DipIFR Syllabus D. Preparation of external financial reports - Definition of a subsidiary - Past Papers ^{1 / 14}

Note 1 – Alpha’s investment in Beta 
On 1 October 2012, Alpha acquired 300 million shares in Beta by means of a share exchange of one share in Alpha for every two shares acquired in Beta. On 1 October 2012, the market value of an Alpha share was $2·40. Alpha incurred directly attributable costs of $2 million on acquisition of Beta. These costs comprised:

– $0·8 million – cost of issuing own shares, debited to Alpha’s share premium account within other components of equity; 
– $1·2 million due diligence costs – included in the carrying amount of the investment in Beta in Alpha’s own statement of financial position.

There has been no change to the carrying amount of this investment in Alpha’s own statement of financial position since 1 October 2012.

On 1 October 2012, the individual financial statements of Beta showed the following reserves balances:

– Retained earnings $125 million. 
– Other components of equity $10 million.

The directors of Alpha carried out a fair value exercise to measure the identifiable assets and liabilities of Beta at 1 October 2012. The following matters emerged:

– Plant and equipment having a carrying amount of $295 million had an estimated market value of $340 million. The estimated remaining useful economic life of this plant at 1 October 2012 was five years. None of this plant and equipment had been disposed of between 1 October 2012 and 30 September 2015.

– An in-process research and development project existed at 1 October 2012 but did not meet the recognition criteria of IAS 38 – Intangible Assets. The fair value of the research and development project at 1 October 2012 was $20 million. The project started to generate economic benefits on 1 October 2013 over an estimated period of four years.

The above two fair value adjustments have not been reflected in the individual financial statements of Beta. In the consolidated financial statements, these fair value adjustments will be regarded as temporary differences for the purposes of computing deferred tax. The rate of deferred tax to apply to temporary differences is 20%.

Alpha uses the proportion of net assets method to calculate non-controlling interests in Beta.

Note 2 – Impairment review of goodwill on acquisition of Beta
No impairment of the goodwill on acquisition of Beta was evident when reviews were carried out on 30 September 2013 and 2014. On 30 September 2015, the directors of Alpha concluded that the recoverable amount of the net assets (including the goodwill) of Beta at that date was $450 million. Beta is regarded as a single cash generating unit for the purpose of measuring goodwill impairment.

Note 3 – Alpha’s investment in Gamma
On 1 October 2014, Alpha acquired 144 million shares in Gamma by means of a cash payment of $125 million. Alpha incurred costs of $1 million associated with this purchase and debited these costs to administrative expenses in its draft statement of profit or loss for the year ended 30 September 2015. There has been no change in the carrying amount of this investment in the financial statements of Alpha since 1 October 2014.

On 1 October 2014, the individual financial statements of Gamma showed the following reserves balances:

– Retained earnings $45 million. 
– Other components of equity $2 million.

On 1 October 2014, the fair values of the net assets of Gamma were the same as their carrying amounts with the exception of some land which had a carrying amount of $100 million and a fair value of $130 million. This land continued to be an asset of Gamma at 30 September 2015. The fair value adjustment has not been reflected in the individual financial statements of Gamma. In the consolidated financial statements, the fair value adjustment will be regarded as a temporary difference for the purposes of computing deferred tax. The rate of deferred tax to apply to temporary differences is 20%.

There was no impairment of the goodwill arising on acquisition of Gamma in the consolidated financial statements at 30 September 2015.

Alpha uses the proportion of net assets method to calculate non-controlling interests in Gamma

Note 4 – Other investments
Apart from its investments in Beta and Gamma, the investments of Alpha included in the statement of financial position at 30 September 2015 are all financial assets which Alpha measures at fair value though other comprehensive income. These other investments are correctly measured in accordance with IFRS 9 – Financial Instruments.

Note 5 – Intra-group sale of inventories 
The inventories of Alpha and Gamma at 30 September 2015 included components purchased from Beta in the last three months of the financial year at a cost of $20 million to Alpha and $16 million to Gamma. Beta supplied these goods to both Alpha and Gamma at a mark-up of 25% on the cost to Beta.

Note 6 – Trade receivables and payables
Group policy is to clear intra-group balances on a given date prior to each year end. All group companies had complied with this policy at 30 September 2015, so at that date there were no outstanding intra-group balances.

Note 7 – Provision 
On 30 September 2015, Alpha finalised the construction of an energy generating facility. The facility has an expected useful economic life of 25 years and Alpha has a legal requirement to decommission the facility at the end of its estimated useful life. The directors of Alpha estimated the costs of this decommissioning to be $34 million – based on prices prevailing at 30 September 2040. At an appropriate discount rate the present value of the cost of decommissioning the facility is $10 million. The directors of Alpha made a provision of $34 million and charged this amount as an operating cost in the financial statements of Alpha for the year ended 30 September 2015.

Note 8 – Long-term borrowings  
On 1 October 2014, Alpha issued 40 million $1 bonds at par. The cost of issuing the bonds was $1 million and this cost was charged as a finance cost for the year ended 30 September 2015. No interest is payable on the bonds but they are redeemable at a large premium which makes their effective finance cost 8% per annum. The bonds are included at a carrying amount of $40 million in the statement of financial position of Alpha at 30 September 2015.

(b) On 15 November 2015, Alpha purchased shares in Theta which gave Alpha a 45% shareholding in Theta. On the same date, Alpha purchased an option which gave Alpha the right to acquire an additional 10% of the shares in Theta from the existing shareholders. This option is exercisable at any time between 15 November 2015 and 30 September 2017 at a price which makes it highly likely the option will be exercised during that period. The directors of Alpha are unsure how to treat Theta in the consolidated financial statements for the year ended 30 September 2016.

Required:  
Advise the directors of Alpha on the appropriate treatment of Theta in the consolidated financial statements for the year ended 30 September 2016 PRIOR to any exercising of the option. (4 marks)

IFRS 3 – Business Combinations – prescribes the method of accounting to be used when an entity (the acquirer) obtains control of a business. Control is not defined in IFRS 3 but a definition is provided in IFRS 10 – Consolidated Financial Statements.

Required:
(i) Define ‘control’ as outlined in IFRS 10. Where relevant, you should provide appropriate explanations for the terms you use in your definition. (4 marks)

Note: Exact wordings NOT required for marks.

Note 1 – Acquisition of Beta
On 1 April 2005, Alpha purchased 80% of the equity shares of Beta and gained control of Beta. Goodwill arising on the acquisition of Beta totalled $80 million. At 1 April 2005, Beta had three cash-generating units and the goodwill on acquisition was allocated to the three units as follows:

– Unit 1 – 40%
– Unit 2 – 35%
– Unit 3 – 25%

No impairment of this goodwill had occurred in the years ended 31 March 2006 to 2013 inclusive. However, in the year ended 31 March 2014, despite Beta making a profit overall, Beta suffered challenging trading conditions. Therefore the directors of Alpha carried out an impairment review on the goodwill at 31 March 2014 and obtained the following results:

None of the assets or liabilities of Beta which Alpha identified on 1 April 2005 remained in the statement of financial position of Beta at 31 March 2013 or 2014. Any impairment of goodwill should be charged to cost of sales.

Alpha measures all non-controlling interests based on their fair values at the date of acquisition of the relevant subsidiary.

Note 2 – Acquisition of Gamma
On 1 July 2013, Alpha acquired 40% of the equity capital of Gamma. The purchase consideration comprised the following:

– An issue of equity shares.
– A cash payment of $65·34 million due on 30 June 2015. On 1 July 2013, Alpha’s borrowing rate was 10% per annum. No entry has yet been made in Alpha’s financial statements regarding this future cash payment.

The other 60% of Gamma’s shares are held by a wide variety of investors, none of whom owns more than 0·5% individually. None of the other shareholders has any arrangements to consult any of the others or make collective decisions. Since 1 July 2013, Alpha has actively participated in establishing the operating and financial policies of Gamma.

When reviewing the net assets of Gamma as at 1 July 2013, the directors of Alpha ascertained the following:

– The properties of Gamma had been revalued at 31 March 2013 and there was no significant difference between their carrying values at 1 July 2013 and their fair values at 31 March 2013.

– The plant and equipment of Gamma had a carrying value at 1 July 2013 of $70 million and a fair value at that date of $78 million. The estimated future useful life of the property, plant and equipment at 1 July 2013 was four years, with zero residual value.

– On 1 July 2013, Gamma was in the process of completing the development of a new method of production which will significantly reduce wastage. As at 1 July 2013, Gamma had recognised an intangible asset of $10 million in its financial statements in respect of this development. The directors of Alpha believed that, as at 1 July 2013, the process had a fair value of $22 million and that the process will produce economic benefits evenly for ten years from 1 January 2014.

– On 1 July 2013, Gamma had a contingent liability which it did not recognise in its own financial statements. This contingent liability still existed, and was still unrecognised by Gamma, at 31 March 2014. As at 1 July 2013, the directors of Alpha believed that the contingent liability had a fair value of $16 million. On 31 March 2014, they reassessed its fair value at $12 million. The reassessment was due to a change in circumstances after 1 July 2013.

The directors of Alpha believe that the facts described in this note mean that Gamma has been a subsidiary of Alpha since 1 July 2013 and wish to consolidate it. Based on the assumption that Gamma is consolidated, no impairment of the goodwill on consolidation is required at 31 March 2014. The profit of Gamma for the year ended 31 March 2014 accrued evenly over the year. However, as noted above, all of the other comprehensive income of Gamma arose after 1 July 2013. Any consolidation adjustments which are necessary as a result of the information given in this note should be regarded as temporary differences for the purpose of computing deferred taxation. The rate of corporate income tax in the jurisdiction in which all three entities are located is 25%.

Note 3 – Presentation of depreciation and amortisation
All depreciation and amortisation charges should be presented as part of cost of sales

Note 4 – Trading between Alpha and Beta
1. Alpha supplies a component to Beta which is used by Beta in its production process. Alpha marks up its cost of production by one-third in arriving at the selling price. In the year ended 31 March 2014, the revenues of Alpha included $30 million in respect of the sale of these components. On 31 March 2014, the inventories of Beta included $6 million. On 31 March 2013, the inventories of Beta included $4·4 million in respect of identical unsold components purchased from Alpha at the same mark up on cost.

2. During the year ended 31 March 2013, Alpha manufactured a machine which was to be used by Beta from 1 April 2013. The costs of manufacture totalled $12 million. On 1 April 2013, Alpha transferred the machine to Beta for an invoiced price of $16 million, including relevant amounts in revenue and cost of sales. Beta included the machine in its property, plant and equipment and depreciated the machine over its estimated useful life of four years, with no residual value.

Any consolidation adjustments which are necessary as a result of the information given in this note should be regarded as temporary differences for the purpose of computing deferred taxation.

Note 5 – Defined benefit retirement benefits plan 
Certain senior executives of Alpha belong to a defined benefit retirement benefits plan. In the financial statements of Alpha, the contributions paid into this plan have been shown as an expense in the statement of profit or loss and other comprehensive income. Relevant information regarding this plan is as follows:

– The pension liability was $60m at 31 March 2013. This liability increased to $68m by 31 March 2014.
– The pension asset was $40m at 31 March 2013. This asset increased to $46m by 31 March 2014.
– The current service cost was $4·5m.
– Alpha’s borrowing rate at 31 March 2014 was 9% per annum. On that date market yields on government bonds were 8% per annum.

The salary costs of the senior executives who belong to this plan are presented in administrative expenses. You should ignore any adjustment to deferred tax as a result of the information included in this note.

Note 6 – Payment of dividends 
On 31 December 2013, Beta paid a dividend of $30 million and Gamma paid a dividend of $20 million. Alpha recognised its share of both dividends in its investment income.

Note 7 – Property revaluations  
It is the policy of the Alpha group to measure freehold properties using the fair value model and all freehold properties were revalued on 31 March 2014. Beta leases all of its properties and all of Beta’s property leases are operating leases. The gains shown in the financial statements of Alpha and Gamma do not take account of the deferred tax implications of the revaluations.

Note 8 – Hedge of future property purchase
On 1 February 2014, Alpha entered into a firm commitment to purchase a property on 31 May 2014 for €40 million. In order to eliminate the impact of currency fluctuations, on 1 February 2014 Alpha entered into a contract to purchase €40 million for $48 million on 31 May 2014. This contract had no cost and Alpha did not record it in the financial statements for the year ended 31 March 2014. On 31 March 2014, the contract had a fair value of $3·6 million (financial asset). Alpha uses hedge accounting whenever permitted by International Financial Reporting Standards. Where a choice of hedge accounting method exists, Alpha uses cash-flow hedge accounting.

You should ignore any adjustment to deferred tax as a result of the information included in this note.

Required:
(a) Discuss the appropriateness of the directors’ view that Gamma became a subsidiary of Alpha on 1 July 2013. (5 marks)

You are the financial controller of Omega, a listed company which prepares consolidated financial statements in accordance with International Financial Reporting Standards (IFRS). The year end of Omega is 31 March and its functional currency is the $. Your managing director, who is not an accountant, has recently prepared a list of questions for you concerning current issues relevant to Omega:

(a) One of my fellow directors has informed me that on 1 January 2014 his spouse acquired a controlling interest in one of our major suppliers, Sigma. He seemed to think that this would have implications for our financial statements. I cannot understand why. Our purchases from Sigma were $1·5 million for each month of our year ended 31 March 2014 and I acknowledge this is a significant amount for us. However, I can’t see how the share purchase on 1 January 2014 affects our financial statements – all the purchases from Sigma were made at normal market rates, so what’s the issue? Please explain this to me and identify any impact on our financial statements. (7 marks)

Required:
Provide answers to the issues raised by the managing director.

Note: The mark allocation is shown against each of the three issues above

Delta is an entity which prepares financial statements to 31 March each year. The functional currency of Delta is the $. During the year ended 31 March 2013 the following events occurred:

(c) On 1 April 2012, the directors of Delta formed a new company, Epsilon. The directors of Delta own all the voting shares in Epsilon. In exercising their votes, the directors of Delta have agreed to act in Delta’s best interests. Epsilon leased an asset from a financial institution and correctly classified this lease as a finance lease. Epsilon immediately leased the asset to Delta on a one year lease. The rentals payable by Delta to Epsilon were set at the same amount as the rentals payable by Epsilon to the financial institution. The terms of the lease from Epsilon to Delta gave Delta the option to extend the lease under exactly the same terms. This extension option will continue to be available on an annual basis until the lease between Epsilon and the financial institution expires. The asset is a vital one in Delta’s production process. Epsilon does not undertake any other transactions. (6 marks)

Required: 
Explain and show (where possible by quantifying amounts) how the three events would be reported in the financial statements of Delta for the year ended 31 March 2013.

Note: The mark allocation is shown against each of the three events above.