Consolidation Book 3 - For Website

This Project is funded by EU
for Bank Accounting Professionals
CONSOLIDATION PART 3
banks2ifrs.ru ruru
Consolidation Part 3
PREFACE
These workbooks are an update of those originally written by the project team
of the European Union funded project Accounting Reform II in the Russian The project team would like to express thanks to those who have contributed
Federation and revised by the project team of the European Union funded their time and thoughts to the content of the workbooks. In particular:
project, Implementation of Accounting Reform in the Russian Federation.
This version has been produced by the European Union funded project The European Union Delegation, Moscow
Transition to IFRS in the Banking Sector.
The Bank of Russia, Moscow
The workbooks cover various concepts of IFRS based accounting. They are
intended to be practical self-instruction aids that professional accountants can
use to upgrade their knowledge, understanding and skills. Note: Material from the following PricewaterhouseCoopers publications has
been used in this workbook:
The purpose of this version is to help bank accountants in the use of IFRS.
-Applying IFRS
Each workbook is a self-standing short course designed for approximately of -IFRS News
three hours of study. -Accounting Solutions
The members of the project team were contributed by PwC Moscow, FBK
Moscow, and European Savings Bank Group Brussels. Although the
workbooks are part of a series, each one is independent of the others.
A basic knowledge of accounting is assumed but if any additional knowledge is

required this is mentioned at the beginning of the section.
Each workbook is a combination of Information, Examples, Self-Test

Questions and Answers.
Contact:
The volumes within each series are described in detail and available for
download from the project web site. e-mail website
anna.voevoda@ru.pwc.com www.banks2ifrs.ru
The copyright of the material contained in each workbook belongs to the
Tel. Fax.
European Union and according to its policy may be used free of charge for any
+ 7 495 772-7091 + 7 495 772-7094
non-commercial purpose.
Moscow, Russia, August 2008 (Updated)
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CONTENTS
1. Consolidation Introduction
1. Consolidation Introduction 3 AIM
2. Definitions 4 The aim of this workbook is to assist the individual in understanding
3. Fair Value Accounting 5 consolidation methodology for IFRS.
4. Disposal of a Subsidiary 15
5. The Equity Method of Accounting 26 CONSOLIDATION APPROACH
6. Associates 27
7. Cost Method 33 To consolidate a business combination requires:
8. Joint Ventures 33
9 Special Purpose Entities / Special Purpose Vehicles 36 (i) identifying the acquirer;
10. Outsourcing contracts: an accidental business combination? 41
11. Carve-out / combined financial statements 43 (ii) determining the acquisition date;
12. Multiple Choice Questions 47
13. Self Test Questions 48 (iii) recognising and measuring the identifiable assets acquired, liabilities
14. Suggested Solutions 51 assumed and any non-controlling interest in the acquiree; and
15. Appendix: IFRS Framework 53
(iv) recognising and measuring goodwill or a gain from a bargain purchase.
OTHER WORKBOOKS Before commencing a consolidation, the accountant should have the full
financial statements of the parent and subsidiaries prepared using the same
Consolidation 1 and 2 concentrate on practical consolidation. accounting policies. This includes statements for companies bought or sold.
The IFRS 3 workbook concentrates on that standard which provides guidance Ideally all subsidiary year-ends should be the same as the parent undertaking.
on specific points, such as the purchase of companies in stages, loss of But IAS 27 permits a maximum difference of 3 months.
control but retention of an associate and reverse takeovers.
Adjustment should be made for any significant differences created by any
subsidiary having a different accounting date.
The length of reporting periods, and any difference in the reporting dates,
should be consistent from period to period.
Transactions between group undertakings should be listed, and inter company

balances reconciled.
Spreadsheets are ideal for producing consolidated balance sheets and income
statements, although bespoke consolidated software is also available.
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FAIR VALUE
2. Definitions Fair value is the value for which an asset could be sold, or a liability
extinguished, between willing independent traders.
UNDERTAKING
An undertaking is any business, either incorporated or unincorporated. MONETARY ASSETS
Monetary assets are money held, assets receivable, and liabilities payable, in
PARENT (NOW CALLED CONTROLLING INTERESTS) cash.
A parent is an undertaking that controls another undertaking.
UNITING OF INTERESTS
SUBSIDIARY Uniting (or pooling) of interests is an alternative method of consolidation.
A subsidiary is an undertaking that is controlled by another. It reflects the merger of two, or more, interests, where no undertaking can be
identified as the acquirer.
GROUP, OR BUSINESS COMBINATION
Two or more companies where one company controls the other(s). IFRS 3 eliminated this method as an option for acquisitions.
Consolidated accounts will be required if one business controls another, ASSOCIATE

whatever are the means of control. An undertaking in which the parent has significant influence, but is neither its
subsidiary, nor part of a joint venture of the parent.
Dissimilar business activities must be consolidated, if they controlled by the
parent undertaking. Indications of significant influence are:
CONTROL  Ownership of 20-50% of the voting shares.

Control is the power to govern the financial and operating policies of an
undertaking to obtain benefits.  Representation on the Board of Directors.
Indications of control are: JOINT VENTURE

A joint venture is an undertaking subject to the joint control of two or more
 Ownership of more than 50% of the voting rights. enterprises. The joint control is usually governed by a contract between the
parties.
 Effective control over more than 50% of the voting rights.
For example, a husband owns 30% and a wife owns 40%. As they are
connected parties, they can exercise control over the subsidiary.
 Controlling the composition of the board of directors.
MINORITY INTEREST (NOW CALLED NON-CONTROLLING INTERESTS)

Minority interest is the part of the results and net assets of a subsidiary
attributable to others outside the group.
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3. Fair Value Accounting Example:
When making an acquisition, you pay the market price (or an amount close to You buy a firm for its net asset value of $1 million. You plan to merge its
the market price) for the undertaking being purchased. business with your own and to make its staff redundant, which will cost you
$0,2million.
You take into account any undervaluation of fixed assets, overvaluation of
inventory or accounts receivable, and future liabilities that have not been You record a provision, in the balance sheet, for the $0,2million by creating
booked in the accounts. goodwill of the same amount.
Consolidated financial statements should reflect these under and There is no impact on the income statement.
overvaluations by revaluing assets and liabilities.
When the redundancies occur, they are charged to the provision, again
This process of revaluing to contemporary market prices is Fair Value avoiding any impact on the income statement.
Accounting.
IAS 37 Provisions, Contingent Liabilities and Contingent Assets details when a
The basic principles of using Fair Value Accounting in consolidated financial provision should be recognised. In the above example a provision is no longer
statements are: allowed to be made and such costs have to be expensed when incurred.
 All assets and liabilities acquired are brought into the consolidated IFRS 3 Business Combinations forbids creating liabilities for future losses, or
balance sheet at fair value on acquisition (exceptions are listed in costs anticipated to be incurred as a result of the acquisition, unless:
IFRS 5, being assets held for sale); - the acquiree had developed plans prior to the acquisition, or
- an obligation comes into existence as a direct consequence of the
 All changes in the values of acquired assets after acquisition are acquisition.
included in the consolidated income statement.
Example:
Establishing market prices for all assets and liabilities can have many
problems in practice and estimates may have to be made. The vendor of a firm wants $25million for it. You only have $22 million now.
One problem that can arise is that any assets / liabilities recognised on You agree to pay the additional $3million, if the first year’s audited profits
acquisition are capitalised, and included in the balance sheet, whereas any exceed $4million. There is therefore a liability created in the consolidated
changes in asset value post-acquisition are included in the income statement. balance sheet for $3m, discounted to a net present value to reflect that
payment will be made in the future.
This could provide scope for manipulation of profits.
For example, provisions may be set up in the balance sheet on acquisition,

and used against items that would normally be charged in the income
statement, thus inflating profit.
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from IFRS 3 (Revised): Impact on earnings − the crucial Q&A for decision the award and also whether or not the options are replacing existing options
makers _PwC held by the employee in the acquired business. Options are likely to be
consideration for post-acquisition service where some of the payment is
Consideration conditional on the shareholders remaining in employment after the transaction.
In such circumstances, a charge is recorded in post-acquisition earnings for
Consideration is the amount paid for the acquired business. Some of the most employee services. These awards are made to secure and reward future
significant changes are found in this section of the revised standard. Individual services of employees rather than to acquire the existing business.
changes may increase or decrease the amount accounted for as
consideration. These affect the amount of goodwill recognised and impact the Some of the payments for the business are earn-outs. How are these
post-acquisition income statement. Transaction costs no longer form a part of accounted for?
the acquisition price; they are expensed as incurred. Consideration now
includes the fair value of all interests that the acquirer may have held It is common for some of the consideration in a business combination to be
previously in the acquired business. This includes any interest in an associate contingent on future events. Uncertainty might exist about the value of the
or joint venture or other equity interests of the acquired business. If the acquired business or some of its significant assets. The buyer may want to
interests in the target were not held at fair value, they are re-measured to fair make payments only if the business is successful. Conversely, the seller wants
value through the income statement. to receive full value for the business. Earn-outs are often payable based on
post-acquisition earnings or on the success of a significant uncertain project.
The requirements for recognition of contingent consideration have also been
amended. Contingent consideration is now required to be recognised at fair The acquirer should fair value all of the consideration at the date of acquisition
value even if it is not deemed to be probable of payment at the date of the including the earn-out. If the earn-out is a liability (cash or shares to the value
acquisition. All subsequent changes in debt contingent consideration are of a specific amount), any subsequent re-measurement of the liability is
recognised in the income statement, rather than against goodwill as today. recognised in the income statement. There is no requirement for payments to
be probable, which was the case under IFRS 3. An increase in the liability for
The selling-shareholders will receive some share options. What effect strong performance results in an expense in the income statement.
will this have? Conversely, if the liability is decreased, perhaps due to under-performance
against targets, the reduction in the expected payment will be recorded as a
An acquirer may wish selling-shareholders to remain in the business as gain in the income statement.
employees. Their knowledge and contacts can help to ensure that the
acquired business performs well. These changes were previously recorded against goodwill. Acquirers will have
to explain this component of performance: the acquired business has
The terms of the options and employment conditions could impact the amount performed well but earnings are lower because of additional payments due to
of purchase consideration and also the income statement after the business the seller.
combination. Share options have a value. The relevant accounting question is
whether this value is recorded as part of the purchase consideration, or as Does it make a difference whether contingent consideration (an earn-out)
compensation for post-acquisition services provided by employees, or some is payable in shares or in cash?
combination of the two. Is the acquirer paying shareholders in their capacity as
shareholders or in their capacity as employees for services subsequent to the Yes, it does make a difference. An earn-out payable in cash meets the
business combination? definition of a financial liability. It is re-measured at fair value at every balance
sheet date, with any changes recognised in the income statement.
How share options are accounted for depends on the conditions attached to
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Earn-outs payable in ordinary shares may not require re-measurement through

the income statement. This is dependent on the features of the earn-out and The revised IFRS 3 has limited changes to the assets and liabilities recognised
how the number of shares to be issued is determined. in the acquisition balance sheet. The existing requirement to recognise all of
the identifiable assets and liabilities of the acquiree is retained. Most assets
An earn-out payable in shares where the number of shares varies to give the are recognised at fair value, with exceptions for certain items such as deferred
recipient of the shares a fixed value would meet the definition of a financial tax and pension obligations.
liability. As a result, the liability will need to be fair valued through income.
Conversely, where a fixed number of shares either will or will not be issued Have the recognition criteria changed for intangible assets?
depending on performance, regardless of the fair value of those shares, the
earn-out probably meets the definition of equity and so is not re-measured No, there is no change in substance. Acquirers are required to recognise
through the income statement. brands, licences and customer relationships, amongst other intangible assets.
The IASB has provided additional clarity that may well result in more intangible
A business combination involves fees payable to banks, lawyers and assets being recognised, including leases that are not at market rates and
accountants. Can these still be capitalised? rights (such as franchise rights) that were granted from the acquirer to the
acquiree.
No, they cannot. The standard says that transaction costs are not part of what
is paid to the seller of a business. They are also not assets of the purchased What happens to the contingent liabilities of the acquired business?
business that are recognised on acquisition.
Many acquired businesses will contain contingent liabilities − for example,
Transaction costs should be expensed as they are incurred and the related pending lawsuits, warranty liabilities or future environmental liabilities. These
services are received. are liabilities where there is an element of uncertainty; the need for payment
will only be confirmed by the occurrence or non-occurrence of a specific event
The standard requires entities to disclose the amount of transaction costs that or outcome. The amount of any outflow and the timing of an outflow may also
have been incurred. be uncertain.
What about costs incurred to borrow money or issue the shares used to There is very little change to current guidance under IFRS. Contingent assets
buy the business. Do these also have to be expensed? are not recognised, and contingent liabilities are measured at fair value. After
the date of the business combination contingent liabilities are re-measured at
No, these costs are not expensed. They are accounted for in the same way as the higher of the original amount and the amount under the relevant standard,
they were under the previous standard. IAS 37. US GAAP has different requirements in this area.
Transaction costs directly related to the issue of debt instruments are Measurement of contingent liabilities after the date of the business
deducted from the fair value of the debt on initial recognition and are amortised combination is an area that may be subject to change in the future.
over the life of the debt as part of the effective interest rate.
If consideration paid and most assets and liabilities are at fair value,
Directly attributable transaction costs incurred issuing equity instruments are what does this mean for the post-combination income statement?
deducted from equity.
Fair valuation of most things that are bought in a business combination already
Asset and liability recognition existed under IFRS 3. The post-combination income statement is affected
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because part of the ‘expected profits’ is included in the valuation of identifiable Those conditions are unlikely to exist at the acquisition date in most business
assets at the acquisition date and subsequently recognised as an expense in combinations. A restructuring plan that is conditional on the completion of the
the income statement, through amortisation, depreciation or increased costs of business combination is not recognised in the accounting for the acquisition. It
goods sold. is recognised post-acquisition, and the expense flows through post-acquisition
earnings.
A mobile phone company may have a churn rate of three years for its
customers. The value of its contractual relationships with those customers,
which is likely to be high, will be amortised over that three-year period.
EXAMPLE - Deferred and contingent considerations
There may be more charges in the post-combination income statement due to
increased guidance in IFRS 3 (Revised) on separating payments made for the Entity A produces and sells sporting goods and clothes. It acquired 100% of
combination from those made for something else. For example, guidance has entity B from Mr Jones in 20X4.
been included on identifying payments made for post-combination employee
services and on identifying payments made to settle pre-existing relationships Entity B sells badminton clothing, shoes, equipment and accessories and has
between the buyer and the acquiree. grown rapidly since incorporation. Mr Jones’s asking price was based on
aggressive profit forecasts, which assume continuing rapid growth and
With contingent consideration that is a financial liability, fair value changes will estimated the fair value of entity B to be 200m.
be recognised in the income statement. This means that the better the
acquired business performs, the greater the likely expense in profit or loss. Fashions in the sporting goods and clothing sector change rapidly.
Can a provision be made for restructuring the target company in the Entity A has taken a more conservative view and estimated the fair value to be
acquisition accounting? 166.5m.Entity A is only prepared to pay Mr Jones’s price if profits reach his
forecast levels.
The acquirer will often have plans to streamline the acquired business. Many
synergies are achieved through restructurings such as reductions in head- Entity A agreed to acquire entity B for 150m plus a further payment of 50m in
office staff or consolidation of production facilities. four years.
An estimate of the cost savings will have been included in the buyer’s This payment will comprise:
assessment of how much it is willing to pay for the acquiree.
(i) a guaranteed minimum payment of 20m with no performance conditions;
The acquirer can seldom recognise a reorganisation provision at the date of and
the business combination. There is no change from the previous guidance in
the new standard: the ability of an acquirer to recognise a liability for (ii) a further payment of 30m if actual profits for the four-year period exceed
terminating or reducing the activities of the acquiree in the accounting for a the cumulative forecast profit.
business combination is severely restricted.
The forecast cumulative profit over the four-year period is 80m.
A restructuring provision can be recognised in a business combination only
when the acquiree has, at the acquisition date, an existing liability, for which Entity A’s management concludes at the acquisition date that it is not probable
there are detailed conditions in IAS 37, the provisions standard. that the forecast levels will be reached.
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Actual profits are 15m in the first year following the acquisition. However, EXAMPLE - Fair values in a business combination
cumulative actual profits are 60m by the end of the second year.
Entity E operates two lines of business: luxury leather goods and perfumes. It
Management conclude at the end of the second year that payment of the acquires entity F, which operates in leather goods and has its own brand. E
additional 50m is probable. Actual profits exceed forecast profits for the final plans to sell F’s products through E’s existing retail network. It also plans to
two years. develop the acquired brand in its perfume business.
How should the deferred and contingent amounts affect the accounting for the Many entities in the luxury business have their own retail network but the fact
purchase consideration? that E also has the perfume business is specific to E only.
The purchase consideration is 150m plus the present value of the guaranteed Should the fair value of the identifiable assets and liabilities of F include any
minimum payment of 20m (16.5m) at the acquisition date (IFRS 3). synergy values arising from the business combination or should the synergy
value be subsumed within goodwill?
The 20m represents deferred purchase consideration and is a financing
transaction. Entity A records 166.5m as its cost of investment, together with a The definition of fair value in IFRS 3 is ‘the amount for which an asset could be
provision for the deferred consideration of 16.5m.The discount of 3.5m is a exchanged or a liability settled between knowledgeable, willing parties in an
finance cost and is recorded as interest expense over the four-year period. arm’s length transaction’. Fair value is measured for each identifiable asset
and liability and is therefore an asset-specific, rather than an entity-specific
An additional amount is payable if entity B achieves a certain level of concept.
performance. The 30m represents contingent consideration.
It follows that the fair value of an asset is determined based on the separate
Management concludes at the date of acquisition that payment is not probable purchase of that asset. The purchaser is assumed to be a hypothetical market
as the forecast profit levels are too aggressive. It considers the fair value to participant, and the market of potential purchasers is made up of all potential
be zero and does not increase the purchase consideration. It reaches the purchasers – both industry and financial buyers.
same conclusion at the end of year one as actual results are below forecast.
Synergies available to more than one market participant should be included in
IFRS 3 allows a maximum of 1 year to change the purchase the fair value of the identifiable assets. The definition of fair value under IFRS
consideration. encompasses the synergies that could be obtained by any market participant
that might buy the asset.
(Had it believed by the end of year 1 that the payment would have to be made,
an adjustment would be made to the purchase consideration to record the As such, those synergies are reflected in the purchase price of the individual
discounted present value of the 30m (IFRS3.32).The revision to purchase asset. All acquirer-specific synergies would not affect the fair value of the
consideration results in the recognition of additional goodwill and a liability. individual asset and should be included in goodwill.
Management revises its estimate at the end of the second year and concludes Synergies that result from the use of E’s retail network to sell products under
that payment of the contingent consideration is probable. F’s brand are market synergies of the luxury industry, as other potential
acquirers of this business also have a retail network. These should be
It is now too late to change the purchase consideration, and any payment reflected in the fair value of the identifiable assets.
will be expensed in the income statement.
Synergies relating to the development of the acquired brand through one of
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E’s existing activities are synergies specific to E and should be included in

goodwill. Can I plc capitalise these valuation costs as part of the cost of acquisition?
IFRS 3 excludes within the cost of the business combination any costs that
Intangible Assets (see IAS 38 workbook) are directly-attributable to the combination such as professional fees paid to
accountants, legal advisers, valuers and other consultants to effect the
Intangible assets should be created as a result of business combinations if combination. These must be expensed and reported as transaction costs.
they meet the IAS 38 criteria. Some of the intangible assets, such as client
lists, would not meet the criteria if internally-generated, but meet the criteria if In our view, directly attributable means that the costs have to have been
purchased in a business combination. incurred to effect the combination.
IAS 38 specifies the accounting treatment of significant classes of intangible Valuation costs incurred prior to the acquisition date must be expensed and
assets, eg in business combinations acquired trademarks, trade names, reported as transaction costs as part of the cost of the combination.
internet domain names, non-competition agreements, customer lists and
databases, customer contracts and the related contractual and non-contractual However, costs incurred post-acquisition to determine the fair value of the
customer relationships, banking or other licenses, favourable lease assets acquired have not been incurred to effect the combination and must be
agreements, construction permits, patented technology, etc. expensed and not considered to be transaction costs of the combination..
Servicing contracts such as mortgage servicing contracts acquired in business This would also apply to other types of valuation costs (eg, for tangible fixed
combinations may be intangible assets except if mortgage loans, credit card assets and pension liabilities).
receivables or other financial assets are acquired in a business combination
with servicing retained, then the inherent servicing rights are not a separate CONSISTENT ACCOUNTING POLICIES
intangible asset because the fair value of those servicing rights is included in Consistent accounting policies must be applied and in preparing consolidated
the measurement of the fair value of the acquired financial asset financial statements, the accounting statements of the acquired company may
have to be adjusted to reflect the same policies of the parent.
EXAMPLE - Business combinations: valuation of assets –transaction EXAMPLE - Different accounting policies for parent and subsidiary
costs
Entity A is preparing its first IFRS financial statements in accordance with
I plc acquired J Ltd during the year. IFRS 3 requires that I plc must allocate the IFRS 1, First-time Adoption of IFRS. One of its subsidiaries, entity B, already
cost of the business to J Ltd’s identifiable assets (including intangibles) and publishes IFRS financial statements.
liabilities at their fair values where they meet the recognition criteria of IFRS 3.
Entity A must therefore include B’s assets and liabilities in its consolidated
Subsequent to the acquisition, I plc has incurred costs from external IFRS financial statements at the same values at which they are included in B’s
organisations in having valuations performed to determine the fair value of the financial statements after consolidation adjustments and the effects of any
assets (particularly intangible assets) acquired. business combination in which entity A acquired entity B (IFRS 1).
I plc’s management argue that the costs would not have been incurred if the Entity B holds fixed interest medium-term debt securities. Entities A and B both
business combination had not occurred and that they are therefore directly intend for these investments to be held until maturity. Entity A has adopted a
attributable to the combination. policy of classifying all financial assets of this type as available for
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sale. However, entity B classifies all these financial assets as held to maturity. benefits of the complementary geographical spread of C’s stores.
Does IFRS 1 prevent entity A from accounting for the fixed interest medium- Is the proposed accounting treatment acceptable?
term debt securities held by entity B as available for sale?
No. IFRS 3 requires that the acquired assets and liabilities are recognised by
No. IFRS 1 requires entity A to apply its accounting policy of available for sale the acquirer at fair value. The fair value should not reflect the acquirer’s
to the financial assets held by entity B because IAS 27 requires that uniform intentions for the use of the assets acquired.
accounting policies are applied when preparing consolidated financial
statements. Accordingly B should recognise C’s brand name as an intangible asset at
E40m and the signage as property, plant and equipment at E10m. The assets
Accounting for entity B’s financial assets as available for sale is therefore should be amortised and depreciated to their residual value over their
appropriate. expected useful lives in accordance with IAS 38 Intangible Assets, and IAS 16.
Property, Plant and Equipment, respectively.
EXAMPLE - Fair values calculation The replacement of the signs will be phased over the two years. As each sign
is replaced the cost of the new sign should be capitalised and any
Entity B operates a national chain of fashion clothing retail stores. During 2006 undepreciated book value of the replaced sign should be written off.
it acquired entity C, which operates a rival fashion clothing retail chain. The
majority of C’s stores are in locations where entity B does not have stores. EXAMPLE - Fair values calculation – financial instruments, insurance
contracts, leases
Entity B’s management have decided to replace C’s brand name over a two-
year period and during this time it will replace the storefront signs with its own Easter Bunny acquires Dark Chocolate Group (DCG) on the 24 March 2008.
brand name. DCG holds a range of financial instruments accounted for in accordance with
IAS 39 including:
The fair values of C’s brand name and the signage to be replaced have been
determined by independent valuations specialists at €40m and €10m a) non-derivative investments classified by DCG as held to maturity, available
respectively. for same and at fair value through profit or loss,
The fair value of the brand name represents the value that a third party would b) hybrid (combined) instruments containing embedded derivatives that have
be willing to pay in an arm’s length transaction. The fair value of the signage to been separated under the requirements in IAS 39,and
be replaced has been calculated based on depreciated replacement cost in
accordance with IFRS 3. c) derivatives to which DCG has applied hedge accounting.
Entity B’s management propose to recognise C’s brand name and signage at Easter Bunny has early adopted IFRS 3 (Revised). How should Easter Bunny
only E4m and E1m respectively in its purchase accounting under IFRS 3 as it account for these financial instruments in its consolidated financial
plans to phase out the brand name and replace the signage over the next two statements?
years.
IFRS 3 (Revised) provides more guidance on the classification or designation
It plans to include the remaining value within goodwill because the benefits of financial instruments than the current standard. It requires Easter Bunny to
that B will receive from the acquisition will be derived largely from synergy treat the financial instruments in the same way as if it had acquired them
individually (rather than in a business combination). Entity C’s management will determine the fair value of the finance lease
payable based on the present value of the estimate future cashflows.
Accordingly, on the acquisition date:
Should C’s management use a discount rate that reflects only entity D’s credit
a) Easter Bunny needs to reassess the classifications of the non-derivative rating or should it use one that reflects the combined credit rating of both
investments held by DCG to reflect Easter Bunny’s intentions and practices. entities C and D to determine the fair value?
This means that some items may be measured on a different basis in the
consolidated accounts of Easter Bunny, than previously by DCG. Entity C’s management should use a discount rate that reflects the credit
rating only of entity D.
b) Easter Bunny needs to reassess whether any embedded derivatives need
to be separated, based on the relevant conditions at acquisition date. As a IFRS 3 requires that the acquirer recognises the acquiree’s liabilities at their
result, embedded derivatives that were not previously separated by DCG may fair values at acquisition date. Fair value is defined in IFRS 3 as the amount
need to be separated and vice versa. for which a liability could be settled between knowledgeable willing parties in
an arm’s length transaction.
c) Easter Bunny needs to reassess the designation of derivative instruments
as hedging instruments to reflect its own risk management policies and The determination of fair value should not, therefore, reflect the acquirer’s
practices. discount rate because this would provide a value specific to the acquirer rather
than a general, nonentity-specific, fair value.
Furthermore, hedge accounting should be restarted as from the acquisition
date. This means that some hedges in particular cashflow hedges that EXAMPLE - Indemnities under IFRS 3 (Revised)
previously qualified for hedge accounting may fail the effectiveness test
required by IAS 39, in which case hedge accounting cannot be continued in Daffodil plc buys 61% of Folly Limited from Bluebell. Per the agreement
the group accounts. Bluebell will indemnify Daffodil for any warranty claims post the transaction.
The warranty relates to inventory sold by Folly before the acquisition.
However, under IFRS 3 (Revised), Easter Bunny does not reassess whether
contracts are classified as insurance contracts in accordance with IFRS 4, Assuming that Daffodil early adopts IFRS 3 (Revised), Business
Insurance Contracts, nor the classification of lease contracts as financial or Combinations, how should Daffodil account for the indemnity on acquisition?
operating leases in accordance with IAS 17, Leases.
IFRS 3 (Revised) clarifies that the indemnity is recognised as an asset of the
acquiring business and therefore does not affect goodwill.
EXAMPLE - Business combinations - lease valuation
The indemnity is measured on the same basis as the indemnified liability
Entity C acquired 100% of entity D in March 2005. C’s management is in the according to the terms of the contract, subject to the need for a valuation
process of determining the fair value of the identifiable assets and liabilities allowance for uncollectability of the asset.
acquired in that business combination.
Where the indemnified liability is not measured at fair value then the
A significant liability of D is a finance lease payable. A condition of the indemnification asset is measured using assumptions consistent with those
acquisition of D by C was that C had to provide the lessor with a guarantee for used in measuring the indemnified item.
the lease payable.
This should result in a matched treatment for the recognition and
measurement of the liability and the related indemnity asset. The resulting -C Continuing national GAAP preparer
income statement gains on the one will offset losses on the other.
B should de-recognise the market share intangible at 1 January 2004 and the
related deferred tax liability. B will therefore increase the goodwill to 9,900
(6,400 + 5,000 . 1,500) at 1 January 2004.
EXAMPLE - Subsidiary transitioning
The subsidiary transition exemption is applied as:
Entity A has reported under IFRS since 1990. Entity A acquired entity B in
2003. B will transition from its national GAAP to IFRS in 2005, with a transition - the results for entity B.s sub-group at 1 January 2004, as
date of 1 January 2004, and will prepare consolidated financial statements for reported to A,
its sub-group. - less consolidation adjustments,
- less the IAS 22 adjustments made by A on acquisition of B.
Entity B acquired a subsidiary, entity C, in 2000 and applied its previous GAAP
business combinations accounting to that acquisition. The result of applying only these adjustments would be the inclusion in B’s
transition balance sheet of the previous GAAP market share intangible asset
When B acquired C it recognised goodwill of 8,000 and an intangible asset of at 5,000, and goodwill of 6,400 (8,000 less four years’ amortisation).
5,000 under its previous GAAP for C’s market share. It also recognised a
deferred tax liability of 1,500 in respect of the market share intangible. Application of the subsidiary transition exemption does not override the
requirement to apply the business combinations exemption in Appendix B of
B amortises goodwill over 20 years under previous GAAP but does not IFRS 1.
amortise the market share intangible.
B’s management must therefore apply the business combinations exemption
The intangible asset does not qualify for recognition under IFRS and would to the market share intangible. It will therefore de-recognise the market share
have been subsumed within goodwill under IAS 22(now IFRS 3), or IFRS 3. intangible at 1 January 2004 and the related deferred tax liability.
Entity A derecognised the market share intangible when it applied IAS 22 to The adjusted goodwill balance of 9,900 is tested for impairment at transition
the business combination in which it acquired B. date. It will also be tested annually thereafter and whenever indicators of
impairment are identified.
Entity B intends to use the subsidiary transition exemption in IFRS 1which
allows a subsidiary to transition to IFRS using the IFRS results that it already
reports to its parent (entity A). EXAMPLE - Group reconstruction
How does this affect the market share intangible? During the year, Louise Ltd reorganises the structure of its group by
establishing a new parent. The shareholders of Louise Ltd exchange their
The corporate structure and key information is summarised as follows: interests in Louise for shares issued by Newparentco.
-A Existing IFRS reporter There have been no changes to the assets and liabilities of the new group
-A acquired B in 2003 when compared with the original group. Furthermore, the owners of Louise Ltd
-B Transitions to IFRS in 2005 have the same absolute and relative interests in the net assets of the original
-B acquired C in 2000 group and the new group immediately before and after the reorganisation.
The IASB recently issued an amendment to IAS 27, Consolidated VCP Newco also uses IFRS. IFRS 3 indicates that where a new company
and Separate Financial Statements. (.newco.) is formed and issues shares to effect a business combination, it
cannot be regarded as the acquirer in the transaction.
Assuming Newparentco can early adopt the amendment, how would it account
for the acquisition of Louise in its separate accounts under IFRS? However, in certain cases, where a newco pays cash, it will be the acquirer.
This will be the case where the newco is in substance an extension of a
In the separate accounts of Newparentco, it has the choice to account for substantive acquirer.
investments in subsidiaries at cost or fair value in accordance with IAS 39.
Therefore, in this scenario, VCP Newco has acquired Opco from A Holdco. It
Newparentco would previously have accounted for this transaction at the fair records the assets and liabilities of the acquired businesses in its consolidated
value of the consideration paid for the investment in Louise − ie, at the fair financial statements at fair value. It also records the 25% minority interest in
value of the equity instruments issued. Opco held by A Holdco.
However, the amendment specifies that if Newparentco accounts for its (b) Newco with third party debt
investment in Louise Ltd at cost, Newparentco measures the investment in
Louise Ltd at its share (in this case, 100%) of the equity items shown in the Entity A arranges loan funding from a financial institution in a new wholly-
separate financial statements of Louise Ltd on the date of reorganisation. owned subsidiary, New Co. The loan is used to fund the acquisition of A’s
100% shareholding in entity B, for cash consideration. A applies IFRS 3 to
This would be the same value as the carrying amount of the net assets of account for common control transactions.
Louise Ltd at that date.
Pre-transaction structure Post-transaction structure
EXAMPLE - Use of a Newco in business combinations
On the assumption that New Co has to prepare consolidated accounts, can
(a) Newco used by a venture capitalist in an acquisition New Co be identified as the acquirer in a business combination and apply
purchase accounting in its consolidated financial statements?
A Holdco holds its businesses through a wholly-owned subsidiary Opco. A
Holdco is intending to sell Opco. Several potential purchasers have been New Co cannot be the acquirer as A has created New Co and is the vendor.
identified.
Therefore, substance is that New Co has been set up to issue shares, acquire
Management of A Holdco are conducting negotiations and preparing Opco for B and then to effect a return of capital from B through the payment of cash to A
sale. Venture Capital Partners (VCP) is the winning bidder and negotiations for the shares in B that were acquired by the New Co (leaving A with more
are concluded. VCP establishes a new company, VCP Newco. cash but an investment with more debt in it when compared with the previous
structure).
VCP Newco raises substantial amounts of debt conditional on the acquisition
of Opco. VCP Newco buys 75% of the shares of Opco from A Holdco for cash. B is identified as the acquirer of New Co, as it is the combining entity that
existed before the combination. The transaction is accounted for as a reverse
Pre-transaction Post-transaction acquisition in New Co.s consolidated financial statements. As a result, B’s
If VCP Newco has to prepare consolidated accounts, can VCP Newco be assets and liabilities are included in New Co’s consolidated financial
identified as the acquirer of Opco in the transaction in terms of IFRS 3? statements at their pre-combination carrying amounts without fair value uplift.
Therefore, a new company that pays cash is not necessarily the acquirer and
the substance of the transaction needs to be evaluated to conclude on the
accounting treatment. Example 1 Sale of Subsidiary
IMPACT OF MINORITY INTERESTS (NOW CALLED NON-CONTROLLING INTERESTS) ON 80% of a subsidiary cost 80 in January 2XX6, when 100% of the net assets of
FAIR VALUES. the subsidiary were valued at 90.
Where the parent co-owns the subsidiary with minority interests, the impact of
the fair value accounting will increase (or decrease) the value of the minority In 2XX9, goodwill of 8 had a net value of 2, after an impairment charge of 6.
interest.
Parent Balance Sheet (after acquisition)
For example if the minority owns 20% of the subsidiary, then 20% of the net
asset revaluation will be attributable to the minority interests. Assets Liabilities
Cash 220 Accounts payable 800
4. Disposal of a Subsidiary Accounts receivable
Investments
1000
200 Accruals 300
S1 Investment 80
PRINCIPLES Fixed Assets 100 Shareholders’ Funds 500
On disposal of a subsidiary, include in the consolidated financial statements: 1600 1600
 Profits / losses to date of disposal

 Gains or losses on disposal Note:
Cost of the investment= Net assets (90)+ goodwill (8)- minority interests (18) =80
The gain /loss is calculated from:
Group share of subsidiary net assets before disposal Subsidiary 1 Balance Sheet (before consolidation)
Less
Group share of subsidiary net assets after disposal, plus the proceeds Assets Liabilities
received Cash 20 Accounts payable 480
Accounts receivable 400
Net assets may include goodwill. Investments 100
Fixed Assets 50 Shareholders’ Funds 90
Proceeds may include a performance-related element (for example, if future 570 570
profits are x then payment will be y). This will be treated as a contingent asset
(gain), and only recognised as profit when it becomes receivable.
P & S1 Group Balance Sheet
It would also be disclosed in the notes to the accounts. Assets Liabilities
A deferred payment may need to be discounted to present value. Accounts receivable 1400 Accruals 300
Investments 300 Minority Interest 18
IAS 37 has more details on accounting for contingent assets.
Goodwill 8 Parent Balance Sheet (after disposal)

2098 2098
Assets Liabilities
Notes: Accounts receivable 1000
Cash= 220+20=240
Accounts Receivable= 1000+400=1400 Investments 200 Accruals 300
Investments= (280-80)+100=300 S1 Investment 0
Fixed Assets= 100+50=150 Fixed Assets 100 Shareholders’ Funds 500
Accounts Payable= 800+480=1280 Profit on sale 20
The investment in the subsidiary was sold in December 2XX9 for 100 and, at 1620 1620
that time, the net assets were valued at 115.
Notes:
Cash= 220+100=320
P 2XX9 Income Statement The parent’s profit on sale =20 (100-80).
Proceeds 100
Cost 80 Example 2 Share Exchange
Parent company’s Gain on sale 20 P owns 100% of S1. This cost 100.
When S1 was acquired the net assets were 90. Today the net assets of S1 are
130.
Group 2XX9 Income Statement
Proceeds 100 S1 retained earnings comprise 30 pre-acquisition profits and 40 post
acquisition profits.
Share of assets 80% of 115 92
Net goodwill At the date of the exchange, following an impairment charge, goodwill of 4
8-(6) 2 remains.
94
Group Gain on Sale 6 P exchanges the shares of S1 for 75% of S2.
Goodwill arising on acquisition of S1 is:

There is a difference between the gain made by the group and the gain made
by the parent company. (Cost less net assets =)
100 90 =10
The group has been recognising the profits made by the subsidiary in each
period since its purchase.
The parent company has not been recognising any profit of the subsidiary
since its purchase, so is recognising any gain, or loss, only on disposal of the
subsidiary.
Parent Balance Sheet (after acquisition)

Assets Liabilities
Investments 250 Accruals 300
S1 Investment 100
1600 1600
S1 Balance Sheet (at date of exchange)
Assets Liabilities
Investments 100
Fixed Assets 50 Share Capital 60
Retained Earnings
Pre-acquisition 30
Post-acquisition 40
580 580
P/ S1 Consolidated Balance Sheet
Assets Liabilities
Goodwill 4
2084 2084
The derivation of these figures appears on the next page.

Derivation of Group Figures (for example on

previous page) Parent Parent S1 S1 Adjustments Adjustments P/S1 P/S1
DR CR DR CR DR CR DR CR
Assets
Cash 150 30 180
Accounts Receivable 1000 400 1400
Investments 250 100 350
Investment in S1 100 100
Investment in S2
Fixed assets 100 50 150
Goodwill 4 4
Liabilities
Accounts payable 800 450 1250
Accruals 300 300
Minority Interests
Shareholders' funds 500 130 96 534
1600 1600 580 580 100 100 2084 2084
Parent Balance Sheet (at date of exchange)
Assets Liabilities
Investments
www.banks2ifrs.ru 250 Accruals 300 18
S2 Investment 130
1630 1630
Shareholders’ funds increase by 30, reflecting the gain on disposal of S1 (130-100 purchase price).
Assets Liabilities
Investments 200 Share Capital 120
Fixed Assets 100 Retained Earnings 80
880 880
The net assets of S2 are worth 200.
The effect of the exchange is:
75% of the net assets of S2 are worth 75% of (120+80)=150
75% of the net assets of S2 have cost 100% net assets of S1 (60+70)=130
The goodwill of 4 relating to S1 is credited in the consolidated balance sheet, with the net assets of S1, reducing consolidated reserves by 4.
Assets Liabilities
Minority Interests 50

Negative Goodwill -20
2360 2360
Notes:
Cash=150+80=230
Accounts Receivable= 1000+500=1500
Investments= 250+200=450
Fixed Assets= 100+100=200
Accounts Payable= 800+680=1480
Negative goodwill arising on consolidation is: Purchase price-net assets 130-150=-20
Minority Interests= 25% of 200=50
Since IFRS 3, negative goodwill is immediately eliminated by writing it off to profit.
LOSS OF CONTROL
The parent may lose control of a subsidiary by disposing of part, or all, of its holding.
This loss of control may either be deliberate, or as a result of a confiscation by a government. An apparent loss of control may occur during a group reorganisation.
Loss of control should be treated as a complete disposal, although it is possible that no disposal proceeds will have been received. Any remaining share that is held is
treated as a new asset obtained at fair value.
Where the disposal is a sale, a gain or loss will arise. If the subsidiary has been confiscated, a loss will probably be suffered.
From a reorganisation, there will be no gain (nor loss), in group terms, unless cash changes hands. In economic terms, nothing has changed.
On cessation, the consolidated financial statements should show:

 The subsidiary results up to the date of cessation
 The gain / loss on cessation.
Any gain / loss is calculated from:

Net assets (including goodwill) attributable to the parent before disposal
Less:
Net assets (including goodwill) attributable to the parent after disposal plus any sale proceeds.
Goodwill, relating to the subsidiary, is written off against consolidated reserves on disposal.
LOSS OF CONTROL – RETENTION OF PART OF THE UNDERTAKING
A new aspect of consolidation, introduced into IFRS in 2008, is the accounting when part of the undertaking is retained, though control is lost.
A partial disposal of an interest in a subsidiary in which the parent company retains control does not result in a gain or loss but an increase or decrease in equity.
(Purchase of some or all of the non-controlling interest is treated as a treasury share-type transaction and accounted for in equity.)
A partial disposal of an interest in a subsidiary in which the parent company loses control but retains an interest (say an associate) triggers recognition of gain or loss on
the entire interest.
A realised gain or loss is recognised on the portion that has been disposed of; a holding gain is recognised on the interest retained, calculated as the difference between
the fair value and the book value of the retained interest.
The accounting is to account for a complete disposal of the undertaking and then recognise the retained part at fair value.
The impact is to eliminate the subsidiary and all goodwill from the balance sheet, and to match it with cash received and the fair value of the associate.
IAS 27 (Revised) – new proposals on minority interests and disposals

from IFRS 3 (Revised): Impact on earnings − the crucial Q&A for decision
makers _PwC
A partial disposal of an interest in a subsidiary in which the parent company

retains control does not result in a gain or loss but in an increase or decrease
in equity under the economic entity approach.
Purchase of some or all of the non-controlling interest is treated as a treasury

transaction and accounted for in equity. A partial disposal of an interest in a
subsidiary in which the parent company loses control but retains an interest
(say an associate) triggers recognition of gain or loss on the entire interest.
A gain or loss is recognised on the portion that has been disposed of; a further
holding gain is recognised on the interest retained, being the difference
between the fair value of the interest and the book value of the interest. Both
are recognised in the income statement.
What happened to minority interest?
All shareholders of a group − whether they are shareholders of the parent or of

a part of the group (minority interest) − are providers of equity capital to that
group.
All transactions with shareholders are treated in the same way. What was
previously the minority interest in a subsidiary is now the non-controlling
interest in a reporting entity.
There is no change in presentation of non-controlling interest under the new

standard. Additional disclosures are required to show the effect of transactions
with non-controlling interest on the parent-company shareholders.
What happens if a non-controlling interest is bought or sold?
Any transaction with a non-controlling interest that does not result in a change
of control is recorded directly in equity; the difference between the amount
paid or received and the non-controlling interest is a debit or credit to equity.
This means that an entity will not record any additional goodwill upon purchase
of a non-controlling interest nor recognise a gain or loss upon disposal of a
non-controlling interest.
How is the partial sale of a subsidiary with a change in control accounted

for?
A group may decide to sell its controlling interest in a subsidiary but retain
significant influence in the form of an associate, or retain only a financial asset.
If it does so, the retained interest is remeasured to fair value, and any gain or
loss compared to book value is recognised as part of the gain or loss on
disposal of the subsidiary.
Consistent with a ‘gain’ on a business combination, the standards take the

approach that loss of control involves exchanging a subsidiary for something
else rather than continuing to hold an interest.
How does the new standard affect transactions with previously

recognised non-controlling interests?
An entity might purchase a non-controlling interest recognised as part of a

business combination under the previous version of IFRS 3 − that is, where
only partial goodwill was recognised.
Alternatively, an entity might recognise partial goodwill under the new IFRS 3
(Revised) and might purchase a non-controlling interest at a later date.
In both cases, no further goodwill can be recognised when the non-controlling

interest is purchased. If the purchase price is greater than the book value of
the non-controlling interest, this will result in a reduction in net assets and
equity. This reduction may be significant.
In the following examples, I/B refers to Income Statement and Balance Sheet.
EXAMPLE - LOSS OF CONTROL – RETENTION OF PART OF THE UNDERTAKING-

1
P holds 80% of S. It was bought as part of a group of companies and 50% is

immediately resold to its management. The remaining 30% will be treated as
an associate.
The cost was 880 including 80 goodwill.
The 50% stake is resold for 600.
The fair value of the remaining stake is 360.
I/B DR CR
Loss on disposal of subsidiary I 280
Investment in subsidiary (including goodwill) B 880
Cash B 600
Sale of subsidiary and elimination of goodwill
Investment in associate (30%) B 360
Profit on disposal of subsidiary I 360
Recognition of associate at fair value
In the above example, the absence of trading means that the accounting in the parent company and consolidated financial statements are identical. The rise in the fair
value is purely as illustration, as it is unlikely to have changed between the time of purchase and resale.
If the above example is changed (see below), so that the stake is sold after a year, and S made a profit of 50, 40 (= 50*80%) accruing to P, other numbers unchanged, P’s
profit and bookkeeping entries will be the same, as the subsidiary is held at cost. It therefore does not reflect the increased value of P.
However, the consolidated financial statements will differ, as they will revalue S to its fair value and include its contribution of 40 in the consolidated income statement:
EXAMPLE - LOSS OF CONTROL – RETENTION OF PART OF THE UNDERTAKING -

2

resold to its management after 1 year. The remaining 30% will be treated as
an associate.
The cost was 880 including 80 goodwill. A profit of 50 was made during the
year, 40 attributable to P’s 80% share in the company.

Consolidated financial statements I/B DR CR
Cash B 600
The consolidated financial statements will show a different gain (or loss) on disposal from the parent financial statements, as the parent balance sheet shows the
investment of a subsidiary at cost, and does not reflect subsequent trading.
In the above case, the net impact on the income statement is the same.
The smaller gain on sale (-40) will be offset by the income (+40).
In the following case (see below), extending the example for another year before the sale, the impact will be different:
EXAMPLE - LOSS OF CONTROL – RETENTION OF PART OF THE UNDERTAKING -

3

resold to its management after 2 years. The remaining 30% will be treated as
an associate.
The cost was 880 including 80 goodwill. A profit of 50 was made during the
first year, 40 attributable to P’s 80% share in the company. A profit of 20 was
made during the second year, 16 attributable to P’s 80% share in the company

Consolidated financial statements I/B DR CR
Cash B 600
Again, the parent financial statements will be as in the first example, recording a profit of 80.
The consolidated financial statements will show a profit of 24 (360-336), plus the trading profit of 20 for year 2. The difference between the 2 sets of financial statements is
the 40 profit recorded in the consolidated financial statements in year 1, but not reflected in the parent financial statements.
If a subsidiary or non-current assets are available (or intended) for sale, the rules of IFRS 5 apply.
EXAMPLE - IFRS 5 and partial disposals
Entity A has a 70% ownership stake in a subsidiary, entity B, which represents

a separate major line of business within the group.
During the year A enters into a binding sale agreement whereby it will dispose
of 40% of its investment in the subsidiary in the next financial year.
How should A disclose the results of B in its consolidated financial statements

at year end? In particular, should it classify entity B as a discontinued
operation under IFRS 5, Non-current Assets Held for Sale and Discontinued
Operations?
The principle for applying IFRS 5 depends on the manner in which an entity
will recover a non-current asset or disposal group.
If an entity will recover the carrying amount of a disposal group principally

through sale rather than through use, IFRS 5 is applicable.
The 40% disposal will result in the assets and liabilities being principally
recovered through sale and a single new asset (associate) being recognised.
Entity A should therefore disclose all of the results and assets of entity B in its
consolidated statements as a discontinued operation in accordance with IFRS
5 at the year end.
Once the disposal is completed, entity A accounts for the resultant associate
using the equity method in IAS 28, Investments in Associates.
The IASB has amended these requirements in its 2007 annual improvements
project. Once the amendment is effective (years beginning on or after 1 July
2009 with earlier application permitted), classification under IFRS 5 for a
subsidiary will be based only on the loss of control of that subsidiary.
For example, if an entity with a 51% holding in a subsidiary entered into a

contract to dispose of only 2% of its holding and this would result in a loss of
control in the future, IFRS 5 would apply.
The amendment also clarifies that all of the subsidiary’s assets and results
would be accounted f or as held for sale prior to the disposal under IFRS 5 and
not just the effective interest to be disposed of.
Held for sale subsidiary with financial assets
Entity D, a subsidiary of entity E, meets the definition of a held-for-sale asset in

accordance with IFRS 5. Financial assets within the scope of IAS 39,
comprise the majority of the value of D. Such assets are outside the scope of
IFRS 5 for measurement purposes (IFRS 5).
On initial classification as held for sale, E measured D at the lower of carrying

amount and fair value less costs to sell (IFRS 5).
If the value of the financial assets within D increase above the initial value of
the disposal group, can E record the increase?
IFRS 5 notes that on subsequent remeasurement of a disposal group, the

carrying amount of any assets and liabilities that are not within the scope of
the measurement requirements of IFRS 5.
They are included in a disposal group classified as held for sale, shall be re-
measured in accordance with applicable IFRSs before the fair value less
costs-to-sell of the disposal group is re-measured.
Therefore, on subsequent re-measurement, the financial assets within the

scope of IAS 39 should be remeasured first in accordance with IAS 39.
The value of the E disposal group as a whole should then be determined and
recorded at the lower of carrying value (ie the current IAS 39 value plus the
carrying amount of other out-of-scope assets and liabilities plus carrying value
of IFRS 5 assets and liabilities) and fair value less costs-to-sell of the disposal
group as a whole.
Group restructuring and treatment of currency translation reserve
IAS 21, The Effects of Changes in Foreign Exchange Rates, requires

exchange differences on net investments in a foreign operation to be
recognised as a separate component of equity in the consolidated financial
statements.
This separate component of equity is commonly referred to as the currency

translation account (CTA). Such exchange differences are recognised in profit
or loss (‘recycled’) on the disposal or partial disposal of the net investment.
In a group restructuring, a foreign operation is transferred from one

intermediate holding company to another.
The group continues to hold a 100% interest in that foreign operation. No third
parties are involved with the group restructuring. Should the CTA be recycled
in the group’s consolidated financial statements?
No. The question is whether the restructuring results in an economic change

from the group’s perspective that constitutes a partial or full disposal.
In this case, the foreign operation continues to be part of the consolidated

group and the restructuring is not a disposal event from the group’s
perspective under IAS 21.
No recycling occurs for the exchange differences recognised in equity.
However, if the intermediate holding company that disposes of the foreign

operation prepares consolidated financial statements under IFRS, the CTA (if
any) that arises at that intermediate reporting level would be recycled on the
group restructuring.
EXAMPLE - Actuarial gains and losses on disposal of a business
Company E has disposed of its main subsidiary F in the year to 31 December

20X6. E has a defined benefit pension scheme and any actuarial gains and
losses arising have been recognised in line with IAS 19, Employee Benefits.
Other standards, such as IAS 39, require recycling of gains and losses that
have previously been taken to equity. As such, on disposal of E, should the
cumulative actuarial gains and losses previously taken to capital be recycled to
the income statement?
Actuarial gains and losses should not be recycled through the income
statement. The IASB considered the possibility of recycling, given that most
gains and losses under IFRS that are recognised outside profit and loss are
recycled.
However, on balance, the IASB concluded that actuarial gains and losses
should not be recycled and IAS 19 confirms this.
Nevertheless, note that the question of recycling will be revisited by the IASB
as part of the project on reporting comprehensive income.
EXAMPLE - Separate financial statements
Parent entity C has decided to sell one of its subsidiaries, entity D. The criteria
in IFRS 5 have been met which means that entity D will be classified as held
for sale.
Entity C is preparing its separate parent company financial statements in

accordance with IFRS. IAS 27 provides a choice of either using cost or fair
value in accordance with IAS 39, when accounting for an investment in a
subsidiary in the parent’s separate financial statements.
Entity C has chosen to account for investments in subsidiaries at fair value in

its separate financial statements.
How does entity C’s policy choice to use fair value for its investment in entity D
affect the application of IFRS 5?
The policy choice provided in IAS 27 on measuring an investment in a

subsidiary at cost or at fair value in accordance with IAS 39 is available for
subsidiaries that are not classified as held for sale in accordance with
IFRS 5.
IFRS 5 requires that immediately before an asset is classified as held for sale
its carrying amount is measured in accordance with applicable IFRSs.
Consequently, the investment in a subsidiary that is accounted for at fair value

in accordance with IAS 39 will be revalued to current fair value at the date that
the IFRS 5 criteria are met.
Subsequent measurement under IFRS 5 is at the lower of carrying amount

and fair value less costs to sell. Parent entity C will therefore freeze the
carrying amount of its investment in the subsidiary held for sale at current fair
value and only re-measure it if fair value less costs to sell falls below this
amount.
The scope restriction set out in IFRS 5, which requires that financial assets
within the scope of IAS 39 continue to be measured in accordance with IAS
39, does not apply to the investment in the subsidiary.
This is because IAS 27 only permits the use of fair value measurement in
accordance with IAS 39 for those subsidiaries that are not held for sale.
IAS 27 also makes clear that subsidiaries classified as held for sale should be
accounted for in accordance with IFRS 5.
EXAMPLE - Paying to sell a subsidiary
Entity A has a subsidiary that management has committed to sell. The criteria
in IFRS 5 for this subsidiary to be classified as held for sale have been met.
The subsidiary is loss-making and entity A has written off the subsidiary’s
property, plant and equipment (PPE) under IAS 36, Impairment of Assets.
The subsidiary also has some sundry working capital. Entity A’s management
considered closing the subsidiary, but this would result in making all the staff
redundant.
Management identified that a third party might be willing to take over the
subsidiary if it was able to utilise some of the assets and workforce, thereby
saving some of the jobs.
However, entity A will need to pay such a third party approximately e20m to
achieve the sale. The subsidiary (disposal group) therefore has a negative fair
value of e20m.
Entity A is committed to its plan to sell the subsidiary but it does not yet have a
binding sales agreement for the disposal.
Should entity A record a liability for the expected payment to a third party on
disposal of the subsidiary as the disposal is considered highly probable in
accordance with IFRS 5?
Entity A should not record a liability for the payment to a third party in respect
of the highly probable disposal.
IFRS 5 requires that a disposal group is measured at the lower of its carrying
amount and its fair value less costs to sell (IFRS 5.15). However, IFRS 5
applies only to the measurement of the non-current assets in the disposal
group.
It does not affect the measurement of current assets and current and
noncurrent liabilities within the disposal group. This is made clear in the basis
for conclusion, BC 22, which states:
The board also noted that the requirements of IAS 37establish when a liability
is incurred, whereas the requirements of the IFRS relate to the measurement

and presentation of assets that are already recognised.
A liability would only be recognised if there was a binding sale agreement as

required by IAS 37. IFRS 5 and IAS 37 both require that the entity is
committed in order to qualify for their respective accounting treatments.
However, the standards require commitment to different things. IFRS 5

requires commitment to a plan to sell for the subsidiary to be classified as a
disposal group held for sale. IAS 37 requires that the entity is committed to the
sale, which it specifies can only be met if there is a binding sale agreement.
EXAMPLE - Presentation of assets and liabilities of spun-off segment
Entity D has a 31 May year-end and has adopted IFRS 5,Noncurrent

Assets Held for Sale and Discontinued Operations. It has spun-off one of its
major business segments to its existing shareholders as part of management’s
decision to focus on the remaining businesses within D’s consolidated group.
It carried out the transaction by creating a new holding company and

distributing the shares in the new holding company to D’s existing
shareholders in proportion to their ownership interests in D.
The decision was taken in April 2005 and the transaction was completed in
July 2005.The disposed business segment meets the definition of a
discontinued operation under IFRS 5.
Management is considering the balance sheet presentation of the assets and

liabilities for the 31 May 2005 financial statements and whether this should
change when presented as comparatives in the 31 May 2006 financial
statements.
IFRS 5 does not permit the assets and liabilities of the business segment to be
presented on two lines. The two-line presentation is restricted to disposal
groups that are held for sale and cannot be extended to disposal by way of a
distribution.
The assets and liabilities of the segment should therefore be presented within
their normal classifications in the balance sheet in the 31 May 2005 financial
statements.
Management should not change this presentation in the 31 May 2006 financial
statements. Although the segment was distributed to shareholders in August
2005 and therefore qualified as a discontinued operation from that date, IFRS
5 does not permit the comparative balance sheet to be amended.
The Reporting segment’s assets and liabilities must therefore continue to be

presented in their normal classifications in the 2005 comparative balance
sheet in the 31 May 2006 financial statements.
However, the results of the discontinued operations for the year ending 31
May 2005, and the three months ending 31 August 2005 should be presented
on a single line in the income statement in the 31 May 2006 financial
statements.
5. The Equity Method of Accounting

The equity method of accounting values the investment at cost, and is adjusted for the investor’s share of post-acquisition profits.
Likewise, the investor's income statement includes is share of post-acquisition profits. The equity method is usually applied to associates and joint ventures.
The equity method can be applied in both parent and consolidated financial statements.
EQUITY METHOD OF ACCOUNTING
Parent Balance Sheet (before acquisition)
Assets Liabilities
1600 1600
P bought 80% of S for 250.
It was bought with other undertakings, and P had determined that S should be sold as quickly as possible, and immediately sought a buyer.
At the time of acquisition, the net assets of S had a value of 200 (100 Share Capital and 100 Pre-Acquisition Profits).
Post-acquisition profits are 70 and the parent’s balance sheet has not changed since the acquisition.
Subsidiary Balance Sheet (after acquisition)
Assets Liabilities
Cash 10 Current Liabilities 300
Accounts receivable 200 Share Capital 100
Fixed Assets 360 Pre-acquisition profits 100
Post-acquisition profits 70
570 570
Parent Balance Sheet including S (equity method)
Assets Liabilities
S (250+56) 306
Profits of S 56
1656 1656
Notes:
Post-Acquisition Profits attributable to are 80% of 70 = 56.
Investment in S comprises purchase price +post-acquisition profits 250+56=306
This method shows the profits of the investment only in the lines of the investment in the subsidiary and the shareholders’ funds.
Goodwill is not shown separately, as there is no breakdown of net assets.

As goodwill that forms part of the carrying amount of an investment in an associate (see next section) is not separately recorded, it is not tested for impairment separately
by applying the requirements for impairment testing goodwill in IAS 36 Impairment of Assets.
Instead, the entire carrying amount of the investment is tested for impairment in accordance with IAS 36 as a single asset, by comparing its recoverable amount (higher of
value in use and fair value less costs to sell) with its carrying amount, whenever application of the IAS 39 indicates that the investment may be impaired.
An impairment loss recorded in those circumstances is not allocated to any asset, including goodwill, that forms part of the carrying amount of the investment in the
associate.
So, any reversal of that impairment loss is recorded in accordance with IAS 36 to the extent that the recoverable amount of the investment subsequently increases.
Other assets and liabilities are not consolidated.
Dividends received from the investee reduce the carrying amount of the investment.
6. Associates
An associate is an undertaking in which the investor has significant influence, and which is neither a subsidiary, nor a joint venture.
The investor in an associate has the opportunity to influence the financial and operating decisions of the associate, but without control over them.
An indication of significant influence would be the ownership of 20%-50% of the voting shares.
Owning more than 50% would give control, and would normally require full consolidation.
If the holding is less than 20% of voting shares, it is presumed that the investor does not have significant influence, unless this can be demonstrated.
Further indications of significant influence are:
 representation on the board of directors or governing body;

 participation in policy-making processes;
 material transactions between the investor and investee;
 interchange of managerial personnel;
 provision of vital technical information.
Associates are accounted for using the Equity Method (see 5. above).
If a loss has been incurred the associate, the investor must recognise its share of that loss, both in the income statement and as a reduction of the investment in associate,
It is important to understand that the investor includes its share of profit, even if it has not received the money in the form of dividends. This becomes a serious issue if the
investor is expected to pay dividends based on its earnings within the associate.
IAS 28 does not apply to investments in associates held by:
(i) venture capital organisations, or
(ii) mutual funds, unit trusts and similar entities including investment-linked insurance funds
Equity accounting: practical difficulties
IFRS News - December 2005 and February 2006
Entities applying the IAS 28 equity method to their associates and joint
ventures are finding some difficult areas. The equity method of accounting
has been around for many years. It is thought to be straightforward and well
understood.
Equity accounting has received little attention from standard-setters in recent

years, despite criticism of it by some as a concept.
IAS 28 was part of the improvements project when various changes pushed
equity accounting closer to accounting for business combinations and
subsidiary accounting by making certain implied requirements explicit and
removing some impracticability exceptions.
However, problems and inconsistencies are arising in application as more

companies move to IFRS. This article examines some of the practical issues
that have arisen and some areas of inconsistency in the accounting literature.
Notional purchase price allocation
What accounting is required when an associate is first purchased? IAS 28

states that ‘the investment in an associate is initially recognised at cost’. This
is straightforward.
The standard goes on to say that, ‘on acquisition of the investment any
difference between the cost of the investment and the investor’s share of the
net fair value of the associate’s identifiable assets, liabilities and contingent
liabilities is accounted for in accordance with IFRS 3.
The equity investment continues to be recognised on one line in the balance

sheet as the IFRS 3-type purchase price allocation and calculation of goodwill
is notional. The notional purchase price allocation (PPA) should include the
investor's portion of the fair value of any intangible assets and contingent
liabilities (whether or not recognised by the associate) and the investor's share
of any fair value step ups or adjustments to recorded assets and liabilities.
The practical challenge is that the investor will seldom have access to
proprietary information about the company.
Most public companies are prohibited from making information available to

shareholders on a selective basis - what one shareholder knows usually needs
to be made available to all shareholders. Thus, the investor needs to calculate
the notional PPA with publicly available information and a substantial degree
of estimation.
Is this notional PPA really required? The answer is yes and part of the answer
is that is explicitly required by the standard. However it can also be crucial so
that the correct share of the associate’s results is recorded post-acquisition.
The share of results will not include the correct amortisation if tangible and
intangible assets are not recorded at their fair value.
Two other potential problems make the notional PPA important. Purchase of
an associate may be the first step in a step acquisition. Goodwill and revised
fair values are needed at each step, so the contemporaneous information that
supports the amount of goodwill present at the date of each transaction is
crucial.
If an associate is impaired, any notional goodwill written off cannot be

reversed, thus, where the associate is a public company, the amount of
notional goodwill is crucial.
Example
Company A, a large pharmaceutical company, buys 30% of Company B, a

small company. B owns a valuable patent that covers a specific prescription
drug. The patent will expire in seven years. Assume that there are no other fair
value adjustments to be recorded.
B earns revenue by licensing the patent to other companies in each major

market. Company A, the investor, must perform a fair value exercise, allocate
value to the patent and amortise it over the remaining life. The charge reduces
the income from the associate and the carrying value of the associate.
Therefore, as the patent expires, the value of the associate will reduce.
If B winds up operations on expiry of the patent, the value of the associate as

represented by the patent intangible asset should have been reduced to nil,
through periodic amortisation and not an impairment charge.
Negative goodwill arising on the acquisition of an associate
The notional PPA might also result in negative goodwill (technically - excess of
the investor’s share of the net fair value of the associate’s identifiable assets,
liabilities and contingent liabilities - as IFRS describes negative goodwill).
Negative goodwill might exist if the associate has a significant unrecorded

contingent liability or the investor managed to secure shares at a discount
price because of the vendor's need for cash.
The negative goodwill should be credited to the investor’s income statement in

the period that the associate is required. This seems inconsistent with the
principle that the associate is recorded initially at cost.
The associate will be recorded at an amount greater than cost where negative
goodwill exists. The standard is explicit on the requirement to recognize
negative goodwill where it exists and this is the natural extension of the
notional PPA concept discussed above.
However, an associate with a carrying value in excess of market value is a

trigger for impairment testing. For any associate acquired in a public market,
cost was presumably market value.
The recognition of negative goodwill may trigger an impairment test, and the
adjustment may well be written off to the income statement. The recognition of
negative goodwill is expected to be rare and any negative goodwill recognised
on acquisition of an associate therefore needs to be robustly supported or the
investor is exposed to an immediate impairment as well.
What does change in proportionate interest mean?
An associate issues shares to new investors and the group’s interest is diluted,
although the entity remains an associate. Should the ‘gain or loss’ arising from
dilution be recorded in the investing group’s income statement or directly in
equity?
IAS 28 requires that changes in an investor's proportionate interest in an

associate that do not arise from the net income of the associate should be
recognised directly in the equity of the investor.
Many have read these words to include gains and losses arising on a dilution
of the investor's interest in the associate, with any anti-dilutive transactions
also recognized in equity.
However, the examples that follow the proportionate interest guidance do not
include dilutions but are rather example of transactions of the associate that
might give rise to equity movements such as fixed asset revaluations or
available for sale securities.
The associate will have debited cash and credited equity in the associate’s
financial statements: nothing has occurred in its income statement. The text in
IAS 28 seems to preclude income statement recognition of gains and losses.
However, the lack of dilution in the examples and the fact that IAS 27 permits
income statement treatment for dilution of subsidiaries seems to provide some
support for gains and losses on associate dilution in the income statement.
However, companies may well be exposed to criticism and regulatory

comment if they use income statement recognition.
Reclassification of associate to ‘available for sale’
IAS 28 says that the carrying amount of an investment when it stops being an
associate is its cost on initial measurement as a financial asset under IAS 39.
IAS 39 requires available-for-sale (AFS) financial assets to be recognised at

fair value. How should these requirements be reconciled when the carrying
value of the associate is not equal to its fair value?
Example
Entity A held a 30% shareholding in entity B and applied equity accounting in
accordance with IAS 28. Entity A sold its shares in B, reducing its investment
from 30% to 10%.
Entity A lost its significant influence over B as a result of this transaction. The
remaining investment in B will therefore be accounted for as an AFS
investment in accordance with IAS 39.
The carrying amount of A’s investment in B immediately before the transaction

was 300. There was also a credit amount of 9 included in A’s equity,
representing A’s share of B’s increases in equity arising from AFS securities
held by B.
Entity A received a consideration of 320. The fair value of the remaining 10%
investment in B is 160.
What should entity A recognise in its income statement and in equity?
Solution
Entity A should recognise a gain on disposal of 129 in the income statement.
This gain comprises two components.
This first is 120, being the difference between the cash received of 320 less
the carrying amount of the proportion sold of 200 (20/30 x 300).
The second component is the transfer of the credit of 9 from A’s equity to the
income statement. This is the amount included in A’s equity as a result of
applying equity accounting to the 30% interest in B.
The whole amount is transferred from equity to the income statement because
A no longer has significant influence over B.
The remaining 10% investment in B is now classified as an AFS asset.
IAS 28 requires the initial measurement of the AFS asset to be the carrying
amount immediately prior to losing significant influence.
The initial measurement of the 10% interest in B is therefore 100 (10/30 x
300).
Subsequent measurement of the AFS asset is to fair value, with changes in

fair value recognised directly in equity in accordance with IAS 39.
Entity A should therefore recognise a gain of 60 directly in equity in its AFS

reserve to reflect the revaluation of the remaining 10% interest in B from its
initial measurement of 100 to fair value of 160.
Associates and common control transactions
What is the accounting that is required when a group reorganises and moves
its interests in associates around? IAS 28 contains no specific guidance. It
states that the concepts underlying the procedures used when an entity
acquired a subsidiary are adopted when an investment in an associate is
acquired.
Example: Group structure

See the diagrams below.
Group Structure
1. A
100% 60%
B C
70%
20%
D
60% 25%
E
Group Structure
2 A
.
80% 60%
B C
20%
90%
D
85% E
C, which also has some subsidiaries, prepares financial statements under

IFRS. It exchanges its interests in its associates D and E in return for a
participating interest in B.
The transaction has taken place under the control of A. Can C treat it as if it
was a common control business combination? Such combinations are scoped
out of IFRS 3 and an entity may choose a policy of using predecessor values.
If C was able to do this, it would carry its equity investment in B at the previous
carrying values of its investments in D and E.
C cannot use the common control exemption. This applies to business

combinations only (acquisition of a subsidiary by a parent); there is no such
exemption in IAS 28.
How should C account for the transaction?
Entity Carrying value in Fair value of

C’s consolidated 100% of
FS business
D 350 2.500
E 200 1.000
B (before transfer) 650
The fair value of B’s net assets before the transaction is 500.
Gain on disposal:
Consideration received (fair value of share of B 130

acquired)
Amounts disposed of 20% - (20% x 90%) x 350 -35
25% - (20% x 85%) x 200 -64
31
Carrying value of associate investment in B group in C’s consolidated financial

statements:
Fair value of 20% of B (includes 30 of notional 130

goodwill)
Carrying value of 18% of D 315
Carrying value of 18% of D 136
581
Solution
C should recognise a gain or loss to the extent it has disposed of part of its
interests in D and E. This gain or loss will be based on the consideration
received, which is the fair value of the interest received in B.
This means that the equity investment in B will be carried at the fair value of
C’s 20% interest in B, plus the previous carrying values of the retained
interests in D and E. C has retained an 18% (20% x 90%) interest in D and a
17% (20% x 85%) interest in E.
There can be no step-up to the fair value of those interests because D and E
are associates of C before and after the transaction.
EXAMPLE - Accounting for long-term loan to associate
Entity A has an associate, entity B. Entity A has made a loan to entity B. The
loan is non-interest bearing and repayable on demand but entity A does not
plan or expect to require settlement of the loan for the foreseeable future. The
loan is not collateralised.
Entity A views the loan to the associate as part of its net investment in the
associate in accordance with IAS 28.
How should entity A account for and classify the loan to entity B?
Entity A should account for the loan in accordance with the guidance in IAS
39, even though it is considered part of the net investment in the associate.
The loan should be initially recognised at fair value in accordance with IAS 39.
A loan that is repayable on demand cannot have a fair value that is less than
the amount repayable (IAS 39).
Consequently the loan should be recognised at the amount leant to entity B.
Subsequent measurement of the loan should be at amortised cost, however,

the loan will continue to be carried at cost under IAS 39. This is because there
is no effective interest rate and so no amortisation to record under the
amortised cost method.
The loan may be classified on the balance sheet either as part of other
receivables or as part of the investment in associates. The notes to the
financial statements should provide an adequate description of the loan
balance so that its nature is clear to a reader of the financial statements.
EXAMPLE - Associates and extent of inter-group elimination
Entity C is a 20% investor in an associate, entity D. (see Consolidation Book 3

for accounting for associates)
During the year, entity C entered into the following transactions with entity D:
- sale of inventory with a cost price of £100 for £200. The stock has not been
sold by entity A at year end; and
- providing management services to entity D and invoicing £200 for these

services.
How should entity C account for the revenue arising from the sale of inventory
and management services?
Many of the procedures appropriate to the application of the equity method are
similar to the consolidation procedures.
Unrealised profits and losses arising from downstream transactions are

eliminated to the extent that the investor is transacting with itself. While the
inventory remains on the associate’s balance sheet, the associate will not be
recording an expense in its income statement.
Therefore a consolidation entry, reducing the revenue arising from the sale of
the inventory by £40 (£200 x 20%), is required to eliminate the unrealised
portion of the gain made in entity C.
The revenue arising from the management services would not be adjusted, as
the management services cost is realised in the associate.
As entity D is equity accounted for, £40 (£200 x 20%) - representing the

portion of the cost relating to entity C - will be reflected in the consolidated
financial statements of entity C; no further elimination entry is therefore
required.
In the following examples, I/B refers to Income Statement and Balance Sheet.
EXAMPLE 1. - associates
P has an associate A, of which it owns 20%. At the balance sheet date A

has inventories that it bought from P at a cost of 100. P made a profit of
25 on the sale.
As the profit was earned by the parent, the parent’s share of profit is
eliminated.
I/B DR CR
Revenue (20%*100) I 20
Cost of sales I 15
Investment in associate (20%*25) B 5
Reduction of group sales, cost of sales and
investment in associate
EXAMPLE 2. - associates
P has an associate A, of which it owns 20%. At the balance sheet date P

has inventories that it bought from A at a cost of 100. A made a profit of
25 on the sale.
I/B DR CR
Share of income of associates I 5
Investment in associate (20%*25) B 5
Reduction of group net income, and
investment in associate
EXAMPLE - Reclassification of associate
Entity A held a 30% shareholding in entity B and applied equity accounting to

this investment in accordance with IAS 28. During the year, entity A sold some
of its shares in B, reducing its investment from 30% to 10%.
Entity A lost its significant influence over B as a result of this transaction. The
remaining investment in B will therefore be accounted for as an available-for-
sale (AFS) investment in accordance with IAS 39.
The carrying amount of A’s investment in B immediately prior to the

transaction was 300.There was also a credit amount of 9 included in A’s equity
representing A’s share of B’s increases in equity.
Entity A received cash of 320 in respect of the transaction. The fair value of
the remaining 10% investment in B is 160.
What should entity A recognise in its income statement and in equity in respect
of this transaction?
Entity A should recognise a gain on disposal of 129 in the income statement.

This gain comprises two components. The first is 120, being the difference
between the cash received of 320 and the carrying amount of the proportion
sold of 200 (20/30 x 300).
The second component is the transfer of the credit of 9 from A’s equity to the
income statement. This is the amount included in A’s equity as a result of

applying equity accounting to the 30% interest in B.
The whole amount is transferred from equity to the income statement because
A no longer has significant influence over B.
The remaining 10% investment in B is now classified as an AFS asset. IAS 28

requires that the initial measurement of the AFS asset is the carrying amount
immediately prior to losing significant influence.
The initial measurement of the 10% interest in B is therefore 100 (10/30 x

300). Subsequent measurement of the AFS asset is to fair value with changes
in fair value recognised directly in equity in accordance with IAS 39.
Entity A should therefore recognise a gain of 60 directly in equity in its AFS
reserve. This reflects the revaluation of the remaining 10% interest in B from
its initial measurement of 100 to fair value of 160.
7. Cost Method
Where the investor has neither control, nor significant influence over the financial and operating decisions of its investment, income should only be recognised when
received in the form of dividends. This is the cost method.
Dividends, in excess of post acquisition profits, (“liquidating dividends”) should be treated as reductions in the cost of the investment.
Losses incurred by the undertaking in which the investment has been made may create an impairment charge. This would arise if the fair value of the investment falls
below the cost of the investment (see IAS 36 workbook).
8. Joint Ventures
A joint venture is a contractual arrangement, whereby 2, or more, parties undertake an economic activity, which is subject to joint control.
These parties are known as the venturers.
No single venturer alone can control the activity, though one party may be designated as the manager of the activity. Unanimous consent on all financial and operating
decisions is not necessary for an arrangement to satisfy the definition of a joint venture—unanimous consent on only strategic decisions is
sufficient.
Joint ventures have many forms including jointly-controlled:

 operations
 assets
 entities.
Jointly-controlled operations (example: aircraft manufacture)

Here the venturers use there own assets and resources, rather than forming a separate entity.
Each venturer bears its own costs and takes a share of the revenue, as determined by the contract.
As the net assets, income and expenses are recognised in the accounts of the venturer, no further information is required to be recorded.
Jointly-controlled assets (example: oil pipelines)

Here the venturers have joint control, and sometimes joint ownership, of assets provided to the joint venture.
Revenues and costs are shared according to the contract.
Each venturer should account for its share in the jointly-controlled assets, any liabilities incurred (including those jointly with other venturers), income, gains and expenses
of the joint venture.
EXAMPLE - Revenue recognition for a pipeline
Entity B has won a contract to construct and operate a gas pipeline. B will
construct the pipeline and the associated infrastructure necessary to operate
it. It will then operate it for 20 years.
B will receive fees under the contract over the 20-year period. It will receive a
reimbursement of construction costs over the five years following construction
plus an annual fee over the 20-year operating period.
Consequently the profit that B will earn for the construction of the pipeline is
included within the annual fee it will receive.
How should B recognise the revenue it receives for constructing and operating
the pipeline?
The two components of the contract, being the construction of the pipeline and
the operation, should be separated and accounted for individually. IAS 11,
Construction Contracts, should be applied to the construction element and IAS
18, Revenue, applied to the operating element.
The present value of the total fees receivable under the contract should be
allocated to the two components based on relative fair value.
The revenue on both components should be recognised on a percentage-of-

completion basis. The construction component will be recognised on the basis
of costs incurred to costs to complete under IAS 11.
The operation includes transporting of the gas, tracking use of the pipeline by
customers, invoicing customers, maintenance, etc. The operation of the
pipeline is therefore provided using an indeterminate number of acts.
The revenue for the operation should therefore be recognised on a straight-

line basis under IAS 18. The revenue recognised under both standards in
advance of the cash received gives rise to a financial receivable. IAS 11, IAS
18 and IAS 39 require the receivable to be recognised initially at fair value.
Consequently the difference between the gross fees receivable under the
contract and the present value of the revenue recognised should be recorded
as interest income using the effective interest method as required by IAS 18.
Jointly-controlled entities (example: foreign sales operations)

Here there is a legal structure to house the joint venture.
Each venturer usually contributes cash or other resources, accounted for as an investment in the jointly-controlled entity.
The entity keeps its own accounting records.
The venturers should account for their share of the entity through the Equity Method of Accounting (see 5. above). IAS 31 currently recommends the use of Proportionate
Consolidation as an alternative.
However, the IASB has said that Proportionate Consolidation will disappear as part of the convergence with USGAAP and has issued an exposure draft to that effect.
Given its limited future life, it is recommended that Proportionate Consolidation not be used by practitioners.
EXAMPLE - Contribution of assets to a joint venture
Entity A and entity B have formed an incorporated joint venture, JV Ltd. JV Ltd
prepares its accounts under IFRS.
On formation, entity A contributed property, plant and equipment, and entity B
contributed intangible assets to the joint venture in exchange for their equity
interests.
On formation, how should JV Ltd record the assets contributed?
JV Ltd should recognise the assets initially at cost in accordance with the
respective standards governing the assets; in this case, PPE under IAS 16,
Property, Plant and Equipment, and intangible assets under IAS 38, Intangible
Assets.
Cost is defined in the IAS 16 and IAS 38 as ‘the amount of cash or cash
equivalents paid or the fair value of the other consideration given to acquire an
asset at the time of its acquisition or construction or,where applicable, the
amount attributed to that asset when initially recognised, in accordance with
the specific requirements of other IFRSs, eg, IFRS 2, Share-based Payment.’
The asset contribution by the venturers upon JV Ltd’s formation is an equity-

settled share-based payment transaction within the scope of IFRS 2. The
scope exclusion of IFRS 2 does not apply, as the formation of a joint venture
does not meet the definition of a business combination.
For equity-settled share-based payment transactions, IFRS 2 requires an

entity to measure the goods received, and the corresponding increase in
equity, directly, at the fair value of the goods received, unless that fair value
cannot be estimated reliably.
IFRS 2 clarifies that there is a rebuttable presumption that the fair value of the
goods received can be estimated reliably.
In the rare situation where the fair value of the goods cannot be reliably
measured, an entity should measure their value, and the corresponding
increase in equity, indirectly, by reference to the fair value of the equity
instruments granted.
As JV Ltd is a newly incorporated company, the fair value of the assets

contributed is more determinable than the fair value of the equity instruments
granted. JV Ltd should therefore measure the assets received and the
corresponding increase in equity at the fair value of the assets received.
The previous practice of recording assets at their predecessor carrying values
is no longer permissible in the light of IFRS 2.
EXAMPLE - Contribution of non-monetary assets to a joint venture in

exchange for an equity interest
Issue
In applying IAS 31 to non-monetary contributions to a jointly controlled entity in

exchange for an equity interest in the jointly controlled entity, a venturer shall
recognise in profit or loss for the period the portion of a gain or loss attributable
to the equity interests of other venturers, except when [SIC-13.5]:
a) the significant risks and rewards of ownership of the contributed non-

monetary assets have not been transferred to the joint venture;
b) the gain or loss on the non-monetary contribution cannot be measured

reliably; or
c) the non-monetary assets contributed are similar to those contributed by the

other venturers.
How should management recognise the gain that results from the transfer of
non-monetary assets in exchange for an equity interest in a joint venture?
Background
Entity D, a joint venture, was established by two venturers as follows:
a) entity A contributes its non-monetary assets. The fair value of the assets
contributed is 400, and their book value is 100.
b) entity B contributes 50% of its shares in one of its subsidiaries, entity C. The
fair value of 50% of the shares in entity C is 400 and the book value is 76.
Entity A and entity B each own 50% of entity D and exercise joint control.
Solution
Entity A should recognise a gain of 150 for the following reasons:
a) the significant risks and rewards of ownership of the contributed non-
monetary assets have been transferred to entity D;
b) the gain on the non-monetary contribution can be measured reliably.

Information on both book values and fair values are available; and
c) the non-monetary assets contributed are not similar to those contributed by

the other venturer (entity B contributed shares).
50% of fair value of the shares of C received 200

less: 50% of book value of entity A’s assets contributed (50)
150
The entries recorded in it’s A's single-entity financial statements are as follows:
Dr Investment 400
Cr Non-monetary assets 100
Dr Gain on disposal 300
Entity A recognises the following further entry in its consolidated financial

statements, to eliminate the portion of the gain that relates to the share of the
non-monetary assets that it still owns and jointly controls:
Dr Gain 150
Cr Investment 150
EXAMPLE - Joint venture with a non-coterminous year-end
Investor F has an overseas joint venture (JV). F prepares financial statements

to the year ending 30 April and the JV prepares financial statements to the
year ending 31 December.
Can investor F use the JV.s December financial statements in preparing its
own financial statements in April?
IAS 31 does not specifically deal with the treatment of non-coterminous

yearends. However, IAS 28 is explicit. IAS 28 requires the use of financial
statements drawn up to the same date as the investor unless it is impractical
to do so.
In particular IAS 28 prohibits a difference of more than three months between

the year-end of the investor and of the associate. We believe a similar stance
should apply to the position between investors and joint ventures that are
accounted for using the equity method.
Differences between the financial statement dates of a jointly-controlled

entity and that of an individual venturer may also arise where the investor uses
the proportionate consolidation method.
IAS 31states that similar procedures should be followed for proportional

consolidation as for the consolidation of a subsidiary under IAS 27. Similar to
IAS 28, IAS 27 prohibits a difference of more than three months between the
year-end of the parent and the subsidiary.
Therefore, investor F should request the JV to prepare special-purpose

financial statements drawn up to the year ending 30 April.
9 Special Purpose Entities / Special Purpose Vehicles

Special Purpose Entities - SPE’s (also called Special Purpose Vehicles - SPV’s) are formed to house assets and/or liabilities that groups wish to eliminate from their
balance sheets. These may be assets such as loans which are being securitised – the bank wants to raise money on the loans without losing the relationship with the
clients.
In the USA, Enron (which subsequently collapsed) used SPE’s to hide large amounts of group loans and to manipulate profits.
SPE’s may be set up in tax havens for insurance and leasing operations to charge group profits for policies and leases whilst minimising tax.
Such a SPE may take the form of a corporation, trust, partnership or unincorporated entity. SPEs often are created with legal arrangements that impose strict and
sometimes permanent limits on the decision-making powers of their governing board, trustee or management over the operations of the SPE.
Frequently, these provisions specify that the policy guiding the ongoing activities of the SPE cannot be modified, other than perhaps by its creator or sponsor (ie they
operate on so-called ‘autopilot’).
The sponsor frequently transfers assets to the SPE, obtains the right to use assets held by the SPE or performs services for the SPE, while other parties (‘capital
providers’) may provide the funding to the SPE.
An entity that engages in transactions with an SPE may in practice control the SPE.
A beneficial interest in an SPE may, for example, take the form of a debt instrument, an equity instrument, a participation right, a residual interest or a lease.
Some beneficial interests may simply provide the holder with a fixed or stated rate of return, while others give the holder rights or access to other future benefits of the
SPE’s activities.
In most cases, the creator or sponsor retains a significant beneficial interest in the SPE’s activities, even though it may own little or none of the SPE’s equity.
The following circumstances may indicate a relationship in which an entity controls an SPE and consequently should consolidate the SPE:
(i) the activities of the SPE are being conducted on behalf of the entity according to its specific business needs so that the entity obtains benefits from the SPE’s
operation;
(ii) the entity has the decision-making powers to obtain the majority of the benefits of the activities of the SPE or, by setting up an ‘autopilot’ mechanism, the entity
has delegated these decision-making powers;
(iii) the entity has rights to obtain the majority of the benefits of the SPE and therefore may be exposed to risks incident to the activities of the SPE; or
(iv) the entity retains the majority of the residual or ownership risks related to the SPE or its assets in order to obtain benefits from its activities.
In general, an SPE is an extension of the group and its functional currency (see IAS 21 workbook) will be the same of that of its parent.
The question for consolidation is whether the group controls the SPE or not. If so, it must consolidate it. (If not, not.) Interpretation SIC 12, ‘Consolidation – Special purpose
entities’ governs this in IFRS.
Control over another entity requires having the ability to direct or dominate its decision-making, regardless of whether this power is actually exercised.
Control may exist even in cases where an entity owns little or none of the SPE’s equity.
The question of control may be obscured by setting up the SPE to work on pre-determined instructions, after which the group can suggest that it has no control of the SPE,
as the SPE is working on autopilot.
It is then a test of whether the group has the risks and rewards of the SPE. If so, it must consolidate it.
Indicators of control over an SPE
(a) Activities
The activities of the SPE, in substance, are being conducted on behalf of the
reporting entity, which directly or indirectly created the SPE according to its
specific business needs.
Examples are:
the SPE is principally engaged in providing a source of long-term capital to

an entity or funding to support an entity’s ongoing major or central
operations; or
the SPE provides a supply of goods or services that is consistent with an

entity’s ongoing major or central operations which, without the existence of
the SPE, would have to be provided by the entity itself.
Economic dependence of an entity on the reporting entity (such as relations of

suppliers to a significant customer) does not, by itself, lead to control.
(b) Decision-making
The reporting entity, in substance, has the decision-making powers to control

or to obtain control of the SPE or its assets, including certain decision-making
powers coming into existence after the formation of the SPE. Such decision-
making powers may have been delegated by establishing an ‘autopilot’
mechanism.
Examples are:
power to unilaterally dissolve an SPE;
power to change the SPE’s charter or bylaws; or
power to veto proposed changes of the SPE’s charter or bylaws.
(c) Benefits
The reporting entity, in substance, has rights to obtain a majority of the

benefits of the SPE’s activities through a statute, contract, agreement, or trust
deed, or any other scheme, arrangement or device.
Such rights to benefits in the SPE may be indicators of control when they are
specified in favour of an entity that is engaged in transactions with an SPE and
that entity stands to gain those benefits from the financial performance of the
SPE.
Examples are:
rights to a majority of any economic benefits distributed by an entity in the

form of future net cash flows, earnings, net assets, or other economic
benefits; or
rights to majority residual interests in scheduled residual distributions or in

a liquidation of the SPE.
(d) Risks
An indication of control may be obtained by evaluating the risks of each party

engaging in transactions with an SPE. Frequently, the reporting entity
guarantees a return or credit protection directly or indirectly through the SPE to
outside investors who provide substantially all of the capital to the SPE.
As a result of the guarantee, the entity retains residual or ownership risks and
the investors are, in substance, only lenders because their exposure to gains
and losses is limited.
Examples are:
the capital providers do not have a significant interest in the underlying net
assets of the SPE;
the capital providers do not have rights to the future economic benefits of
the SPE;
the capital providers are not substantively exposed to the inherent risks of
the underlying net assets or operations of the SPE; or
in substance, the capital providers receive mainly consideration equivalent to a

lender’s return through a debt or equity interest.
Implications for special purpose entities (SPEs) - PwC Inform Jan 2006
So when would this result in an SPE being classed as a subsidiary? Take the
following example, where a parent gained the majority of the benefits arising
from an SPE and its operating and financial policies were predetermined.
Under IFRS such an SPE would be treated as a full subsidiary as it is caught

by the provisions of SIC 12, which interprets the control criteria set out in IAS
27, ‘Consolidated and separate financial statements’.
Who’s in control?
The definition of a parent may give rise to an anomaly in that in certain

situations it may seem that there are two parents. For example, one company
may appear to be exercising dominant influence yet another may have the
power to do so.
This situation is likely to arise when the shareholder with the power to exercise
dominant influence chooses to be passive and does not prevent the other
shareholder from actually exercising dominant influence.
Where more than one undertaking appears to be the parent, only one can
have control. Control is defined as the ability to direct the financial and
operating policies of another with a view to gaining economic benefits from its
activities.
The shareholder with the power to exercise dominant influence has control
under the revised definitions despite choosing to be passive.
Practical example
An example of the ability to exercise control would be call options that give a
shareholder the power to exercise dominant influence. For example, say
company A owns five per cent of company B, but in addition has call options
exercisable at any time that would give it all the voting rights in company B.
Although company A's management does not intend to exercise the call
options, the existence of the options and company A's ability to exercise them
at any time to gain control of company B gives company A the power to
exercise dominant influence.
The presence of the options means that the operating and financial policies
are set in accordance with company A's wishes and for its benefit as the other
shareholders of company B are mindful of the options in voting on operating
and financial policies, as should company B make a decision not in
accordance with company A's wishes, company A has the power to exercise
the call options and reverse the decision.
EXAMPLE - Loans to customers
Entity A is a parent company that prepares consolidated financial statements.

Some of A’s subsidiaries are in the business of providing loans to customers.
These loans are sold to trusts set up as special purpose entities (SPEs) under
a securitisation arrangement to achieve lower financing costs.
Entity A holds a beneficial residual interest in the SPE trusts and consolidates
the SPEs under SIC-12, in its consolidated financial statements.
A is preparing its separate financial statements in accordance with IAS 27,

Consolidated and Separate Financial Statements,and would like to account for
its investments in its subsidiaries at fair value in accordance with IAS 39.
Should entity A’s beneficial interest in its SPEs be accounted for in the same
way as its conventional subsidiaries in its separate financial statements?
Yes. The SPEs that qualify for consolidation under SIC-12 in consolidated
financial statements are subsidiaries in the context of IAS 27.Consequently if A
elects to account for its subsidiaries in accordance with IAS 39 in its separate
financial statements, this election applies equally to its SPEs.
Entity A may choose to account for its subsidiaries including its interest in its
SPEs as available-for-sale financial assets, or it may elect to classify them at
fair value through profit and loss in its separate financial statements, provided
it meets the conditions in IAS 39 for that classification.
Entity A should apply its accounting policy choice consistently to all of its
subsidiaries including SPEs.
Examples of transactions, relationships and structures that

may be impacted by SIC-12
Leasing/property
 Sale-leasebacks of property or equipment;
 Built-to-suit property or equipment subject to an operating lease (for
example, office buildings, manufacturing plants, aeroplanes);
 Synthetic leases (lease structures that are treated as operating leases
for accounting purposes, even though the lessee is considered the
owner for tax purposes); and
 Certain partnerships in property investments.
Financial assets
 Transactions involving the sale/transfer of financial assets such as
receivables to an SPE (for example, factoring arrangements or
securitisations);
 Transactions involving a commercial paper conduit, such as
sponsoring a conduit to purchase and securitise assets from third
parties;
 Securitisation transactions involving commercial-debt obligations,
collateralized bond obligations and commercial-loan obligations; and
 Entities used to hedge off-balance sheet positions.
Start-ups, research and development

 Funding arrangements for research and development;
 Newly formed entities that are designed to manage or fund the start-up
of a new product or business;
 Entities sponsored/funded by venture capital, private equity or financial
entities; and
 Entities in the developmental stage.
Vendor financing
 Structures designed to help customers finance the purchase of
products and services (ie, vendor financing), often in collaboration with

a financial institution.
Insurance
 Insurance associations (reciprocals); and
 Reinsurance securitisations.
Transactions involving management, officers and employees

 The transfer or sale of assets to an entity owned by a single employee
or by members of an entity’s management;
 Management of an unconsolidated asset or business by an entity or its
officers; and
 The funding of an entity’s independent equity by another entity’s
managing members.
Obligations associated with other entities

 Certain captive arrangements operated on behalf of an investor;
 An entity’s guarantee of:
(i) an unconsolidated entity’s performance or debt, or
(ii) the value of an asset held by the unconsolidated entity
(including explicit and implicit guarantees);
 An entity’s contingent liability should an unconsolidated entity default;
 A transaction with an embedded ‘put’ option that enables the entity or
an outside party to sell the assets and/or operations back to an entity;
 A transaction with an embedded call option and/or operations that
were previously sold to another entity;
 An entity’s enhancement of another entity’s credit (for example, via
escrow funds, collateral agreements, discounts on transferred assets
and take-or-pay arrangements); and
 An agreement requiring an enterprise to make a payment if its credit is
downgraded.

Rights to assets
 Rights to use an ‘under construction’ asset not recorded in the entity’s
balance sheet (the debt used to fund the construction being recourse
only to that specific asset);
 Leasing assets from an entity that financed these assets with debt that
is recourse to the individual asset rather than to all of the lessor
entity’s assets;
 The transfer of financial assets to an entity subject to debt that is

recourse only to those financial assets rather than to all of the entity’s
assets;
 Variable lease payments, variable license-fee payments or other
variable payments for the right to use an asset (for example, the
payments change with fluctuations in market interest rates); and
 Ownership of an asset that an entity holds for tax purposes but does
not record on its balance sheet.
Other
 Outsourcing arrangement – particularly when an entity’s own
employees/assets are sold prior to any entity and will continue to
provide services to the seller;
 Sale of assets or operations where the seller retains some governance
rights and/or an economic interest;
 The purchase of businesses or assets by a third party or a newly
formed entity on behalf of another company (ie, an off-balance-sheet
acquisition vehicle);
 Investments made through intermediaries in entities that generate
losses from a financial reporting perspective;
 Tolling arrangements with project finance companies;
 Transactions in which an entity’s primary counterparties are financial
institutions (for example, banks, private equity funds and insurance
companies);
 Arrangements with an entity whose capital structure (often the equity)
is partially owned (or provided) by a charitable trust;
 An unconsolidated entity whose name is included in the entity’s name;
 When an entity provides administrative or other services on behalf of
an unconsolidated entity or services its assets; and
 When an unconsolidated entity provides financing or other services
exclusively to an entity, its vendors or customers.
Source ;SIC-12 and FIN 46R -The substance of control (PwC)
10. Outsourcing contracts: an accidental business combination?

IFRS News - March 2006
Outsourcing contracts are common. Many companies use outsourcing contracts to reduce costs, increase efficiency and focus on the core business. There are many
different types of outsourcing arrangements, and the financial reporting of them can be complex.
The expected outcome is generally that the outsourcing arrangement will be treated as a service arrangement, but an outsourcing contract may be classified as a business
combination, lease or service concession.
Whether it is a business combination, a lease, a construction contract or a service arrangement will depend on the contract with the customer; but the assessment requires
management’s judgment.
Companies may outsource any or all functions they consider can be done more efficiently by a third party. This can be a function as peripheral as catering for a large head
office or IT management for a law firm.
Other less obvious outsourcing contracts might be private finance initiatives, contract drug manufacturing, prison management and waste management services.
Financial reporting of these contracts raises several questions: is there a business combination? How should upfront payments by the outsourcer be treated? How should
revenue and costs be recognised?
What are the potential implications of IFRIC 4? IFRIC debated some of these questions as part of the Service Concession Arrangements exposure draft; however, none
have been definitively answered, and the completion of an interpretation is not expected soon.
Have you acquired a business?
The first step in analysing an outsourcing transaction is to determine whether a business combination has taken place. A large outsourcing contract usually includes some
of a company’s significant processes.
The company transfers assets, staff and processes to the outsourcer. These three in combination should be able to provide output on their own, which is a business as
defined by IFRS 3.
Some factors such as a limited contract life can refute the business combination conclusion. The transaction will give rise to a business combination if full control is
transferred to the outsourcer for the expected useful life of the assets.
A business combination is more likely where the ‘outsourcee’ is assembling similar contracts to extract synergies and asset efficiency. A business combination results in
the outsourcer recording assets and liabilities at fair value and goodwill.
Accidental business combinations are seldom welcomed by senior management or the investor community. It is difficult to assess whether or not a contract results in a
business combination, particularly when existing customer processes are combined with the existing processes of the outsourcer.
The outsourcer should therefore carefully assess agreements as they are being structured to avoid unintended financial reporting effects.
Build and run components
A contract may require the outsourcer to build a platform to deliver the service (for example, an IT platform, plant or large equipment). This is often referred to as the ‘build’
phase of the contract, to be followed by the ‘run’ phase.
Management should assess whether the build and run phases should be accounted for separately. Factors to consider are whether the asset and the service are to be
delivered separately ie, the customer can use the asset separately from the service and whether a reliable measure of revenue for the asset and the service can be
obtained.
The build element, when separable, is generally recognised in accordance with IAS 11, Construction Contracts, as the item is being built to the specifications of the
customer as a result of a negotiated contract.
The run element is generally recognised as a service contract in accordance with IAS 18, Revenue.
Run revenues and costs
Activities to be delivered under a run component of a bundled outsourcing contract are usually services, either discrete or continuous. Revenue should be recorded on a
percentage-of-completion basis.
However, the measurement of completion, given the nature of the services delivered, is usually based on ‘output’ indicators (volumes of transactions, survey of
interventions and similar measures).
Measures of completion based on input measures such as costs (cost-to-cost method) is not appropriate for such contracts, as it is unlikely that cost incurred represents
the progress of the service to date.
Revenue is generally recorded on a straight-line basis if services to be delivered are performed by an ‘indeterminate number of acts’.
Certain contracts include the payment of an upfront amount by the outsourcer to the customer. When services received for such a payment are not identifiable, the
payment usually represents the granting of a discount. This is recognised as a reduction of revenue over the service period of the contract.
Recognition of costs may be even more challenging than recognition of revenue. Contract revenue and expenses ‘are recognised respectively by reference to the stage of
completion of the contract activity’. Expenses in an outsourcing contract because of the necessary start-up activities are often front-loaded.
Outsourcing is a developing industry, with an increasing number of processes being transferred to outsourcers and requiring start-up activities with significant front-loaded
expenses. New contracts may be signed at the same time as the outsourcer is adapting its structure to offer new services.
The outsourcer should determine which of these up-front expenses relate to the implementation of a specific contract, as opposed to costs incurred at its discretion to
modify or transform its own business. This may depend on the maturity of the outsourcer’s business.
Some historical outsourcers are developing their structures to face this demand; other corporations are setting up new outsourcing businesses, often starting with their
existing IT functions, while many existing IT companies are expanding into outsourcing.
For expenses that relate to the services to be delivered, work in progress is recognised if the costs are recoverable. There will also be numerous other costs (employee
restructuring, transfer to a new location, development of new processes) that are normal operating costs of the business that should be expensed as incurred or that may
give rise to intangible or tangible fixed assets.
Implications of IFRIC 4
IFRIC 4, Determining whether an Arrangement contains a Lease, is effective from 1 January 2006. Most outsourcing contracts include assets; these outsourcers will need
to determine whether their outsourcing contracts include a lease.
The challenge is to assess whether specific assets exist in the arrangement. This determination should be made on an asset-by-asset analysis. This includes obtaining a
precise understanding of the use of the asset: is the service based on that specific asset, or could it be delivered, in accordance with the terms of the contract by other
means?
For example, a catering outsourcer may provide meals for a customer from its central facilities, which are also used for other customers; conversely, it may use a dedicated
facility constructed solely for the purpose of that customer’s contract. If the asset is used solely for the company, it would be a lease of the specific asset by the customer.
The asset is not deemed specific to the customer if the outsourcer uses the asset for a number of customers, and no lease would exist.
11. Carve-out / combined financial statements

IFRS NEWS - MARCH 2008
IFRSs provide very limited guidance on the preparation of carve-out/combined financial statements. The answers to the questions may be different in different countries.
Consultation with the relevant experts and lawyers is crucial.
What are ‘carve-out’ and ‘combined’ financial statements?
The terms ‘carve-out’ and ’combined’ financial statements have a similar meaning. Combined financial statements are the aggregate of the financial statements of
segments, separate entities or groups, which fail to meet the definition of a ‘group’ under IAS 27.
Carve-out financial statements are the separate financial statements of a division or lesser business component(s) of a consolidated or larger entity.
The term used varies by country and regulator. For example, the UK commonly refers to ‘combined’ financial statements and the US refers to ‘carve-out’ financial
statements.
When can carve-out/combined financial statements be prepared?
Preparation of carve-out/combined financial statements is seldom straightforward. Common issues include:
• whether carve-out/combined financial statements can be presented;
• determining what the reporting entity is;
• how to measure assets and liabilities; and
• how to allocate different types of costs, income, taxes etc.
Participants agreed that carve-out/combined financial information should be prepared only when all of the entities concerned have been under common control during the
track record period and form a ‘reporting entity’.
“Carve-out/combined financial statements are usually prepared in contemplation of a capital market transaction and might be required by the local regulator.” David
Smailes
What are the regulatory requirements and market practice regarding the preparation of carve-out/combined financial statements?
Most territories have no specific regulatory requirements for the preparation of combined financial statements. The most detailed and structured guidance available is that
issued by the SEC with respect to US GAAP, and the UK Annexure to the Standard for Investment Reporting (SIR) 2000 for the presentation of financial information in an
investment circular.
Many territories find this guidance useful. However, since most carve-out or combined financial information is prepared with a view to a capital market transaction, experts
recommend entities clear potential issues with the local regulator in advance, as different regulators may take different views.
“The general principles governing preparation of carve-out financial statements have been developed over the last two decades and captured through SEC speeches,
comment letters and past examples of carve-out financial statements.” Neil Dhar
Conscious about the need to define a framework which provides guidance to EU preparers, the European Commission is currently working on a project to issue the
equivalent of SIRs. The first part of the project looks at pro formas.
“Under French GAAP, aggregating financial statements of separate legal structures is allowed in certain circumstances.
This practice has evolved while transitioning to IFRS to a model which looks beyond the legal structures and considers the business of the reporting entity.” Thierry
Charron
What is the difference between carve-out/combined financial statements and pro forma financial statements?
Making the distinction is important because an audit opinion cannot be issued for pro forma financial statements.
The same principle is applied consistently in all respondents’

territories:
• carve-out/combined financial statements present historical financial information prepared by aggregating the financial information of entities under common management
and control, which did not form a legal group.
• Pro forma financial statements present hypothetical financial information created to present an illustration of how a capital market transaction might have affected an
“issuer” of securities, had a specific transaction or series of
transactions been undertaken at the commencement of the period being presented, or at the balance sheet date presented.
The meaning and interpretation of the term ‘pro forma’ might differ from territory to territory, and there might be some differences in the preparation of pro forma financial
statements.
“In some territories carve-out/combined financial statements have been referred to as ‘pro forma’ and presented as audited historical financial information.
This use of the same term for dissimilar financial information should not be confused with the concept of illustrative pro forma financial information on which a compilation
opinion rather than an audit opinion is given, as contemplated by the European Prospectus Regulation and associated guidance.” David Smailes
“Germany has issued a standard governing the preparation of pro forma financial information (as has the SEC in its Regulation S-X). In all cases, there should be some
basis or framework to support the compilation of pro forma financial information.” Nadja Picard
What is a ‘reporting entity’, and what are the general indicators that a reporting entity exists for which IFRS financial statements can be prepared?
The IFRS Framework defines reporting entity as “an entity for which there are users who rely on the financial statements as their major source of financial information
about the entity”.
Capital market specialists look at all the facts to assess whether a reporting entity exists. These include:
• Whether the assets and liabilities included in the carve-out are legally bound together through:
– a legal reorganisation of a group/groups that has occurred after the reporting date, but prior to the publication of the financial statements;
– a reorganisation that will happen simultaneously with a proposed IPO, disposal or similar transaction; or
– an agreement that was signed and in place throughout the historical financial period. The written agreement cannot be put in place retrospectively; or
• Whether the assets and liabilities are all owned by the same party, and whether there is evidence that they have been managed together as a single economic entity
during the track record period?
All the owner’s assets and liabilities managed in this way should be included.
“A material level of transactions between the businesses or with common customers/suppliers would make it more difficult to present meaningful carve-out/combined
financial statements for one of the businesses.” David Smailes
‘Managed together’ is not usually interpreted as meaning that a group with two business segments can not present carve-out/ combined financial statements for one of the
two segments.
However, presentation of carve-out/combined financial statements would require further analysis of the relationships between the two segments to determine whether the
business segments are related or interdependent, or if there are any material inter-business relationships.
Example
An acquisition company, Newco, has been created. The directors of Newco prepare an IPO prospectus which includes a commitment to use the proceeds of the IPO to
acquire a segment of an existing third party company, Opbus.
Opbus did not previously report separate financial information and is a mix of legal entities and divisions.
The issuer is Newco. The prospectus must include an audited track record for the business of Newco but this is not represented by Newco’s legal financial information.
Typically the prospectus would therefore include:
• Carve-out/combined historical financial information on Opbus; and
• Pro forma information for the enlarged Newco group, illustrating how Newco’s financial information would have looked if Newco had already acquired Opbus.
Example
When one entity, which is managed together with others as part of the same business segment, will not be subject to the legal reorganisation, should the entity be included
in the reporting entity?
It is important not to present misleading information: A high level of transactions between the business excluded and the carve-out group could lead to misleading carve-
out financial statements.
For example if the excluded business was a loss-making entity as a result of transactions with the carve-out group which were not performed at arm’s length.
This is a complex issue when regulatory approval is sought. It requires judgement and should be addressed upfront when planning for carve-out/combined financial
statements. Neil Dhar
What are the allocation principles for assets, liabilities, income and expenses?
The most common areas where allocations have to be made are headquarters costs, income taxes, debt and interests. Each situation is unique and requires consideration
based on the facts available.
“Factors usually considered when doing the allocation include:
– Will the assets and liabilities be transferred to the carved-out group?
– Was there any intra group recharge between the parent and the carved-out group, eg legal, accounting, finance expenses? and
– Have the recharges been made on an arm’s length basis?”

Gabriele Matrone
Allocations can only be made to the extent of the costs actually incurred by the larger group. That is, no allocation can be made on a “what if” basis.
For example, allocation would not be made on the basis of estimating what the expenses of the carved-out business would have been if it had had its own legal
department. Such an approach would be more akin to proforma financial information.
Quality of the information is a pre-requisite for the allocations. These must be performed to a standard that allows presentation within IFRS financial statements and, in
most cases must be auditable.
If quality information does not exist, a preparer should provide sufficient disclosure in the notes to enable readers of the carve-out/combined financial statements to
understand how the future financial position, performance and cash flows of a stand alone business may differ.
Whichever method is used to allocate assets, liabilities, income and expenses, clear and meaningful explanations in the notes are essential for a good understanding of
the financial statements.
The UK and SEC material referred to above provides useful guidance in respect of allocation.
Kennedy Liu shares some recent comments from the Hong

Kong Stock Exchange
“Please disclose the basis of allocation in the basis of preparation”
“Has management disclosed its judgement that the carveout is appropriate in the critical accounting policies?”
“Has management disclosed details of the carve-out business in the basis of preparation?”
“Advise and disclose the basis on how “common control” is established.”
“Is it appropriate to use the carve-out approach or the discontinued operation approach in preparing the financial statements?”
“Does the carve-out satisfy the criteria under UK Standard for Investment Reporting 2000?”
“Do the carve-out financial statements comply with HKFRS/IFRS?”
How are income taxes dealt with?

Respondents identified the following examples:
Tax position Treatment of tax

The entities that comprise the Tax expenses, assets and liabilities
carved-out business filed separate are accounted for in accordance with
tax returns the tax returns.
The entities that comprise the carved- a) Separate tax return approach:
out business were part of a under this method, income tax is
consolidated tax group. recalculated and accounted for
as if the entity had always filed
tax returns separately. Particular
attention should be paid to tax
losses when the tax asset has
already been used by another
entity in the group that is not
part of the carved-out business.
Or
b) Actual tax incurred: this
method would be possible if
the parent recharged taxes to
the entities that comprise the
carve-out/combined business.
How should debt and interest expense be allocated?

Respondents agreed that intercompany debt between the carved-out business and the parent should be reinstated in the carve-out/combined financial statements, along
with the associated interest expense incurred.
Example
Financing of 100 was provided in the past. 150 of group debt will be allocated in the restructuring:
100 should be allocated to the carved-out business as it reflects the amount attributable to the carved-out business.
However, in certain circumstances, it might also be acceptable to allocate 150, rolled back to the balance sheet of the earliest year presented along with the related interest
expense, as long as the additional 50 does not represent a pro forma type adjustment.
An analysis of the final capital structure (pre transaction) should also be performed.
“A practical difficulty, arising when interest free loans were

granted by the parent to the entities that comprise the carvedout
business, is that the allocation of the actual interest expense
requires an analysis of the capital and debt structure of the
wider group. For example, if the interest free loans were backed
by interest-bearing loans that are external to the group, the
interest paid on these loans could be used.”
Gabriele Matrone
How much assurance can auditors give on carveout/ combined financial statements?
There is accepted practice of giving some kind of assurance on
carve-out/combined financial statements when the financial
statements are those of a reporting entity and can be
satisfactorily audited.
An audit opinion might refer to “true and fair” or “fair presentation

in accordance with IFRS”. However, in certain circumstances, it
might be more appropriate to refer to the basis of preparation.
The greater the number of adjustments and allocations that have
to be made to achieve a carve-out/combined presentation, the
less likely it is that an IFRS opinion can be issued.
”Referring to the basis of preparation is widely accepted in the

UK for an opinion given on historical financial information
presented in an investment circular under SIR 2000.” David Smailes
An ‘emphasis of matter’ paragraph is also commonly used in

the auditors’ opinion. This explains that the carved-out business
has not operated as a separate entity, and that the financial
statements are not necessarily indicative of results that would
have occurred if the business had been a separate stand-alone
entity during the period presented, nor is it indicative of future
results of the business.
“It is common practice in Hong Kong to issue an unqualified
audit opinion without an ‘emphasis of matter’ paragraph. Even

so, it would usually be appropriate to include such disclosures in
the notes to the carve-out/combined financial statements.” Kenny Liu
What are the practical challenges faced in the preparation of carve-out/combined financial statements?
The practical challenges vary depending on circumstances.

Respondents highlighted three key areas:
1. The structure of the carved-out business:
Financial statements are easier to prepare when they are an
aggregation of separate legal entities each of which has their
own stand-alone financial statements. Preparation of
financial statements is more complex when it entails carving
out portions of legal entities.
2. The interactions between the carve-out/combined business

and the rest of the group:
The extent of those interactions determines the complexity
of identifying and reinstating inter-company transactions and
allocating income, expenses, assets and liabilities.
3. The quality of the accounting records, internal controls,

processes and systems:
The financial statements must be prepared reliably and must
be auditable.
“One practical difficulty we face is segregating working capital

balances, such as accounts receivable, accounts payable and
inventory.” Neil Dhar
12. Multiple Choice Questions

Choose the answer that is closest to what you feel best answers the question:
1. IFRS 3 Business Combinations forbids:
1) Using fair values.

2) Creating liabilities for future losses.
3) Including fair values and historic cost in the same balance sheet.
2. If fair values differ from historic cost, minority interests will:
1) Benefit from any increase in valuations.

2) Not benefit from any increase in valuations.
3) Be ignored.
3. In a sale of a subsidiary, deferred payments:
1) Are prohibited.
2) May be discounted to present value.
3) Should be excluded from financial statements.
4. On a sale of a subsidiary, remaining goodwill:
1) Should be transferred to the Parent’s balance sheet.

2) Should be amortised over 5 years.
3) Should be written off in full against group reserves.
4) Should remain unchanged in the consolidated balance sheet.
5. Loss of control of a subsidiary:
1) Should be treated as a disposal.

2) Should be treated as a disposal, but neither gain, nor loss should be recognised.
3) Should be re-valued every year, using an inflation index.
6. The equity method of accounting values the investment:
1) By measuring the dividend stream, discounted to present value.

2) At cost, plus for the investor’s share of post-acquisition profits.
3) At fair value, less cost of disposal.
7. In the equity method of accounting, Goodwill:
1) Must be shown separately from goodwill derived from subsidiaries.

2) Is not calculated.
3) Should be amortised over no more than 20 years.
8. An associate is an undertaking in which the investor has:
1) Control that is only temporary.

2) Significant influence, and which is neither a subsidiary, nor a joint venture.
3) Control of financial decisions, but not operating decisions.
4) Control, but no board membership.
9. A joint venture is:
1) More than one investor owns shares in a company.

2) A contractual arrangement, whereby parties undertake an economic activity, which is subject to joint control.
3) Firms of different nationalities sell assets to an economic activity.
10. In a jointly-controlled operation:
1) All assets are pooled.

2) Venturers use their own assets and resources.
3) All assets must be leased.
4) Separate accounts are mandatory.
11. In jointly-controlled assets:
1) Revenues and costs are shared according to the contract.

2) Venturers use their own assets and resources.
4) All profits must be shared equally.
12. In jointly-controlled entities:

2) All profits must be shared equally.
3) A legal structure houses the joint venture.
4) No accounts are required.
13. Self Test Questions

1. SALE OF SUBSIDIARY
75% of a subsidiary cost 65 in January 2XX6, when 100% of the net assets of the subsidiary were valued at 80.
Required: Prepare the P & S1 Group Balance Sheet on acquisition and the Parent Balance Sheet after disposal.
Parent Balance Sheet (January 2XX6)
Assets Liabilities
S1 Investment 65
1600 1600
Subsidiary 1 Balance Sheet (January 2XX6)
Assets Liabilities
Investments 100
570 570
P & S1 Group Balance Sheet on acquistion
Assets Liabilities
Cash Accounts payable
Accounts receivable Accruals
Investments Minority Interest
Fixed Assets Shareholders’ Funds
Goodwill
The investment in the subsidiary was sold in December 2XX6 for 100. The Parent Balance Sheet had remained unchanged prior to the sale.
Parent Balance Sheet (after disposal)
Assets Liabilities
Investments Shareholders’ Funds
S1 Investment Profit on sale
Fixed Assets
2. SHARE EXCHANGE
P owns 100% of S1. This cost 100. When S1 was acquired the net assets were 70.
Today the net assets of S1 are 150.
S1 retained earnings comprise 10 pre-acquisition profits and 80 post acquisition profits.
At the date of the exchange Goodwill of 6 remains to be written off.
P exchanges the shares of S1 for 60% of S2.
Prepare the P/S1 and the P/S2 Consolidated Balance Sheets.
Parent Balance Sheet
Assets Liabilities
Accounts receivable 100 Accruals 300
Investments 250
S1 Investment 100
1600 1600
Assets Liabilities
Investments 100 Retained Earnings 10
Fixed Assets 50 Pre-acquisition Profit
Post-acquisition Profit 80
580 580
Assets Liabilities
Accounts receivable
Investments Accruals
Fixed Assets
Goodwill Shareholders’ Funds
Parent Balance Sheet (at date of exchange)
Assets Liabilities
Investments 250
S2 Investment 150 Accruals 300
1650 1650
Shareholder’s funds = 500 + 50 Profit on sale of S1
Assets Liabilities
Investments 200 Share Capital 120
Fixed Assets 100 Retained Earnings 0
600 600
Assets Liabilities
Investments Minority Interests
Fixed Assets Shareholders’ Funds
Negative Goodwill
3. Equity Method of Accounting
Parent Balance Sheet (before acquisition)
Assets Liabilities
1600 1600
P bought 75% of S for 250. It was purchased with other undertakings, and P had determined that S should be sold as quickly as possible, and immediately sought a buyer.
At the time of acquisition, the net assets of S had a value of 170 (100 Share Capital and 70 Pre-Acquisition Profits).
Now, post-acquisition profits are 100.

The parent’s balance sheet has not changed since the acquisition.
Required: Prepare the Parent Balance Sheet including S using the Equity Method.
Subsidiary Balance Sheet
Assets Liabilities
Cash 10 Current Liabilities 300
Pre-acquisition profits 70
Fixed Assets 360 Post-acquisition profits 100
570 570
Assets Liabilities
Investments S Shareholders’ Funds
Fixed Assets Profits of S
14. Suggested Solutions

Answers to Multiple Choice Questions:
1. 2) 5. 1) 9. 2) 13. 2)
2. 1) 6. 2) 10. 2)
3. 2) 7. 2) 11. 1)
4. 3) 8. 2)
Answers to Self-test Questions:
1.
P & S1 Group Balance Sheet (January 2XX6)
Assets Liabilities
Investments 300 Minority Interest 20
Goodwill 5
2110 2110
Parent Balance Sheet (after disposal)
Assets Liabilities
S1 Investment 0
Profit on sale 35
1620 1620
2.
Assets Liabilities

Fixed Assets 150
Goodwill 6 Shareholders’ Funds 556
2086 2086
Notes:
Shareholder’s funds l= 500+80-goodwill (30-6)= 556
Assets Liabilities
Investments 450 Minority Interests 48
Goodwill 78
2178 2178
Notes:
Goodwill= 150-72=78
Minority Interests= 40% of 120
Shareholder’s Funds= 556-(goodwill) 6
3.
Assets Liabilities
Investments 200 Shareholders’ Funds 500
S (250+75) 325
Fixed Assets 100 Profits of S(75% of 100) 75
1675 1675
15. Appendix: IFRS Framework
ALL INTERNATIONAL STANDARDS APPLY IN FULL TO CONSOLIDATED ACCOUNTS
(EXCEPT WHERE OTHERWISE STATED). THE FOLLOWING ARE THE MORE IMPORTANT:
1.12 IASB FRAMEWORK

(Concepts that underlie the preparation and presentation of financial
statements for external users.)
1.13 INTERNATIONAL ACCOUNTING STANDARDS
IAS 1 Presentation of Financial Statements
(A complete set of financial statements includes the following:

a. balance sheet;
b. income statement
c. a statement showing either:
(i) all changes in equity; or
(ii) changes in equity other than those arising from capital
transactions with owners and distributions to owners;
d. cash flow statement; and
e. accounting policies and explanatory notes.)
IAS 7 Cash Flow Statements

IAS 21 The Effects of Changes in Exchange Rates
(especially Financial Statements of Foreign Operations)
IAS 22 Accounting for Business Combinations (now IFRS 3)
IAS 27 Consolidated Financial Statements and Accounting for
Investment in Subsidiaries
IAS 28 Accounting for Investments in Associates
IAS 31 Financial Reporting of Interests in Joint Ventures
IAS 36 Impairment of Assets
IAS 39 Financial Instruments: Recognition and Measurement
IFRS 1 First-time Adoption of IFRS This publication has been produced with the assistance of the European Union.
IFRS 3 Business combinations The contents of this publication are the sole responsibility of ZAO
IFRS 5 Disposal of Non-Current Assets and Presentation of Discontinued “PricewaterhouseCoopers”, FBK and European Savings Bank Group and can in
Operations no way be taken to reflect the views of the European Union.

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This Project is funded by EU

for Bank Accounting Professionals

A basic knowledge of accounting is assumed but if any additional knowledge is

Each workbook is a combination of Information, Examples, Self-Test

Transactions between group undertakings should be listed, and inter company

Consolidated accounts will be required if one business controls another, ASSOCIATE

CONTROL  Ownership of 20-50% of the voting shares.

Indications of control are: JOINT VENTURE

 Controlling the composition of the board of directors.

MINORITY INTEREST (NOW CALLED NON-CONTROLLING INTERESTS)

3. Fair Value Accounting Example:

For example, provisions may be set up in the balance sheet on acquisition,

Earn-outs payable in ordinary shares may not require re-measurement through

E’s existing activities are synergies specific to E and should be included in

 Profits / losses to date of disposal

Goodwill 8 Parent Balance Sheet (after disposal)

Goodwill arising on acquisition of S1 is:

Parent Balance Sheet (after acquisition)

S1 Balance Sheet (at date of exchange)

P/ S1 Consolidated Balance Sheet

The derivation of these figures appears on the next page.

Derivation of Group Figures (for example on

1600 1600 580 580 100 100 2084 2084

Parent Balance Sheet (at date of exchange)

S2 Balance Sheet (at date of exchange)

The net assets of S2 are worth 200.

The effect of the exchange is:

75% of the net assets of S2 are worth 75% of (120+80)=150

P/ S2 Consolidated Balance Sheet

Fixed Assets 200 Shareholders’ Funds 530

Since IFRS 3, negative goodwill is immediately eliminated by writing it off to profit.

On cessation, the consolidated financial statements should show:

Any gain / loss is calculated from:

LOSS OF CONTROL – RETENTION OF PART OF THE UNDERTAKING

IAS 27 (Revised) – new proposals on minority interests and disposals

A partial disposal of an interest in a subsidiary in which the parent company

Purchase of some or all of the non-controlling interest is treated as a treasury

What happened to minority interest?

All shareholders of a group − whether they are shareholders of the parent or of

There is no change in presentation of non-controlling interest under the new

What happens if a non-controlling interest is bought or sold?

How is the partial sale of a subsidiary with a change in control accounted

Consistent with a ‘gain’ on a business combination, the standards take the

How does the new standard affect transactions with previously

An entity might purchase a non-controlling interest recognised as part of a

In both cases, no further goodwill can be recognised when the non-controlling

EXAMPLE - LOSS OF CONTROL – RETENTION OF PART OF THE UNDERTAKING-

P holds 80% of S. It was bought as part of a group of companies and 50% is

EXAMPLE - LOSS OF CONTROL – RETENTION OF PART OF THE UNDERTAKING -

P holds 80% of S. It was bought as part of a group of companies and 50% is

The 50% stake is resold for 600.

EXAMPLE - LOSS OF CONTROL – RETENTION OF PART OF THE UNDERTAKING -

P holds 80% of S. It was bought as part of a group of companies and 50% is

The 50% stake is resold for 600.

EXAMPLE - IFRS 5 and partial disposals

Entity A has a 70% ownership stake in a subsidiary, entity B, which represents

How should A disclose the results of B in its consolidated financial statements

If an entity will recover the carrying amount of a disposal group principally

For example, if an entity with a 51% holding in a subsidiary entered into a

Held for sale subsidiary with financial assets

Entity D, a subsidiary of entity E, meets the definition of a held-for-sale asset in

On initial classification as held for sale, E measured D at the lower of carrying

IFRS 5 notes that on subsequent remeasurement of a disposal group, the