top stories

Share

by Ronnie Patton 26 Oct 2004 Diploma in Financial Management Relevant to Module A

This article is complementary to the 'Joint Forces' article published in the previous issue of finance matters (Issue 60). The first article considered the different types of investments which one company might make in another, and described the appropriate accounting treatments. The purpose of this article is to demonstrate the techniques used when applying the accounting treatments.

The best way to do this is through worked examples. The following facts are common to each of the examples below.

On 1 August 2002, Over Ltd bought shares in Under Ltd. The balance on the profit and loss account of Under Ltd at that date was £220,000. Both companies prepare accounts to 31 July each year. The accounts for the year to 31 July 2004 are summarised below:

Profit and loss account for the year ended 31 July 2004

	Over £000	Under £000
Turnover	758	340
Cost of sales	285	148
Gross profit	473	192
Expenses	274	105
Operating profit	199	87

Balance sheet at 31 July 2004

	Over £000	Under £000
Tangible fixed assets	1,842	445
Investment in Under	400
Current assets	528	127
Creditors: amounts falling due in less than 1 year	(315)	(95)
Net current assets	213	32
Creditors: amounts falling due in more than one year	(120)	(27)
Total net assets	2,335	450
Share capital (in £1 shares)	1,200	50
Profit and loss account	1,135	400
	2,335	450

Goodwill on the acquisition of the shares in Under is to be amortised over ten years.

Example 1
Over has taken control of Under by acquiring 75% of the shares, and controls the board of directors.

Calculation 1 - goodwill
Goodwill is defined as the difference between the cost of the investment and the value of the net assets which were acquired. The cost is reported in the balance sheet of the investor: £400,000.

To calculate the value of the net assets acquired, we need to reconstruct the capital and reserves section of the balance sheet of the investee at the date of the acquisition. As there is nothing to suggest that any additional shares have been issued by Under, we can assume that the shares on issue at the date of the acquisition is the same as the balance sheet value at 31 July 2004, ie £50,000.

In this case, the information includes the balance on the profit and loss account: £220,000. (In some questions it may be necessary to deduce the balance on the profit and loss account by deducting the profit since the date of the acquisition from the balance sheet value.)

This means that at the date of acquisition, the net assets were financed as follows:

	£000
Share capital	50.00
Profit and loss account	220.00
Total	270.00	= value of net assets

Over acquired 75% of the shares, so the value of the net assets acquired was:
£270,000 x
75% £202,500

Therefore the goodwill on acquisition is:

	£000
Cost of investment	400.00
less Value of net assets acquired	202.50
	197.50

• This gives rise to an annual amortisation charge of £19,750.
• As the shares were acquired two years ago, the amortisation to date is £39,500 (two years at £19,750 per annum).
• The value of unamortised goodwill at 31 July 2004 is £158,000.

Calculation 2 - consolidated reserves
The reserves reported on the consolidated balance sheet will be made up of three elements:

• retained profits of the investor
  plus
• group share of the retained profit of the investee since the acquisition
  less
• goodwill amortised to date.

These figures are:

	£000
Retained profits of Over1	1,135.00
Profits of Under since the acquisition: at 31 July 2004	400.00
at acquisition	220.00
thus since acquisition	180.00
Group share (75%)	135.00
	1,270.00
less Goodwill amortised to date2	39.50
Group retained profits	1,230.50

Notes:

1. From the balance sheet
2. From calculation 1

As Over acquired only 75% of the shares, the remaining 25% share is held by outside interests. This is reflected in the figure for minority interests. It is important to remember two things about the minority interest. First, this amount is only reported if the investee is a subsidiary - it is not included if the investee is an associate. Secondly, the calculation is carried out at the balance sheet date.

Calculation 3 - minority interest
The value of net assets of Under at 31 July 2004 is £450,000. As 25% is owned by outside interests, the value of the minority interest is £112,500.

Consolidation process - subsidiary
It is perhaps easiest to prepare the consolidated balance sheet first, followed by the consolidated profit and loss account.

Over Group Ltd: consolidated balance sheet as at 31 July 2004

	£000
Fixed assets1	2,287.0
Goodwill2	158.0
Current assets3	655.0
Creditors: amounts falling due within 1 year4	(410.0)
Net current assets5	245.0
Creditors: amounts falling due after more than 1 year6	(147.0)
	2,543.0
Share capital7	1,200.0
Profit and loss account8	1,230.5
	2,430.5
Minority interest9	112.5
	2,543.0

Notes (Workings £000):

1. Over 1,842 + Under 445
2. Unamortised - calculation 1
3. Over 528 + Under 127
4. Over 315 + Under 95
5. 655 - 410
6. Over 120 + Under 27
7. NB investor only!
8. Calculation 2
9. Calculation 3

Consolidated profit and loss account for year ended 31 July 2004

	£000
Turnover1	1,098.00
Cost of sales2	433.00
Gross profit3	665.00
Expenses4	398.75
Operating profit5	266.25
Minority interest6	21.75
Profit for year7	244.50
Retained profit b/f8	986.00
Retained profit c/f9	1,230.50

Notes (Workings £000):

1. Over 758 + Under 340
2. Over 285 + Under 148
3. 1,098 - 433
4. Over 274 + Under 105 + goodwill 19.75
5. 665 - 398.75
6. Under operating profit x 25%
7. 266.25 - 21.75
8. Calculation 4
9. Calculation 2

From the above it can be seen that the consolidated profit and loss account is obtained by adding the results for the two companies together, and including the relevant amounts for:

• annual amortisation of goodwill - this should be included as an expense
• minority interest - this is the minority share of the profit after tax (tax has not been included in our example, hence operating profit is the same figure as profit after tax).

Calculation 4 - retained profit brought forward
The value of the consolidated profit and loss account brought forward can be calculated as the balancing figure between the profit for the year and the consolidated profit and loss carried forward. However, in an exam, it may be necessary to demonstrate your understanding by showing how this figure is made up. Essentially this means that calculation 2 must be reproduced using the values from one year before. Thus we have:

	£000
Retained profits of Over 31 July 20041	1,135.00
less retained profit for year2	199.00
retained profits of Over at 31 July 2003	936.00
Profits of Under since the acquisition:
at 31 July 2004	400.00
at acquisition	220.00
thus since acquisition	180.00
year to 31 July 2004	87.00
to 31 July 2003	93.00
Group share (75%)	69.75
	1,005.75
less goodwill amortised to 31 July 20033	19.75
Group retained profits at 31 July 2003	986.00

Notes:

1. From balance sheet
2. From profit and loss
3. From calculation 1

Example 2
Over has acquired a significant influence on Under by acquiring 35% of the shares, and has representation on the board of directors.

Calculation 1 - goodwill
The value of the net assets at the date of acquisition is calculated in the same way as in Example 1:

	£
Share capital	50,000
Profit and loss account	220,000
Total	270,000	= value of net assets

In this case, Over acquired 35% of the shares, so the value of the net assets acquired was:
£270,000 x
35% £94,500

Therefore the goodwill on acquisition is:

	£
Cost of investment	400,000
less value of net assets acquired	94,500
	305,500

This gives rise to an annual amortisation charge of £30,550. As the shares were acquired two years ago, the amortisation to date is £61,100. The value of unamortised goodwill at 31 July 2004 is £244,400.

Calculation 2 - consolidated reserves
The calculation is structured in the same way as in example 1, but care must be taken to include the correct share of the profit of the investee and the correct charge for goodwill:

	£
Retained profits of Over1	1,135.00
Profits of Under since the acquisition:
at 31 July 2004	400.00
at acquisition	220.00
thus since acquisition	180.00
Group share (35%)	63.00
	1,198.00
less Goodwill amortised to date2	61.10
Group retained profits	1,136.90

Notes:

1. From balance sheet
2. From calculation 1

Calculation 3 - balance sheet value of associate

	£
Net assets of Under	450,000
Group share	157,500
add Unamortised goodwill1	244,400
	401,900

Note:

1. From calculation 1

Consolidation process - associate
Remember there is no need for minority interest because:

• only the group share of the profit of the associate is included in the profit and loss account
• only the group share of the net assets of the associate is brought into the balance sheet
• the associate will only be reflected in one line on each of the profit and loss account and balance sheet.

Over Group Ltd: consolidated balance sheet as at 31 July 2004

	£000
Fixed assets1	1,842.00
Interest in Associate2	401.90
Current assets3	528.00
Creditors: amounts falling due within 1 year4	(315.00)
Net current assets5	213.00
Creditors: amounts falling after more than 1 year6	(120.00)
	2,336.90
Share capital7	1,200.00
Profit and loss account8	1,136.90
	2,336.90

Notes (Workings, £000):

1. Over only
2. Calculation 3
3. Over only
4. Over only
5. 528 - 213
6. Over only
7. NB investor only!
8. Calculation 2

Consolidated profit and loss account for year ended 31 July 2004

	£000
Turnover1	758.00
Cost of sales2	285.00
Gross profit3	473.00
Expenses4	304.55
Operating profit5	168.45
Share of operating profit in associate6	30.45
Profit for year7	198.90
Retained profit b/f8	938.00
Retained profit c/f9	1,136.90

Notes (Workings, £000):

1. Over only
2. Over only
3. 758 - 285
4. Over 274 + goodwill 30.55
5. 473 - 304.55
6. 87 x 35%
7. 266.25 - 21.75
8. Calculation 4
9. Calculation 2

Calculation 4 - retained profit brought forward
The retained profit forward can be calculated as follows:

	£000
Retained profits of Over 31 July 20041	1,135.00
from balance sheet less retained profit for year2	199.00
from profit and loss retained profits of Over at 31 July 2003	936.00
Profits of Under since the acquisition: at 31 July 2004	400.00
at acquisition	220.00
thus since acquisition	180.00
year to 31 July 2004	87.00
to 31 July 2003	93.00
Group share (35%)	32.55
	968.55
less Goodwill amortised to 31 July 20033	30.55
from calculation 1
Group retained profits at 31 July 2003	938.00

Notes:

1. From balance sheet
2. From profit and loss
3. From calculation 1

Ronnie Patton is examiner for Module A of the Diploma in Financial Management

Back to top