THE INSTITUTE OF CHARTERED ACCOUNTANTS OF SCOTLAND

FINANCIAL REPORTING

CONTENTS Page
ACCOUNTING FOR INVESTMENTS...........................................................................1 15.1 INTRODUCTION...................................................................................................1 15.2 OBJECTIVES..........................................................................................................1 15.3 INITIAL RECORDING OF AN INVESTMENT ..................................................1 15.4 ACCOUNTING IN THE INVESTORS OWN ACCOUNTS................................4 15.5 INVESTMENTS GIVING CONTROL OR INFLUENCE.....................................5 15.6 REQUIREMENT FOR ADDITIONAL INFORMATION.....................................7 15.7 LEGAL AND PROFESSIONAL REQUIREMENTS FOR GROUP ACCOUNTS ........................................................................................................................................10 15.8 OBJECTIVES AND FORM OF GROUP ACCOUNTS.......................................10 15.9 ASSOCIATE COMPANIES AND JOINT VENTURES......................................12 15.20 SIMPLE INVESTMENT IN GROUP ACCOUNTS...........................................12 15.10 SUMMARY.........................................................................................................13

ICAS 7

TPS FINANCIAL REPORTING

MODULE 15

ACCOUNTING FOR INVESTMENTS

15.1 INTRODUCTION
Many companies make investments by buying shares in other companies. These investments can be at different levels (eg 1%, 10%, 25%, 80%, 100% of the shares of the other company) which give different degrees of power. Specific accounting methods and requirements have arisen for dealing with these different levels of investment. These are contained in a number of accounting standards.

notes

15.2 OBJECTIVES
After completing this module you should be able to: 1. record an investment in an individual companys own accounts; 2. describe the deficiencies of individual accounts in dealing with subsidiaries; 3. outline alternative methods of accounting for subsidiaries and the method required by accounting standards; This module acts only as an introduction to this topic. More formal definitions, scrutiny of standards and application of techniques will be covered in subsequent modules on group accounting.

15.3 INITIAL RECORDING OF AN INVESTMENT

An investment arises when one company (the investor) buys shares in another company or undertaking (the investee). The investor is acquiring a new asset and will have to pay for this (the payment is often referred to as the consideration). The basic double-entry is: Dr Investment Cr Bank (or other form of consideration) Example 1 Alpha Ltd buys 25,000 1 ordinary shares of Beta Ltd at 4 each for cash. This will be recorded in the accounts of Alpha as: Dr 100,000 Cr 100,000

Investment in Beta Ltd Bank being investment in Beta.

Note that although the nominal value of the shares is 1 the price paid for each share is 4. The price that a buyer is willing to pay depends on many factors including:
1

MODULE 15

TPS FINANCIAL REPORTING

notes

the

the investors perceptions of the future prospects of investee the net assets of the investee the past trading record of the investee possible synergies between the two parties

TPS FINANCIAL REPORTING

MODULE 15

If one company pays for the shares in another by issuing new ordinary shares of its own then the credit entry would be to share capital (and usually also share premium). Assume that Alpha issues 20,000 of its 25p ordinary shares to acquire the 25,000 ordinary shares in Beta (the market value of each Alpha 25p share is 5). The entry would be: Dr Investment Cr Share capital Cr Share premium 100,000 5,000 95,000

notes

being issue of ordinary shares to acquire shares in Beta. The shares have cost Alpha the same (100,000) but the cost has been funded by the issue of shares rather than cash. The relevant figure for the investment is 100,000 as that is the value of the shares given by Alpha. A combination of types of consideration can be given eg cash, debentures, preference shares, ordinary shares. The shares in the investee are usually bought from existing shareholders (perhaps through the stock exchange). It is important to realise that the investees balance sheet is unaffected as the transaction is between the investor and the existing shareholders of the investee. All the investee has to do is record the change in its register of members. Shareholders of Investor Shares in investee Consideration Investor Co. Investee Co. Shareholders of Investee

Investor buys shares from existing shareholders. Once the investment has been made the investor must decide how to classify it in its balance sheet. If the intention is to retain the investment only for the short term then it should be classified as a current asset investment, otherwise it will be a non-current investment. You will be able to achieve the first learning objective of the module.

MODULE 15

TPS FINANCIAL REPORTING

notes

15.4 ACCOUNTING IN THE INVESTORS OWN ACCOUNTS

Balance sheet the investment initially is recorded at cost until either it is sold or an impairment occurs when it should be written down. Cost includes directly attributable acquisition costs. The investment can remain at this amount or can be accounted for under IAS 39 i.e. revalued to fair value every year (refer to module 7). Profit and loss account only dividends received and receivable will be included as these are the amounts that are realised from the investors point of view. It is prudent to record only dividends actually received, but if a dividend has been declared by the investee but has not been received it would normally be accrued as a dividend receivable. The journal entry is: Dr Bank (for dividends received) Debtors (for dividends receivable) Cr Profit and loss investment income being recording of investment income The above treatment should be adopted in the investor companys own accounts irrespective of the level or the classification of investment in the other company. Example 2 Gamma Ltd owns 100% of the ordinary shares of Delta Ltd. Delta paid a dividend of 65,000 on 15 October 2005 and declared a dividend of 110,000 at 31 December 2005. The directors of Gamma Ltd are confident that the dividend will be paid and have no intention of selling the shares in Delta Ltd.
Required: What accounting entries will be made by Gamma Ltd for the year to 31 December 2005?

15.10.05 Dr Bank 65,000 Cr P/L investment income being dividend received 31.12.05 Dr Debtors dividends receivable110,000 Cr P/L investment income being accrued dividends receivable

65,000

110,000

TPS FINANCIAL REPORTING

MODULE 15

15.5 INVESTMENTS GIVING CONTROL OR INFLUENCE

Any additional accounting requirements for investments will depend on the relationship between the investor and the investee. The relationship between the two will be determined by the degree of control or influence the investor has over the investee. This is usually linked to the percentage shareholding. There are four levels or categories of investment: (i) (ii) (iii) (iv) (i) ordinary investment investment in an associate investment in a joint venture investment in a subsidiary Ordinary or simple investment Where the investor does not exercise significant influence over the operating and financial policies of the other entity. This is normally a holding of less than 20%. Investment in an associate Where the investor does exercise significant influence over the operating and financial policies of the other entity, which is normally through holdings of 20% or more, but less than 50%.

notes

(ii)

(iii) Investment in a joint venture Where the investor shares control (through a contractual arrangement) jointly with others. (iv) Investment in a subsidiary Where the investor controls the operating and financial policies of the other entity, normally through holdings of more than 50%. Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. This usually arises through owning over 50% of the voting shares (normally the ordinary shares) in the company. By having the majority of votes a majority of the board of directors can be appointed by the investor and this gives day-to-day control. There are other ways of securing control which are dealt with in a later module on group accounting. An investor may have joint control through a contractual arrangement with one or more other venturers. Here all the venturers will have to agree on key operating and financial policies. No single joint venturer is in a position to control unilaterally the enterprise. Significant influence is the power to participate in the operating and financial policy decisions of entity, but is not control of these. Over time the investee will generally implement policies that are consistent with the strategy of the investor and avoid implementing policies that are contrary to the investors interests. This degree of influence usually arises from
5

MODULE 15

TPS FINANCIAL REPORTING

notes

holding between 20% and 50% of the shares of the other entity. The investor usually has at least one representative on the board of the investee.

TPS FINANCIAL REPORTING

MODULE 15

15.6 REQUIREMENT FOR ADDITIONAL INFORMATION

Most investments held by commercial companies are in subsidiaries. As mentioned above, a subsidiary is controlled by the investing company which is referred to as the parent or holding company. In this situation it is possible for the directors of the parent to effectively hide significant information from the shareholders. Example 3 Consider the following parent company balance sheet of BP plc at 31 December 2004. The reported turnover for 2004 was $294,849 million (BP reports in US $). Identify three unusual aspects of the balance sheet. Commentary 1. BP plc had no tangible fixed assets - what about the oil rigs, refineries, petrochemical works, petrol stations vehicles, offices etc? Where are they? Does BP not own or control any? This zero tangible fixed assets figure can be contrasted to over $87 billion of investments. How did BP generate over $294 billion of turnover with no tangible fixed assets? There also appears to be no stock. Were all BP filling stations empty on 31 December 2004? Was there no refining being done? Relatively few creditors and no finance debt. Of total assets of over $89 billion only $9.5 billion was financed by creditors (and almost all of this was trade creditors).

notes

2.

3.

How can we make sense of the situation? BP plc is the parent company which controls a large number of subsidiaries and, in common with many other listed parent companies, is little more than an investment holding company. Operational activities are carried out through subsidiary companies. The parent company sets strategy and monitors performance but the actual operations take place in the subsidiaries. If the shareholders of BP were to receive only the accounts of the holding company they would not have full information about the assets and liabilities controlled and operated by their company and its directors. They could not properly hold the directors accountable for the performance obtained from the use of these assets. They would see zero fixed assets and stock in the balance sheet. They would also have limited information about the financial performance for the period - the main item they would see would be dividends. The turnover, operating expenses and operating
7

MODULE 15

TPS FINANCIAL REPORTING

notes

profit of the group would not be apparent. To rectify this situation there is a requirement for companies which have subsidiaries to prepare, in addition to their own individual accounts, a set of group accounts which effectively combine the accounts of the parent and its subsidiaries as if they were one company. The effect of this can be dramatic.

TPS FINANCIAL REPORTING

MODULE 15

Below is the group balance sheet from BP plc for 2004. Note that: 1. Instead of there being no tangible fixed assets there is over $96 billion in the group. In addition there is over $12bn of intangible fixed assets mostly relating to oil and gas exploration. BP has not run out of fuel. There is $15.7 billion of stock. Total assets are $191.1 billion (over twice the previous figure) and liabilities are over $114bn (almost 12 times the parent company figure!).

notes

2. 3.

These differences arise, not from errors in the BP plc parent company accounts, but from the group structure that BP has adopted and illustrates the need to look beyond the parent company where a number of companies are under common control. We can see from note 46 to BPs accounts (next page) that BP identifies 46 of its more important subsidiaries (all but two of which are 100% owned) see next page. It is in these companies that the principal assets, liabilities and operations lie. Without group accounts this information would be hidden from the ultimate owners, the shareholders of BP plc, who would be unaware of the extent of the assets under the control of the directors whom they elect to represent their interests. All they see is the cost of acquiring or setting up the subsidiaries not what actual assets and liabilities the group has control of at each balance sheet date. The shareholders can use the group profit and loss account to judge whether a reasonable return has been earned on the group assets. You will now be able to achieve the second learning objective.

MODULE 15

TPS FINANCIAL REPORTING

notes

15.7 LEGAL AND PROFESSIONAL REQUIREMENTS FOR GROUP ACCOUNTS

A group is a parent and all its subsidiaries. The problem of accounting for groups only arose when businesses started operating as groups. This occurred firstly in the USA and around the time of the First World War in the UK. Nobel Industries (the forerunner of ICI) in 1920 was the first company in the UK to draw up a consolidated balance sheet. The Stock Exchange required the publication of consolidated accounts for new issuers of shares in 1939. The first legislative requirement was in 1947 and successive Companies Acts have continued and extended the requirements. Current statutory requirements are in the CA 1985. Section 227 (1) requires a company to prepare group accounts if it is a parent company at the end of a financial year. A parent adopting IAS is required by IAS 27 Consolidated and separate financial statements, to prepare consolidated financial statements (with certain exceptions). There are a number of other IASs which deal wholly or partly with group accounting issue. These include IAS 21, 27, 28, 31 and 39 and IFRS 3. These will be covered in relevent modules.

15.8 OBJECTIVES AND FORM OF GROUP ACCOUNTS

The overall objective is to present the results and state of affairs of the group as if they were those of a single entity. Group accounts are designed to extend the reporting entity to include other entities that are subject to the control of the holding company. This involves treating the net assets and activities of subsidiaries held by the holding (or parent) company as if they were part of the holding companys own net assets and activities. This is achieved by a process of consolidation. Consolidation is a technique which requires that individual assets, liabilities, income, expenses etc of parent and subsidiaries are added together on a line by basis to give aggregates for the group. There are principal variations: (i) the the line two

Proportional consolidation When the investor holds less than 100% of a subsidiary, only the investors share of the items is included. Full consolidation The investor includes 100% of the items in its consolidated financial statements. Where the investors ownership is less than 100% of the

(ii)

10

TPS FINANCIAL REPORTING

MODULE 15

shares, all of the assets etc are included and a minority interest is recognised. This minority interest represents the share of the assets, liabilities, profit etc that are attributable to other owners outside the group.

notes

11

MODULE 15

TPS FINANCIAL REPORTING

notes

IAS 27 requires full consolidation of subsidiaries. The principal reason for this is that the full method discloses all of the assets, liabilities, profits and losses that are under the control of the group directors and for which they should be held accountable. From now on the term consolidation or consolidated or group accounts will imply the full consolidation approach. You should now be able to achieve the third learning objective.

15.9 ASSOCIATE COMPANIES AND JOINT VENTURES

Associates are accounted for in group accounts using the equity accounting method. Joint ventures can be accounted for using proportional consolidation or equity accounting. Both of these are dealt with in module 18.

15.20 SIMPLE INVESTMENT IN GROUP ACCOUNTS

While subsidiaries, joint ventures and associates are dealt with differently in group accounts as compared with individual accounts, simple investments are dealt with in the same way in both ie, held at cost (or fair value) in balance sheet and only dividends received and receivable in the income statement.

12

TPS FINANCIAL REPORTING

MODULE 15

15.10 SUMMARY
Accounting for Investments

notes

In parent's individual books

In group accounts

13

MODULE 15

TPS FINANCIAL REPORTING

notes

B/S
Dr Investment
(their shares) X

Cr whatever you pay with X (eg Bank Share capital Share premium Debentures)

Control Subsidiary Full consolidation

Joint control Significant influence Joint venture Associate Proportional consolidation or Equity a/c Equity a/c

Little/ No influence B/S: Inv @ Cost P/L: Div income

14

TPS FINANCIAL REPORTING

MODULE 15

notes

15