Consolidation - Gum Limited - Case Study Example

Running header: Consolidation Student’s name: Instructor’s name: Subject code: Date of submission Abstract This report is aimed at helping the management of Gum limited in deciding whether to prepare consolidated financial statements for itself and a number of investments it owns in accordance to AASB 10. In so doing, the paper begins by introducing the topic of consolidation of financial statements and why companies find it necessary to prepare consolidated financial statements. The report then explains in detail the provision of AASB 10 in regard to control of a parent and its subsidiaries that necessitates the preparation of consolidated financial statements. Each of Gum’s investments have thus been analyzed with an aim of establishing where control lies in a bid to establish which of the investments are Gum’s subsidiaries and hence should form the Gum group. Finally, the report gives a recommendation in respect of the investments for which Gum limited is required to prepare consolidated financial statements. Introduction Companies combine for a number of factors in a bid to improve their performance while pursuing common goals. In other times, companies may be forced to sell some of their stakes to other companies due to the need to raise adequate capital or even be able to clear debts when they are not in a position to do so owing to financial constraints. As they combine, some powers and rights and hence controls are transferred to the investing company hence giving rise to parent companies and subsidiaries. The law requires that the parent companies prepare consolidated financial statements for the group at the end of each trading period. This is done in a bid to present an aggregated look at the parent company’s financial position as well as that of its subsidiaries. This helps the investors therein in gauging the group’s overall financial health as opposed to the health of the individual companies that make up the group. THE REQUIREMENTS OF AASB 10 IN RESPECT OF THE CONTROL CRITERION Companies usually find it worthy combining in a bid to better pursue common goals or increase profitability. In a case where a reporting entity gains control of another entity, it is required to prepare consolidated financial statements in accordance to AASB 10. The standard requires an investor regardless of its involvement’s nature with an entity to determine whether it is a parent through investigating whether it controls the other entity. AASB 10 par.6 states that an entity controls another when it is exposed or has rights to variable returns from its being involved with the other entity while having the ability to affect the returns through its power over the investee. As such, an entity will have control over the other in a number of cases including; First, when the entity has power over the investee: In this regard, power arises from the entity having existing rights which give it current ability to direct the relevant activities that significantly affect the returns of the investee. It is worth noting that determination of power is not straight forward at times. Paragraph 10 and 11 of AASB 10 state that powers arise from rights. Assessing power may be straight forward such as when it is obtained directly and solely from the voting rights granted by equity instruments including shares and could be assessed through consideration of the voting rights from the shareholding. On the other hand, the assessment could be more complex requiring more than one factor to be considered for instance when power arises from contractual agreements. The capacity to exercise power rather than actual exercising of power is considered in considering whether an entity is a subsidiary. Thus, if the entity has current ability to direct the relevant activities, then it has power although its rights of directing have not been exercised. Secondly, when it has exposure or rights, to variable returns from its involvement with the investee (Australian Accounting Standards Board, 2011). Thus when control is deemed to exist, the mount of returns to be derived from interest in another firm is expected to vary with regard to the efforts and performance of both the investor and investee. N entity is therefore said t control another if it not only has power over the other but also since it has the ability to use the power in affecting the investor’s returns from its being involved with the investee. Lastly when it has the ability to use its power over the investee in affecting the amount of returns it gets from the investment. As such, when an entity has decision making rights and hence a principal ought to consolidate their accounts. In this regard, receivers and managers of organizations experiencing financial difficulties would not need to consolidate a controlled entity’s financial statements with own statements since apart from the professional fees they receive, the parties concerned would not be managing the organizations or own benefits but rather on behalf o creditors and owners. AASB 10 also provides that only one party can be in control of an entity before the controlling entity is considered to be the parent of the group. Thus, if the entity jointly controls another one, the entity will not be considered a subsidiary. There a number of situations in which control is deemed to exist including when a majority of voting rights are held by the investing entity. In addition, where an investor holds considerable voting rights in the investee and where less than a majority of the voting rights are held by the investor and where the rest of the balance of the voting rights are widely spread among different owners, then control can be said to exist. Potential voting rights are represented by instruments that have the potential if exercised or converted to give the entity voting power. They include share options, and convertible notes (Australian Government, 2011). Thus, these potential voting rights are considered in considering capacity to control. Control can also be passive or delegated but delegated power is not considered control and hence such an entity would not be required to consolidate its financial statements. The entity in which control lies 1. In this case, Gum has a 25% interest in the share capital of Wattle Pty Ltd with the remaining 75% of the share capital being owned by wattle founders. The founders having no familiarity with the industry and hence have given Gum three seats in the board while the founders have taken two seats. Although Gum takes the lead on all the company’s decisions, the owners closely monitor the business through the two seats they hold on the board. In this case, the majority ownership of the company is held by Mr. and Mrs. Rose given that they own 75% of the company’s shares with only 25% of the shares being held by Gum. Though Gum has majority of shares in the board is held by Gum, the potential voting rights as stated above are determined through assessing the percentage holding in terms of shares. These voting rights determine the level of control that an entity has on the investee. Ideally if the board is to make decisions, Mr. and Mrs. Rose vote would have a weight of 75% while the three seats given to Gum would only have 25% weight. This is notwithstanding the fact that Mr. and Mrs. Rose allow Gum to take the lead on all the company’s decision. According to AASB 10, in deciding whether an entity is a subsidiary, it is not necessary that the investor has actually exercised its power. Thus, in this case, it does not matter that the founders and the majority shareholders do not exercise their power. The fact is that Mr. and Mrs. Rose who are the owners of Wattle Pty Ltd have the control of the company through their 75% shareholding. Hence in this case, control lies with Wattle Pty Limited since the shareholders control 75% of the company’s shareholding. 2. The relationship between Acacia Pty Ltd and Gum has been occasioned by the fact that Acacia owes Gum a lot of money which Acacia has found difficulties in settling. As such, an agreement has been reached for Gum to take control of Acacia finances for five years till the debt is repaid in full. Despite this, Gum has no seat in Acacia board of directors. As such, it is clear that Gum does not have control in Acacia since it does not own any shares in Acacia. According to AASB 10, in assessing control, we assess the existence of potential voting rights and would include shareholdings which will show the firms capacity to control the other. Furthermore, Gum has no seat in the board and hence cannot influence any decision (Carol, 2013). In fact, the board can even vote eject Gum executive from its finances without Gum objecting provided the debt is repaid. In this case therefore, control lies with Acacia Pty limited. 3. In this case, both the companies own 50% shareholding in Box limited and hence they have equal voting rights with equal seats in the board. However, the companies have an arrangement whereby Gum supplies the finances to Box limited on normal commercial terms which is secured using the company’s assets. On the other hand Lily provides management and entrepreneurial flair to Box and hence receives management fee based on net profit after the interest to Gum has been paid. AASB 10 states that only one party can be in control of an entity before that controlling entity can be considered to be the parent company. Where an entity jointly controls another entity, then that entity cannot be considered to be a subsidiary. Based on the potential voting rights therefore, both Gum and Lily jointly control Box limited. As such, no entity can be said to be the parent o Box limited. It should be noted that though Lily is in charge of managing ox Limited, this is an agreement that has been reached by the two company’s where Gum on the other hand supply finance. As such, no company can claim control of Box limited but rather control lies with both the companies. 4. In this case, Gum Trading Trust is owned 100% by the directors of Gum Limited and hence the trust is a fully owned subsidiary of Gum Limited. Furthermore, the income is distributed to the three directors of Gum limited fully. The trust deed also gives full control f the trust to Gum over the operating and financing decisions of the trust. In this case, it can be concluded that Gum has potential control over Gum trust limited through its 100% shareholding. As such, in this case, the control of Gum Trust Limited lies with Gum limited. 5. In this case, Gum holds 75% interest in Orchid Limited that arose after Gum converted a substantial loan it had made to Orchid into equity at the invitation of Orchid since Orchid was trading poorly and hence loans recovery seemed uncertain. Despite this fact, Gum is a passive investor with no seats in Orchid’s board of directors and has no say in financial or operational decisions of Orchid. It can therefore be assumed that Gum has delegated its right to manage the company to the board of Orchid limited bearing in mind that it owns 75% of Orchid’s equity (Paul, 2015). According to AASB 10, delegated authority is not considered control in assessing control. Furthermore, it is clear that Gum has potential voting rights in Orchids up to 75%. As stated above, the issue is not whether an entity has actually exercised its right or potential voting right but rather whether it possesses the potential voting rights. In this case, though Gum chooses not to exercise its power or voting right, it holds the majority of voting rights in Orchids limited. In this case therefore, control lies with Gum limited. Whether consolidation is required Paragraph 2 of AASB 110 requires that an entity that controls one or more other entities (Subsidiaries) to present consolidated financial statements. As such in this case, Gum will only be required to prepare consolidated financial statements where it has control over the other entity and is therefore the parent entity. As such, consolidation will be required as follows; 1. It has been established that although Gum limited exercises delegated/donated control over Wattle Pty Limited, it only has 25% shareholding and hence Wattle Pty Limited with 75% of shareholding is the parent entity. In this case therefore, Gum Pty Limited is not required to prepare consolidated financial statements. This will be the role of Wattle Pty Limited according to AASB 10. 2. In this case, it has been established that Gum Limited has no control over Acacia Pty limited and hence no consolidation is required since no company has invested in the other in terms of potential voting rights (Hove, 2006). 3. In this case, it has been established that both Lily Pty Limited and Gum Pty Limited jointly control Box Pty Limited and hence no company can claim control over the other. Since no company can claim to be a parent entity in this case, no consolidation will be required. 4. In this case, it has been established that although Gum Pty limited does not involve itself with the running of Orchid Pty Limited, it holds the majority potential voting rights and hence it is the parent entity. As such, AASB 10 requires it to prepare consolidated financial statements for the company. 5. In this case, it has been established that Gum Trust Limited is a wholly owned subsidiary of Gum Pty Limited. As such, Gum Pty limited ought to prepare consolidated financial statements in accordance with AASB 10. Conclusion This report has briefly introduced the issue of consolidation of financial statements with an aim of establishing why companies find it necessary to prepare consolidated financial statements. The report has then analyzed the requirements of AASB 10 with an aim of establishing the criteria for deciding whether to prepare consolidated financial statements. This criterion has been used in analyzing all the investments of Gum limited with an aim of establishing where control lies and thereby deciding whether consolidated financial statements should be prepared and who ought to prepare them. It has been concluded that Gum limited should prepare consolidated financial statements in respect to Orchid Pty Limited and Gum Trust Limited since it holds majority shareholding in them and hence it has control over the companies being their parent. This has been done in reference to the criteria set out in AASB 10. References: Australian Accounting Standards Board, 2011, AASB 10: Consolidated financial statements, Retrieved on 14th May 2015, from; http://www.aasb.gov.au/admin/file/content105/c9/AASB10_08-11.pdf Australian Government, 2011, AASB 10, Retrieved on 14th May 2015, from; http://www.comlaw.gov.au/Details/F2014C00495 Carol, M2013, Consolidation: Preparing and understanding consolidated financial statements, London, Rutledge. Paul, M2015, Consolidated financial statements: A step by step approach, Sydney, Prentice Hall. Hove, R2006, Consolidated financial statements, Western Australia, Cengage Learning. Read More