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RISK ASSESSMENTS AND INTERNAL CONTROL

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Title: RISK ASSESSMENTS AND INTERNAL CONTROL


1
Consolidated Financial Statements and Accounting
for Investments in Subsidiaries
Background Regulatory Framework The Financial
Statement prepared for a group of companies is
govern by the Companies Act No 17 of 1982 and
Sri Lanka Accounting Standard No 26
Consolidated Financial Statements and Accounting
for Investment in Subsidiaries Consolidated
financial statements are prepared in accordance
with Sri Lanka Accounting Standards.
2
Control (for the purpose of this
Standard) is the power to govern the financial
and operating policies of an enterprise so as to
obtain benefits from its activities. A
subsidiary is an enterprise that is controlled
by another enterprise (known as the parent). A
parent is an enterprise that has one
or more subsidiaries. A group is a
parent and all its subsidiaries. Consolidated
financial statements are the financial statements
of a group presented as those of a single
enterprise. The minority interest is that part
of the net results of operations and of net
assets of a subsidiary attributable to interests
which are not owned, directly or indirectly
through subsidiaries, by the parent.
3
  • Control
  • Control has been defined as the power to govern
    the financial and operating policies of an
    enterprise. Generally these decisions are taken
    by the board of directors and are appointed by
    the share holders of the enterprise. There fore
    the control is presumed to exist in the following
    circumstances
  • when the parent owns, directly or indirectly
    through
  • subsidiaries, more than one half of the
    voting power of an
  • enterprise

4
  • Control also exists even when the parent owns one
    half or less of the voting power of an enterprise
    when there is
  • When it has power over more than one half of
    the voting rights
  • by virtue of an agreement with other
    investors
  • Power to govern the financial and operating
    policies of the
  • enterprise under a statute or an agreement
  • Power to appoint or remove the majority of the
    members of
  • the board of directors or equivalent
    governing body
  • power to cast the majority of votes at meetings
    of the board of
  • directors or equivalent governing body

5
Why Consolidated Financial Statement The capital
contributed by the shareholders of the parent
company are normally invested in the subsidiary .
Therefore such shareholders of the parent company
would like to know not only the results and net
assets of the parent company but also the aspects
of the subsidiary. They would more prefer to know
in respect of funds they have contributed the
total return rather the return only on the parent
company. A parent company should present
consolidated financial statements to its share
holders. A parent which issues consolidated
financial statements should consolidate all
subsidiaries( Foreign and domestic)
6
  • A subsidiary should be excluded from
    consolidation when
  • Control is intended to be temporary because the
    subsidiary is
  • acquired and held exclusively with a view to
    its subsequent
  • disposal in the near future
  • It operates under severe long-term restrictions
    which
  • significantly impair its ability to transfer
    funds to the parent

7
A parent that is wholly owned subsidiary of
another parent company need not to present
consolidated financial statements provided the
latter parent present consolidated financial
statements. A Owns 100 B Owns 60
C Thought B is a parent, B need not to
prepare the consolidated financial Statements as
it is wholly owned subsidiary of A
8
  • Consolidation Procedures
  • Consolidated Balance Sheet
  • In preparing consolidated balance sheet, the
    balance sheets of parent and the subsidiaries are
    combined on a line-by-line basis by adding
    together like items of assets, liabilities,
    equity.
  • In order that the consolidated financial
    statements present financial information about
    the group as that of a single enterprise, the
    following steps are then taken
  • The carrying amount of the parent's investment
    in each
  • subsidiary and the parent's portion of
    equity of each subsidiary
  • are eliminated
  • Inter company trading should be eliminated.

9
Balance sheet of the parent company and the
subsidiary as at 31st March 2006 are as follows.
Parent Company Balance Sheet Assets
Parent Subsidiary Non Current
Assets Property, Plant Equipments 1,500,000
550,000 50,000 Rs 10 each shares in
Subsidiary at cost 5,00,000
2,000,000 Current Assets Stock 160,000
130,000 Debtors in Subsidiary
50,000 Other Trade Receivable 110,000 160,000

70,000 Cash at Bank 100,000
60,000 520,000

260,000 Current Liabilities Creditors in
Parent (50,000) Creditors
(120,000) 400,000
(60,000) 150,000
2,400,000
700,000 Capital Reserves 200,000 Rs 10 each
Ordinary shares 2,000,000 50,000 of Rs 10
each ordinary shares
500,000 Reserves
400,000
200,000
7,900,000
700,000
10
  • Some item may appear in the balance sheet of the
    parent company and its subsidiary but not at the
    same amount
  • The parent company may acquire the subsidiary at
    a consideration
  • greater or lesser than their nominal value.
    The assets will appear in the
  • parent company balance sheet at cost, while
    liability will appear in the
  • subsidiary balance sheet at nominal value.
    This difference raises the
  • issue of Good Will.
  • Some time parent company may not acquire all the
    shares of the
  • subsidiary. This raises the issue of Minority
    interest.
  • The inter company balances may out of step
    because of the goods or
  • cash in transits.
  • Parent company may have acquired proportion of
    the loan stock of the
  • subsidiary balance sheet.

11
The balance sheet of H ltd and its subsidiary S
ltd as at 31st March 2006 are given below. H Ltd
has acquired the all the ordinary shares and
60 of the loan stock of its subsidiary.
The different of the current account arises
because of goods in transits. Prepare the
consolidated balance sheet of H Ltd.
12
Minority Interest The minority interest is that
part of the net results of operations and of net
assets of a subsidiary attributable to interests
which are not owned, directly or indirectly
through subsidiaries, by the parent. So a
proportion of the net assets of such subsidiaries
in fact belongs to investors from outside the
group. In the consolidated balance sheet it is
necessary to distinguish this proportion from
those assets attributable to the group and
financed by share holders fund. The
consolidated procedure for dealing with partly
owned subsidiaries is to calculate the proportion
of ordinary shares, preference shares and
reserves attributable to minority interests.
13
Balance sheet of the H Ltd and its subsidiary S
Ltd are given below as at 31st March 2006.
14
Adjustment for the dividend When the subsidiary
company pays a dividend during the accounting
period, no adjustment is required when
consolidation. But adjustment is required when
the subsidiary company proposed dividend but not
yet paid. In this case the first step is to
ensure that accounts of both subsidiary and
parent company are reflecting the proposed
dividend. If they have not accrued first the
proposed dividend should be accrued in both
companies accounts. Then on consolidation, The
dividend payable in subsidiarys accounts will
cancel with the dividend receivable in the
parents accounts. If the subsidiary is a
wholly owned one, there will be complete
cancellation, If it is only partly owned there
will be only part cancellation. The un
cancelled portion will be the amount belongs to
minority share holders and this will appear in
the consolidated balance sheet as a current
liability.
15
Balance sheets of the H Ltd and its subsidiary S
Ltd are given below as at 31st March 2006.
16
  • Additional information
  • Neither company has yet provided for any
    dividend, you are required to provide for
  • - The preference dividend of S Ltd
  • - A proposed ordinary dividend of 10 By S Ltd
  • A proposed ordinary dividend of 15 By H Ltd
  • You are required to prepare the consolidation
    balance sheet

17
Good Will Arising On Consolidation
The amount paid over and above the value of the
tangible assets acquired of a subsidiary is
called good will arising on consolidation. Any
excess of the cost of the acquisition over the
acquirer's interest in the fair value of the
identifiable assets and liabilities acquired as
at the date of the exchange transaction should be
described as goodwill and recognised as an
asset. Goodwill acquired in a business
combination represents a payment made by the
acquirer in anticipation of future economic
benefits from assets that are not capable of
being individually identified and separately
recognised. Goodwill acquired in a business
combination shall not be mortised. Instead, the
acquirer shall test it for impairment annually or
more frequently if events or changes in
circumstances indicate that it might be impaired.
in accordance with SLAS 41, Impairment of Assets.
18
Negative Good Will
  • If the acquirer's interest in the net fair value
    of the identifiable assets, liabilities and
    contingent liabilities recognised exceeds the
    cost of the business combination, the acquirer
    shall
  • Reassess the identification and measurement of
    the acquiree's identifiable assets, liabilities
    and contingent liabilities and the measurement of
    the cost of the combination and
  • (b) Recognise immediately in profit or loss any
    excess remaining after that reassessment.

19
Reserves
The net asset or the share holders interest of
a subsidiary consists of ordinary share capital
and the reserves. At the point of acquisition of
a company (Subsidiary), it is very important to
make a distinction between pre acquisition
reserves and Post acquisition reserves. Pre
acquisition reserves are those reserves of the
subsidiary exist at the date of acquisition by
the parent Post Acquisition Reserves are those
reserves of the subsidiary which arose after the
acquisition.
20
When consolidating the financial statements of
the parent and subsidiaries, pre acquisition
reserves of subsidiary companies are not
aggregated with the parent companys reserves
instead they charged to the cost of control
account. But the post acquisition reserves of the
subsidiaries aggregated with the parent companys
reserves when consolidating the financial
statements.
21
H Ltd acquired the ordinary ordinary shares of
the S Ltd on 31st March 2006 when draft balance
sheet of each company as follows
H Ltd acquired its investment in S Ltd on
01/04/2004 when the revenue reserves of S Ltd
stood at Rs 10,000. There has been no change in
the share capital and capital reserves of S Ltd
since that date. At 31st March 2006 S Ltd had
invoiced H Ltd for goods to the value of Rs 2,000
which had not been received by H Ltd.
22
Inter Company Trading
We have come across where one company in a group
in trading with another group company. Any
debtor, creditor balances outstanding between
companies are cancelled on consolidation. So
there will not be any problem if all such inter
group transactions are undertaken at
cost. However each company in a group is a
separate entity and may wish to teat other group
companies in the same way as any other customer.
In this case, a company (A Ltd) buy goods at one
price and sell them at a higher price to another
group company( B Ltd). The accounts of A ltd will
quite properly include profit earned on sales to
B. Similarly B Ltd balance sheet will include
stock at their cost to B Ltd at the amount at
which they were purchased from A.
23
H Ltd acquire all the shares in S Ltd when the
reserves of S Ltd stood at Rs 15,000 Draft
balance sheet for each company are as follows.
24
During the year S Ltd sold goods to H Ltd Rs
75,000 The profit from to S Ltd being 20 of
selling price at the balance sheet date Rs 22,500
of these goods remain unsold in the stocks of H
Ltd. At the same time H Ltd owed S Ltd Rs 18,000
for goods bought and this debt is included in the
creditors of H Ltd and the debtors of S Ltd.
25
Acquisition of a subsidiary during its Accounting
Period When a holding company acquires a
subsidiary during its accounting period the only
accounting entry will be those recording the cost
of the acquisition in the holding companys books
at the and of the accounting year it will be
necessary to prepare consolidated Financial
Statements. The subsidiary company accounts to be
consolidated will show the subsidiary profit or
loss for the whole year. For consolidation,
profit need to distinguish between profit earn
before the acquisition and profit earned after
the acquisition.

26
H Ltd acquires 80 of the ordinary shares of S
Ltd on 31st December 2005. On 31st March 2005 S
Ltd accounts showed a share premium account of Rs
6,000 and revenue reserves of Rs 22,500. The
balance sheet of two companies as at 31st March
2006 are set out below. Neither company has paid
or propose any dividend during the year. You are
required to prepare the consolidated balance
sheet of H Ltd as at 31st March 2006.
27

28
Dividend out of requisition profits

The holding company as a member of the subsidiary
company is entitled to its share of dividends.
When a subsidiary company pays out a dividend
soon after the question it is important to
decide, those dividends are paid out of pre
acquisition profit or post acquisition
profits. If the dividends comes from pre
acquisition profit there is no problem, the
holding company simply credit the relevant amount
to its profit loss account as with any other
dividend income. However if the dividend is paid
from pre acquisition profits, the double entry is
as follows Cash Account Dr Investment in
Subsidiary Account Cr
29
Then the holding companys balance sheet disclose
the investment as in subsidiary at cost less
amount written down (Group proportion of the
dividend paid out of pre acquisition profit by
the subsidiary) We need next to consider how it
is decided whether a dividend is paid from pre
acquisition profits. If the holding company
acquires shares in subsidiary at the beginning of
the accounting period and the dividend was in
respect of the previous accounting period
clearly the dividend was paid from profit earned
in the period before acquisition. If the shares
are acquired during the accounting period of the
subsidiary the example will illustrate the fact
that the dividend is paid out of the pre
acquisition profit or not.

30
Example. H ltd acquired 16,000 of the 20,000
ordinary shares of S Ltd on 1st April 2005 for Rs
500,000. S ltd balance sheet as at 31st March
2005 showed a proposed ordinary dividend of Rs
80,000 and retained reserves of Rs 240,000. The
balance sheet of the two companies at 31st March
2006 are given below.

31
Revaluation of a subsidiary companys assets on
acquisition

SLAS 25 Defined the Goodwill as the difference
between the purchase consideration paid by the
holding company and the fair value of the assets
acquired from the subsidiary. The balance sheet
of the subsidiary company at the date of its
acquisition may not guiding to the fair value of
its assets. Until now we have calculated the
goodwill as the difference between the cost of
the investment and the book value of the net
assets acquired by the group. If this calculation
is to comply with the definition in SLAS 25, we
must ensure the book value of the subsidiarys
net assets is the same as their fair value.
32
  • There are two possible ways of achieving this
  • The subsidiary company might incorporate any
    necessary
  • revaluation in its own books of accounts.
  • The revaluation may made as a consolidation
    adjustment without
  • being in corporate in the subsidiarys books.
    In this case we must
  • make the necessary adjustments to the
    subsidiary companys
  • balance sheet as a working .
  • It is very important to note that when
    depreciable assets are devalued there may be a
    corresponding alteration in the amount of
    depreciation charged during year and accumulated
    depreciation.


33

Example H Ltd acquired 75 of the subsidiary
shares of S Ltd on 1st April 2005, at the date
fair value of S Ltds Property, Plant
Equipment was Rs 460,000 greater than their net
book value, and the balance of retained profits
was Rs 420,000. This balance sheet of both
companies as at 31st March 2006 are given below.
S Ltd has not incorporated any revaluation in
this books of account. H Ltd has devalued its
Property. Plant Equipment on 1st April 2005,
addition of Rs 60,000 would have been needed
depreciation charged in the profit Loss account
for 2005/06 Prepare the H Ltd consolidated
balance sheet as at 31st March 2006
34

35
Piecemeal Acquisitions

A holding company may acquire a controlling
interest in the share of subsidiary as a result
of successive share purchases, rather than by
purchasing the all shares on the same day. For
the purpose of consolidation, it is necessary to
decide what reserves of the subsidiary are pre
acquisition profits, but since the acquisition
has occurred in several stage, it is not
immediately clear how to decide what they are.
36
If a controlling interest is achieved by means of
a build up of share acquisition over a period of
time. So that the present reserves include
elements which are pre acquisition as regards
some block of shares hold but post acquisition as
regards other blocks shares the problem faced in
deciding how much of the present reserves belongs
to the good will calculation is really one of
interpretation. The general rule is that the pre
and the post acquisition reserves and profits
should be established at each purchase of shares
if it can be assumed that each purchase is
substantial and there is an objective of gaining
ultimate control when these assumptions are
present the pre and post acquisition profit
should only be established when control has been
gained.

37
Ignore share purchases which keep the buying
company shares of equity below 20 make no step
by step method calculations before the bought
company becomes an associated company. This is on
the rough and ready assumptions that on
insertions as to obtain control does not exits
until associated company status in reached for
the partly bought company. When the purchase of
shares first take a companys holding above 20
(up to 50) treat all the share purchases up to
this date as a single block of purchase for the
purpose of calculating pre acquisition profits.
For future purchases up to the time when control
is eventually acquired, the step by step method
should be applied.

38
H Ltd acquires shares in S Ltd , which has issued
ad fully paid share capital of 200,000 Rs 10
ordinary shares, on these separate dates.

You are required to calculate the pre acquisition
profits of the H group in S Ltd eventually become
a subsidiary on 31 /12/ 2005
39

Reserves as at 31st March 2006 is Rs 1,500,000
Share capital 200,000 of Rs 10 each. Prepare Cost
of Control Account, Minority Interest and
Consolidated reserve Account as at 31st March
2006.
40
Consolidated Profit Loss Account

When leaning consolidated profit and loss account
it is very important to consider the aspects of
Inter company trading, Inter company dividends,
pre acquisition profit and Disclosure
requirements.
41
H Ltd acquire 75 of the subsidiary S Ltd on the
company incorporation in 2004. The summarised
Profit Loss Account of the companies for the
year ending 31st March 2006 are set out below.

42
Inter company Dividend

S Ltd Capital consist of 20,000 6 Rs 10
Preference shares and 20,000 Rs 10 ordinary
shares on 1st April 2002, the date of S Ltd
Incorporated, H Ltd Acquired 6,000 of the
preference shares and 15,000 of the ordinary
shares in S Ltd. The profit Loss Account of
these two companies for the year ended 31st March
2006 are set out below.
43

44
  • Pre Acquisition Profits
  • The figure for retained profits at the bottom of
    the consolidated profit and loss account must be
    the same as the figure for retained profits in
    the consolidated balance sheet.
  • The retained profit of the consolidated balance
    sheet comprises
  • The whole of the holding companys retained
    profit and
  • A proportion of the subsidiary companys retained
    profit. That is the group share of post
    acquisition retained profit in the subsidiary
    from the total retained profit of the subsidiary.


45
  • We must there fore exclude both the minority
    share of the total retained profits and the group
    share of pre acquisition retained profits. A
    similar procedure is necessary in the
    consolidated profit and loss account. There fore
    the figure for profits brought forward should
    only include the group share of the post
    acquisition retained profit.

46
  • If the subsidiary is acquired during the
    accounting period it is there fore necessary to
    apportion its profit for the year between pre
    acquisition and post acquisition element. There
    are two approaches which may be used for this in
    the consolidated Profit and loss Account.
  • The whole year method
  • Part year method

47
With the whole year method, the whole of the
subsidiarys turnover cost of sales so on are
included in the consolidated P L. A deduction
is then made lower down the schedule to exclude
the profit accruing prior acquisition. With the
part year method entire P L Account of the
subsidiary split between pre and post acquisition
proportion. Only the post acquisition proportion
is included in the consolidated P L.

48
H Ltd acquire 60 of the equity of S Ltd on 1st
July 2005. The profit and loss account of the two
companies for the year ended 31st March 2006 are
set out below. Prepare the consolidated profit
Loss account using two methods

49
Summarised profit and loss account for the year
needed 31st March 2006 of H Ltd and its
subsidiary S Ltd are set out below.

50
  • Additional Information
  • H Ltd acquired 80 ordinary shares of S Ltd on
    1st April 2005.
  • Balance of the profit and loss account of S
    Ltd as at
  • 01.04.2005 was Rs 50,000
  • S Ltd has not utilised pre acquisition profit
    to propose the
  • dividends
  • H Ltd has not accounted dividend proposed by S
    Ltd on accrual
  • basis.
  • You are required to prepare the consolidated
    Profit and Loss account as at 31st March 2006.

51
Summarised profit and Loss account for the year
ended 31st March 2006 of H Ltd and its subsidiary
S Ltd are given below.

52
  • Additional Information
  • H Ltd acquired 80 Ordinary shares, 50
    Preference shares
  • and 50 Debentures on 1st April 2005.
  • H Ltd sold its goods to S Ltd at cost plus 50
  • Stocks of S Ltd as at 31st March 2006 includes
    goods purchased
  • from H Ltd for Rs 300,000.
  • S Ltd did not utilise any pre acquisition
    profit to declare dividends
  • H Ltd has accounted interest and dividend
    (receivable ) On
  • accrual basis
  • You are required to prepare the consolidated
    Profit and Loss account as at 31st March 2006.


53
Summarised profit and Loss account of the H Ltd
and Its Subsidiary S Ltd for the year ended 31st
March 2005 are given below.

54
  • Additional Information
  • H Ltd acquired 5/6 of the ordinary shares, 4/5 of
    the preference shares and ½ of the debentures of
    S Ltd on 01.04.2000.
  • Balance of the profit and loss account of S Ltd
    as at 01.04.2000 was Rs 12,000
  • H Ltd has accounted for interest and dividends on
    accrual basis.
  • S Ltd did not utilised any pre acquisition profit
    to declare dividends.
  • Fixed Assets of S Ltd were re valued for the
    purpose of acquisition and revaluation surplus
    was Rs 20,000.
  • S Ltd depreciate its fixed Assets at 25 per
    annum on straight line method.
  • You are required to prepare the consolidated
    profit and loss Account for the year ended 31st
    March 2005.


55
Summarised profit and Loss account of the H Ltd
and Its Subsidiary S Ltd for the year ended 31st
March 2006 are given below.

56
  • Additional Information
  • H Ltd acquired 3/4 of the ordinary shares, 3/5 of
    the preference shares and ½ of the debentures of
    S Ltd on 01.04.2005
  • Balance of the profit and loss account of S Ltd
    as at 01.04.2005 was Rs 10,000
  • H Ltd has accounted for interest and dividends on
    accrual basis.
  • S Ltd did not utilised any pre acquisition profit
    to declare dividends.
  • You are required to prepare the consolidated
    profit and loss Account for the year ended 31st
    March 2006.

57
Income Statement for the Publication Purpose
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