IAS 27 - Consolidations

1. IAS 27 - Consolidations

2. Executive summary • IFRS and US GAAP are fairly well converged with respect to business consolidations. • The general consolidation model is basically the same under IFRS and US GAAP, with some differences related to the determination of control. • In certain circumstances, both IFRS and US GAAP allow up to a three-month difference between the reporting dates of a parent and a subsidiary. Significant events during this gap period require adjustment under IFRS, while US GAAP only requires disclosure. • IFRS requires that accounting policies be conformed between a parent and its subsidiaries, while differences are permitted under US GAAP. • Upon initially obtaining control, IFRS provides two options for the parent in valuing non-controlling interests (NCI) (full fair value or fair value of identifiable assets), while under US GAAP, only the full fair-value method is allowed.

3. Executive summary • Special-purpose entities (SPEs) under IFRS and variable-interest-entities (VIEs) under US GAAP are evaluated for consolidation. For these entities, IFRS is focused more on control, while US GAAP is focused principally on determining the primary beneficiary based on both the power to direct the activities of the VIE and the obligation to absorb losses or the right to receive benefits. • The accounting guidance for jointly controlled entities is generally similar under IFRS and US GAAP when the equity method of accounting is used. IFRS, however, provides a choice of the equity method of accounting or proportionate consolidation for jointly controlled operations. US GAAP only allows the proportionate consolidation when it is industry practice.

4. Progress on convergence The IASB is working on a consolidation project that would replace the amended IAS 27 and SIC 12. The IASB has issued: ED 10, Consolidated Financial Statements, in December 2008, which proposes to replace the amended IAS 27 and SIC 12 and provide a single-standard consolidation model as well as revise the definition of control and enhance disclosures. In February 2010, the IASB tentatively decided to combine the disclosure requirements for subsidiaries, JVs and associates within a comprehensive disclosure standard that will address a reporting entity's involvement with other entities. This comprehensive disclosure standard will also include disclosures related to risks associated with structured entities that the reporting entity does not control. The current project plan envisages the issue of the comprehensive disclosure standard in the second quarter of 2010 in response to the current global financial crisis and a revised consolidation standard in the fourth quarter of 2010.

5. Progress on convergence In June 2009, the FASB issued: SFAS No. 166, Accountingfor Transfers of Financial Assets, an amendment of SFAS No. 140, which eliminated the concept of qualified SPEs. SFAS No. 167, Amendments to FASB Interpretation No. 46(R), which requires ongoing reassessments of whether an enterprise is the primary beneficiary of a VIE. In February 2010, ASU No. 2010-10, Consolidation (Topic 810): Amendments for Certain Investment Funds, was issued, which defers the effective date of SFAS No. 167 for certain investment funds. As part of their joint project on business consolidations, the Board’s objectives are to develop one consolidation model that can be applied to voting interests and VIEs. The Boards have set a goal that during the second quarter of 2010 the FASB will issue an exposure draft on consolidations. After considering comments on the exposure draft, the Boards currently plan to issue a final standard in the second half of 2010. It is currently likely these projects will result in additional convergence, however, future developments should be monitored. IFRS 10, 11, and 12 have been issued and will be effective January 1, 2013.

6. Consolidation model US GAAP IFRS An entity is generally required to consolidate entities it controls. Similar Similar Control is presumed to exist if the parent owns more than 50% of the voting stock. Similar – when an entity has the ability to govern the financial and operating policies of another entity, such as an SPE, to obtain benefits, control exists and consolidation should occur. A risks-and-rewards model is used to evaluate the need to consolidate VIEs.

7. Consolidation model • Under US GAAP, all entities are first evaluated for consolidation as potential VIEs. An entity is considered to be VIE if: (1) it has insufficient equity to carry on its operations without additional financial support; (2) as a group, the equity holders are unable to make decisions about the entity’s activities; or (3) the entity has equity that does not absorb the entity’s losses or receive its benefits. The primary beneficiary (determined based on the consideration of both the power to direct the activities of the VIE and the obligation to absorb losses or the right to receive benefits) is required to consolidate the VIE. If the entity is not a VIE, then it is evaluated for consolidation based on voting control. In 2009, US GAAP eliminated the concept of a qualifying SPE.

8. Consolidation model US GAAP IFRS Requires full elimination of revenues, expenses and asset transfers between companies of a consolidated group. Similar

9. Consolidation model US GAAP • Currently potential voting rights are generally not considered when assessing control of non-VIEs. (Note: the FASB has tentatively decided to consider voting rights when assessing control.) • Does not currently have a de facto control model. • ASC 810 may also result in the significant shareholder consolidating an entity. IFRS • Potential voting rights are considered if they are currently exercisable, regardless of intent and ability to exercise those rights. • Considers de facto control. De facto control may occur when there is only one significant shareholder that owns less than 50% of the voting stock andother shareholders are disbursed and generally don’t exercise their voting rights at annual meetings.

10. Consolidation model US GAAP IFRS Because the IFRS definition of control is much broader than US GAAP, it is possible to reach different conclusions as to control. However, for public companies, the SEC has a much broader notion of control, which is more similar to IFRS. Under the SEC’s definition, control exists when one entity possesses the power to direct policies of another entity, either by ownership of voting shares, by contract or by other means. (Note: the FASB has tentatively decided to adopt a de facto control concept. The FASB currently believes a company must have demonstrated de facto control before it consolidates an entity for which it has less than 50% voting control. The IASB would not require demonstration of the ability to exert de facto control before consolidating an entity.)

11. Consolidation model US GAAP • Combined financial statements are permitted if the entities being combined are under common control or management. IFRS • Combined financial statements are generally not acceptable as general purpose financial statements, except under rare circumstances requiring a true and fair override.

12. Example 1 Company A owns 49% of the voting stock of Company B. Company A has a currently exercisable option to purchase an additional 2% of the voting stock at a cost of $50 per share. The shares are currently valued at $30. Consolidation considerations – voting rights example • Would Company A consolidate Company B under US GAAP or IFRS? Explain your answer.

13. Example 1 solution: US GAAP: Company A would not have to consolidate Company B since under US GAAP potential voting rights are not considered. IFRS: Company A would have to consolidate Company B under IFRS because potential voting rights must be considered if they are exercisable, regardless of the intent or ability to exercise those rights. Consolidation considerations – voting rights example

14. Example 2 The Rich family started a local bank in 1920. The family still owns 40% of the stock of the local bank through its Rich Holding Company (RHC). RHC prepares it financial statements under US GAAP. RHC may need to consolidate the local bank because of the de facto control rules. Consolidation considerations – de facto control example • Is this statement true or false under US GAAP?

15. Example 2 solution: False. The de facto control concept is an IFRS concept that doesn’t exist under US GAAP. Consolidation considerations – de facto control example

16. Example 3 The Summer family owns and operates a ball bearing company and a drug store. The family is seeking a bank loan. The bank has requested combined financial statements be prepared. Consolidation considerations example – combined financial statements • Is this presentation acceptable under US GAAP and/or IFRS? Explain your answer.

17. Example 3 solution: US GAAP: Yes. Combined financial statements would be acceptable under US GAAP since the ball bearing company and the drug store are under common control and common management. IFRS: No. Combined financial statements are generally not acceptable as general purpose financial statements under IFRS, except under rare circumstances requiring a true and fair override. Consolidation considerations example – combined financial statements

18. Presentation of consolidated financial statements US GAAP IFRS Generally requires the preparation of consolidated financial statements when consolidation criteria are met. Similar In certain instances, up to a three-month difference is allowed between the reporting dates of a parent and a subsidiary. Similar

19. Presentation of consolidated financial statements US GAAP • If consolidation criteria are met, consolidation generally is required. • US GAAP does provide for certain industry-specific exceptions from consolidation (e.g., investment companies). IFRS • Also generally requires consolidation if the consolidation criteria are met. However, IFRS provides for limited circumstances when a parent does not have to present consolidated financial statements, if all the following criteria are met: • The shareholders of the parent do not object. • The parent does not have any debt or equity instruments traded in public markets, and it is not in the process of registering public debt or equity. • The immediate or ultimate parent must prepare and publish consolidated IFRS financials.

20. Presentation of consolidated financial statements US GAAP • Allows up to a three-month difference between the year-end of the parent and the subsidiary. IFRS • Permits up to a three-month lag if it is impractical to prepare subsidiary financial statements as of the same date. • IAS 1.7 states, “… a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so.” • Possible examples of impractical situations might arise when a subsidiary’s accounting systems are manual, or there are significant estimation processes that require additional time to prepare and evaluate.

21. Presentation of consolidated financial statements US GAAP • If a subsidiary has a year-end that precedes the parent’s year-end, significant events during this time period must be disclosed in the financial statements of the parent, but adjustments are not typically made to the financial statements. • A parent and a subsidiary are permitted to have different accounting policies. This is most likely to occur when the subsidiary is following some specialized industry guide. IFRS • Requires adjustment of the financial statements to reflect the impact of significant events during this period. • The accounting policies of the subsidiary must be the same as its parent. When they differ, it will result in the need for top-side adjustments in consolidation to conform the subsidiary’s accounting policies to those of its parent.

22. Example 4 Low Tech, a US-based company, has a June year-end. It acquired Company B in the Amazon Basin in August. Company B lacks a sophisticated accounting system and requires 60 to 70 days to close its books at the end of each quarter. Part of the reason for the delay in closing the books is there are several complex accounting estimates that must be re-evaluated each quarter. Low Tech has evaluated the accounting systems and the estimation processes, but has not been able to find a way to expedite the quarterly closing process. Difference in year-end example • Can Low Tech consolidate Company B based on a May year-end under either US GAAP or IFRS? Explain your answer.

23. Example 4 solution: US GAAP: US GAAP allows up to three months difference between the year-end of the parent and the subsidiary. IFRS: IFRS permits up to a three-month lag if it is impractical to prepare subsidiary statements as of the same date. IAS 1.7 states, “... a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so.” It appears the impractical requirement has been met so a May year-end for Company B would be acceptable. Difference in year-end example

24. Example 5 The Parent Company has a June 30 year-end and its wholly owned subsidiary has a May 31 year-end. Assume all the requirements for different reporting dates have been met. On June 15, a competitor introduces a new technology-enhanced product which makes obsolete $10.0 million of Parent Company’s inventory and $2.0 million of the subsidiary’s inventory. Significant events during a difference in year-end example • What would be the impact on the consolidated June 30 financial statements under US GAAP and IFRS? • Show any required journal entries as of June 30.

25. Example 5 solution: US GAAP: US GAAP requires significant events during this time period to be disclosed in the financial statements of the parent. Adjustments for significant events that occur in the gap period generally are not recorded under US GAAP. Cost of sales of parent $10,000,000 Inventory of parent $10,000,000 Significant events during a difference in year-end example

26. Example 5 solution (continued): IFRS: IFRS requires adjustment of the financial statements to reflect the impact of significant events during the gap period. Cost of sales of parent $10,000,000 Inventory of parent $10,000,000 Cost of sales of subsidiary $2,000,000 Inventory of subsidiary $2,000,000 Significant events during a difference in year-end example

27. Minority interest (NCI) • Both US GAAP and IFRS utilize the concept of a non-controlling interest (NCI). ASC 810-10-65-1 defines this concept as: “A non-controlling interest, sometimes called a minority interest, is the portion of equity in a subsidiary not attributable, directly or indirectly, to a parent.” • US GAAP and IFRS generally are converged as it relates to NCI. US GAAP IFRS • Changes in the ownership interest of a subsidiary (that does not result in loss of control) will generally be accounted for as an equity transaction (paid-in capital) and will have no impact on goodwill, nor will they give rise to a gain or loss. Similar

28. Minority interest (NCI) US GAAP IFRS Upon a loss of control of a subsidiary, a new basis recognition event occurs, where essentially a gain or loss is recognized on 100% of the interest held. The retained NCI will be remeasured to fair value and will impact the gain or loss recognized upon disposal. The gain or loss is calculated as follows: proceeds plus the fair value of any retained interest plus the carrying amount of NCI in the former subsidiary minus the carrying amount of the former subsidiary’s net assets, plus or minus components of equity reclassified to profit or loss. Similar

29. Minority interest (NCI) US GAAP IFRS Losses applicable to NCI are allocated to those interests even if that results in a deficit position. Similar NCIs are generally classified on the balance sheet as equity, separate from the equity of the parent, and both present income from NCIs as an allocation of that period’s comprehensive income. Similar

30. Minority interest (NCI) US GAAP • Upon obtaining control, the acquisition of NCI must be measured at fair value, including goodwill. IFRS • Upon obtaining control, there is a choice to initially measure NCI at fair value, including goodwill, on the date of acquisition (fair value method) or at the fair value of the NCI’s proportionate share of the acquiree’s identifiable net assets as measured at the acquisition date (without goodwill) (proportionate method). This choice is to be made for each business combination.

31. Example 6 Under both US GAAP and IFRS, which of the following is not a consideration related to consolidations? Consolidation considerations – general example • SPEs • Focus on control • Restrictions on NCIs being negative • Elimination of revenues and expenses between members on a consolidated group • None of the above

32. Example 6 solution: There is no restriction on NCI (minority interest) being negative under US GAAP or IFRS. Consolidation considerations – general example

33. Example 7 A parent owns 70% of a subsidiary. The carrying amount of the NCI of 30% is $150 million under the full fair-value method. There are no amounts accumulated in other comprehensive income for this subsidiary. The parent acquires an additional 10% from the NCI for $60 million in cash. Assume the parent used the full fair-value method to initially measure the NCI upon obtaining control of the subsidiary. NCI – fair-value method example • Prepare the required journal entries to record the acquisition of the additional 10% interest in the subsidiary under US GAAP and IFRS.

34. Example 7 solution: In recording the acquisition of the additional 10% interest in the subsidiary, under US GAAP and IFRS, the carrying amount of the NCI is adjusted to reflect the change in ownership interests in the subsidiary’s net assets since the transaction does not result in a change in control. Any difference between the amount by which the NCI is adjusted and the fair value of the consideration paid is attributed to the parent. The journal entry to record the additional 10% interest in the subsidiary under both US GAAP and IFRS would be as follows: NCI $ 50,000,000(1) Additional paid-in capital 10,000,000 Cash $60,000,000 (1) (10%/30% = 33.33%) x $150,000,000 (rounded) NCI – fair-value method example

35. Example 8 In 2010, Company A acquires 70% of the voting stock of Company S for $770,000 in cash. At the date of acquisition by Company A, the fair value the identifiable net assets of Company S is $900,000. The fair value of the 30% NCI is $300,000. Company A paid a $70,000 control premium to obtain control over Company S. NCI – fair-value and proportionate methods example • Show the calculations and journal entries to record Company A’s investment in Company S under the fair-value method and the proportionate method.

36. Example 8 solution: Proportionate method: Cash $770,000 Company A’s portion of the fair value of the identifiable net assets in Company S (630,000)(1) Goodwill $140,000 (1) $900,000 x 70% = $630,000 Journal entry: Fair value of identifiable net assets $900,000 Goodwill 140,000 Cash $770,000 NCI 270,000(2) (2) $900,000 x 30% = $270,000 NCI – fair-value and proportionate methods example

37. Example 8 solution (continued): Fair-value method: Cash $770,000 Fair value of the NCI 300,000 Fair value of the identifiable net assets of Company S (900,000) Goodwill $170,000 Journal entry: Fair value of identifiable net assets $900,000 Goodwill 170,000 Cash $770,000 NCI 300,000 NCI – fair-value and proportionate methods example

38. Disclosures US GAAP IFRS Disclosure of the general consolidation policy is required. Similar If a consolidated subsidiary has a different year-end than the parent, a disclosure is required. The reason for the different year-end also should be disclosed. Similar Disclosure of any changes in the subsidiaries being consolidated is required. Similar

39. Disclosures US GAAP • If a subsidiary has a year-end that precedes the parent’s year-end, significant events during this time period must be disclosed in the financial statements of the parent, but adjustments typically are not made to the financial statements. • Does not have this option. IFRS • Requires adjustment of the financial statements to reflect the impact of significant events during this period. • Provides for limited circumstances when a parent does not have to present consolidated financial statements, if certain criteria are met. Disclosure that the financial statements reflect the exemption from consolidation is required.