 disclosure exemptions, 2.5 discounted deferred consideration, 5.21 due diligence, 12.9 fair value adjustments, 4.2 foreign currency translation, nonmonetary items, 10.6 goodwill amortisation, 4.2, 5.32 cash-generating units, valuation of, 5.33–5.34 deferred consideration, and, 5.21 deferred tax adjustment, 4.8 differences between UK GAAP and IFRS/ IAS 4.9, 5.32, 5.35 negative goodwill, 5.35 non-controlling interests, relevance of, 4.9, 5.24 purchase method of accounting, and, 5.18 group audits, 12.9 group reconstructions, and, 4.8, 11.2 group relief, 4.9 intangible assets, 5.36 inventory allowances, 5.25 joint ventures assets acquired, deferred tax on, 4.6 choice of accounting model, 7.12 disclosure, 7.16 material errors, correction of, 5.28 merger method of accounting, compared with, 11.2 net assets acquired, of, 4.2 purchase method of accounting goodwill, 5.18 quoted instruments, 5.19 unquoted instruments, 5.20 quoted instruments, 5.19 reliability requirement, 4.2

255

Index Fair value measurement – contd subsidiary companies deferred tax on unremitted earnings, 4.4 held as part of investment portfolio, 5.7 loss-making subsidiaries, 4.8 unincorporated entity assets acquired deferred tax on, 4.7 unquoted instruments, 5.20 unremitted earnings, deferred tax on associate assets acquired, 4.5 joint venture assets acquired, 4.6 overview, 4.3 subsidiary assets acquired, 4.4 unincorporated entity assets acquired, 4.7 Finance costs purchase method of accounting, 5.22 Financial and operating policies definition, 5.2 Financial institutions definition, 2.3 disclosure requirements exemptions, 2.5 generally, 2.3 Financial Reporting Council Kingman Review, 2.1 role and objectives, 2.1 transition to ARGA, 2.1 Financial Reporting Standards, 1.1 applicability, 2.2 consistency, 2.1 cost effectiveness of application, 2.1 Financing activities functional currency, 10.2 Financing transactions definition, 3.8 Five-year rule accounting reference dates, 5.13 Foreign currency translation applicable financial reporting provisions, 1.2 average rate, use of, 1.4, 10.6 balance sheet total, 1.4 closing rate, use of, 1.4, 10.6

Foreign currency translation – contd definitions functional currency, 10.1 individual financial statements, 10.1 net investment in foreign operation, 10.1 presentation currency, 10.1 equity amounts, retranslation, 10.10 foreign exchange gains and losses consolidated cash flow statements, 9.15 differences between FRS 102 and IFRS, 10.9 monetary assets translated at year end, 10.8 recognition, 10.8 foreign operation acquisition of, goodwill on, 10.12 functional currency, 10.3 net investment in, recognition of, 10.1 functional currency autonomy, interpretation of, 10.4 changes in, 10.7 choice of, 10.2, 10.10 definition, 10.1 financing activities, 10.2 foreign branch, of, 10.3 foreign operation, of, 10.3 identification of, 10.4 operational activities, 10.2 primary economic environment, 10.2 reporting foreign currency transactions in, 10.5–10.6 test for, 10.4 gains and losses see Foreign exchange gains and losses group audits, 12.20 historical rates, use of, 10.10 hyperinflation currencies, and, 10.10 individual financial statements, 10.1 intra-group transactions and balances generally, 10.11 intra-group loans, 10.11 net investment in foreign operations, 10.11 introduction, 10.1

256

Index Foreign currency translation – contd monetary assets foreign exchange gains and losses, recognition of, 10.8 historical costs, functional currency measurement, 10.6 net investment in foreign operation, 10.9 qualifying considerations, 10.9 net investment in foreign operation intra-group transactions and balances, 10.11 recognition, 10.9 non-monetary assets foreign exchange gains and losses, recognition of, 10.8 measured at historical cost, 10.6 revaluation of, 10.8 non-monetary items fair value measurement, 10.6 historical costs, measurement at, 10.6 presentation currency, 10.10 recognition rules, 10.5–10.6 recycling requirements, 10.10 reporting foreign currency transactions in functional currency implications of, 10.5 recognition rules, 10.6 subsequent measurement rules, 10.6 spot rate, use of, 10.6 subsequent measurement rules, 10.5–10.6 transaction date, 10.6 transactions denoted in foreign currency, 10.6 turnover, 1.4 year end foreign currency monetary amounts, 10.6 year end foreign currency non-monetary amounts, 10.6 Foreign exchange gains and losses consolidated cash flow statements, 9.15 differences between FRS 102 and IFRS, 10.9

Foreign exchange gains and losses – contd recognition difficulties with, 10.8 methods of, 10.8 monetary assets translated at year end, 10.8 Foreign operations acquisition of, goodwill on, 10.12 extension of an entity, as, 10.3–10.4 foreign branches, 10.3 foreign currency translation, 10.9 functional currency, 10.3 intra-group transactions and balances, 10.11 net investment in, 10.9 reporting entity, as, 10.3 Fraud group audits, 12.18, 12.19 Friendly societies financial institutions, as, 2.3 Functional currency autonomy, interpretation of, 10.4 Ball Holdings v HMRC, 10.4 changes in, 10.7 choice of, 10.2, 10.10 definition, 10.1 foreign branch, of, 10.3 identification of, 10.4 primary economic environment, 10.2 reporting foreign currency transactions in implications of, 10.5 recognition and subsequent measurement rules, 10.6 test for, 10.4 Future dividends deferred tax on, 4.4 Future losses liabilities for, 5.25 G Goodwill acquisition of foreign operation, on, 10.12 amortisation, 4.2, 5.32, 12.9 applicable FRS provisions, 1.2, 2.12

257

Index Goodwill – contd business combinations, and, 2.12 applicable provisions, 1.2, 2.12 calculation, 5.18, 5.37, 12.9, 12.13 initial recognition of goodwill, 5.31 negative goodwill, 5.35, 5.40 carrying amount of parent’s investment, elimination of, 5.9 deferred consideration, and, 5.21 fair value measurement, 4.2, 5.18 assets acquired, of, 4.2, 5.18, 10.12 cash-generating units, valuation of, 5.33–5.34 differences between UK GAAP and IFRS/ IAS 4.9, 5.32, 5.35 foreign operation, acquisition of, 10.12 negative goodwill, 5.35 non-controlling interests, relevance of, 4.9, 5.24, 5.29, 5.33 foreign currency translation, 10.12 group audits, 12.9, 12.13 impairment of, 5.32–5.34 assets, and, 6.14 losses, reversal of, 5.32 reviews, 5.32 investments in associates equity method of accounting, 6.10, 6.13 fair value adjustments, 6.13 investment to associate ownership/ status change, 8.2 negative goodwill fair value measurement, 5.35 group audits, 12.9 reconciliation for, 5.35 purchase method of accounting calculation, 5.18, 5.31, 5.37 deferred consideration, and, 5.21 recognition and measurement, 5.15, 5.30–5.35 valuable consideration requirement, 5.31 recognition and measurement acquisition of subsidiary, 5.31 CIR v Muller, 5.30 generally, 5.15, 5.30 impairment of goodwill, 5.33–5.34

Goodwill – contd recognition and measurement – contd initial recognition, 5.31 intangible assets, separate identification, 5.35 notionally adjusted goodwill, 5.33 subsequent measurement, 5.32 sale of, 5.33 useful lives of, 5.32 Gross interpretation, 1.4 non-controlling interests, gross method of accounting, 5.24 Gross assets see Balance sheet total Group accounts see Consolidated financial statements Group audits acquisition of subsidiary, 12.9, 12.15 anti-money laundering, 12.18 audit procedures analytical procedures, 12.11 audit software, use of, 12.10 business consolidation, 12.10, 12.13 controls, test for effectiveness of, 12.10 evidence collection and analysis, 12.15–12.17 intra-group transactions and balances, 12.10, 12.11, 12.12 investments in subsidiaries, 12.9 subsequent events procedures, 12.15 substantive procedures, 12.14 audit software programmes advantages and disadvantages, 12.10 tailoring, 12.10 audit strategies, 12.4, 12.6 auditors acceptance, 12.3 competence, 12.1, 12.3 objectives, 12.2 business consolidation audit procedures, 12.10 communication component auditors, with, 12.8, 12.17 group governance, with, 12.19 group management, with, 12.18

258

Index Group audits – contd communication – contd importance of, 12.8 internal control deficiencies, of, 12.18, 12.19 component auditors communication with, 12.8, 12.17 evaluation of work of, 12.17 opinions of, 12.18 reliance on, 12.7 responsibility for, 12.7 risk assessment, 12.5 confirmation statements, 12.14 consideration, 12.9 contingent consideration, 12.9, 12.15 deferred consideration, 12.9 deferred tax, 12.9, 12.15 definitions component, 12.2 component auditor, 12.2 significant component, 12.2 disposals, evidence of, 12.15 documentation, 12.23 due diligence, 12.15, 12.19 ethical compliance, 12.8 evidence appropriateness of, 12.16–12.17 disposals, of, 12.15 evaluation of, 12.16 examples of, 12.15 necessary for, 12.1 sufficiency of, 12.15–12.17 written representations, 12.15 exemptions parent declaration of guarantee, 1.13 subsidiary companies, 1.13 fair value measurement, 12.9 fraud, identification and treatment, 12.18, 12.19 goodwill amortisation, 12.9, 12.13 negative goodwill, 12.9 group engagement teams, 12.7 communication with, 12.8 competence, 12.3, 12.7 documentation, 12.23 evidence collection and analysis, 12.15–12.17

Group audits – contd group engagement teams – contd negligence, 12.7 objectives, 12.1 regulatory controls, 12.7 responsibilities, 12.1, 12.4, 12.7 support letters, 12.14, 12.21 group structures, 12.15 impairment of assets, 12.9 internal controls deficiencies in, 12.8, 12.18, 12.19 documentation of, 12.4 effectiveness, tests for, 12.10 intra-group transactions and balances audit procedures, 12.10, 12.11, 12.12, 12.14, 12.15 introduction, 3.1, 12.1 investments in subsidiaries audit procedures, 12.9 costs, 12.9 management charges, 12.12, 12.14 material misstatements communication of, 12.8 correction of, 12.17 detection of, 12.14 risk of, 12.5–12.6, 12.8, 12.10 materiality level change, reasons for, 12.6 communication, 12.8 determination, 12.6 influences on, 12.6 objectives, 12.1 overseas subsidiaries challenges, 3.1, 12.20 foreign currency translation, 12.20 treatment of, 12.20 planning phase complexities of, 12.1 considerations during, 12.4 internal controls, documentation of, 12.4 limitations of scope, 12.4 prior audits, review of, 12.4 risk assessment, 12.5 presentation challenges, 3.1

259

Index Group audits – contd risk assessment factors for consideration, 12.5 management bias, 12.8 material misstatements, 12.5–12.6, 12.8, 12.10 subsidiaries, acquisition of, 12.9, 12.15 exemption from, 1.13 investments in, 12.9 support letters, 12.14 support letters, 12.14, 12.21 transnational audits accounting requirement differences, 12.22 challenges of, 12.22 Group reconstructions accounting periods generally, 11.3 new parent with short accounting period, 11.3 deferred tax on unremitted earnings, 4.8 definition, 11.1 disclosure, specific requirements, 11.5 fair value measurement, 4.8, 11.2 incomplete accounting, 11.3 introduction, 11.1 merger method of accounting investment has carrying amount greater than nominal value of shares acquired, 11.2 investment has carrying amount less than nominal value of shares acquired, 11.2 movement on other reserves, differences shown as, 11.2 non-controlling interests, applicability to, 11.2 shares issues when applying, 11.2 use of, 11.1–11.2 merger relief, 11.4 share premiums, treatment of, 11.4 Group relief distribution, classed as, 4.9 overview, 4.9 transferred at less than applicable tax rate, 4.9

Group structures D-shaped group structures, 3.6 group audits, 12.15 overview, 3.6 types of, 3.6 vertical group structures, 3.6 Groups of companies auditing see Group audits classification eligibility criteria, 1.4 example, 1.4 individual companies that are parent companies, 1.5 consolidated financial statements control, date of acquisition or loss, 3.3–3.4 exemption criteria, 1.8 control acquisition of, 3.5 interpretations, 3.2–3.3 joint control, 3.3 loss of control, 3.4, 5.3, 8.6 step acquisitions, 3.5, 5.3 definitions, 1.4, 3.2, 5.1 dissimilar activities, 5.5 fair value of assets acquired, 4.9 group relief, 4.9 group structures, types of, 3.6 H Hyperinflation currencies foreign currency translation, and, 10.10 I IFRS regime differences from UK GAAP see Differences between UK GAAP and IFRS Impairment of assets applicable financial reporting provisions, 1.2, 2.12 cash-generating units, 5.33–5.34 disclosure exemptions, 2.5 goodwill, and allocation of loss, order of, 5.34 group audits, 12.9 impairment losses, 5.32–5.34, 12.9

260

Index Impairment of assets – contd goodwill, and – contd impairment of, 5.32–5.34 notionally adjusted goodwill, 5.33 impairment losses carrying amount, restrictions on, 5.34 cost method of accounting, 6.9 goodwill, 5.32–5.33, 12.9 investments in associates, 6.9, 6.14 joint venturer which is not a parent, 7.11 order of allocation, 5.34 reversal, 5.32 investments in associates, 6.9, 6.14 reversal of loss, 5.32 test for, 6.14 Impracticable definition, 5.13, 6.16 Income tax see Taxation Incomplete accounting business combinations, 5.27 group reconstructions, 11.3 retrospective adjustments, 5.27 Individual accounts definition, 1.4, 10.1 Individual companies classification, 1.5 Individual financial statements definition, 1.4 Ineligible groups definition, 1.12 exemption available to, 1.12 implications of, 1.12 Initial recognition goodwill, 5.31 investments in associates, 6.21 Insurance companies ineligible groups exemption, and, 1.12 Insurance contracts reporting standards, 1.1, 2.1, 2.7 Intangible assets acquisition of, 5.36 amortisation, 5.32, 5.36 applicable FRS provisions, 2.12 artistic-related assets, 5.36 business combination, acquisition during, 5.36

Intangible assets – contd capitalisation, 5.36 contract-based assets, 5.36 customer-related assets, 5.36 differences between UK GAAP and IFRS/ IAS, 5.36 examples, 5.36 fair value measurement, 5.36 identification of, 5.36 intellectual property, 5.36 marketing-related assets, 5.36 recognition separately from goodwill, 5.36 technology-based assets, 5.36 Intellectual property intangible assets, 5.36 Interest intra-group loans, in allocation of, 3.10 below market-rate of interest, 3.8, 5.11 deduction from group investment income, 5.11 interest-free loans, 3.8 measurement difference, 3.8–3.9 Interim financial reports accounting reference dates, 5.13 content, 2.8 reporting requirements, 1.1, 2.8 Intermediate payment arrangements special purpose entities, accounting treatment, 5.8 Intra-group loans consolidation process dividends, 5.11 elimination of, 5.10 finance costs, 5.11 interest, deduction of, 5.11 treatment in, 5.10 differences between old UK GAAP and FRS 102, 3.7 discount factor, calculation of, 3.8 53-week loan terms, 3.13 financial statement recognition by borrower/ lender, 3.8 group audits, 12.14

261

Index Intra-group loans – contd interest allocation of, 3.10 below market rate of interest, 5.10 deduction from group investment income, 5.11 interest-free loans, 3.8 interest-free loans, 3.8, 5.10 measurement difference avoidance measures, 3.13 definition, 3.8 subsequent measurement, 3.9 on-demand loans, 3.13 between subsidiaries, 3.12 from subsidiary to parent, 3.11 Intra-group transactions and balances consolidation process dividends, 5.11 elimination of, 5.10 finance costs, 5.11 immateriality exclusions, 5.10 interest, deduction of, 5.11 intra-group losses, 5.10 intra-group profit in inventory, elimination of, 5.10 intra-group profit on transfer of fixed asset, 5.12 loans, 5.10 plant and equipment, 5.10 sales and purchases, 5.12 treatment in, 5.10 unrealised profits and losses, 5.12 dividends, 5.11 elimination of generally, 5.10 group level, at, 3.7 finance costs, 5.11 financing transactions, 3.8 foreign currency translation generally, 10.11 intra-group loans, 10.11 net investment in foreign operations, 10.11 group audits, 12.10, 12.11, 12.12, 12.14, 12.15 immateriality exclusions, 5.10 interest, deduction of, 5.11

Intra-group transactions and balances – contd intra-group loans below market rate of interest, 5.11 deduction from group investment income, 5.11 differences between old UK GAAP and FRS 102, 3.7 interest, allocation of, 3.10 interest-free loans, 3.8, 5.11 measurement difference, 3.8–3.9, 3.12–3.13 between subsidiaries, 3.12 from subsidiary to parent, 3.11 intra-group losses, 5.10 intra-group profit in inventory, elimination of, 5.10 intra-group profit on transfer of fixed asset, 5.12 loans, 5.10 measurement difference avoidance measures, 3.13 definition, 3.8 intra-group loans, 3.8–3.9, 3.12–3.13 subsequent measurement, 3.9 overview, 3.7 plant and equipment, 5.10 sales and purchases, 5.12 substance over form requirement, 3.7 unrealised profits and losses, 5.12 Inventory allowances purchase method of accounting, 5.25 Investing activities examples, 9.3 Investment portfolios consolidated financial statements, exemption from, 5.7 investments in associates as part of, 6.3 subsidiary company as part, 5.7 Investment trusts financial institution, as, 2.3 Investments in associates accounting for choice of method, 6.8, 6.17 fair value, 6.8 financial statement, applicable to, 6.2

262

Index Investments in associates – contd consolidated accounting limitations, 6.8 consolidated cash flow statements cash paid to/ received from, 9.11 dividends, 9.11 cost method of accounting, and choice of, 6.8, 6.20 dividends and distributions, 6.9 impairment of assets, 6.9, 6.14 definitions associates/ associated undertakings, 6.4 significant influence, 6.4 derecognition of, 6.19, 8.3 disclosure requirements company law obligations, 6.26 equity method of accounting, 6.1, 6.27 financial reporting obligations, 6.27–6.28 generally, 6.25 risk management, 6.28 small entities, applicable to, 6.28 dividends and distributions cost method of accounting, 6.9 equity method of accounting, 6.11, 6.18 fair value models, 6.23 equity method of accounting, and accounting method differences, adjustment for, 6.17 coterminous reporting dates, 6.16 disclosure obligations, 6.1, 6.27 discontinuance, 6.19 dividends and distributions, 6.11, 6.18 exceptions to, 6.3 fair value adjustments, 6.13 goodwill, 6.10, 6.13 investor transactions with associates, 6.15 limitations, 6.8 long-term loans, 6.15 loss of significant influence, 6.7, 6.19 losses in excess of investment, 6.18 non-applicability to, 5.7, 6.19

Investments in associates – contd equity method of accounting, and – contd potential voting rights, 6.12 provisions and contingencies, recognition of, 6.18 requirement for, 6.3 unrealised profits and losses, elimination of, 6.15 fair value models accounting policy options, 6.8, 6.20 disclosure obligations, 6.27 dividends and distributions, 6.23 fair value through profit or loss, 6.24 guidance on, 6.22 initial recognition, 6.21 small entities, disclosure by, 6.28 subsequent measurement, 6.22 transactions costs, 6.21 investments held as part of an investment portfolio, 6.3 participating interests, 6.4 significant influence benchmarks, 6.4 definition, 6.4 loss of, 6.7, 6.19, 8.3 ownership interest less than 20 percent, 6.4 ownership interest more than 20 percent and entity treated as an associate, 6.6 ownership interest more than 20 percent but entity not treated as an associate, 6.5, 6.19 small entities disclosure requirements, 6.28 fair value measurements, 6.28 risk management, 6.28 Ireland small entities, consolidated financial statements, 1.7 J Joint ventures accounting methods for choice of, 7.8 cost model of accounting, 7.11

263

Index Joint ventures – contd accounting methods for – contd equity methods of accounting, 4.6, 6.19, 7.9 fair value method, 7.12, 7.16 generally, 7.1 impairment losses, 7.11 jointly controlled entities, 7.8 micro-entities, 7.1 acquisition, influences of associate, change in status to become, 8.4 subsidiary, change in status to become, 8.7 applicable financial reporting standards, 1.2 associate, change in status to become, 8.4 business combinations, and, 2.12 control arrangements consent, 7.2 contractual arrangements, 7.2 equity method of accounting, 4.6 joint control, 3.3, 7.2, 8.4 loss of joint control, 8.4 deferred tax on unremitted earnings, 4.6 definition, 7.2 disclosure requirements generally, 7.16 risk management, 7.17 small entities, 7.17 equity method of accounting deferred tax, 4.6 loss of significant influence, 6.19 venturer is a parent, 7.9 financial statements, information included in venturers’ assets and liabilities, 7.4–7.5 venturers’ expenses, 7.4–7.5 venturers’ share of income, 7.4–7.5 group issues group sells to the joint venture, 7.14 joint venture sells to the group, 7.14 ineligible group, part of, 1.12 joint control definition and interpretation, 3.3, 7.2 investors that do not have, 7.15

Joint ventures – contd jointly controlled assets, 7.3, 7.5 jointly controlled entities accounting policy election, 7.7 associate status, acquisition or disposal resulting in change to, 8.4 disclosure requirements, 7.16 equity method of accounting, 8.4 generally, 7.3, 7.6 investment portfolios, held as part of, 7.10 venturer is a parent, 7.9 venturer is not a parent, 7.8, 7.11 jointly controlled operations, 7.3–7.4 other investments, differences from, 7.2 risk management, 7.17 small entities, 7.17 subsidiaries, change in status to, 8.7 transactions between venturer and joint venture, 7.13 types of, 7.3 venturers parent, as, 7.9 recognition in financial statements, 7.4 transactions between venturer and joint venture, 7.13 use of own assets and resources, 7.4 L Large companies classification, 1.4 employees, average number of, 1.4 Large group definition, 1.4 Leaving the EU see Brexit Liabilities business combinations, costs of, 5.24–5.26, 5.28 contingent liabilities, 5.24, 5.26, 5.28 fair value measurement, 5.24 future losses, for, 5.25 onerous contracts, 5.26 restructuring costs as, 5.26

264

Index Limited liability partnerships micro-entities, applicability as, 2.9 Loans intra-group loans see Intra-group loans M Managed on unified basis control as, 5.4 definition, 5.4 Managerial personnel significant influence, and, 6.4 Master Trust schemes ineligible groups exemption applicability, 1.12 Materiality consolidated financial statements, subsidiary exemptions, 5.6, 5.7 group audits, 12.6, 12.8 Maturity analysis consolidated cash flow statements, 9.27 Measurement difference avoidance mechanisms, 3.13 definition, 3.8 intra-group loans, 3.8–3.9, 3.12–3.13 subsequent measurement, 3.9 Medium-sized group definition, 1.4 Merger method of accounting book values, use of, 11.2 called-up share capital, 11.2 fair value measurement, compared with, 11.2 group reconstructions, and investment has carrying amount greater than nominal value of shares acquired, 11.2 investment has carrying amount less than nominal value of shares acquired, 11.2 movement on other reserves, differences shown as, 11.2 non-controlling interests, applicability to, 11.2 shares issues when applying, 11.2 use for, 11.1–11.2 loss of control of subsidiary, and, 8.6

Merger method of accounting – contd overview, 11.2 purchase method of accounting, differences from, 11.2 Merger relief group reconstructions, 11.4 Micro-entities charities, 1.4 definition, 2.9 financial reporting regime exclusions, 1.1, 1.4, 2.10 reporting obligations, 1.1 parent of group, as classification, 1.5 consolidated financial statement procedures, applicability, 1.7, 2.9 partnerships as, 2.9 presentation and disclosure requirements exemptions, 2.5, 2.9 generally, 1.1 Mid-year acquisitions consolidated profit and loss account preparation, 5.37 control, 100 percent indication of, 5.37 goodwill calculation, 5.37 pre- and post-acquisition reserves, 5.37 time-apportionment, 5.9, 5.37 MiFID investment companies ineligible groups exemption applicability, 1.12, 2.10 Minority interest definition, 5.29 Minority shareholders request of consolidated financial statement by, 1.9, 1.11 Monetary definition, 10.6 Monetary assets examples, 10.6 foreign currency translation foreign exchange gains and losses, recognition of, 10.8 historical costs, functional currency measurement, 10.6 net investment in foreign operation, 10.9 qualifying considerations, 10.9

265

Index Money contingent consideration, and, 5.23 time value of, 5.23 Mutual funds financial institution, as, 2.3 N Negative goodwill fair value measurement, 5.35 group audits, 12.9 purchase method accounting, 5.35 reconciliation for, 5.40 Net interpretation, 1.4 non-controlling interests, net method of accounting, 5.24 Net assets fair value of assets acquired, 4.2 reliable measurement, 4.2 Non-controlling interests allocations exceptions, 5.24 share of unrealised profits, 5.12 consolidated cash flow statements, 9.10 consolidation process allocation exceptions, 5.24 allocation of share of unrealised profits, 5.12 consolidated cash flow statements, 9.10 deferred tax, 5.24 employee benefits, 5.24 fair value measurement, 4.9, 5.24–5.25 goodwill, 4.9, 5.24, 5.29 interpretation, 5.9, 5.29 net vs. gross methods of accounting, 5.24 purchase method of accounting, 5.15, 5.24 recognition of interests, 5.24, 5*29 separate presentation of, 5.9 share of subsidiary’s net assets at balance sheet date, 5.9 deferred tax, 5.24 definition, 5.29 dividends paid to, 9.10

Non-controlling interests – contd employee benefits, 5.24 fair value measurement, 4.9, 5.24–5.25, 5.29 goodwill, 4.9, 5.24, 5.29 group reconstructions, 11.2 interpretation, 5.9, 5.29 net vs. gross methods of accounting, 5.24 purchase method of accounting, 5.15, 5.24 recognition of interests, 5.24, 5*29 separate presentation of, 5.9 share of subsidiary’s net assets at balance sheet date, 5.9 unrealised profits, allocation of share of, 5.12 Non-monetary assets examples, 10.6 foreign currency translation foreign exchange gains and losses, recognition of, 10.8 measured at historical cost, 10.6 revaluation of, 10.8 O Onerous contracts generally, 5.26 Open-ended investment companies (OEICs) financial institution, as, 2.3 Operating activities cash flows from, 9.21–9.22 examples, 9.2 Operational activities functional currency, 10.2 Overseas subsidiaries group accounts challenges, 3.1, 12.20 treatment of, 12.20 group audits foreign currency translation, 12.20 P Parent companies audit exemptions subsidiary companies, declaration of guarantee, 1.13

266

Index Parent companies – contd consolidated financial statements 50–90 per cent ownership, 1.9 90 per cent ownership, 1.8 preparation obligations, 5.1 small entities provisions, applicability, 1.7 subsidiary companies included, 1.10 subsidiary companies not included, 1.10 control interpretation, 3.2 loss of control, 5.3, 8.6 definition, 1.4, 5.1 investment in associates, accounting treatment of see Investments in associates significant interest, 3.2 size of, 1.5 Parent entities definition, 2.3, 2.5 Participating interests definition, 6.4 Partnerships micro-entities, applicability as, 2.9 qualifying partnerships, 2.9 Plant and equipment consolidation, intra-group transactions and balances, 5.10 disclosure exemptions, 2.5 Post-acquisition reserves mid-year acquisitions, 5.37 Post-employment benefit plans special purpose entities, and, 5.8 Pre-acquisition reserves mid-year acquisitions, 5.37 Presentation of financial statements see also Consolidation process definitions financial institutions, 2.3 parent entities, 2.3 qualifying entities, 2.3 disclosure requirements, 2.3 content, 2.4 exemptions, 2.3 financial institutions, 2.3 parent entities, 2.3 qualifying entities, 2.3

Profit and loss accounts see also Consolidated profit and loss accounts business combinations, impact of, 5.25 negative goodwill, 5.35 purchase method of accounting, 5.25 Property, plant and equipment consolidation, intra-group transactions and balances, 5.10 disclosure requirements, 2.5 Provisional accounts disclosure requirements, 5.28 time limits for adjustments, 5.28 Provisions and contingencies contingent consideration, 5.23, 5.28 contingent liabilities, 5.24, 5.26, 5.28 equity method of accounting, and, 6.18 recognition of, 6.18 Public benefit entities business combinations, 2.12 consolidated financial statements, 8.6 subsidiaries, 8.6 Public interest financial reporting standards, and, 2.1 Purchase method of accounting acquisition date, determination of, 5.15, 5.17 business combinations deferred tax, 4.8 use for, 5.15 consolidation process acquirer, identification of, 5.15, 5.16 acquisition date, determination of, 5.15, 5.17 contingent consideration, 5.23, 5.28 cost of business combination see Costs deferred consideration, 5.21 discounted deferred consideration, 5.21 goodwill, recognition and measurement of, 5.15, 5.30–5.35 non-controlling interests, recognition and measurement, 5.15, 5.24–5.29 quoted instruments, 5.19 requirement to use, 5.15 unquoted instruments, 5.20

267

Index Purchase method of accounting – contd deferred tax, 4.8 goodwill calculation, 5.18, 5.31, 5.37 deferred consideration, and, 5.21 recognition and measurement, 5.15, 5.30–5.35 inventory allowances, 5.25 merger method of accounting, differences from, 11.2 Q Qualifying consideration definition, 10.9 Qualifying entities definitions, 2.3, 2.5 disclosure requirements exemptions, 2.5 generally, 2.3 ineligible organisations, 2.3 Qualifying partnerships micro-entities, applicability as, 2.9 Quoted instruments purchase method of accounting, 5.19 R Readily convertible interpretation, 9.5 qualifying consideration, and, 10.9 Recognition contingent consideration, 5.23, 5.28 contingent liabilities, 5.24, 5.26, 5.28 foreign exchange gains and losses, 10.8 goodwill initial recognition, 5.31 subsequent measurement, 5.32 intangible assets, 5.36 investments in associates, 6.18 net investment in foreign operation, 10.1 non-controlling interests, 5.24, 5.29 Regulated markets definition, 1.12 Related party disclosures exemptions, 2.5 Reporting dates coterminous reporting dates, 5.13, 6.16 initial accounting incomplete at, 5.27 non-coterminous reporting dates, 5.13

Restructuring costs business combinations, 5.25 Revenue disclosure requirements, 5.39 Review of financial reporting standards cash flow statements acquisition or disposal of subsidiaries, 9.24 background, 9.7, 9.17 cash and cash equivalents, 9.19–9.20 financing cash flows, 9.25 findings, 9.18 interest and dividends, treatment of, 9.22 investing cash flows, 9.23 liquidity risk disclosures, 9.26 maturity analysis, 9.27 supplier financing arrangements, 9.30 working capital arrangements, 9.30 Covid-19 pandemic, and, 2.1 effective from dates, 2.1 Exposure Drafts, 2.1 Kingman Review, 2.1 purpose, 2.1 timescales for, 2.1 Risk assessment component auditors, of, 12.5 factors for consideration during, 12.5 group audits generally, 12.5 management bias, 12.8 material misstatements, 12.5–12.6, 12.8, 12.10 Risk management disclosure requirements investments in associates, 6.28 joint ventures, 7.17 small entities, 6.28, 7.17 S Separate financial statements consolidated financial statements, and, 2.11 definition, 1.4

268

Index Share-based payments disclosure exemptions, 2.5 non-controlling interests, recognition of, 5.24 purchase method of accounting, 5.24 Significant influence benchmarks, 6.4 control, and, 3.2, 6.4 definition, 3.2, 6.4 investments in associates loss of, 6.7, 6.19, 8.3 ownership interest below 20 percent, 6.4 ownership interest more than 20 percent and entity treated as an associate, 6.6 ownership interest more than 20 percent by entity not treated as an associate, 6.5, 6.19 Small entities see also Micro-entities classification, 1.4 disclosure requirements investments in associates, 6.28 joint ventures, 7.17 employees, average number, 1.4 risk management, 6.28, 7.17 Small groups classification generally, 2.10 parent company, size of, 1.5 qualifying conditions, 2.10 definition, 1.4 ineligible groups, 1.12, 2.10 preparation of consolidated accounts exemption criteria, 2.10 parent company, by, 2.10 size test, 1.5, 1.12, 2.10 Software group audits, for, 12.10 Special purpose entities control of, 5.8 employee benefit trusts, 5.8 employee share ownership plans, 5.8 intermediate payment arrangements, as, 5.8 post-employment benefit plans, and, 5.8

Specialised activities accounting treatment, 2.12 Statement of accounts definition, 1.4, 10.1 Statement of Recommended Practice (SORP) applicable standards, 2.2 Step acquisitions consolidation, challenges of, 8.1 trends, 3.5 Subsidiary companies accounting dates different from parent company, 5.13 acquisition date, 3.4 acquisition or disposal change to financial investment status, 8.6 consolidated cash flow statements, 9.12–9.14, 9.16 date of, 3.4 deemed disposals, 8.9 goodwill, 5.31, 8.6, 12.9 group audits, 12.9, 12.15 sale, 5.3 asset seizure by local government, 5.3 associates, differences from, 6.4 audit exemptions, 1.13 cash-generating unit, as, 5.33 consolidated cash flow statements acquisition of subsidiary, 9.12–9.13 assets and liabilities, 9.14 disposal of subsidiary, 9.12, 9.14 consolidated financial statements, exemption from choice of accounting policy, 5.7 dissimilar activities, 5.5 generally, 1.12 information only obtained with disproportionate expense, 5.7 limitations, 5.5–5.6 long-term restrictions hinder rights of parent over assets or management, 5.7 materiality considerations, 5.6, 5.7 significant influence, equity method treatment as associate, 5.7, 6.7

269

Index Subsidiary companies – contd consolidated financial statements, exemption from – contd subsidiaries as part of investment portfolio, 5.7 subsidiary interests held with view to subsequent resale, 5.7 control loss of, 5.3, 8.6 transfer of, 5.3, 5.7 definition, 5.1, 5.2 dissimilar activities, information on, 5.5 fair value of assets acquired deferred tax on unremitted earnings, 4.4 loss-making subsidiaries, 4.8 group audits acquisitions, treatment of, 12.9, 12.15 exemption from, 1.13 investments in, 12.9 support letters, 12.14 intra-group loans loans between subsidiaries, 3.12 loans from subsidiary to parent, 3.11 liquidation or insolvency, 5.3, 5.7 loss of control, 5.3, 8.6 overseas subsidiaries foreign currency translation, 12.20 group accounts, 3.1, 12.20 group audits, 12.20 parent declaration of guarantee, 1.13 sale of, 5.3 transactions between subsidiaries change in ownership status, and, 8.5 change to financial investment status, 8.6 transfer of control, 5.3, 5.7 Substance over form requirement generally, 1.3 intra-group transactions, 3.7 Support letters group audits, 12.14, 12.21

T Taxation deferred tax see Deferred tax group relief, transferred at less than applicable tax rate, 4.9 Traded companies definition, 1.7, 1.12 ineligible groups, and, 1.12, 2.20 Transaction costs purchase method of accounting, 5.22 True and fair requirements applicability to financial reporting requirements, 2.2 criminal offence, failure to comply as, 1.6 definition, 1.6 expectations gap, and, 1.6 fair value measurement see Fair value measurement Trust arrangements de facto control, 5.2 U UCITS management companies ineligible groups exemption applicability, 1.12, 2.10 Unified management control, basis of, 5.4 Unincorporated entities deferred tax assets, 4.7 interests in, 4.7 Unit trusts financial institution, as, 2.3 Unquoted instruments purchase method of accounting, 5.20 Unremitted earnings deferred tax on associates, from, 4.5 future dividends, 4.4 group reconstructions, from, 4.8 joint ventures, from, 4.6 overview, 4.3 parent lack of control over dividend payment, 4.4 subsidiaries, from, 4.4

270

Index V Venture capital trusts financial institution, as, 2.3 Voting rights convertible debt, 5.2 definition, 5.2 majority, 5.2

Voting rights – contd potential voting rights, 5.2 substantive rights, 5.2 W Written representations group audits, 12.15

271

272