All right! I think we are almost there. Just a few more smaller topics to cover.

Today, we will cover on “Tax effect on unrealised intragroup profits and losses” and “Intragroup dividends”

Without further delay, let’s jump straight into first topic.

Tax effect on unrealised intragroup profits and losses

We have discussed FRS 12 before in Part 3 of this series where during the initial fair value adjustment phase on acquisition date, as a result of new liability provisions or adjustment of land fair value etc. results in balance sheet adjustments where the other leg of FV adjustments hits Goodwill. Such adjustments leads to Deferred tax eg. an increase in legal provision will require an additional deferred tax asset figure when calculating the Goodwill.

This topic is a bit different in the sense that firstly, this is subsequent to acquisition date and not acquisition date itself. Secondly, Intragroup profit and loss will hit P&L (duh?!) and thus opening R/E will be involved. The concept however remains the same:

• If the recovery of or settlement of the carrying amount of an asset or liability have a future tax payment consequences, then a deferred tax exists
• The deferred tax should be treated in the same way how the underlying transaction is accounted for.

This topic can be summarised into 4 main permutations:

Year	Profit	Double Entry
Current Year	Profit Decreased	DR Deferred Tax CR Tax Expense
Current Year	Profit Increased	DR Tax Expense CR Deferred Tax
Previous Year	Op. Profit Decreased	DR Deferred Tax CR Op. R/E
Previous Year	Op. Profit Increased	DR Op. R/E CR Deferred Tax

The entries above serves as a general guide. The key is to always follow the underlying transaction. In our earlier example in Part 7 of our series, we say that unrealised profit for interco inventory sale is deemed as realised in the subsequent year before recalculating the URP again. Hence, Deferred tax must be calculated the same way. Here’s the logic:

Year	Double Entry
Prev Year URP deemed realised	DR Op R/E CR Cost of Sale
Deferred Tax as per permutation 3	DR Deferred Tax CR Op. R/E
*Deemed Deferred Tax realised	DR Tax Expense CR Deferred Tax
New Current Yr URP	DR Cost of Sale CR Inventory
Deferred Tax as per permutation 1	DR Deferred Tax CR Tax Expense

*An additional step to realise the deferred tax into P&L, just like the underlying previous year URP

Let’s visualise this with an example:

P acquired 80% of S in 2015, of which its R/E was $200. Since 2017, S sells goods to P at cost plus 33.33%. P’s stock at end of 2017 includes $80 that are bought from S. For 2018 the interco sales was $300, $200 of which remained with P at year end. Tax rate is 20% . Let’s simulate for 2018:

Description	Workings	Double Entry
Prev Year URP deemed realised	80 * (0.33/1..33) = $20	DR Op R/E CR Cost of Sale
Deferred Tax as per permutation 3	$20 * 20% = $4	DR Deferred Tax CR Op. R/E
*Deemed Deferred Tax realised	$4	DR Tax Expense CR Deferred Tax
New Current Yr URP	200 * (0.33/1..33) = $50	DR Cost of Sale CR Inventory
Deferred Tax as per permutation 1	$50 * 20% = $10	DR Deferred Tax CR Tax Expense

	P	S	DR	CR	Consol Bal.
Sales	280	500	300		480
Less: Cost of Sales	150	300	50	300	180
				20
Gross Profit	130	200			300
Interest Income	–	–			–
Less: Distribution exp.	–	–			–
Less: Admin exp.	30	70			100
Op. Profit	100	130			200
Less: Interest Exp	–	–			–
PBT	100	130			200
Less: Tax	30	40	4	10	64
PAT	70	90			136
Other Comp. Inc
FV Gain	–	–			–
Reval. Surplus	–	–			–
Total Comp. Inc	70	90			136
PAT attributable to:
Shareholders of P 70 + (80%* [90-50+20-4+10])					122.8
NCI (20% * [90-50+20-4+10])					13.2
					136
Total Income attributable to:
Shareholders of P 70 + (80%* [90-50+20-4+10])					122.8
NCI (20% * [90-50+20-4+10])					13.2
					136

	P	S	DR	CR	Consolidated Bal.
Land	100	50			150
Investment	240	–		240	–
Stock	200	300		50	450
A/R	–	–			–
Bank	160	150			310
Deferred Tax	–	–	4	4	10
			10
	700	500			920
Share Capital	500	100	80		500
			20
Retained Earnings	180	330-50+10-4+4	160		252
			58
A/P	20	70			90
Loan Payable	–	–			–
NCI	–	–		20	78
				58
	700	500			920

Following is a breakdown on how the retained earnings + current year profits is being dissected:

Pre-acquisition	Amt	P%/NCI%	P/NCI
Share capital	100	80%	80
		20%	20
Retained Earnings	200	80%	160
		20%	40
Post-acquisition (Before Current Year)
Retained Earnings (330-200-90)	40-20+4	80%	19.2
		20%	4.8
Post-acquisition (Current Year)
Retained Earnings	90-50+20-4+10	80%	52.8
		20%	13.2

You can get the group’s R/E by adding P R/E + share of S Post R/E = 180 + 19.2 + 52.8 = 252

The 58 cancelled as NCI’s share of R/E is derived by S R/E * 20% = (330-50+10-4+4) * 20% = 58

Finally, the NCI of 78 is simply just share of S Share capital + S R/E = (100 + 330-50+10-4+4) * 20% = 78

On top of the deferred tax, I think this example is also a very good showcase how the upstream profits affect the Balance Sheet and PnL. You may wonder why in P&L the profits are allocated on the basis of [90-50+20-4+10] while in balance sheet it becomes [330-50+10-4+4]. I think the best way to explain this is because 330 is the S’s R/E that isn’t corrupted with past year’s upstream profit cancellation, so if you were to use the same PnL basis on Balance Sheet, it becomes double counting. PnL on the other hand, needs to reflect all past group adjustments since it is on periodic basis and not on YTD basis.

Intragroup Dividend

Dividends in Singapore is typically single tier, meaning it is taxed once at payer side and receiver does not get taxed again. Dividends generally, is not a very complicated topic. As dividends are typically declared at year end, so they end up being accrued instead of being paid out. The following are the typical cancellation entries to deal with them:

Description	Double Entry
P&L side	DR Div Income CR Div Expense
Balance Sheet side	DR Div Payable (R/E) CR Div Receivable

As you can see, the dividends adjustment doesn’t really hurt the P&L, the only noteworthy issue here is that it affects the retained earnings, which means it will flow to your Statement of Equity.

If the dividends payer is only a partially owned subsidiary, then the amount needs to be split according to the % and offset against NCI accordingly.

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All materials produced on this website, including this article, is based on author’s best interpretation of accepted accounting standards and his own experience. Any information bias, inaccuracies, misstatements, obsolesce are unintentional and should strictly not be held liable against the author. The author is not responsible for any losses, monetary or non-monetary, as a result of using these materials.

Phew! Last post was lengthy isn’t it? 🙂

Today, we will cover on “Intragroup sale of depreciable assets” and “Intragroup charges”

Without further delay, let’s jump straight into first topic.

Intragroup sale of depreciable assets

This topic is complicated in the sense that subsequent depreciation is treated as gradual realisation of unrealised profit (URP). This is because the PPE depreciates faster so long as the PPE was sold with profit. The faster speed in depreciation must be equalised back to the same depreciation rate as if the sale never happened together with reversal on initial profit from sale of PPE.

Let’s visualise this with an example:

P acquired 60% of S in 2012. In Dec 2015, S sold machinery to P for $400. The machinery was bought in Jan 2011 for $600 and had accumulated depreciation of $300 when it was sold to P. Group’s policy was to depreciate this over 10 years on straight line and to provide full year depreciation whenever it has been in used for more than 6 months.

At this point, it is important to note that the asset has exactly reached the halfway point of its life before it was sold to P.

P’s double entries (Buyer)

DR	PPE(Cost)	400
CR	Bank	400

S’s double entries (Seller)

DR	Bank	400
CR	PPE (Cost)	600
DR	PPE (Acc. Dep)	300
CR	Gain on Sale of PPE	100

Hence at end of 2015, year of the sale from S to P, the following consol entries will revert back to the state as if the transaction never occured:

2015 Consolidation entry

DR	Gain on Sale of PPE	100
DR	PPE (Cost)	200
CR	PPE (Acc. Dep)	300

The entry above is pretty straightforward. The objective was just to de-recognise the URP and transform the cost and depreciation back to 600-300. In 2016 and 2017 however, because of the difference in depreciation rate if the sale happened and if it didn’t happen, we need to adjust for the difference.

	If sale didn’t happen	If sale happened
Cost	600	400
No. of Years	10	5
Depreciation/Year	60	80

As you can see from above, the interco sale caused an acceleration of depreciation by 20 every year, which should be adjusted for:

2016 Consolidation entry

DR	Opening R/E	100
DR	PPE (Cost)	200
CR	PPE (Acc. Dep)	300
DR	PPE (Acc. Dep)	20
CR	Depreciation Expense	20

In 2017, the entries repeats itself, except with additional adjustments for the accelerated depreciation:

2017 Consolidation entries

DR	Opening R/E	100
DR	PPE (Cost)	200
CR	PPE (Acc. Dep)	300
DR	PPE (Acc. Dep)	40
CR	Opening R/E	20
CR	Depreciation Expense	20

Another way to see the $20 adjustment/year is to see it as gradual realisation of sale to outside party given the fact that the $100 profit on sale of PPE gradually decrease over 5 years at $20/year from the increase in depreciation at entity level. Hence, from that logic, both the $100 profit and $20/year adjustment belongs to the seller S. Another way to prove that both $100 and $20/year belongs to seller S is to assume the PPE stayed with group until the end without selling to external vendor. The the consol adjustment in the final year would look like this:

2020 Consolidation entries

DR	Opening R/E	100
DR	PPE (Cost)	200
CR	PPE (Acc. Dep)	300
DR	PPE (Acc. Dep)	100
CR	Opening R/E	80
CR	Depreciation Expense	20

If you observe the entries above, they actually net off each and hence are exactly the same. (So technically, in the last year, no consol adjustment is required lah…)

Let’s now take a look what happens if P sells off the asset in 1st day of 2018 for $250. Again, we need to do a comparison of what happens if the sale happened and if the sale didn’t happen:

	If sale didn’t happen	If sale happened
Sale Proceed	250	250
– Cost	600	400
– Acc. Dep	420 ($600 * 7/10 years)	160 ($400 * 2/5 years)
Book Value	180	240
Profit	70	10

So if you take the difference of 70 – 10, you get 60, which should always tie to 2017 ending R/E (DR 100 CR 20 CR 20). This 60 should always be 60, regardless of selling price. Henceforth, we consider the URP realised and pass the following entry in 2018:

2018 Consolidation entries upon sale to external party

DR	Opening R/E	60
CR	Profit on sale of PPE	60

Let’s now assume S’s R/E was $200 and the PPE is still with P (not realised) when it was acquired and we are ready to build the 2018 consolidated statements:

DR	Opening R/E	100
DR	PPE (Cost)	200
CR	PPE (Acc. Dep)	300
DR	PPE (Acc. Dep)	60
CR	Opening R/E – 2 Yrs * 20	40
CR	Depreciation Expense	20

	P	S	DR	CR	Consol Bal.
Sales	800	500			1,300
Less: Cost of Sales	500	150			650
Gross Profit	300	350			650
Interest Income	–	–			–
Less: Distribution exp.	–	–			–
Less: Admin exp.	200	100		20	280
Op. Profit	100	250			370
Less: Interest Exp	–	–			–
PBT	100	250			370
Less: Tax	30	70			100
PAT	70	180			270
Other Comp. Inc
FV Gain	–	–			–
Reval. Surplus	–	–			–
Total Comp. Inc	70	180			270
PAT attributable to:
Shareholders of P 70 + (60%* [180+20])					190
NCI (40% * [180+20])					80
					270
Total Income attributable to:
Shareholders of P 70 + (60%* [180+20])					190
NCI (40% * [180+20])					80
					270

	P	S	DR	CR	Consolidated Bal.
Land	300	500			800
PPE (cost)	400	–	200		600
PPE (Acc. Dep)	(240)	–	60	300	(480)
Investment	180	–		180	–
Stock	–	–			–
A/R	–	–			–
Loan Receivable	–	–			–
Bank	160	200			360
	800	700			1,280
Share Capital	500	100	60		500
			40
Retained Earnings	200	530-100+40+20	120		374
			196
A/P	100	70			170
Loan Payable	–	–			–
NCI	–	–		40	236
				196
	800	700			1,280

Following is a breakdown on how the retained earnings + current year profits is being dissected:

Pre-acquisition	Amt	P%/NCI%	P/NCI
Share capital	100	60%	60
		40%	40
Retained Earnings	200	60%	120
		40%	80
Post-acquisition (Before Current Year)
Retained Earnings (530-200-180)-100+40	90	60%	54
		40%	36
Post-acquisition (Current Year)
Retained Earnings	180+20	60%	120
		40%	80

You can get the group’s R/E by adding P R/E + share of S Post R/E = 200 + 54 + 120 = 374

The 196 cancelled as NCI’s share of R/E is derived by S R/E * 40% = (530-100+40+20) * 40% = 196

Finally, the NCI of 236 is simply just share of S Share capital + S R/E = (100 + 530-100+40+20) * 40% = 236

Most importantly, I want you to follow the figures in red and see that we need to assign BOTH the initial $100 profit and subsequent $20/year depreciation to S and understand that the assignment of profit is applicable not just to current year profits, but also to the opening balance. You can understand it as a permanent assignment.

Intragroup charges

This is a very short discussion for scenario where P’s interco transaction is in P&L while S capitalise it in balance sheet. A good example is FRS 23 that governs construction financing, which give rise to 3 possible scenarios

• P loans S. P recognise interest income in P&L while S recognise in balance sheet. From group’s perspective, this loan never happened.

DR	Loan Payable
DR	Interest income
CR	Loan Receivable
CR	Asset in Construction (Interest amount)

• P borrows from bank and then loans to S. P recognise interest income in P&L with A/P to bank and loan A/R from S while S capitalise the interest as per FRS 23. From group’s perspective, the underlying nature of this transaction is bank financing and FRS 23 is in effect. This is not a loan from P. Hence, the capitalised interest will stay capitalised.

DR	Loan Payable
DR	Interest income
CR	Loan Receivable
CR	Interest Expense

• Same situation as above except P charge a higher interest to S compared to the interest it pays the bank. In this case, the interest recognised should be pegged to the bank’s and an additional leg is required to reversed out the inflated portion of the interest out from the Asset in Construction

DR	Loan Payable
DR	Interest income
CR	Loan Receivable
CR	Interest Expense
CR	Asset in Construction

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All materials produced on this website, including this article, is based on author’s best interpretation of accepted accounting standards and his own experience. Any information bias, inaccuracies, misstatements, obsolesce are unintentional and should strictly not be held liable against the author. The author is not responsible for any losses, monetary or non-monetary, as a result of using these materials.

As per previous post, consolidation subsequent to acquisition date has a few topics,

Today, we will cover on “Intragroup sale of non-depreciable assets” and “Intragroup sale of stock”

Before we begin however, I thought perhaps it will be good to recap some important lessons from previous learnings:

1. The objective of consolidation is not just to combine the figures of multiple entities controlled under the same umbrella, but also to treat them as 1 entity by zero-ising any inter-group transactions as the combined entity cannot be buying or selling to itself.
2. Goodwill is simply the difference between COI and FVNIA. Any past G/W recognized at subsidiary level should be ignored and cancelled against R/E first before calculating the new G/W.
3. In consolidation under the “Acquisition method” where P holds majority but not 100% (a.k.a NCI exists),
   • P’s COI is cancelled against (Subsidiary SC * Holding %) + (Subsidiary Pre-Acquisition R/E * Holding %).
   • Any Subsidiary Post-Acquisition R/E * Holding % belongs to P. That’s means P’s group R/E = (P’s R/E) + (Subsidiary Post-Acquisition R/E * Holding %). This is NOT cancelled against COI.
   • Therefore NCI = (Subsidiary S/C * NCI%) + (Subsidiary R/E * NCI%). For NCI, it’s not so important to distinguish between Pre-acquisition and Post-Acquisition since there’s no cancellation against COI.
4. All intercompany transactions must be cancelled against one another. This includes ICO Sales/COGS, ICO interest income/expense, ICO A/P and A/R, ICO loans etc.
5. Unrealised profits occurs when goods sold are sold within the group for a profit, but still have not yet left the group to external parties. Unrealised profits has 2 important considerations.
   • Timing: if profits was unrealised in Year 1 but realised in Year 2, then the amount must be eliminated in Year 1 but in year 2, the same amount must be deducted from opening R/E and added to current year R/E. You may understand this as a transfer of Year 1 profit to Year 2 since the profits are only realised in Year 2.
   • NCI: NCI will be affected if it’s upstream but not affected if its downstream because in a downstream transaction, the unrealised profits are recognised at P side and hence, no adjustment to NCI.

*Takes a sip of water* We are now ready to begin the most basic inter-group cancellations:

Intragroup sale of non-depreciable assets

This section will dedicated to selling of interco non-depreciable assets a.k.a land. Land is the easiest topic to start because there’s no depreciation complication and hence, we will use this opportunity to illustrate how consolidation entries differs at different points:

Lets assume P acquired 80% of S in year 2011:

In 2012, P bought a piece of land for $200

P’s double entries

DR	Land	200
CR	Bank	200

In 2013, P sold to S for $300

P’s double entries

DR	Bank	300
CR	Land	200
CR	Profit from Land sale	100

S’s double entries

CR	Bank	300
DR	Land	300

As P has recognised a profit on sale of land while S has recognised an inflated price of the land, we need to revert the figures back to original figures as if the sale never happened. Here’s how:

Consolidation entries

CR	Land	100
DR	Profit from Land sale	100

From 2014 to 2017, the land stayed on S’s balance sheet at $300. Hence, the consolidation entry needs to stay in effect to reflect the price of land as $200 instead of $300.

Consolidation entries

CR	Land	100
DR	Opening R/E (P)	100

Finally in 2018, the land was sold for $450. Here, because the land was recorded in S $300 before any consolidation adjustment, the profit at entity level is actually only $450-$300 = $150. However, let’s not forget at consolidation level, we treat it worth only $200, the original P’s purchase price. If based on P’s purchase price and not S, we have a total profit of $250, not just $150. You can also say from group’s point of view, the $100 profit was only realised in 2018 when the land was finally sold to an outsider.

S’s double entries

DR	Bank	450
CR	Land	300
CR	Profit from Land sale	150

Consolidation entries

CR	Profit from Land sale	100
DR	Opening R/E (P)	100

An important distinction here is that the CR of $100 is P’s profit, not S’s, because P sold to S and hence, the profit is P’s.

Take note also the consolidation entry to adjust the group profit to decognise the $100 unrealised profit will reduce the group profit in 2013 and increase the group profit in 2018. In between those years, as the adjustments is done against opening balance, the group profit is unaffected.

Intragroup sale of stock

With an understanding on the basis of consolidation entries, lets now tackle the issue on intragroup sale of stock.

First thing to note is Cost of Sale = OB + Purchase – CB. If function of expense is used, then any consolidation adjustment is made against Cost of Sale. If its nature of expense, then consol adj to OB and CB is made against Change in Stock figure while purchase adjustment is made against purchase figure.

Let’s kick off straight away with an example:

P owns 90% of S, where the pre-acquisition R/E is $2,000

S sells upstream to P at 25% markup.

In 2017, the annual interco sale is $300, of which $50 was still in P’s inventory at year end.

In 2018, the annual interco sale is $500, of which $35 was still in P’s inventory at year end.

Before we build the P&L and BS for 2017, lets first examine the relevant consolidation entries in 2017 and 2018 first

2017 Consolidation entries

DR	Sales	300
CR	Cost of Sales(Purchase)	300
DR	Cost of Sale (Change in Stock) – $50 * (25%/125%) – (in S)	10
CR	Closing Inventory	10

2018 Consolidation entries

DR	Opening R/E (in S)	10
CR	Cost of Sale (Change in Stock) – $50 * (25%/125%) – (in S)	10

DR	Sales	500
CR	Cost of Sales(Purchase)	500
DR	Cost of Sale (Change in Stock) – $35 * (25%/125%) – (in S)	7
CR	Closing Inventory	7

The purpose of illustrating 2018 entries is to showcase the concept of how unrealised profit consol adjustments in inventory is deemed as realised in subsequent year (adjusted against opening R/E) and then re-calculated again for current year end. This is different from the earlier discussion on sale of Land, where turnover to external party is not as fast as inventory. Other than that, the concept is the same.

Another discussion point is why adjust the unrealised profit $10 against Cost of Sale and not sale. In terms of Gross Profit, whether you DR COGS or DR Sales, the Gross Profit will still be the same, but it does goes back to the first point we made that all consol adj on inventory must be made against Cost of Sale. So, there you go.

Going back to 2017…

	P	S	DR	CR	Consol Bal.
Sales	2,800	5,000	300		7,500
Less: Cost of Sales	1,500	3,000		300	4,210
			10
Gross Profit	1,300	2,000			3,290
Interest Income	–	–			–
Less: Distribution exp.	–	–			–
Less: Admin exp.	300	800			1,100
Op. Profit	1,000	1,200			2,190
Less: Interest Exp	–	–			–
PBT	1,000	1,200			2,190
Less: Tax	300	400			700
PAT	700	800			1,490
Other Comp. Inc
FV Gain	–	–			–
Reval. Surplus	–	–			–
Total Comp. Inc	700	800			1,490
PAT attributable to:
Shareholders of P 700 + (90%* [800-10])					1,411
NCI (10% * [800-10])					79
					1,490
Total Income attributable to:
Shareholders of P 700 + (90%* [800-10])					1,411
NCI (10% * [800-10])					79
					1,490

	P	S	DR	CR	Consolidated Bal.
Land	1,000	500			1,500
Investment	2,700	–		2,700	–
Stock	2,000	3,000		10	4,990
A/R	–	–			–
Loan Receivable	–	–			–
Bank	1,300	1,500			2,800
	7,000	5,000			9,290
Share Capital	5,000	1,000	900		5,000
			100
Retained Earnings	1,800	3,300-10	1,800		2,961
			329
A/P	200	700			900
Loan Payable	–	–			–
NCI	–	–		79	429
				350
	7,000	5,000			9,290

Following is a breakdown on how the retained earnings + current year profits is being dissected:

Pre-acquisition	Amt	P%/NCI%	P/NCI
Share capital	1,000	90%	900
		10%	100
Retained Earnings	2,000	90%	1,800
		10%	200
Post-acquisition (Before Current Year)
Retained Earnings (3,300-2,000-800)	500	90%	450
		10%	50
Post-acquisition (Current Year)
Retained Earnings	800-10	90%	711
		10%	79

You can get the group’s R/E by adding P R/E + share of S Post R/E = 1,800 + 450 + 711 = 2,961

The 329 cancelled as NCI’s share of R/E is derived by S R/E * 10% = 3290 * 10% = 329

Finally, the NCI of 429 is simply just share of S Share capital + S R/E = (1,000 + 3,290) * 10% = 429

Most importantly, this example is also a demonstration on how upstream interco transaction works compared to downstream.

If you follow the “10” highlighted in red, you can see why it is so important for distinguish whether the unrealised profit belongs to S or to P. Since the seller is S in the example for interco stock, the unrealised profit is adjusted at S side. Hence, it has the following domino effect:

• Starting with P&L, the NCI calculation is based on (S’s profit – URP) * NCI%. This reduces the NCI figure as compared to a downstream transaction, which would just be (S’s profit) * NCI%
• From the perspective of P, upstream profit is calculated as P’s profit + (S’s profit – URP) * NCI%. In downstream where P recognise the URP, and therefore when URP is reversed, P will absorb the full impact.
• At the R/E section of the balance sheet, you can also see that “10” is deducted from S side. Technically, you can also reflect this as a consolidation entry in “DR” column and the 2 columns would be balanced, but I just thought showing it under S’s R/E would make it more clear how important it is to determine whether the URP belongs to P or S. Similarly, if it was a downstream transaction, the “10” would deducted at P side and would also affect the Statement of Equity.

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All materials produced on this website, including this article, is based on author’s best interpretation of accepted accounting standards and his own experience. Any information bias, inaccuracies, misstatements, obsolesce are unintentional and should strictly not be held liable against the author. The author is not responsible for any losses, monetary or non-monetary, as a result of using these materials.

As per previous post, consolidation subsequent to acquisition date has a few topics, mainly:

• Consolidated Statement of Comprehensive Income
• Pre and Post acquisition reserves
• Intragroup account balances
• Unrealised Intragroup Profits and Losses
• Intragroup sale of non-depreciable assets
• Intragroup sale of stock
• Intragroup sale of depreciable assets
• Intragroup charges
• Tax effect on intragroup profits and losses
• Intragroup dividend
• Other consolidation adjustments

Today, we will cover on “Intragroup account balances” and “Unrealised Intragroup Profits and Losses”

Intragroup account balances

Usually within a group, P and S would have sales and purchases from one another. This means that at P&L level, sales and purchases are inflated and needs to be cancelled off. At balance sheet side, there will be interco AR and AP that are still unpaid which will also require cancellation. Sometimes there will be complications arising from cash in transit where one side paid but is not received at the other end. Same logic applies if there’s any intercompany loans and interest where these transactions needs to be offset. Its imperative that the consolidation adjustments reflects these transactions because at group level, P and S is 1 entity and this entity cannot buy or loan money to itself.

Following is an example that demonstrates how these transactions can be cancelled out:

P acquired 80% of S for $160 3 years ago when S’s R/E was $100 and share capital was $100.

In current year, P sold to S $100 worth of goods, which represented entire group’s intra-group sales and purchase. All sales and purchased have been realised to outside parties, but only $80 have been settled by S to P. However, P only received $70 due to late bank settlement. P also provided a loan $6 to S, incurring a YTD interest expenses of $1.

	P	S	DR	CR	Consol Bal.
Sales	800	500	100		1200
Less: Cost of Sales	500	300		100	700
Gross Profit	300	200			500
Interest Income	1	–	1		–
Less: Distribution exp.	66	59			125
Less: Admin exp.	35	20			55
Op. Profit	200	121			320
Less: Interest Exp	–	1		1	–
PBT	200	120			320
Less: Tax	60	30			90
PAT	140	90			230
Other Comp. Inc
FV Gain	–	–			–
Reval. Surplus	–	–			–
Total Comp. Inc	140	90			230
PAT attributable to:
Shareholders of P 140 + (80%* 90)					212
NCI (20% * 90)					18
					230
Total Income attributable to:
Shareholders of P 140 + 0 (80% * (90+0) )					212
NCI (20% * (90+0) )					18
					230

	P	S	DR	CR	Consolidated Bal.
Land	200	200			400
COI	160	–		160	–
Stock	200	100			300
A/R	140	70		20	180
				10
Loan Receivable	6	–		6	–
Bank	44	30	10		84
	750	400			964
Share Capital	500	100	80		500
			20
Retained Earnings	160	230	80		264
			46
A/P	90	60	20		130
Loan Payable	–	10	6		4
NCI	–	–		66	66
	750	400			964

A few important observations from above:

• Notice the PAT doesn’t change. Most consolidation entries do not affect PAT because eg. every $1 sale is cancelled against $1 of COGS. Same concept applies to elimination of Interest Income and Interest Expense.
• Similarly in balance sheet, the $20 in AP is cancelled against AR. However, do note the additional $10 for cash in transit, which is CR A/R DR Bank. The effect of this is to assume the cash has been received and the bank reconciliation will show the cash in transit. This entry will also help to match the amount outstanding shown in P’s amount owed and S’s amount owing. Similar elimination is applied to the interco loan payable and receivable.

Following is a breakdown on how the retained earnings + current year profits is being dissected:

Pre-acquisition	Amt	P%/NCI%	P/NCI
Share capital	100	80%	80
		20%	20
Retained Earnings	100	80%	80
		20%	20
Post-acquisition (Before Current Year)
Retained Earnings (140-100)	40	80%	32
		20%	8
Post-acquisition (Current Year)
Retained Earnings	90	80%	72
		20%	18

You can get the group’s R/E by adding P R/E + share of S Post R/E = 160 + 32 + 72 = 264

The 46 cancelled as NCI’s share of R/E is derived by S R/E * 20% = 230 * 20% = 46

Finally, the NCI of 66 is simply just share of S Share capital + S R/E = (100 + 230) * 20% = 66

If you can understand the above, you are almost there. Hang in there! 🙂

All that’s left to understand is to see how the P’s share of profit in P&L flows to the Statement of Equity, and hence how its matched to Balance’s Sheet ending R/E:

	P	S	DR	CR	Consolidated Bal.
Opening R/E	90	140	80		122
			28
Current Yr Profit	140	90	18		212
Dividend	(70)	–			(70)
Ending R/E	160	230			264

Notice that the above SOE is purely to derive Group’s R/E, which only includes P’s share of S Post acquisition R/E. This means that P’s share of pre-acquisition R/E (100 * 80%) and all NCI R/E (140 + 90) * 20% = 46 needs to removed.

Unrealised Intragroup Profits and Losses

The topic of Unrealised Intragroup Profits and Losses is a supplement to the cancellation of Sales and COGS above for P selling the goods to S for $100. However, this is based on assumption that S managed to sell away all goods bought from P to external parties, which is known in consolidation as fully realised intercompany profits. However, if the goods have not been sold out of the group at time of consolidation, it is considered unrealised and must be eliminated. To illustrate the necessity of such cancellation, here’s a flow of double entries to follow the flow of goods if its realised:

P’s double entries

DR	Interco A/R (S)	100
CR	Sale	100
CR	Inventory	80
DR	COGS	80

S’s double entries

DR	Inventory	100
CR	Interco A/P (P)	100
DR	A/R (External)	110
CR	Sale	110
CR	Inventory	100
DR	COGS	100

In the example above, because the profits are fully realised, there’s a Interco Sale and Interco COGS of $100 to cancel. However, if the profits are not realised, the last 4 lines in S’s entries are not passed and it effectively becomes just a transfer of inventory ownership from P to S and P has recognised a $20 profit margin from the transfer of ownership to S. The $20 cannot be recognised in consolidation and must be eliminated.

Such elimination comes with complications. The first complication is timing. If profits was unrealised in Year 1 but realised in Year 2, then the amount must be eliminated in Year 1 but in year 2, the same amount must be deducted from opening R/E and added to current year R/E. You may understand this as a transfer of Year 1 profit to Year 2 since the profits are only realised in Year 2.

The next complication comes from partially owned subsidiaries. In this scenario, the widely adopted practice is to differentiate between downstream profits (P sells to S) or upstream profits (S sells to P). NCI will be affected if it’s upstream but not affected if its downstream. It may not sound logical at first, but in a downstream transaction, the unrealised profits are recognised at P side and hence, no adjustment to NCI. This practice is also known as the “Full proportionate method”, summarised as per below:

• Eliminate 100% of unrealised profits or loss regardless of wholly owned or not
• Adjusting the unrealised profits against the profits of selling entity. (NCI is affected if and only if S is selling entity.

That’s not all. If you go back to the flow of accounting entries above, the original cost of inventory to P is only 80, but after the transfer of ownership to S, the inventory is recorded as 100. There’s needs to be an entry to bring the value of inventory as 80, the original value that P bought for.

Once we have adjusted for the unrealised profits and revert the asset value back to original, we have achieved a set of values that is as if there were no interco transactions for any goods that have not been sold outside of the group. That’s the guiding principal that we must be aligned to always.

There are also other complications, such as when P sells to S for $80 for goods worth $100. Is this case, should the $20 be realised or unrealised? The answer is to consider whether the $20 is real or artificial. The the goods is truly damaged and net realiseable value is only $80, then the $20 is real does not require elimination. If the $80 goods is artificial and can actually be sold for $100 to external parties, then the $20 needs to be eliminated.

This topic will be further expanded in future discussions.

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All materials produced on this website, including this article, is based on author’s best interpretation of accepted accounting standards and his own experience. Any information bias, inaccuracies, misstatements, obsolesce are unintentional and should strictly not be held liable against the author. The author is not responsible for any losses, monetary or non-monetary, as a result of using these materials.

We have concluded on our requirements for consolidation, which can be summarised as follow:

• Recognizing COI, Cash or Equity transferred at legal entity level
• Determination of power and control
• Fair value adjustments and its deferred tax implications
• Calculation of Goodwill and NCI

All of the above are balance sheet focused since any profits before acquisition date does not belong to acquirer. However, any profits subsequent to acquisition date requires allocation to parent and NCI, which will involve P&L. Following is a summary of topics that will be covered for this topic:

• Consolidated Statement of Comprehensive Income
• Pre and Post acquisition reserves
• Intragroup account balances
• Unrealised Intragroup Profits and Losses
• Intragroup sale of non-depreciable assets
• Intragroup sale of stock
• Intragroup sale of depreciable assets
• Intragroup charges
• Tax effect on intragroup profits and losses
• Intragroup dividend
• Other consolidation adjustments

From here on, I will also drop the the acquirer and acquiree naming conventions, since the transaction has already gone through and the ownership has been transferred. I will address them as parent (P) or subsidiary (S). Other short forms you may encounter are Cost of Investment (COI) and Fair Value of Net Identifiable Assets (FVNIA).

Consolidated Statement of Comprehensive Income

This is an introduction on how the P&L side looks like after consolidation. We will assume no interco transactions during the year to demonstrate the most basic form. Acquisition at 60% on first day of financial year.

	P	S	DR	CR	Consol Bal.
Sales	100	80			180
Cost of Sales	30	20			50
Gross Profit	70	60			130
Operating exp.	20	30			50
PBT	50	30			80
Tax	15	10			25
PAT	35	20			55
Other Comp. Inc
FV Gain	10	10			20
Reval. Surplus	50	20			70
Total Comp. Inc	60	30			90
PAT attributable to:
Shareholders of P (60%* 55)					47
NCI (40% * 55)					8
					55
Total Income attributable to:
Shareholders of P (60% * (90+55) )					125
NCI (40% * (90+55) )					20
					145

As you can see from above, despite a 60% acquisition, consolidation of Statement of Comprehensive Income is simply an addition line by line on 100% basis. The allocation of PAT and Total Comprehensive income is only done at the last section. An important note here is that after the allocation of PAT, allocation of “Total Comprehensive Income” is next, which is actually PAT + “Other Comprehensive Income”.

Sounds easy? Your next question would then be how would that translate to Balance Sheet?

Pre and Post acquisition reserves

To answer the question immediately above, we need to understand the concept of pre and past acquisition reserves. Sometimes, its easy to mis-conceptualise pre-acquisition reserves as not belonging to Parent. That’s not true at all. In truth, the purpose of splitting pre and post acquisition reserves is to capture how much the subsidiary’s reserves was acquired upon the payment of COI (Pre-acquisition) and how much of subsdiary’s profit belonged to parent after the COI was paid (Post-acquisition). If you think of COI = Subsidiary’s Reserves + Goodwill, you will see that an acquisition is just a parent buying out the current shareholders for the reserves that belonged to them in exchange for a % of all future profits earned.

With that understanding in mind, here’s how the balance sheet looks like for a 90% acquisition which at date of acquisition, the subsidiary had a share capital of 100 and retained profit of 20.

	P	S	DR	CR	Consolidated Bal.
Land	400	150			550
COI	108	–		108	–
A/R	200	–			200
Bank	92	30			122
	800	180			872
Share Capital	500	100	90		500
			10
Retained Earnings	200	30	18		209
			3
A/P	100	50			150
NCI	–	–		13	13
	800	180			872

Breakdown of consolidation working as follows:

Pre-acquisition	Amt	P%/NCI%	P/NCI
Share capital	100	90%	90
		10%	10
Retained Earnings	20	90%	18
		10%	2
Post-acquisition
Retained Earnings (30-20)	10	90%	9
		10%	1
NCI’s share of Pre & Post R/E (2+1)			3

If you notice the above, unlike previous blog posts for acquisition date entries, the subsidiary’s R/E does not cancel off to zero anymore. there’s a balance of 9 which is added to P’s R/E. This cements our understanding that any profits post acquisition belongs to P. Take note however, while the cancellation P’s share of R/E is a pre-acquisition figure (“18”), NCI’s share of R/E is a pre +post acquisition figure (“3”).

Take note also NCI’s figure of “13” = Share Capital at acquisition date (“10”) + R/E at acquisition date (“2”) + R/E post acquisition date (“1”). So in practice, to calculate NCI’s R/E, you can simply take all YTD R/E of 30 *10% = 3.

So since NCI is the addition of initial external shareholder interest + % of external subsequent profits, is it possible the NCI becomes a debit balance if the subsidiary is making huge losses? The answer is yes as per FRS 110.

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All materials produced on this website, including this article, is based on author’s best interpretation of accepted accounting standards and his own experience. Any information bias, inaccuracies, misstatements, obsolesce are unintentional and should strictly not be held liable against the author. The author is not responsible for any losses, monetary or non-monetary, as a result of using these materials.

To recall the learnings in my immediate prior post, there are 4 main elements for consolidation at date of acquisition:

1. Basic combination of financial statements
2. Adjustments for the fair values of assets and liabilities
3. Goodwill – Balance of cost of investment less fair value (FV) of net identifiable assets
4. Non-controlling interest (NCI)

For the purpose of this post, we will now focus on discussion on point number 3 and 4. While previous examples often equate Cost of Investment (COI) to be same value of acquiree’s Fair Value of Net Identifiable Assets (FVNIA), even after performance of the fair value adjustment exercise, this is not realistic. Often, when an acquisition or merger happens, acquirer or merger partners are expecting synergy to happen, which is when the combined entity is greater than the sum of all parts. For that, the acquirer is willing to pay a premium above acquiree’s FVNIA. For the purpose of consolidation, this is called “Goodwill”. FRS 103 defines “Goodwill” as ‘an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized’. From acquiree’s point of view, they also want a price as high as possible to give up control. On the flip side, its also entirely possible acquirer underpays for the acquisition that results in “Negative Goodwill”. A possible scenario for this to happen is when acquiree is in distress and owners are willing to cash out at a bargain to acquirer.

Goodwill

An important thing to note about Goodwill is it is subject to FRS 36 Impairment of Assets but not subject to amortisation. Following is an example of an acquisition in which the COI is 200 but acquiree’s FVNIA is only 170.

	A	B	DR	CR	Consolidated Bal.
Goodwill on Conso	–	–	30		30
Land	400	150	50		600
Cost of Investment	200	–		200	–
A/R	200	–			200
Bank	10	20			30
	810	170			860
Share Capital	550	100	100		550
Retained Earnings	160	20	20		160
Loan	–	50			50
A/P	100	–			100
	810	170			860

Another important thing to note about Goodwill on acquisition date is if acquiree has any prior Goodwill not related to the acquisition, the treatment of this unrelated Goodwill should be to:

• Ignore it during calculation of Goodwill on Consolidation.
• Offset it against the reserves of the subsidiary before cancellation against COI

The net effect of doing this is to hide or pretend the unrelated subsidiary Goodwill isn’t there and refresh the Goodwill calculation back to zero for the purpose of calculating the present acquisition Goodwill at acquisition date. Following is a demonstration of how this pans out:

	A	B	DR	CR	Consolidated Bal.
Goodwill on Conso	–	–	30		30
Subsi Goodwill	–	50		50	–
Land	400	150	50		600
Cost of Investment	200	–		200	–
A/R	200	–			200
Bank	10	20			30
	810	220			860
Share Capital	550	100	100		550
Retained Earnings	160	70	50		160
			20
Loan	–	50			50
A/P	100	–			100
	810	220			860

As you can see from the example above, acquiree’s prior Goodwill of 50 is offset against the reserves first, then the acquiree’s FVNIA comes down to 170 which is then compared against the COI of 200 to get the Goodwill of Consolidation of 30.

Non-Controlling Interest (NCI)

We are now ready to move on to our next discussion, Non-Controlling Interest (NCI). NCI occurs when the acquisition is not a full 100% but acquirer has control. (How acquirer can gain control has been discussed before, but to simplify our discussion, we will assume any shareholding >50% is enough to gain control.) If for example, the acquisition is only for 80%, then the 20% belongs to shareholders outside of acquirer, also defined as Non-Controlling Interest (NCI). The consolidation exercise will still be on 100% basis as before, but 20% of net assets and profits will need to be allocated to NCI. FRS 110 governs the presentation of the NCI, which indicates that it must be presented as equity.

An important discussion of NCI is measurement. FRS 103 gives us 2 choices on how to measure NCI:

• Base on fair value (market price of shares)
• Proportionate share of acquisition date FVNIA

The main difference between these 2 methods is that the first method gives the entire consolidation exercise an additional NCI goodwill, calculated by taking the (market price of share * number of NCI share) and net against (NCI % * FVNIA). The second method just assumes NCI does not have a NCI Goodwill. In summary, the first method inflate the Goodwill on Consolidation and the NCI with an arbitrary figure derived from share price while second method don’t.

In current industry practice, most people use the second method and don’t use the first and for very good reasons.

• Firstly, NCI’s Goodwill really doesn’t add much value to calculations. On the contrary, it makes the entire consolidation exercise more complex that it should be by introducing share price as a variable. This makes any consolidation proof to require a record of the share price that was used.
• Secondly, not every company is listed and thus the choice of share price value used can be highly contentious and quite frankly, difficult to justify.

For simplicity (cause I am lazy), I will demonstrate how NCI is calculated using the second method. For this example, the acquisition is for 80% @ COI of 180. Land was fair valued to 250 from 200 with any future sale of land attracting a 20% tax rate.

	A	B	DR	CR	Consolidated Bal.
Goodwill on Conso	–	–	28		28
Land	–	200	40		250
			10
Cost of Investment	180	–		180	–
A/R	100	10			110
Bank	60	10			70
	340	220			458
Share Capital	200	100	80		200
			20
Retained Earnings	60	50	40		60
			10
A/P	80	70			150
Deferred tax	–	–		8	10
				2
NCI	–	–		38	38
	340	220			458

Breakdown of consolidation working as follows:

Fair Value Adj. Exercise	Amt	P%/NCI%	P/NCI
Increase in Land FV	50	80%	40
		20%	10
20% Deferred Tax on Land FV	(10)	80%	(8)
		20%	(2)
Total FV adjustment	40
Add on:
Acquiree’s FVINA at acq. date	150
Acquiree’s FVINA after FV exercise	190	80%	152*
NCI’s share of FVINA		20%	38
Thus to derive Acquirer Goodwill:
Acquirer COI	180
Acquiree’s share of FVINA	152*
Goodwill on consolidation	28

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All materials produced on this website, including this article, is based on author’s best interpretation of accepted accounting standards and his own experience. Any information bias, inaccuracies, misstatements, obsolesce are unintentional and should strictly not be held liable against the author. The author is not responsible for any losses, monetary or non-monetary, as a result of using these materials.

Definition

“Control” is defined by FRS 110 by the following:

• “Power” over the investee
• Entitled to “Returns” from involvement with investee
• Ability to influence “Returns” from investee through its “Power”

As a supplement to above, it maybe helpful to consider the design and nature of the investee as well as its relevant activities and how decisions about these activities are made.

Power

The glossary of “Power” as provided by FRS 110 is as follow:

• Existing rights: Voting rights from equity instruments or rights from contractual arrangements
• Current ability: Ability to direct relevant activities even if rights are yet to be exercised
• Relevant activities: Activities that generate return for the company. In a company with 2 or more different relevant activities, each with a different influencer or director, the activity with that generate the most return is the most relevant.

As Varys from “Game of Thones” put it:

Power resides where men believe it resides.

It’s a trick. A shadow on the wall.

And a very small man can cast a very large shadow.

Following are a few forms of “large shadow”:

• Voting rights or potential voting rights
• Ability to influence investee’s key management personnel
• Rights to adjust or approve any changes in the relevant activities

It is also noteworthy that in cases where power is solely determined by voting rights, it is not necessary to have >50% to have power. You only need to be the majority shareholder, even if its only 40%. Voting rights sometimes can also be indirect which can be illustrated easily using the example of Ultimate Holding Company – Parent – Child.

There are many instances in which “Power” can be subjective. For example, if it takes only 2 other minority shareholder to overrule 1 majority shareholder, the power of the majority shareholder here is very fragile and not always straightforward. Most of such cases usually involves majority shareholder with <50% share and all facts and circumstances must be considered. Considerations such as past voting patterns and size and dispersion of minority shareholders are crucial.

Potential convertible voting rights that are substantive must also be part of the consideration for “Power”. Key word here is “substantive”, meaning the option to convert is probable. The exercise price must not be too expensive compared to current market price and the owner of option must have enough capital to exercise.

Contractual obligations are another form of power. Although rare, these are contracts that requires consent of shareholders to rescind, which may enable control over sales or purchase of the company. An important distinction here however, is that “protective rights” included in contract is NOT a form of power. A typical example of a “protective right” is bank seizure of assets in event of loan default.

There are also a lot of other unique scenarios where voting rights does not translate to power. For example, shareholders does not have any voting rights for a company under judiciary management.

Returns

The key to understanding “Control” is that its NOT sufficient to be just be a beneficiary to investee’s returns. Providing a loan and receiving interest for example, is not sufficient to have control. Power is when you are the beneficiary of investee’s return AND is able to use its power to influence investor’s return.

Principal vs Agent

Then there comes the good ol’ accounting issue of principal vs agent. Guidance from FRS 110 is such that all decision makers, delegated on not, must consider the following to determine whether it is acting as agent or principal:

• Scope of decision making ability authority
• Rights held by other parties
• It’s remuneration
• Exposure to variability of returns through other interest

In my opinion, the key criteria here is remuneration. So long as the decision maker is receiving remuneration to act on someone’s behalf at a fixed rate independent of performance of investee, it is very likely he/she is only an agent. Even if the rate is base on a percentage on the performance of investee, the amount of returns must be significant enough in order for it be a principal. 1% or 2% of overall returns doesn’t cut it.

Another consideration is probably how likely he/she can be removed or replaced without cause. A decision maker who can be removed or replaced easily is unlikely to have control.

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All materials produced on this website, including this article, is based on author’s best interpretation of accepted accounting standards and his own experience. Any information bias, inaccuracies, misstatements, obsolesce are unintentional and should strictly not be held liable against the author. The author is not responsible for any losses, monetary or non-monetary, as a result of using these materials.

Date of acquisition is the single most important date of consolidation. It is the date where:

• acquirer obtains control
• all assets and liabilities acquired are fair valued
• consolidations of results initiates, which also directly determines which financial year the acquisition sits in

Elements of consolidation

There are 4 main elements for consolidation at date of acquisition:

1. Basic combination of financial statements
2. Adjustments for the fair values of assets and liabilities
3. Goodwill – Balance of cost of investment less fair value (FV) of net identifiable assets
4. Non-controlling interest (NCI)

For the purpose of this post, we will assume 3 and 4 is negligible and focus our discussion on 1 and 2. What this means is that all examples provided in this post will have the cost of investment = acquiree’s equity, however in future posts, you will find that such assumptions are not realistic in real life applications.

Basic Combinations

Following is an example of how an investment cost of 120 is cancelled against acquiree’s equity for a 100% acquisition:

	A	B	DR	CR	Consolidated Bal.
Land	400	150			550
Cost of Investment	120	–		120	–
A/R	200	–			200
Bank	40	20			60
	760	170			810
Share Capital	500	100	100		500
Retained Earnings	160	20	20		160
Loan	–	50			50
A/P	100	–			100
	760	170			810

If you notice from above, the “Cost of Investment” line has been zerorised. This is because every consolidation under the “Acquisition Method”, is combined at 100% basis, regardless of whether its a 100% subsidiary or 60% subsidiary. The allocation of profit base on holding% will be at a separate line and will be discussed in the future.

Hence from above, its also correct to say “Cost of Investment” line under the “Acquisition Method” will always be zero after consolidation. This is cancelled against subsidiary’s “Retained Earnings” and “Share Capital”. You can also visualize this entry as a way to prevent double counting since without this entry, the Gross Assets and Equity would be unfairly inflated.

Fair Value adjustments

There are 2 forms of fair value adjustments. The first form is when subsidiary’s liabilities or assets are not at fair value and thus during consolidation, it needs to be reflected as being part of the “Cost of Investment”. I see this as a necessary step to ensure the acquisition is base on a fair valuation that minimize overpayment or underpayment. Once you understand the reason behind the steps, its much more easier to remember why and how.

Following is an example on how a Land asset belonging to subsidiary is revalued from 150 to 200 at date of acquisition:

	A	B	DR	CR	Consolidated Bal.
Land	400	150	50		600
Cost of Investment	170	–		170	–
A/R	200	–			200
Bank	40	20			60
	810	170			860
Share Capital	550	100	100		550
Retained Earnings	160	20	20		160
Loan	–	50			50
A/P	100	–			100
	810	170			860

As you can see from above, the additional land adjustment of 50 has been included into the “Cost of Investment”. Without the fair value adjustment, the “Cost of Investment” would have stayed at 120.

The second form of fair value adjustment is to recognize any assets of liabilities that were not on subsidiary’s balance sheet at date of acquisition. This is because sometimes internally generated intangible assets such as brands, copyrights or R&D projects cannot be capitalized under FRS 38 Intangible assets but at consolidation level, this is allowed. Another accounting standard that has uneven treatment between consolidated level and entity level is FRS 37 Contingent Assets and Liabilities. Here, we have to be very careful since FRS 37 has 2 different types of contingent liabilities, one which can be upgraded from disclosure to a balance sheet item at consolidation level, one of which cannot. The first type of contingent liability defined by FRS 37 is possible obligation arising from past event that is subject to an uncertain event. An example would be compensation to CEO in event of dismissal. Its not appropriate to accrue for such an expense when the condition has not been triggered. This type of contingent liability will not be in the balance sheet, not even at consolidation level. What will be upgraded is the other type of contingent liability in FRS 37 that is defined as present obligation arising from past event but is not recognized because outflow of resources requirement is not probable. An example is a legal compensation that lawyers are of the opinion there’s a 20% chance of $100 payout. In the consolidated balance sheet, a $20 Provision for Legal Fee must be accrued.

Following is an example on how a the same $20 disclosure at subsidiary level is upgraded to a balance sheet item at date of acquisition:

	A	B	DR	CR	Consolidated Bal.
Land	400	150	50		600
Cost of Investment	150	–		150	–
A/R	200	–			200
Bank	40	20			60
	790	170			860
Share Capital	530	100	100		530
Retained Earnings	160	20	20		160
Provision	–	–		20	20
Loan	–	50			50
A/P	100	–			100
	790	170			860

As always in accounting, timing and nature is a crucial consideration here. FRS 103 says that the assets and liabilities acquired must be part of the exchange between acquirer and acquiree in the business combination. This means that although its not abnormal for accruals such as provision for restructuring to be recognized as part of acquisition date entry, it can only do so if it’s not incidental to acquisition. If the restructuring plan was announced before the acquisition, then yes, it is allowed. However, if the restructuring plan wouldn’t have happened if there wasn’t any acquisition, then this is incidental and should not be part of the acquisition date entry. This is not something that is being “exchanged” since acquiree didn’t get paid to be restructured. Another issue to illustrate the scope of this requirement is due diligence fee paid by acquirer prior to the acquisition. This is clearly disallowed to be part of acquisition cost since its not for the benefit of subsidiary nor was the acquisition cost meant to cover the due diligence cost.

Just to re-emphasis my earlier opinion again, the purpose of the fair value adjustment exercise is to ensure the “Cost of Investment” is fairly accounted for. Afterall, the definition of fair value is:

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between knowledgeable market participants at the measurement date

The keyword here is “knowledgeable”, meaning both the acquirer and acquiree is fully aware of what is being paid for and what is the market value. This means undervalued land must be re-valued. This means internally generated assets must be included in the cost. This means legal fee, even if its less than 50% chance of being paid out, must be recognized. This also means they know what is NOT being paid for. Due diligence is most definitely not. FRS 103 is basically of the assumption that both the acquirer and acquiree are knowledgeable market participants. Any excess paid over the fair value of the net tangible assets is strictly voluntarily, known by both acquirer and acquiree and hence, known the name “Goodwill” which we will introduce briefly next.

Tax Effects on Fair Value Adjustments

The key takeaway of this section is to show that the deferred tax effect of fair value adjustment should be accounted for as an adjustment to the goodwill figure. There’s a lot to unpack here. Firstly, you need to understand that FRS 12 calls for any changes to future tax payment as a result of recovery or settlement of carrying amount of an asset and liability to be recognized as deferred tax asset or liability. To simplify further, basically if the fair value adjustment has any future tax consequence, then it needs to be adjusted for now. Second thing to unpack here is that FRs 12 also says the effect of deferred tax must be recognized in the same way the underlying assets or liability was accounted for. As a result of this principle, the tax figure is accounted as an adjustment to Goodwill because this is the line that represents the differences between Cost of Investment and fair value of net tangible assets. At this point, you may be very confused why is it that previous examples, the increase in fair value value of land or provision for legal fee went into the Cost of Investment line. That’s because previous examples were designed in such a way where Cost of Investment coincidentally equate to the value net tangible assets after the fair value adjustment exercise. The truth is, most of the time, the Cost of Investment and fair value of net tangible assets are 2 entirely different figures and any difference between the 2 is recorded as Goodwill because acquiree would want a premium over the fair value of net tangible assets. Goodwill will be discussed in further detail in the next post, but in the mean time, please see an example below where the fair value adjustment exercise produced a Provision for Legal fee of $20 that is tax deductible when it is subsequently paid. Statutory tax rate is 20%.

[Carrying amount $20 - tax base of $0] * 20% = $4 Deferred Tax Asset

	A	B	DR	CR	Consolidated Bal.
Land	400	150	50		600
Cost of Investment	150	–		150	–
A/R	200	–			200
Bank	40	20			60
Deferred Tax Asset	–	–	4		4
	790	170			864
Share Capital	530	100	100		530
Retained Earnings	160	20	20		160
Provision	–	–		20	20
Loan	–	50			50
A/P	100	–			100
Negative Goodwill	–	–		4	4
	790	170			864

Another thing to note here is that if the fair value adjustment results in lesser tax payment now and more tax payment in future, its a deferred tax liability. If it results in more tax payment now and lesser tax payment in future, its a deferred tax asset.

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All materials produced on this website, including this article, is based on author’s best interpretation of accepted accounting standards and his own experience. Any information bias, inaccuracies, misstatements, obsolesce are unintentional and should strictly not be held liable against the author. The author is not responsible for any losses, monetary or non-monetary, as a result of using these materials.