Corporate Financial Reporting

ACCT2542
Corporate Financial Reporting & Analysis

Semester 2 2009 Version 1.0.3
Contents
Page 3 Page 7 Page 10 Page 15 Page 19 Page 24 Page 26 Page 30 Page 33 Page 36 Page 40 Page 44 Accounting for Income Tax Consolidation Accounting Principles Consolidation Accounting Wholly Owned Subsidiaries Consolidation Accounting Intragroup Transactions Consolidation Accounting Minority Interests Consolidation Accounting Indirect Ownership Accounting for Associates Asso The Equity Method Accounting for Interests in Joint Ventures Introduction to Corporate Financial Reporting Presentation of Financial Statements Earnings Per Share Principals of Disclosure
Copyright Ka Hei Yeh 2009 First Edition published October 2009. (Revised February 2010)
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Corporate Financial Reporting g & Analysis Semester 2 2009
Accounting for Income Tax

Background Accounting for income tax is not as easy as it seems. A businesss accounting profit is rarely ever the same as its tax profit (or taxable income). This is because they are determined using different rules. As such, methods must be used to find out a businesss tax profit based on its accounting profit by using the balance sheet and other accounting information. Finding Taxable Profit from Accounting Profit As such, our first step is to define how we get from accounting profit to taxable profit. We generally take the following steps: 1. 2. 3. 4. 5. Find the accounting profit Add back any expenses that are not tax deductible Deduct away any revenues that are not considered assessable income Add any assessable incomes which are not considered revenue Deduct any tax deductions that are not expenses
Following this, we should get our taxable profit. This is explained later. Permanent and Temporary Differences The differences between accounting and tax profit can either be permanent or temporary. Permanent differences are differences that affect one of either of the profits and will never affect the other. Such examples include: Government Grants Tax Exemptions/Deductions
Tax exemptions and deductions are permanent because both accounting and tax profit take into account the expenditure from things that cause exemptions and deductions (such as a tax deduction on purchases of new vehicles) but only tax profit will take into account the exemption/deduction by further reducing the tax profit whereas it does not further reduce accounting profit. A permanent difference can affect accounting profit more but not tax profit. Permanent differences are not explicitly defined in the AASB 112 (Income Tax Standard) but it does state that any that appear must be disclosed in the financial reports. Temporary differences are those that occur in both accounting and tax profit but they occur in different periods. They are defined in the AASB 112 as, differences between the carrying amount of an asset or liability in the balance sheet and its tax base. Carrying Amount is the amount at which the asset or liability is recorded on the balance sheet. Tax Base is the amount which is attributed to the asset or liability for tax purposes. These two may or may not be the same.
Corporate Financial Reporting & Analysis Semester 2 2009
Examples of temporary differences include: Interest revenue Instantly recognised by accounting profit, but only recognised in tax profit when actually cashed out. Provision for long service leave Instantly recognised by accounting profit, but only recognised when the long service leave is actually paid for.
Calculating the Tax Base of an Asset and Liability The tax base of an asset is calculated by taking the carrying amount and: Deducting future taxable amounts Adding future deductible amounts
For a liability, we simply add future taxable amounts and deduct future deductable amounts; which is the opposite of what is done for assets. Example: In our provision for long service leave (a liability), assume we put $1000 in there as our expense for this year. We know from the above that provision for long service leave is fully tax deductable only when it is paid out. This is a future deductible amount as it can be deducted in the future; but not now. As such the tax base of this would be $1,000 + $0 - $1,000 = $0. Taxable and Deductible Temporary Differences Temporary differences can be further split into two types based on the asset or liabilitys carrying amount and tax base. Taxable temporary differences result in greater taxable income in the future, such as: An assets carrying value exceeds its tax base, or, A liabilitys carrying value is exceeded by its tax base.
Since this causes a greater taxable income in the future, this taxable temporary difference, when multiplied by the tax rate, gives the deferred tax liability. (i.e. the amount of tax that the business ultimately has to pay in the future because of this temporary difference.) Examples of a taxable temporary difference include: interest revenue (this is not treated as assessable income until the actual cash is received), accelerated depreciation (where depreciation is accelerated for tax purposes) and capitalised costs (as opposed to being expensed). Deductible temporary differences result in a lower taxable income in the future. This occurs when: An assets carrying value is exceeded by its tax base, or, A liabilitys carrying value exceeds its tax base.
These will result in a lower taxable income in the future and, when multiplied by the tax rate, gives the deferred tax asset amount. (i.e. the business has already paid for the tax and will not need to pay any it when the amount is recovered or settled in the future.) Examples of a deferred tax asset include: provisions (as seen before, all provisions are tax deductible when paid out) and allowance for doubtful debts (only deductable when it does go bad). Components in Accounting for Income Tax From what weve seen above, a companys total tax liability can be split into two parts: Current Tax This is the tax that the business has to pay now during the current period. Deferred Tax This is the tax that the business will be required to pay when the asset is realised or a deduction when the liability is expensed.
The Statement of Taxable Income The Statement of Taxable Income basically shows the tabular process of finding taxable profit by deduction from the firms accounting profit and other information (as stated on Page 3). A thorough illustrative example is provided from Slide 39 to Slide 50 of Week 1 lecture notes. Another example can also be found in Picker et al, Page 189 and Page 207. Note that in the process of finding the carrying value of items in the statement may require you to find missing values through the reconstruction of T-Accounts. Refer to ACCT1511 notes if you have forgotten how to do this. After finding the current tax liability (say $11,000), we need to do the following journal entry: Dr Income Tax Expense Cr Current Tax Liability The Deferred Tax Worksheet The Deferred Tax Worksheet is simply an extension of the process we use to find taxable or deductable temporary differences. Although the worksheet looks complex, the process is simple: 1. 2. 3. 4. 5. 6. Take the entire firms assets and liabilities and list out their current carrying value. Deduce the tax bases of all those assets and liabilities. Calculate the difference between the carrying value and the tax value. Based on the kind of asset or liability, place it as a taxable amount or a deductible amount. Add all these taxable and/or deductible temporary differences. Multiply these two figures by the tax rate to find the deferred tax asset and deferred tax liability respectively. 7. Deduct the respective beginning balances to find the adjustment required. 11,000 11,000
A thorough illustrative example is provided from Slide 51 to Slide 59 of Week 1 lecture notes. Another example can also be found in Picker et al, Page 200. After finding the adjustment values for both Deferred Tax Asset and Deferred Tax Liability, we will need the following journal entry: Dr/Cr Deferred Tax Asset [Debit if the adjustment is positive; Credit if negative.] Dr/Cr Deferred Tax Liability [Credit if the adjustment is positive; Debit if negative.] Dr/Cr Income Tax Expense [This balances the journal out so it depends on the above two.] Tax Losses Sometimes, a business may have more deductions than assessable income (although very rarely). In this case, the tax office will not reimburse the firm with cash. Instead, they will defer the deduction until a period where there is no tax loss and the company can then realise the deferred tax asset. Asset Revaluation and Tax Previously, we have learnt that if we revalue an asset, such as a land, we would do the following: Dr Land Cr Asset Revaluation Reserve 10,000 10,000
This is technically correct when there is no tax. However, when we have tax, we also need to tax the Asset Revaluation Reserve at the current tax rate (30% in Australia). We would need to also include the following journal entry: Dr Asset Revaluation Reserve Cr Deferred Tax Liability 3,000 3,000
We can shorten the above two into a single journal entry to save time. Dr Land Cr Income Tax Expense Cr Deferred Tax Liability 10,000 7,000 3,000
We will also need to reflect this in our deferred tax journal entry by also adding: Dr Asset Revaluation Reserve 3,000
Consolidation Accounting - Principles
Consolidation Accounting Principles

Background Consolidation accounting is accounting for business combinations (i.e. more than one entity). This means things such as creating a balance sheet, income statement etc. for the entire business group as one whole. Naturally this is similar to normal accounting but there are differences we need to understand. Business Combinations To have a business combination, there must be control. Control is defined as, the power to govern the financial and operating policies of an entity or business so as to obtain benefits from its activities. To gain this control, an entity usually needs to have the majority of voting rights in the entity in question. It does not matter if a business does not exercise its power over another entity as long as it holds power. Example: Company A has 49% of shares in Company B. Company C has 51% of shares in Company B. Therefore, Company C has control over Company B. If Company A has 49%, but the other 51% was owned by many other individuals, then Company A has control of company B. In the above example, Company A is the, parent and Company B is the, subsidiary. When lots of companies are holding shares in each other, it is very hard to determine who has control. As such, many entities use this as a way to avoid consolidation but still be considered a group. There are many ways of achieving control over another company. These can be: Script acquisitions: Company A buys shares in Company B in exchange for shares in Company A. This means that people who have shares in Company B end up with shares in Company A. Purchase method: Directly buying shares in another company to gain control.
At the moment, we will only look at parent-subsidiary relationships where one company controls another. We will look at other relationships such as joint-ventures later. Determining the Cost of Acquisition When a parent acquires control over a subsidiary, it measures the cost of combination as the fair values of assets, liabilities and equity acquired at the date of exchange. We must note that this can be different to the carrying amount of the asset on the subsidiarys balance sheet. Any costs directly associated with the acquisition must also be attributed as a cost of acquisition.
The acquirer shall only recognise assets and liabilities that can have their fair values measured reliably; including intangible assets and contingent liabilities. Recall that fair values can be determined through various methods including: The current market value of the asset/liability An estimated value based on comparison with something that has equal or almost equal features. The present value of the asset/liability The net selling value of the asset/liability The depreciated replacement cost of the asset
Goodwill Goodwill is the excess that is paid to acquire a business based on its fair value. i.e. If the fair value of a firms assets and liabilities equals $45,000 but the acquirer paid $50,000 to acquire the business, then $5,000 can be attributable as goodwill. Goodwill can only be recognised by the firm being acquired and only purchased goodwill can be recognised. That is, only an entity which has been purchased before can have goodwill. Excess The opposite of goodwill is excess. This is when the acquirer pays less than the fair value of the assets and liabilities of the entity being acquired. Unlike goodwill, excess is immediately recognised as a profit or loss. An excess rarely occurs and if you end up with an excess, you should double check to make sure you did not make any mistakes. Even the AASB 3 assumes that excesses result from mathematical calculation errors as this is very rare. If, after recalculation and double checking, an excess still results, you can then recognise it. The journal entry to immediately recognise excess as a gain is: Dr Excess Cr Gain on Acquisition of Subsidiary The Consolidation Method There are three stages to the consolidation method. These are: 1. Line-by-line aggregation This is simply adding up the same accounts in the parent and the subsidiary together, such as adding both entities accounts receivables together etc. 2. Elimination and adjustments for intra-group activities This is the process of removing any internal activities between the parent and subsidiary. If the parent sold something to the subsidiary, in terms of the company, nothing has changed, so we need to eliminate this activity. XXXXX XXXXX
A simple example will help clear this up: Put $4 into your left pocket. Call your left pocket Company A and your right pocket Company B. Now, take $4 and move it to your right pocket. You have just simulated an inter-group transaction between Company A and B. But look at yourself, as a person (the entity), you still have $4. All you did was move the money around. This is exactly what we are trying to eliminate. 3. Allocation to minority interest This is the allocation that is required when the parent does not own 100% of the subsidiary and must allocate a portion of the equity to the minority interest. The Consolidation Worksheet The Consolidation Worksheet is used to tabulate the above process. It looks like as below: Parent Ltd Capital Ret. Earnings Liabilities Assets -Goodwill -Investment -Others Subsidiary Ltd Elimination Entries Dr Cr Consolidated Balance
Here, we simply add across, taking into account any elimination entries. Elimination entries are those journal entries that we take the remove intra-group activities such as mention before. Note that the two Debit and Credit columns must equal each other. We use the consolidated balance to prepare the consolidated financial statements. We must also note that these journal entries and the consolidation worksheets are all temporary; we only use them for one time. The next time we need to do the statements again, we must go through the entire process again from scratch to produce the consolidated statements.
Consolidation Accounting Wholly Owned Subsidiaries

Background Wholly owned subsidiaries are those where a parent has 100% of the shares in the subsidiary, meaning that they have full control. Adjustments for Fair Value When adjusting assets to their fair value, we use the following journal entry: Dr Asset Cr Business Combination Valuation Reserve However, remember that when we increase the value of any asset, there is a tax consequence that we must also take into account. In this case: Dr Business Combination Valuation Reserve Cr Deferred Tax Liability It must be noted that this is the consolidation entry that is required when an assets fair value is higher than its carrying amount at the date of acquisition. The same entries can also be used for recognising an intangible asset at fair value, except here we use the full amount instead of the difference between fair value and carrying amount. For recognising contingent liabilities, we use the following: Dr Business Combination Valuation Reserve Cr Liability Dr Deferred Tax Asset Cr Business Combination Valuation Reserve Acquisition Analysis Acquisition analysis is used primarily to find goodwill or excess. We conduct it by: 1. Finding the net fair value of identifiable assets and liabilities. This is the same as taking equity. 2. Deducting the cost of combination. Example: The Parent paid $2 per share for 100,000 of shares in Subsidiary for complete ownership. At the date of acquisition, the Subsidiary had $120,000 in share capital and $60,000 in retained earnings.
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Additionally, the fair value of land and equipment are $250,000 and $100,000 respectively. Their carrying amounts are $240,000 and $95,000 respectively. The acquisition analysis would thus be: Equity = $120,000 + $60,000 + ($250,000 - $240,000) x 0.7 [BCVR Land] + ($100,000 - $95,000) x 0.7 [BCVR Equipment] = $190,500 = 100,000 x $2 = $200,000 =$9,500
Cost of Combination Goodwill The journal entries would be:
Dr Retained Earnings Dr Share Capital Dr Business Combination Valuation Reserve Dr Goodwill Cr Shares in Subsidiary
60,000 120,000 10,500 9,500 200,000
Note that in the example, we have BCVR as a debit figure of $10,500. When we do the individual journal entries later, we eliminate our equity acquired against this debit figure when we account for the increase in tax liability due to increase in carrying amount. Example: Dr Land Cr Business Combination Valuation Reserve Cr Deferred Tax Liability Dr Equipment Cr Business Combination Valuation Reserve Cr Deferred Tax Liability 5,000 3,500 1,500 10,000 7,000 3,000
Notice how we have now eliminated $10,500 from BCVR after the adjustments (the Credits equal the Debits so it is eliminated) which is exactly the amount we need to eliminate from above. Dealing with Differences in Depreciation When assets that depreciate are revalued, their level of depreciation will be different to what is required for the group as a whole. Example: Following on from the previous example if the equipments carrying value in the Subsidiary is $95,000 and it is depreciated at 20% per year, the subsidiary would record a depreciation expense of $19,000 per year.
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For the group, this equipment is worth $100,000 so the depreciation expense per year should be $20,000. This is a $1,000 increase over what is actually recorded so we must record the extra depreciation in the consolidation entries as follows: Dr Depreciation Expense Cr Accumulated Depreciation Dr Deferred Tax Asset Cr Income Tax Expense 1,000 1,000 300 300
Note that in the example, such an entry can only be made in the year of acquisition because it directly affects the firms expense accounts. Recall that expense accounts are closed at the end of each year to retained profits. Thus for the following year, the journal will need to be as follows: Dr Depreciation Expense1 Dr Retained Earnings (Opening)2 Cr Accumulated Depreciation3 Dr Deferred Tax Asset4 Cr Income Tax Expense5 Cr Retained Earnings (Opening)6 1,000 1,000 2,000 600 300 300
1. This years additional depreciation expense. 2. Last years additional depreciation expense. We cannot directly debit from depreciation expense from last year as the account has been closed to retained earnings so we debit from that instead. 3. Total accumulated depreciation. Not an expense account that is closed so we can change it. 4. Deferred Tax Asset results from increase in expense meaning less tax to be paid. 5. This years tax expense should decrease from more expenses. (30% tax rate) 6. Last years tax expense should also be less from more expenses, but cannot be directly debited from as it has been closed. Credit retained earnings instead. (30% tax rate) Sale of Assets after Acquisition Date The Subsidiary owns land of $240,000 in our example previously. If this was sold in the following year at $275,000 to an external party, the subsidiary would have recorded the following: Dr Cash Cr Land Cr Gain on Sale of Land 275,000 240,000 35,000
However, when we consolidate, we value the land at $250,000 and not $240,000. This means the gain on sale of the land must be reduced by $10,000. Thus, we would need to adjust it as follows: Dr Gain on Sale of Land Cr Income Tax Expense Cr Transfer from BCVR Dr Transfer from BCVR Cr BCVR 10,000 3,000 7,000 7,000 7,000
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Note that if this was not in the period where acquisition took place, we would debit Retained profits (opening) instead of Transfer from BCVR. We would also include this directly in the pre-acquisition entries. Recall that the pre-acquisition entries were: Dr Retained Earnings Dr Share Capital Dr Business Combination Valuation Reserve Dr Goodwill Cr Shares in Subsidiary Add the following journal in: Dr Retained Earnings (Opening) Cr Business Combination Valuation Reserve Results in: Dr Retained Earnings Dr Share Capital Dr Business Combination Valuation Reserve Dr Goodwill Cr Shares in Subsidiary Goodwill Impairment When goodwill is recorded after acquisition, it is usually amortized/impaired. Goodwill is only recorded on the consolidation journals. Example: Following from our example, our acquisition resulted in $9,500 of recognised goodwill. If $1,900 was impaired this year, our journal entry would be as follows: Dr Impairment Loss Cr Accumulated Impairment Losses 1,900 1,900 67,000 120,000 3,500 9,500 200,000 7,000 7,000 60,000 120,000 10,500 9,500 200,000
In the next year, we would need to put the expense into retained profits since the impairment loss expense account has been closed to it. That is: Dr Impairment Loss Dr Retained profits (opening) Cr Accumulated Impairment Losses 1,900 1,900 3,800
These two entries in the example are sometimes placed into the pre-acquisition entry.
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Excess Excess is immediately recorded as income in the period of acquisition by crediting the excess account. In any other period, we put it into the retained profits account. Dividends When the subsidiary issues dividends, the parent will be the only entity getting those dividends as it holds all the shares in that subsidiary. A dividend payout is, as such, treated as a reduction in the cost of acquiring the subsidiary. Example: The subsidiary declared a dividend of $10,000 and the parent bought those shares cumdividend, the parent has a right to that dividend. Thus, to the parent, this represents a return of $10,000 on their investment in the subsidiary. As such, the entry in the parents books would be: Dr Investment in Subsidiary Dr Dividend Receivable Cr Cash 190,000 10,000 200,000
However, when we do consolidation, we need to eliminate the dividend payable from the subsidiary and the dividend receivable from the parents book. This entry is: Dr Dividend Payable Cr Dividend Receivable 10,000 10,000
If a dividend is declared and paid, we use the following: Dr Investment in Subsidiary Cr Dividend Paid Cr Retained Profits (opening) 10,000 10,000 [If current year] 10,000 [If previous year(s)]
If the dividend has been declared, but has not been paid yet, we use the following: Dr Investment in Subsidiary Cr Dividend Declared Dr Dividend Payable Cr Dividend Receivable 10,000 10,000 10,000 10,000
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Consolidation Accounting Intragroup Transactions

Background A large part of doing consolidation is removing transactions between the entities that are part of the consolidation. Simple Eliminations Most elimination entries (journal entries to eliminate intragroup activities) are based very much on common sense. That means, simply reversing what was done before. Example: The parent company provided $10,000 worth of management services to subsidiary. The subsidiary paid the entire sum in the period it was accrued. In this case, the parent would have recorded $10,000 of management fee revenue while the subsidiary would have recorded $10,000 of management fee expense. In this case, we simply reverse that. i.e.: Dr Management Fee Revenue Cr Management Fee Expense $10,000 $10,000
If the subsidiary had only paid a fraction (i.e. not the entire sum) we also remove that because an entity having a payable to and a receivable from itself means it does not owe anything. Dr Accounts Payable Cr Accounts Receivable XXXXX XXXXX
This same logic can be applied to many other things such as dividends and borrowings. Transfer of Inventory For inventory we only need to eliminate it if inventory has been sold in between the entities. In these cases, the entity will see the cost of the inventory as the price at which it was originally paid for when it first entered the entity. The entity will see the sale of the inventory as the revenue gained when it left the entity. Example: The parent bought 200 boxes of apples at $8 per box from a supplier. During the same year, the parent sold all 200 boxes of apples to the subsidiary at $10 per box. The subsidiary then sold these boxes to consumers at $12 a box in the same year. In this case, the parent would have recorded $1,600 in Cost of Goods Sold and $2,000 in Sales Revenue. Likewise, the subsidiary would have recorded $2,000 in Cost of Goods Sold and $2,400 in Sales Revenue.
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If we add these together, it would mean the entity as a whole had $3,600 in Cost of Goods Sold and $4,400 in Sales Revenue. As we can see, this is not the case! Thus, we must eliminate the entry made between the two as it is an intragroup transaction. Dr Sales Revenue Cr Cost of Goods Sold 2,000 2,000
The above example only applies when the goods have been bought, transferred and then sold in the same period. In the case of when inventory has not been entirely sold at the end of the year but it has been transferred, we must also revalue inventory depending on if it was transferred at a profit or loss. Example: If, in the previous example, only 150 boxes of apples were sold at the end of the year and 50 remained, the journals that the parent and subsidiary have would be as follows: Parent: Dr Cost of Goods Sold Cr Sales Revenue Subsidiary: Dr Cost of Goods Sold Dr Inventory Cr Sales Revenue 1,500 500 1,800 1,600 2,000
In this case, the remaining inventory is not worth $500 to the entity because it was bought by the parent for $400 previously. This means we need to eliminate inventory by $100. The true Cost of Goods Sold is 150x$8=$1,200 meaning we must also eliminate the extra. Sales Revenue must be written down by $2,000 as well. Dr Sales Revenue Cr Cost of Goods Sold Cr Inventory 2,000 1900 100
Remember! When we change the carrying amount of an asset, we must also include the tax consequence. In this case it is (assuming a tax rate of 30%): Dr Deferred Tax Asset Cr Income Tax Expense Transfer of Plant When plant and is sold by the parent to the subsidiary or vice versa, we need to eliminate the gain or loss on sale of that plant. We would also need to adjust depreciation because the two companies would depreciate it at different rates. The consolidated entity as a whole must depreciate it at the same rate as the company which first bought it does. 30 30
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Example: A parent company sells plant to the subsidiary for $90,000 on the 1st January 2009. This plant was bought on the 1st January 2008 by the subsidiary for $100,000. It is depreciated at 20% over 5 years. The subsidiary Here we would note that the depreciation should be $20,000 per year and that one year has already past so the carrying amount would be $80,000. This means the plant was sold at a gain of $10,000 to the subsidiary. Also to note that since the subsidiary carries the asset at $90,000 and assuming it will also depreciate it at the same rate, it will only depreciate $18,000 per year (90,000/5) and not the $20,000 at which it was previously. Consolidating requires that this be the latter figure. In this case, we must: Eliminate the extra $10,000 carrying amount. Eliminate the extra sale of the plant at $80,000. This is recorded in the parents books. Add back the extra $2,000 of depreciation. Eliminate the proceeds of $90,000 for the sold plant recorded on the subsidiarys books. As such, we use the following journal entry: Dr Proceeds from plant transfer Dr Plant at cost Cr Carrying amount of plant sold Cr Accumulated Depreciation Dr Income Tax Expense Cr Deferred Tax Liability 90,000 10,000 80,000 20,000 3,000 3,000
Note that if the above happened two years later, we would also need to separate each years depreciation adjustment as depreciation expense is closed off to retained profits at the end of each year. The proceeds from plant transfer and carrying amount of plant sold account is also closed off and would need to be referenced to retained profits. For 1st January 2010, the entry would be: Dr Opening Retained Earnings Dr Plant at Cost Cr Accumulated Depreciation Dr Opening Retained Earnings Cr Deferred Tax Liability Dr Opening Retained Earnings Dr Depreciation Expense Cr Accumulated Depreciation Dr Deferred Tax Asset Cr Income Tax Expense Cr Opening Retained Earnings 10,000 10,000 20,000 3,000 3,000 2,000 [For 1st Year Depreciation] 2,000 [For 2nd Year Depreciation] 4,000 1,200 600 600
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Transfer of Land Unlike plant, land does not depreciate. Thus, we only have to deal with the elimination of the movement of land around the company. Example: The parent bought land on the 1st January 2009 for $100,000. It then sold this land to its subsidiary for $120,000 one year later. The subsidiary then sold this land for $150,000 to an external party another two years later. At the date of sale, the entry required would be: Dr Proceeds from transfer of land Cr Carrying amount of land sold Cr Land at cost Dr Deferred Tax Asset Cr Income Tax Expense 120,000 100,000 20,000 6,000 6,000
In the next year, the land is not sold so there is unrealised profit: Dr Opening retained earnings Cr Land at cost Dr Deferred Tax Asset Cr Opening retained earnings 20,000 20,000 6,000 6,000
In the year after when the land is sold, we can finally recognise the profit with: Dr Opening retained earnings Cr Carrying amount of land sold Dr Deferred Tax Asset Cr Opening retained earnings 20,000 20,000 6,000 6,000
Deagan Chapter 29 provides many more worked examples on intragroup transactions.
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Consolidation Accounting Minority Interest

Background Parents do not always necessarily own 100% of their subsidiaries to have control over them. They may have control, but have less than complete ownership. The other owners of the subsidiary are called the minority interest. It is also sometimes known as outside equity interest. Minority interest is defined as, that portion of profit or loss and net assets of a subsidiary attributable to equity interests that are not owned, directly or indirectly through subsidiaries, by the parent. Whats Different? We still use the same techniques and methods that we used for wholly owned subsidiaries. That is, we: Do line-by-line aggregation at 100%. Eliminate intragroup activities at 100%.
By 100%, we mean that we add the full amounts to each other. Even if the parent (100%) owns 70% of a subsidiary, we do not add 100% of the parent and 70% of the subsidiaries accounts together. We add 100% of both the companys accounts together. There is, however, one intragroup activity that we do not add 100% of and that is dividends. This is because dividends are paid out according to how much of the subsidiary the parent holds. So if the parent only holds, say 80% of the company, it is only entitled to 80% of the dividends of which is intragroup. The remaining 20% is to an external party (the Minority Interest) and thus, is not intragroup so it does not need to be eliminated. Methodology in Attributing to Minority Interest To find who holds what and how much of equity, we first find how much is attributable to the minority interest. Once we have found this, we know that the residual amount is what is attributable to the parent company. We should find minority interest by splitting the whole process into three distinct time periods. 1. Minority Interest in Pre-Acquisition Equity 2. Minority Interest in Post-Acquisition changes to Equity 3. Minority Interest in Current Period Profit/Loss Minority Interest in Pre-Acquisition Equity We need to adjust our pre-acquisition entry to take into account that the parent has only taken a percentage and not the entire ownership of the subsidiary. We only take a percentage (the percentage the parent owns) of the net fair value acquired in the subsidiary.
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Example: A parent company has paid $70,000 to obtain 75% of the shares in a subsidiary. At that date, everything in the subsidiarys books was recorded at fair value except for plant which has a fair value of $2,000 higher than its carrying amount. The subsidiary had retained earnings of $20,000 and share capital of $70,000. Thus, our acquisition entry would be: = $70,000 + $20,000 + $2,000 x 0.7 [BCVR Plant] = $91,400 Net fair value acquired = $91,400 x 75% 1 = $68,550 Cost of Combination = $70,000 Goodwill =$1,450 The journal entries would be: Dr Retained Earnings Dr Share Capital Dr Business Combination Valuation Reserve Dr Goodwill Cr Shares in Subsidiary
1
Equity
15,000 1 52,500 1 1,050 1 1,450 1 70,000
Note here that we have only acquired 75% ownership.
In the example, the rest of the equity is directly attributable to the minority interest as they are the holders of that equity. The journal entry is essentially the same except that there is no goodwill and we credit the minority interest instead. Example: Following on from the previous example, 25% of equity is attributable to minority interest: Dr Retained Earnings Dr Share Capital Dr Business Combination Valuation Reserve Cr Minority Interest Minority Interest in Post-Acquisition changes to Equity When there are changes to equity such as retained earnings, reserve accounts and the business combination valuation reserve, part of it is attributable to the minority interest. The most important is recognising retained earnings. We usually do the entry for retained earnings after all journal entries requiring the use of the retained earnings account are completed. This is because these accounts all impact on the opening retained earnings account which will affect 5,000 17,500 350 22,850
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how much is attributable to the minority interest. This means you should eliminate intragroup activities before allocating minority interest here. Example: A parent owns 75% of a subsidiary which had $10,000 of retained earnings at acquisition date. Three years later, that subsidiary now has $60,000 in retained earnings. Previously, the parent sold plant that that had a carrying amount of $50,000 to the subsidiary at a profit of $5,000. Both companies depreciate in straight-line over 5 years. First, we need to adjust for the plant: Dr Opening Retained Earnings Dr Plant at Cost Cr Accumulated Depreciation Dr Opening Retained Earnings Cr Deferred Tax Liability Dr Opening Retained Earnings Dr Depreciation Expense Cr Accumulated Depreciation Dr Deferred Tax Asset Cr Income Tax Expense Cr Opening Retained Earnings 5,000 5,000 10,000 1,500 1,500 1,000 1,000 2,000 600 300 300
Notice how there are references to Opening Retained Earnings here. Aggregating this would give us a debit figure of $7,200 for Opening Retained Earnings. Moving on to adjusting retained earnings, we note that there is an increase of $50,000 in retained earnings. This needs to be adjusted lower by $7,200 as seen from above. Thus, the change in retained profits would be $42,800. We need to attribute 25% of this to minority interest as follows: Dr Retained Earnings Cr Minority Interest 10,700 10,700
Basically put, the minority interest is only interested in the profits contributed to the entity after all adjustments have been made. If there is movement between equity accounts, the minority interest also has interest in those movements. Thus, a certain percentage (how much is attributable to the minority) must be allocated to them. Example: If $1,000 was moved from retained earnings to the general reserve. (75% ownership) Dr General Reserve Cr Minority Interest 250 250
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Changes in the Business Combination Valuation Reserve and Minority Interest During pre-acquisition, we may have assets which have a fair value higher than their carrying amounts, we have end up with a journal entry as follows: Dr Inventory Cr Deferred Tax Liability Cr Business Combination Valuation Reserve 10,000 3,000 7,000
(Assuming we had Inventory with a fair value $10,000 higher than its carry amount) When this inventory is sold in the next period (remember we assume that all opening inventory is sold in the year), we need to reduce Minority Interest because this would have already been reflected in retained earnings. Not doing this would mean double-counting and getting a wrong figure. Thus: Dr Minority Interest Cr Business Combination Valuation Reserve 1,750* 1,750*
* The firm holds 75% ownership so only 25% of BCVR needs to be eliminated. Minority Interest in the Current Period After adjusting for changes in previous periods, we move to the current period. In this period of time, we are most concerned with: Dividends Transfers between equity accounts Profit or Loss for the period
If $1,000 of dividends were declared in the current period by the subsidiary of which 75% is owned by the parent, then we would need the following journal entry: Dr Dividend Payable Cr Dividend Declared Dr Dividend Revenue Cr Dividend Receivable 750 750 750 750
(To eliminate the intragroup dividend of 75%) Dr Minority Interest Cr Dividend Declared 250 250
(To attribute 25% of the dividend to the Minority Interest) If the dividend was paid out in the same period, we simply change a few journals so it becomes: Dr Dividend Revenue Cr Dividend Paid 750 750
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Dr Minority Interest Cr Dividend Paid
250 250
If there were transfers between reserves (such as one in the general reserve), the minority interest has interest in the movement from these reserves. As such, a $5,000 movement from general reserve to retained earnings with 75% ownership would take the following form: Dr Transfer from General Reserve Cr General Reserve Profit for the Period If the closing retained earnings are not given in the year, we can figure this out by taking our adjusted opening balance figure, taking away all expenses and adding revenues. Otherwise, we can find out profit for the period by taking the retained earnings at the end of the period, adding back any distributions and deducting the last periods retained earnings away. A portion of this would be allocated to the minority interest: Dr Minority Interest Share of Profit Cr Minority Interest Unrealised profits in Upstream Transactions Upstream transactions are those which are from the subsidiary to the parent. These have an impact on unrealised profits for the subsidiary which in turn, impacts on minority interest. Since these profits are unrealised, we need to reverse a portion of these allocations to minority interest since they have already been put into retained earnings. Example: A subsidiary sells $18,000 worth of inventory to the parent at $2,000 profit during the year. At the end of the year, the parent has not sold any of the inventory in question. The parent holds 75% of the subsidiary. Here, we simply take the profit generated ($2,000) which is unrealised in terms of the group. We then need to tax this since it has not been taxed and then allocate 25% of it to the minority interest. That is 2000x0.3x0.7 meaning the following: Dr Minority Interest Cr Minority Interest Share of Profit 350 350 XXXXX XXXXX 1,250 1,250
Note that when this is realised, we will reverse this transaction so that we credit minority interest and debit its share of the profit instead.
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Consolidation Accounting Indirect Ownership

Background Prior to this stage, we have only considered the situations where the subsidiary itself does not control any other company. However, if the subsidiary has control over another business (that is, it is the parent of a parent-child child relationship), then the owners ners of the parent would have interest in that. We call these parent-child-grandchild relationships. The Parent-Child-Grandchild Grandchild Relationship In this course, we will only consider the relationship where a parent company has control over a subsidiary that also controls a subsidiary of its own. However, note that in reality, there are many other types of relationships which lead to indirect ownership. Graphically this relationship relati is:
Parent
Child
Grandchild
Direct Minority Interest (DMI) is the minority interest that is directly linked to the subsidiary that has that minority interest. Indirect Minority Interest (IMI) is the minority interest that has interest in another company though the subsidiary. subsi Graphically, , DMI is shown as: as DMI: 20% 80% 60% DMI: 40%
Parent
Child
Grandchild
DMI is actually the minority interest we were dealing with in the previous section. However, notice in this diagram that the 20% DMI in the Child also has an interest in the Grandchild since they own the Child. Likewise, the Parent has an interest in the Grandchild through the Child. We calculate their interests by multiplying their eir percentages along the route taken to get from DMI to the respective subsidiary. Example: In the previous diagram, the parent has 80% of the Child whom has 60% of the Grandchild. Thus, the Parent has 80% x 60% = 48% 48 indirect ownership of the grandchild. ild. The DMI of the child has 20% control of the Child whom has 60% interest in the Grandchild. Thus, there is IMI of 20% x 60% = 12% in the Grandchild. For the entity as a whole, the 12% IMI and the 40% DMI in the Grandchild totals to 52% that must be attributable to MI in any of the Grandchilds profits. profits
Corporate Financial Reporting g & Analysis Semester 2 2009
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Rules for Allocating to Indirect Minority Interest and Direct Minority Interest DMI is interested in both pre and post acquisition equity of the subsidiary but however, IMI is only interested in post acquisition equity. Thus, our pre-acquisition entry does not need to take into account any IMI. Basically, we follow the same process we outlined to find MI in the previous section. Recall: 1. MI Share of Pre-Acquisition Equity 2. MI Share of Changes in Equity from Acquisition Date to the Beginning of Current Period 3. MI Share of Changes in Equity in the Current Period. Note that we have already established that IMI does not need to be taken into account in the pre-acquisition equity, thus, IMI applies to steps 2 and 3 while DMI applies to all steps. Intragroup Transactions, Indirect Minority Interest and Direct Minority Interest The required elimination entries for intragroup transactions are generally the same as with just minority interest. However, we simply need to know which type of minority interest is impacted. To find this, we simply note which company within the group recorded the profit of the transaction. The Parent recorded it: No effect on any Minority Interest The Child recorded it: Impact on Direct Minority Interest only. The Grandchild recorded it: Impact on both Direct Minority Interest and Indirect Minority Interest.
Dividends, Indirect Minority Interest and Direct Minority Interest As a rule of thumb, only Direct Minority Interests gain dividends and Indirect Minority Interests do not gain any. This is because companies only pay dividends to those who directly hold their shares. This means that only people who are direct owners (the parent company and the direct minority interest) gain any dividends. This means that Indirect Minority Interests do not. However, we must adjust Minority Interests share of profit for the increase in profit as a result of a grandchild paying dividends to the child company. This is because the Indirect Minority Interest of the grandchild is the Direct Minority Interest of the child company and thus, has a right to the increase in profits resulting from a dividend payment. This should be allocated accordingly to how much Indirect Minority Interest exists.
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Accounting for Associates The Equity Method

Background In Consolidation Accounting, we looked at the case where the parent had control over the subsidiary. In this part, we look at the case where the company has significant influence, but does not have control. This means the company has around 20% to 49% of voting rights in the company. This is where we use the equity method. Significant Influence Significant Influence is broadly defined as having 20% to 49% of the voting rights of a company. However, note that this is a quick guide and a company may have significant influence even if their level of voting rights is below 20% or exceeds 49%. However in this course, for simplicitys sake, we consider 20% to 49% of voting rights as having significant influence. We must also note that the equity method does not apply to: Venture Capital Organisations Immaterial Investments
Accounting for Investments We account for investments at cost at the acquisition date of the investment in question. As with consolidation, dividends from pre-acquisition profits are seen as a return of investment. However, as of May 2008, the ASB is now trialling an international standard where all dividends are realised as just revenue and not a return on investment. For this course however, we will still treat them as a return on investment. Dividends from post-acquisition profits are return on investment and are recorded by the investor as dividend revenue. Where do we apply the Equity Method? The Equity Method is applied depending on the situation of the investor. If the investor already prepares consolidated financial statements, then the equity method is applied in the consolidated worksheet. The cost method is first applied in the financial statements of the parent entity before the equity method is applied during consolidation. Although you do not need to know the exact journals and details of the cost method (since we are only interested in the equity method), you should have a brief idea of what the cost method does so that you can If the investor does not prepare consolidated financial statements, then the equity method is applied in the accounting records of the investor.
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Applying the Equity Method The investment in an associate is usually recognised at cost at acquisition date with the carrying amount being varied at later periods to reflect the investees post-acquisition profits. Any distributions such as dividends from the investee will also reduce the investments carrying amount. The investors share of the profits or losses in the investee must also be reflected in the investors profit or loss for the period. We also need to adjust the carrying amount of the investment for any changes in equity that are not reflected in the profit or loss of the investor. These include land, plant and equipment revaluations. Remember, as always, we must not forget the income tax implications of these changes. Like with consolidation, shares in a company can be acquired with goodwill or at a discount. We find these in much the same way as we do for normal consolidation; through an acquisition analysis. We must also adjust depreciation in the investees profit/loss if the fair value of the asset differs from the recorded value at acquisition date (We did the same thing with consolidation). Example: A Ltd has acquired 25% of B Ltd for $150,000. At acquisition date, all assets of B Ltd in their books were recorded at their fair values. B Ltd had $300,000 of share capital and retained earnings of $200,000 at acquisition date. Prepare the acquisition analysis and required journals at the date of acquisition. Equity: Net fair value acquired: Cost of Combination: Goodwill: If we assume the investor is a parent: Dr Investment in B Ltd Cr Cash1 150,000 150,000 $300,000 + $200,000 = $500,000 25% x $500,000 = $125,000 $150,000 $25,000
Recording an Associates Profit or Loss and any Dividend Payments There are slight differences that we need to take into account when recording down an associates profit/loss and any dividend payments for that period depending on whether the investor is a parent or not. The following table on the next page outlines the basic differences between the two in terms of recording the investors share of profits, losses and dividend payments.
Note that this can also be Accounts Payable. It depends on how A Ltd has acquired B Ltd. We assume this to be cash if it is not mentioned how.
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If the Investor is a Parent All records in the Consolidation Worksheet
If the Investor is not a Parent All records in the Investors Accounts Year 1 Acquisition Journal Entry DR Investment in B Ltd DR Investment in B Ltd CR Cash CR Cash Recording share of associates profit or loss for the period DR Investment in B Ltd DR Investment in B Ltd DR Share of Income Tax Expense* DR Share of Income Tax Expense* CR Share of associates profit or loss* CR Share of associates profit or loss*
Note: Flip this journal around to record a loss. Note: Flip this journal around to record a loss.
DR Dividend Revenue CR Investment in B Ltd
Recording dividends in the current period DR Dividend Receivable CR Investment in B Ltd

Note: Dividend Receivable can also be Cash depending on whether the dividend has been received yet. If cash, then a journal is needed later to record receipt.
Note: This is an elimination journal entry that is required to eliminate the revenue recognised under the cost method.
Year 2 Recording share of associates profit or loss for the period and prior periods To record profits this period. DR Investment in B Ltd DR Investment in B Ltd DR Share of Income Tax Expense* CR Opening Retained Earnings2 CR Share of associates profit or loss*
To record profits from last period. Note: The investor has already recorded last years share of profit/loss and does not need to record it again since it is still in the investors books. For a consolidated entity, the consolidation worksheets are compiled again at the end of each period. This is not the case here. Note: Flip this journal around to record a loss.
DR Investment in B Ltd DR Share of Income Tax Expense* CR Share of associates profit or loss*
Note: Flip each journal around to record a loss in the respective period a loss is incurred.
Note that in the above table, we assume that the associate was acquired with all assets recorded at fair value at acquisition date. If this was not the case, we simply adjust the share of the associates profit or loss that the investor has. To find out how much we need to adjust by we do a simple calculation.
Example:
Note here that this entry includes Share of Income Tax Expense and Share of associates profit or loss. The amount we credit to Opening Retained Earnings is the difference between the two. Any dividends can also be eliminated against here. Example: If the dividend paid in the last period was $5,000, we would reduce both sides of this journal by $5,000. *Note that if you are not given the amount of income tax expense, but are given the level of net profit. Then you may omit Share of Income Tax Expense and simply change the next entry from Share of associates profit or loss to Share of associates after tax profit or loss.
2
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When A Ltd acquired 25% of B Ltd, B Ltd had recorded a plant at $300,000. However, its fair value was $350,000. The plant has a useful life of 10 years. Thus, the additional depreciation we need to recognise each period (assuming one year) is: [ ($350,000 - $300,000) / 10 ] x 25% = $1,250 However, we need to take into account the tax effect of this. Assuming that the corporate tax rate is 30% the after tax effect would be: $1,250 x 0.7 = $825. This is the extra amount that we need to deduct from the amount that is attributable to the investor. If B Ltd had made a $100,000 profit for the year, of which 25% ($25,000) is attributable to the investor, we would need to deduct $825 from that so that the investors share of the associates profit is now $24,175. Treating Losses that Exceed the Carrying Amount of the Investment If an associate occurs so many losses that it causes the carrying amount of the investment to drop below zero, the use of the equity method is to be suspended. The carrying amount of the investment will never go below zero, and any extra losses from that period and any period later will be unrecognised. This loss will only be recognised when the associate makes profits that are equal to the unrecognised losses and at this point, the equity method is to be used again.
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Accounting for Interests in Joint Ventures

Background Joint Ventures are where two or more companies decide to form a new entity under shared control. This means that all the assets, liabilities and equity of the new entity are shared between the controlling companies. This also means that one single company cannot have control over the entity. All decisions must be made by all the owners of the joint venture. All Joint Ventures are contractually bound. They cannot be formed without one. Joint Ventures Joint Ventures can be split into three different types: Jointly Controlled Operation (JCO) Such as manufacturing aircraft where the different components (wings, avionics, tail, interior etc.) may be constructed by different companies and brought together to make a complete aircraft. All these companies share risk and return. Jointly Controlled Asset (JCA) Such as an oil pipeline, electrical power grid etc. Companies will share in the maintenance and usage of the asset. Jointly Controlled Entity (JCE) A joint venture where a new entity is created and profits are shared.
Methods to Account for Joint Ventures The AASB 131 currently allows two methods to account for joint ventures: The One-Line Method This method is where the venturer simply makes a simple entry into their accounts to note the investment in the joint venture and the assets given up to do so. This method can only be used by JCEs but is not preferred. The Line-by-Line Method (also known as Proportional Consolidation) This method is where the venturer records its proportionate ownership of the assets, liabilities, revenues and expenses in its accounts. The AASB 131 requires this method for JCOs and JCAs. It prefers companies use this method over the one-line method for JCEs.
All the One-Line Method does is recognise the investment in the joint venture with the following journal: DR Investment in Joint Venture CR Cash Under the Proportional Consolidation method, this is similar for the current period. DR Cash in Joint Venture CR Cash
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However, in the next period when the venturer knows what the cash has been used on in the joint venture, it must then reverse the above and allocate the cash to appropriate accounts such as: DR Cash DR Plant DR Land Cr Cash in Joint Venture We take the figures for these from the books of the joint venture. However, we only take the required percentage. I.e. If we only own 50% of the venture, we will only recognise 50% in this journal. Jointly Controlled Operations In JCOs, each individual venturer: Recognises assets, liabilities, expenses and revenues in the operation in its own financial statements. Uses their own property, plant and equipment. This means that each venturer can use their own depreciation method and time frame. Carries their own inventory in the operation. Capitalises costs in the operation in a work-in-progress account.
JCOs are preferred over JCEs most of the time because they are not considered a separate economic entity as a JCE is. This means there is no equity, no tax, less regulation and less liability. Also mentioned is that JCOs allow each venturer to use their own depreciation method, which can allow for more tax savings. Jointly Controlled Assets JCAs are similar to JCOs in how they are recognised. Any jointed held assets are recorded in the venturers own financial statements. Any liabilities and expenses that are incurred from it are also split and recorded in their own financial statements. Jointly Controlled Entities JCEs are entirely separate economic entities from the venturers. The JCE itself controls all the ventures assets, liabilities, expenses and revenues. In short, the JCE itself is like any other business entity in that it prepares its own financial statements and controls itself. The venturers simply provide cash or any other necessary resources to the JCE for it to function. JCEs are popular because it allows established firms to undertake higher risk projects. If the project fails, the liability is only limited to the JCE and not the venturers companies. It also allows the bypassing of some restrictions such as limitations on foreign ownership. If one company is local and another international, the international company can bypass this by creating a JCE with the local company.
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Transactions between the Joint Venture and the Venturer There are a few rules that apply when a venturer purchases or sells an asset to the joint venture. When the venturer sells an asset to the joint venture, it can only recognise the gain or loss on the sale of the asset which is attributable to other venturers. Such that if the venturer has a 25% stake in the joint venture, it can only recognise 75% of the gain or loss. If a venturer buys an asset from the joint venture, the share of profits from the sale can only be recognised when the venturer then sells the asset out to another entity other than the joint venture. Losses when buying or selling are recognised immediately. Transferring Assets to a Joint Venture When transferring assets to a joint venture, we usually use the following entry: Dr Cash Cr Equipment 150,000 150,000
Here we are assuming that we put up $300,000 worth of equipment to transfer to the joint venture. Since we have 50% interest in the joint venture, we only need to credit 50% of the equipments value since we still own the other 50%. Likewise, we now have 50% of the cash the other venturer put in ($300,000). If the fair value of the equipment was different to its carrying amount, then we need to adjust this. Assuming the carrying amount of the equipment was $200,000 and the fair value of it is $300,000, the journal entry would be instead be: Dr Cash 150,000 Cr Equipment 100,000 Cr Profit on Sale of Equipment 50,000
However for the other venturer, the journal entry would be the same either way: Dr Equipment Cr Cash 150,000 150,000
In short, we see other venturers contributions as the fair value and not the carrying amount as recorded by the venturer that contributed the asset.
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Introduction to Corporate Financial Reporting

Background Financial Accounting is the process of collecting and processing financial information for users both internal and external to the organisation in question. The objective of financial reporting is to provide a true, fair (this is disputable), relevant and reliable view of the corporation to its users to help them make informed decisions. Types of Reports Reports can either be general purpose or special purpose. General purpose reports are those that: Comply with the AASB Framework Are tailored to meet needs common to all users
These are usually the regularly yearly financial statements that the corporation is required to produce. Special purpose reports are those that are designed to meet a specific need required from a specific group, such as a bank requiring a report on liquidity etc. Regulation of Financial Reporting In Australia, five main bodies create or enforce accounting frameworks from the AASB. These are: The Financial Reporting Council (FRC) This body has oversight of the AASB and auditing standards. It monitors the effectiveness of auditing. The Australian Accounting Standards Board (AASB) The neutral standards setter for accounting standards. Currently, however, it relies on the International Financial Reporting Standards (IRFS) as Australia has adopted these. The AASB may sometimes change a few things and introduce an Australian version of the equivalent IFRS. The Australian Securities and Investment Commission (ASIC) This body is the corporate watchdog. It monitors corporations in Australia, inspects auditors and also reviews compliances. The Financial Reporting Panel This panel resolves disputes between the ASIC and corporations about treatments of specific line items in financial reports. This removes the need for court proceedings which can be costly to the corporation and also removes the need for detailed accounting laws to go through courts that usually do not understand them enough to make a well informed decision.
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The Australian Stock Exchange (ASX) The ASX operates the market for financial securities and ensures that they comply with listing rules and also have continuous disclosure of any information that, in general, will influence the share price. Note that Accounting Standards are laws.
Who is Required to Report? Companies that meet any two of the following three criteria do not have to prepare accounts, apply standards or be audited. Consolidated Gross Operating Revenue less than $25 million. Consolidated Gross Assets less than $12.5 million. Less than 50 employees.
However, it will have to prepare accounts, apply standards and be audited if it is requested by ASIC or any shareholder that owns more than 5% of voting rights. Disclosing Entities Entities who must report are known as disclosing entities. These companies are required to file biannual reports. Disclosing entities are those that: Have securities quoted on the ASX Have securities issued with a prospectus Have securities issued during a takeover Have securities issued with an compromise agreement Are corporations that take loans
The Annual Report The annual report is comprised of: Balance Sheet (also known as the Statement of Financial Position) Income Statement (also known as the Statement of Financial Performance) Statement of Cash Flows Statement of Changes in Equity Notes to Financial Statements Directors Declaration This is a declaration by the director that the accounts are a true and fair view of the business and that they comply with all accounting standards. It should also state any significant events after balance date and also state if they believe the firm will be able to pay all outstanding debts on time. A director can only declare this after a CEO or CFO has declared it. Directors Report This report is from the directors of the company. They briefly state what the business has done during the year, any significant changes in the past or upcoming, significant post-
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balance date events and compliances. Most importantly, the report includes a statement of corporate governance. Auditors Report This is the report by the auditors who confirm that the financial statements are a true and fair representation of the company in question.
Materiality Materiality is whether the information has the ability to influence decisions or accountability of managers. For example, a $1 pen in a multi-billion dollar firm would be immaterial seeing as the purchase of a single $1 pen will not influence decision making. However, the purchase of company cars is material as it would considerably change the firms accounting figures which could lead to different decisions being made. Materiality is normally determined using professional judgement on behalf of management. Management may also use the AASB 1301 to find arbitrary guidelines to determine materiality. These guidelines are:

5% - Immaterial >5% and <10% - Grey Area. Requires professional judgement. 10% - Material
These are all based on the base value amount. Note that this is only a guide and the substance of each transaction must be considered carefully. All material information must be presented while immaterial information may be omitted. The Conceptual Framework The Conceptual Framework was conceived by the AASB and shows the nature, function and limitations of financial accounting and reporting. It must be noted that the framework is not a standard and does not have to be applied. It is considered a source that preparers of financial statements go to when seeking a standard interpretation of a particular standard.
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Presentation of Financial Statements

Background The presentation of financial statements is covered by the AASB 101 which is the equivalent to the IAS 1 with a few minor changes. Financial statements are structured representations of the financial position and performance of the company. The AASB 101 Within the AASB 101 are eight different considerations that we must take into account when applying the standard to financial statements. These are: 1. Fair presentation and compliance with IFRSs This means fairly representing the effects of all transactions and absolute compliance with the AASB. Management may state, in the notes, why they believe compliance will be misleading but they must still apply the standard. 2. Going-concern Financial statements should be prepared on the grounds that the firm is a going concern unless management actually intends to liquidate or cease trading. Any uncertainty must be disclosed. 3. Accrual basis of accounting Except for the Statement of Cash Flows, all other statements must be prepared on an accrual basis. 4. Consistency Financial statements should be in the same format and also consistency between periods for easy comparison. It is only allowed to change if the firms operations changes significantly or a newly modified AASB standard requires a different presentation. 5. Materiality and Aggregation As mentioned previously, all dissimilar material items must be presented individually. They must not be aggregated. 6. Offsetting Items in the financial statements should not offset unless it accurately reflects the substance of transactions or events. 7. Frequency of Reporting Complete set (Balance Sheet, Income Statement, Statement of Changes in Equity, Statement of Cash Flows and notes to the financial statements) of financial statements required annually. Reasons for changing the reporting period must be disclosed. 8. Comparative Information The financial statements must disclose at least 2 years of data in each statement. If there has been a change in accounting policy, 3 years is required. The AASB 101 only applies to general purpose financial statements. That means that companies which do not have to prepare these or companies that are preparing special purpose statements do not have to abide by the standard.
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The Statement of Financial Position The Statement of Financial Position (Balance Sheet) measures a businesss assets, liabilities and equity. Its main use is to provide information on the companys financial position including capital structure, liquidity, solvency and flexibility. Note that the AASB101 allows you to use either name for this statement. This statement is very limited in terms of its usage and interpretability. As such, it is best to use with the notes to the financial statements. It is also limited by the fact that assets can be measured at a variety of costs, intangibles are not recognised and the fact that off-balance sheet items exist. All assets and liabilities must be classified as current or non-current and they must meet the criteria to be labelled an asset or liability. Recall the definition of an asset and liability. Line items should also be listed from the most liquid to the least liquid form. The standard requires, at a minimum: Property, Plant and Equipment Investment Property Intangible Assets Financial Assets Investment accounted for under equity method Biological assets Inventories Trade and other receivables Cash and cash equivalents Held for sale assets Trade and other payables Provisions Financial liabilities Current taxes Deferred taxes Non-controlling interested presented within equity Issued capital and reserves attributable to the owners of the parent
The Statement of Comprehensive Income The Statement of Comprehensive Income is also known as the Statement of Financial Performance or more popularly as the Income Statement. Note that the AASB101 allows you to use either name for this statement. It presents the entire firms revenues and expenses incurred in the period. This statement can either be done in one whole statement or split into two statements. One shows just the components of profit and loss and the other shows components of other comprehensive income.
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The AASB 101 requires all items of revenue and expenses to be listed in the statement and as such, is a prime source for performance information and also performance prediction. It is limited by the fact that managers may make biased judgements on the handling of some expenses and/or revenues which can skew results. The standard requires, at a minimum: Revenue Finance cost Share of profit and loss of associates/JVs accounted for using the equity method Tax expense After-tax profit(loss) of discontinuing operations/assets Profit or loss Profit/Loss attributed to non-controlling interests Profit/Loss attributed to owners of the parent This is the splitting point if we want to use the two-statement approach. The remaining points go on the other statement. If we want a one statement approach, combine both together. Each component of other comprehensive income classified by nature Share of other comprehensive income of associates/JVs accounted for using the equity method Total comprehensive income Total comprehensive income attributed to non-controlling interests Total comprehensive income attributed to owners of the parent In addition to the above minimum line items, the AASB 101 requires separate disclosures of certain things to enhance understandability. These include: Inventory & Property, Plant and Equipment Write-Downs Restructuring costs Losses/Gains on Disposals Profits/Losses on discontinued operations Litigation settlements Reversal of provisions
Nature and Function of an Expense The statement of comprehensive income requires that line items be classified by either their nature or function. Generally, a function of expense can be broken down into many smaller natures of expense. If an expenses by function method is used, the breakdown of the nature of expenses must be disclosed. For example, cost of sales is a function of expense. However, purchases of materials and employee costs are the nature of the expense. Both of these are considered part of the cost of sales.
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The Statement of Changes in Equity This statement shows the changes in each component of equity throughout the period. It puts the opening balances out first, shows all adjustments during the year and then the closing balance for the period. The Cash Flow Statement This statement was studied in depth in ACCT1511: Accounting and Financial Management 1B. Recall that this is the only statement that does not require the use of accrual basis of accounting. This statement has already been covered and is not covered in this course. The Notes to the Financial Statements These are made to enhance understandability of the financial statements. Typically, the first note is a summary of all accounting policies the firm uses. This section should also disclose all contingent liabilities, unrecognised contractual commitments, risk management objectives and policies. Generally, if something is disclosed separately from the main financial statements, it indicates the existence of an unusual item.
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Earnings Per Share
Earnings Per Share

Background Earnings Per Share (EPS) is the net income earned for every ordinary share the company as issued. It is usually used as a measure of the profitability of the company to its shareholders. Calculating Basic EPS Calculating basic EPS is simple as long as we follow some rules: Preference dividends must be deducted from NPAT. Only ordinary shares are counted. Basic EPS is just finding the average number of shares in the period and dividing it by NPAT. Calculating the Number of Ordinary Shares Shares come in a variety of flavours. These can range from preference shares to party-paid shares. Preference shares must be deducted because EPS only uses the number of ordinary shares. Partly-paid shares must be weighted depending on how much is paid. Example: ABC Ltd has a net profit after tax of $100,000. It has 250,000 shares on issue of which 50,000 are preference shares and 100,000 with an issue price of $2 and are paid to $1. All shares have dividend rights. Calculate EPS. In this question, we need to deduct the 50,000 preference shares and weight the 100,000 partly paid shares. The partly-paid shares are paid to 50%, so we only take 50% of the total amount of partly-paid shares (100,000 x 0.5 = 50,000). As such, the amount of ordinary shares is: 250,000 50,000 (100,000 x 0.5) = 150,000 Thus, our EPS would be $100,000 / 150,000 = 0.6667. That is, 66.67 cents per share. Impact of a Rights Issue A rights issue is when the company issues an offer to current shareholders to give them the right or option to buy additional shares at a future date and at a specific price. These are usually given at the current market price of the share or lower. If it is sold at lower than market price, it is considered to have a bonus element. Example: CBA Ltd had 150,000 shares on issue on the 1st July 2008. On the 1st January 2009, CBA Ltd had a rights issue with no bonus element. An additional 50,000 shares were issued at this time. On the 30th June 2009, the firm had NPAT of $100,000. Calculate the weighted average number of shares (WANOS) and EPS.
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Earnings Per Share
Here, we should split the calculation up into steps: First, we had 150,000 shares for the first 184 days of the year. Then, with the additional 50,000 issued, we held a total of 200,000 for the other 181 days so the weighting is 180/365. Thus our WANOS would be: Number of Shares 150,000 200,000 Days 184/365 181/365 WANOS 75,616 99,178 Total WANOS: 174,794
Thus EPS would be $100,000 / 174,794 = 0.5721 (57.21 cents per share). Bonus Issues Bonus issues are where existing shareholders are given new shares proportionate to how much they already currently hold. Since bonus issues always contain a bonus element, they must always be adjusted. In the Americas, this is known as a stock split. Companies do bonus issues to lower the price of shares so that they are more liquid. Bonus issues are necessary because firms keep growing in value. A notable example is Berkshire Hathaway Inc. (NYSE: BRKA) which had a share price of US$148,220 per share at the end of 2007. This was because the company wants to attract long-term investors and not short-term speculators to the business and, as such, has never had a single bonus issue since opening in 1839. At such a high price, not many investors can afford to hold BRKA shares. The Adjustment Factor The adjustment factor is needed when a there is a bonus issue or if a rights issue has a bonus element. Adjustment factor = [(P0 x N0) + Pr] / P0(N0 +1) Where: P0 is the last market price, N0 is the number of shares required for one right, Pr is the price of the right plus the PV of dividends forgone if the right is not taken. We use this adjustment factor to increase the number of shares prior to the bonus issue as if it was there since the beginning of the period. That is, we adjust the number of shares prior to the bonus issue/rights issue. It is also used to adjust EPS for prior periods for comparison (if the bonus issue had occurred previously). When applying the adjustment factor when calculating Basic EPS, we apply the factor to all share holdings before the date of the bonus issue. However, when using the alternate method (not the method in the above example) to calculate WANOS, we do not need to add the bonus issue as an extra line item since the adjustment factor already takes this into account. Adding an extra line item for the bonus issue will simply result in double counting of the number of bonus shares issued.
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Earnings Per Share
Diluted Earnings Per Share Diluted EPS is calculated the same way as basic EPS except that we theoretically imagine if all potential ordinary shares were actually converted to ordinary shares in that period. This could be from options on a companys shares etc. It is diluted because it will always result in more shares and the more shares there are, the more diluted EPS becomes. In calculating EPS, all interest paid associated with converted notes must also be added back. This is because we assume the notes have been converted to shares at the beginning of the period and, as such, there is no interest to be paid on notes that no longer exist. Calculating WANOS for Diluted EPS We calculate WANOS in the same way as we did for basic EPS, but we go further by taking into account all options, partly paid shares, convertible notes and preference shares. It must be noted that we only add potential ordinary share issues that will dilute EPS. Those that increase EPS are excluded since this is diluted EPS. To see if a potential ordinary share is dilutive or not, we simply do a calculation to find Incremental EPS. If this is smaller than Basic EPS, then it is dilutive and we add it. Otherwise, we discard it. Incremental EPS is found by finding the savings we would get if the potential ordinary share was converted at the beginning of the period. This is usually the savings from interest payments that we would not have had to make. This figure (after tax) is then divided by the number of potential shares that would have been issued or converted. Diluted EPS and Options Options are easily treated in diluted EPS but they must all be looked at separately. We need to know the exercise price and also the current market price of shares. If the options exercise price is less than the current market price, we will need to include this in calculation of potential ordinary shares. However, if the options exercise price is greater than the current market price, we will not include it. This is because any investor would know it would be a very stupid move to buy the shares from the option when it could buy them from the market for a cheaper price. Options do not generate cash flows so they are always seen as dilutive and thus, we include them in the calculation of diluted EPS. Only the portion of the Option that is issued for no consideration is added to the EPS calculation. Example: A firm has 100 options in the market which give the holder the right to purchase 1000 shares each at $2.50. The average share price of the firm was $3.00 for the year. These options are dilutive in that the share price is higher than the exercise price; hence it is included in the calculation of Diluted EPS. There is also no profit or adjustment for an Option. In this
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Earnings Per Share
case, the firm has 100 x 1000 = 100,000 new shares worth $250,000 in total. The number of shares that would have been issued at market price is 250,000 / 3 = 83,333. This means that 16,667 shares were issued for no consideration. As such, when calculating Diluted EPS, we will only take into account 16,667 extra shares issued and not 100,000. Partly Paid Shares and Diluted EPS To account for partly paid shares when calculating diluted EPS, we use a method similar to Options in that we find the amount of shares that have been issued for no consideration. Such as if 10 million partly paid shares were only paid up to $1 (full price $2) and the average market price was $2.50, the amount of shares issued for no consideration would be 10 million x ($1 / $2) 10 million / $2.50 = 1 million. This formula to calculate the amount of shares issued for no consideration is thus: Total Partly Paid Shares x ( Paid To / Full Price ) Total Partly Paid Shares / Average Market Price Remember to multiply by the amount of days outstanding if required. Earnings Per Share as a Measure EPS cannot be used by itself to make decisions. Like most other measures, we need to use a combination of them to make an informed decision. Disclosure of Earnings Per Share The WANOS used to calculate both Basic EPS and Diluted EPS must be disclosed in the financial statements so that users of the financial statements can guesstimate their own level of WANOS and subsequent EPS depending on their assessment of the firm. Items that are not dilutive, thus excluded from calculation, must also be disclosed. Diluted EPS Example This example continues on from the Options example on page 42. Most importantly, it uses the figure of 16,667 shares issued for no consideration. The firm had 1,000,000 ordinary shares at the beginning of the period. In addition, the firm issued 200,000 shares worth $3 partly-paid up to $1.50 at the beginning of the period. Finally, the firm also had convertible notes worth $250,000 that could be converted to 250,000 shares. The tax rate is 30% and the prevailing WACC is 9%. The firms Basic EPS for the period was $1.65 and total profits after tax were $2 million. Average share price was $2.20 for the period. Calculate the firms Diluted EPS. First, we must find out if the convertible notes are dilutive by calculating incremental EPS. The interest savings after tax would be: $250,000 x 0.09 x (1 0.3) = $15,750. The amount of convertible shares is 250,000 so incremental EPS is 15,750 / 250,000 = $0.063. This is less than basic EPS and thus, it is dilutive.
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Earnings Per Share
The partly-paid shares are now presumed to be fully-paid when calculating Diluted EPS. The amount issued for no consideration is 250,000 x ($0.50 / $1) 250,000 / $2.20 = 11,364 shares. Number of Shares 1,100,000 11,364 16,667 250,000 Days 365/365 365/365 365/365 365/365 WANOS 1,100,000 11,364 16,667 250,000 Total WANOS: 1,378,031
Total profits after tax are $2,000,000 but we must remember the interest savings of $15,570 from the convertible notes. Thus, total profits after tax are $2,015,570. Thus, Diluted EPS is: $2,015,570 / 1,378,031 = $1.46
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Principles of Disclosure
Background Disclosure is a very important part of accounting and financial reporting. Only though proper disclosure, can users of that information make an informed decision in regards to the company. In particular, a company should disclose its accounting policies, methods of estimation and any errors in the financial statements. Accounting Policies Accounting policies are the principles and standards applied in the companys financial statements. A change in accounting policy is only allowed if it is either required by the standard or because the business can clearly justify why a change to a new policy is would result in a more reliable and relevant view of the company. This is restrictive so that financial statements can be consistent and that managers cannot manipulate different policies to maximise revenues and/or minimise expenses. Once an accounting policy has changed (whether forced or voluntarily), it must be applied retrospectively to at least 3 years prior up to the point where it is impractical to do so. In this case, the firm should retrospectively apply up to the earliest period where it is practical to do so (this may be the current period). When selecting an accounting policy, the company must first look at any official AASB standards and interpretations of what they are trying to account for a transaction. If this fails, they then must use the AASB Framework and if even this fails to supply a decision, the company should look at any compatible standards/interpretations from other standard-setting bodies such as the IASB. Accounting Estimates Accounting estimates are all estimated used in the financial statements. This can include the estimated carrying amounts of assets to how inventory is estimated (LIFO, FIFO, Weighted Average). Estimates are usually regularly changed when new information arises to more accurately reflect the firms financial position. Changes in accounting estimates do not have to be applied retrospectively, meaning that things, such as depreciation, are instead, depreciated at slower or faster rates than it previously was to take into account the existing depreciation. Accounting estimates do not have to be applied retrospectively because estimates are based on information available at that time with professional judgement. This means using a retrospective application on old figures with new information that was unknown at that time is not wanted. As usual, any change in accounting estimates must be disclosed accompanied by a reason. Accounting estimates can be distinguished from accounting policies because estimates generally use numbers while policies do not.
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Accounting Errors Accounting errors are simply just errors that arise in the financial statement. These can be something as simple as a typo, mathematical error or misinterpretation. Errors found must be fixed and corrected retrospectively by restating the comparative amount or the opening balance of the earliest period presented on the financial statements. In reality, no company generally issues a correction to a financial report as it opens them up to a large legal front. Stakeholders in the business can sue them for incompetence because they relied on a certain figure which was found to be wrong. Only the most obvious of all errors is usually corrected. Events after Balance Sheet Date Managers of a company are required to disclose any material events, circumstances or information that has occurred after the reporting date but prior to the date the statements are authorised. There are two types of events, these being: Adjusting Events These are events that provide new information about existing items that have already been incurred at balance sheet date. This could be a pending lawsuit (contingent liability) at balance sheet date that has now found the company guilty (thus a liability) after balance sheet date. These events are to be adjusted and reflected on the financial statements. Adjusting events are recognised in the statements by either it being brought into the account or by the way of a note. If no estimate can be made, it must be explained in the note. If the firm is no longer a going concern after reporting date, the financial statements are no longer to be prepared on a going concern basis. This means that assets may be valued at their market selling prices to more accurately reflect the firms possible liquidation value. Determining whether a firm is a going concern or not requires very professional judgment into the matter. Non-Adjusting Events These are events that change things that were not at balance sheet date, such as the sale of property after balance date. These events do not have to be adjusted in the financial statements but the standard requires a note to disclose the event including its nature and estimated financial impact.
This document ends here.

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Corporate Financial Reporting & Analysis

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