Chapter 5 consolidated

Financial Statements (Part 2)

Intercompany transactions
Intercompany transactions are transactions between a parent and
a subsidiary. The effects of these transactions are eliminated when
preparing consolidated financial statements because the parent and
the subsidiary are viewed as a single reporting entity. This is like the
statement "You cannot transact with your own self." To exemplify,
let me tell you a story.

Story: The Bear Group

During 20x1, Papa Bear buys a pair of sandals for PIOO from
Goldilocks, an unrelated party. The sandals don't fit Papa BeaYs
enormous feet so Papa Bear sells them to Mama Bear for P150.

Question: From the point of view of the Bear Family, how

much 'thousehold income" is realized?

Answer: Obviously, none. The family can't get rich even if the
Papa and the Mama sells to each other all day long! YO

The atries in the separate books of Papa and Mama are as

follows:

The 20x1 year-end individual financial statements of

entities show the following:
Mama
150
Inventory

Sales 150 Cost of sales

(100)
Gross
profit

When the Bear Family's consolidated financial

statements are prepared, the intercompany transaction between
Papa and Mama is eliminated. It is as if the sale never occurred.
InAlCh case,
> the consolidated sales and cost of sales should be zero,
and the consolidated inventory should be measured at
its original cost of PIOO.

Papa recognized a profit of P50. However, this is

considered unrealized (because 'no one can earn profit from
transactions with himself'), and therefore must be eliminated. The profit
 will be recognized only when it is realized — meaning, the inventory is
sold to an unrelated party.
Based on our analyses above, we can draft the
consolidated information as follows:
Consolidated

100
Inventory (0 + 150 - 50 unrealized profit)
Sales (150 + O -150 intercompany sale)
Cost of sales + O - 150 interco. sale + 50 unrealized
profit) Gross profit
Notes:
Both sales and cost ofsales are eliminated at the sale
price even though Papa Bear's cost of sales is stated at
cost. Cost ofsales is adjusted again for the unrealized
profit. This method simplifies the consolidation
process if consolidation entries are prepared (see
'Tradihonal accounting method' below).
If the sale was made on account, the intercompany
accounts receivable and accounts payable shall also
be eliminated. We can reconcile the computed amounts using
formulas:

Sale price of intercompany sale in current year 150

Cost of intercompany sale in current year (100)

Profit from intercompany sale in current year 50

Multiply by: Unsold portion of inventory as of year-
end 100% Unrealized gross profit in ending inventory — current yr.
50

Ending inventory of Parent (Papa Bear)

150
Ending inventory of Subsidiary (Mama Bear)
(50)
Less: Unrealized profit in ending inventory
100 Consolidated endin invento
 150
Sales of Parent (Papa Bear)
of Bear)
(150)

Sales Subsidiary (Mama

Cost of sales of Parent (Papa Bear)

Cost of sales of Subsidiary (Mama Bear) (150)
Less: Intercompany sales during the current period 50
Add: Unrealized profit in ending inventory
The following are the common intercompany transactions that are
eliminated when preparing congolídafcd financial statement"'
Intercompany sale of inventory b, Intercompany
sale of property, plant, and equipment
Intercompany dividends d,
Intercompany bond transactions

Intercompany sale of inventory

Intercompany sales are either:

1, Downstream — the parent sells to the subsidiary

2, Upstream the subsidiary sells to the parent
Parent (Investor)
Downstream Upstream
Subsidia (Investee)
It is important to identify whether an
intercompany sale is downstream or upstream because
only upstream sales affect noncontrolling interests.
The entity that recognizes profit from a sale transaction is the
seller.
 In a downstream sale, the parent recognizes the profit.
NCI is not affected because the profit pertains solely to
the owners of the parent.
In an upstream sale, the subsidiary recognizes the profit.
NCI is affected because the profit pertains to both the
owners of the parent (because Of their interest in the
subsidiary) and the NCI (the other owners of the
subsidiary).

Parent says, "What is mine is mine alone (downstream).

VThatis yours is ours (upstream)."
Intercompany sale of property, plant and equipment
Intercompany sales of property, plant, and equipment are also
identified as either downstream or upstream because only
upstream sales affect non-controlling interests.

Accounting procedures:
a. Any gain or loss is deferred and
i. amortized over the asset's remaining life, if the asset is
depreciable.
ii. not amortized, if the asset is non-depreciable.
b. If the asset is subsequently sold to an unrelated party or
otherwise derecognized, the unamortized balance of the
deferred gain or loss is recognized in profit or loss.
c. In a downstream sale, the gain or loss is adjusted to the
controlling interest only. Therefore, NCI is not affected.
d. In an upstream sale, the adjustments for the gain or loss are
shared between the controlling interest and NCI. Therefor e,
NCI is affected.
 e. The unamortized balance of the deferred gain or los s is
eliminated when consolidated financial statements are
prepared.

Illustration: Consolidation — Intercompany PPE transacti0n

On January 1, 20x1, ABC Co. acquired 800/0 interest in XYZ,

Information on Jan. 1, 20x1 (acquisition date):

XYZ's net idenffiable assets have a carrying amount of
P74,000 and a fair value of P90,000. The difference is due to
the following:

Intercompany dividends
When the investment in subsidiary is measured at cost or in
accordance with PFRS 9, dividends received from the
subsidiary are recognized in profit or loss.
When the investment in subsidiary is measured using
the equity method, dividends received from the subsidiary
are recognized as reduction to the carrying amount of the
investment,
In any case, the dividends must be eliminated when
the consolidated financial statements are prepared. It is as
ifthe parent never received the dividends. Therefore:
a. If the dividends were recognized in profit or loss, eliminate
the dividend income in the consolidated statement of
profit of loss.
b. If the dividends were recognized as reduction to the investment
account, add back the dividends to the investment account.
 Consolidation — Intercompany dividend
transacti0n On January 1, 20x1, ABC acquired 80% interest in
XYZ, Inc•

Information on acquisition date (Jan. 1, 20x1):

• XYZ's net identifiable assets have a carrying amount Of
P74,000 and fair value of P90,000. The difference is due to the
following:
Intercompany bond transaction
When a parent or a subsidiary acquires bonds issued by the other,
both the investment in bonds and the bonds payable are eliminated
in the consolidated financial statements.
The bonds payable are considered extinguished from the
point of view of the group. Therefore:
a. The difference between acquisition cost of the investment
in bonds and the carrying amount of the bonds payable on
the acquisition date is recognized as gain or loss in the
consolidated statement of profit or loss; and
b. Any interest expense and interest income recognized
after the intercompany transaction are eliminated in the
consolidated financial statements.

Illus&ation: Consolidation — Intercompany bond

transaction On January 1, 20x1, ABC acquired 80%
interest in XYZ, Inc.

Infonnation on acquisition date (Jan. 1, 20x1):

• XYZ's net identifiable assets have a carrying
amount of
 P74,000 and fair value of P90,000. The difference is due to the

Fair value
Carrying valueFair ad •ustntent
(FVA) amount
Inventory 20,000 24,000

40,000 52,000
Totals 60,000 76,000

e remaining useful life of the equipment is 6 years.

ABC measured the NCI at 'proportionate share
Chapter 5: Summary
Intercompany sale of inventory

Sale price of intercompany sale in current year

Realized
Cost ofgross profit in beginning
intercompany sale ininventory — current yr,
current year
profit from intercompany sale in current (xx)
year
Multiply by: Unsold portion of invéntory as of year- xx%
end Unrealized gross profit in ending inventory —
current yr.

Sale
Profitprice
fromofintercompany
intercompanysale
saleininprior
prioryear
year
xx
Cost of intercompany
Multiply sale in of
by: Unsold portion prior year as of beg. of
inventory (xx)
xx
yr. %

Ending inventory of Parent

Ending inventory of Subsidiary
 Unrealized profit in ending inventory

Less:
(xx)
Sales of Parent
Sales of Subsidiary
Less: Intercompany sales during the current period (xx)

Cost of sales of Parent

Cost of sales of Subsidiary xx
Less: Intercompany sales during the current period (xx
)
Add: Unrealized profit in ending inventory xx
Less: Realized profit in beginning inventory (x
x)
De eciation of fair value ad'ustment FVA on invento
Consolidated cost o sales
Intercompany sale ofproperty, plant and equipment The
unamortized deferred gain or loss is eliminated consolidated
financial statements are prepared. Intercompany dividend
If the parent recognized the dividend as dividend income
dividend income is eliminated from the consolidated profit or
loss.

Intercompany bond transaction

The bonds are considered extinguished, A gain or loss is
recoglized in the consolidated financial statements.

PROBLEMS:

PROBLEM 1: MULTIPLE CHOICE - THEORY

1. Perez, Inc. owns 80% of Senior, Inc. During 1992, Perez sdd
goods with a 40% gross profit to Senior. Senior sold all
 these goods in 1992. For 1992 consolidated finami
statements, how should the summation of Perez and Senit
income statement items be adjusted?
a. Sales and cost of goods sold should be reduœd by
intercompany sales.
b. Sales and cost of goods sold should be reduced by
80%0t the intercompany sales.
c. Net income should be reduced by 80% of the gross
profit on intercompany sales.
d. No adjustment is necessary.
(Adapted)

2. Water Co. owns 80% of the outstanding common stock

Co. On December 31, 1989, Fire sold equipment to
Wata price in excess of Fire's carryin bgalantusheet a
nt, but less than original cost. On a consolidated at
Decrrnbd3 1989, the carrying amount of the (cost less
depreciation) equipment should be reported at:
a. Water's original cost.
Chapter 6 consolidated
Financial Statements (Part 3)

Leanttng Objectives
1, Account for the effect of impairment of goodwill on the
consolidated financial statements.
Determine the effects of changes in ownership Interests that
(a) result in loss of control and (b) does not result in loss of
control.
3. Describe the importance of consolidation and the
theories su rtin consolidation.
hpairment of Goodwill
When NCI is measured at proportionate share, goodwill is attributed
only to the owners of the parent. Therefore, anv
Impairment of goodwill is also attributed only to the owners of the

When NCI is measured at fair value, goodwill is attributed to

both the owners of the parent and NCI. Therefore, any
impairment of goodwill is allocated to both the owners of the
parent and NCI.

Illus&ation: Impairment of goodwill

January 1, 20x1, ABC acquired 80% interest in XYZ, Inc. by
Issuing 5,000 shares with fair value of P15 per share,

Inþrntati0't on acquisition date (Jan. 1, 20x1):

XYZ's net identifiable assets have a carrying amount of
P74,000 and fair value of The difference is due to the
following:
Consolidated total liabilities
Case #1
( ro ortionate) Case

Total liabilities of ABC co. 73,000 Total liabilities of

XYZ, Inc. 30,000 Consolidated total liabilities
103,000
103,0
Consolidated totale ui
Case #1
Case
( ro ortionate) t2
air value)
Share capital of ABC Co. 170,000 170mo Share premium of
ABC Co. 65,000 65m Retained earnin s (Ste 5) 120,200 120,400
Owners of the parent 355,200 355,400
Non-controlling interests (Step 4) 20,800 21,350 Consolidated total e ui
376,000 376,750
 Intercompany items in-transit and restatements
Each of the group members' individual financial statements
are adjusted first for the following before consolidation:
a. Accruals and deferrals of income and expenses and
corrections of errors;
b. In-transit items — items arising from intercompany
transadioß that were already recorded by one party but not
yet by the other (e.g., intercompany deposits in transit,
outstanding checks, credit memos, and debit memos).
c. Hyperinflationary economy — the financial statements of a
member that reports in a currency of a hyperinflati0M
economy are restated first in accordance with PAS 29 before
they are consolidated. This is discussed in Chapter 9.
d. Currency translations — the financial statements of a
subsidiaq whose functional currency is different from the
groupt presentation currency are translated first in
accordance PAS 21 before they are consolidated. This is
discus$V Chapter 10.
Current accounts (elimination ofnccounts receivable)
Inventory transactions (unrealized profit in ending inventory)
Equipment transaction (unamortized balance ofdeferred logs)
Bond transaction (car ing amount investment in bonds)
Consolidated total assets

Total liabilities Of Peter Co.

Total liabilities of Simon Co,
Fair value adjustments, net
Effect of intercompany transactions:
Current accounts (elimination ofaccounts payable)
Bond transaction (car •n amount ofbonds payable)
Consolidated total liabilities

Share capital of Peter Co.

Consolidated retained earnings (Step 5)
Equity attributable to owners of the parent
Non-controlling interest (Step 4)
Consolidated total e ui

Continuous assessment
 An investor reassesses whether it controls an investee if
circumstances indicate that there are changes to one or
more three elements of control.

Changes in ownership interest not resulting to loss of If

the parent's ownership interest in a subsidiary changes
not result to loss of control, the change is accounted
equity transaction.
The carrying amounts of the controlling controlling
interests are adjusted to reflect the changeS relative
interests in the subsidiary, The difference between

adjustment to the NCI and the fair value of the considerati0n or

received is recognized directly in equity and attributed owners of
the parent. No gain or loss is recognized in profit
ÑnsolidiJtion journal entries are as follows:

NCI
measured at 'ro ortionate share
Case n: N CI measured at air value

Notice in all the 'scenarios' above that no adjustment is

made to goodwill because control is not lost. Instead, all
adjustments are made directly in equity (i.e., NCI and parent's
retained earnings).

Loss of control
A parent can lose control of a subsidiary in much the same way it
can obtain control. That is, with or without a change in absolute
or relative ownership levels and with or without the investor
being involved in that event. Examples:
a. Control is lost even without a change in the parent's ownership
interest when the subsidiary becomes subject to the control of a
government, court, administrator or regulator, or as a result of a
contractual agreement.
b. Control is lost even without the parent being involved in that
event if decision-making rights are given to another party or
the decision-making rights previously granted to the parent
have elapsed.
Control is lost if the parent ceases to be entitled to receive returns.
Control is lost if the parent's previous status as a principal ges
to an agent.
When a parent loses control over a subsidiary, the parent
Shan:
a. Derecognize the assets and liabilities of the former
subsidie from the consolidated statement of financial
position
b. Recognize any investment retained in the former subsid•
its fair value at the date control is lost and subseq—
account for the investment in accordance with relevant
c. Recognize the gain or loss associated with the loss of
in profit or loss. This is attributed to the former
controls interest.

The gain or loss on disposal of controlling interest is

computed follows:

Consideration received (atfair value)

Investment retained in the former subsidiary (at fair
NCI (carrying amount)
Total
Less: Former subsidiary's net identifiable assets (carrytng
 Goodwill (carrying amount)
Gain or loss on disposal of controlling interest
OR

OR

Investment retained in the former subsidiary (atfair 100,00

0
value)
NCI (Cd tn amount - nancial statements) 25,000
Total 20,000
XYZ's net identifiable assets at fair value (130K —
30K)

Consideration received (atfair value)

145,000
Goodwill (sec amsolidated nancial statements) (100,000) Gain or loss on disposal of

controlling interest
Notice that the loss of control is accounted for prospectively.
No retrospective adjustments are made to the consolidated retained
earnings.

Derecognition of other comprehensive income

When control is lost, the parent derecognizes amounts previously

rognized in other comprehensive income (OCI) as follows:
 b. Actuarial gains or losses on defined benefit plans directly in equity
c. Unrealized gains or losses on FVOCI investments directly in equity
d. Translation gains or losses on foreign operations profit or loss
profit or loss
e. Effective portion of cash flow hedges
The first three are accounted for directly in equity (i.e., transferred directly
to retained earnings) because PAS 1
of Financial Statements prohibits the reclassification
adjustment for these items. The last two are transferred to profit
or loss as reclassification adjustments.

Illustraäon: Loss of control — Derecognition of OCI

January 1, 20x1, ABC Co. acquired 80% interest in XYZ, Inc.
On this date, XYZ's net identifiable assets have a fair value
of b0,000. NCI is measured at proportionate share. The
business COmbination resulted to goodwill of P3,000.
Remember the followin
• Consideration less Change in NCI =
Chan e in ownershi interest Does
Direct ad 'ustment ine As sale of
not result to loss of cmtrol
subsidiary:
• Deconsolidate as follows:
Cash (ft"tsideration received)
Results to loss of control
Accountin treatment As Investment retained
an equity transaction: NCI
Goodwill
• No gain or loss is Net identifiable assets Xx
recognized Gain on disposal
Sale of a subsidiary to an associate or joint venture
If a parent loses control of a subsidiary by selling its interest in the
subsidiary to an associate or a joint venture, the gain or loss from the
transaction is recognized in the parent's profit or loss only to the
extent of the unrelated investors' interests in that associate or joint
venture. The remaining part of the gain is eliminated against the
carrying amount of the investment in that associate or joint venture.

Former subsidiary becomes an associate or joint venture

 If the parent retains an investment in the former
subsidiary and the former subsidiary is now an
associate or a joint venture, the parent recognizes the part Of the
gain or IOS resulting from the remeaSurement at fair value of the
investment retained in that former subsidiary in its profit Of loss
only to the extent of the unrelated investors' interests Ill the new
associate or joint venture. The remaining part of that gain is
eliminated against the carrying amount of the investment retained
in the former subsidiary.
subsidiary becomes an associate or joint Venture
If the parent retains an investment in the former subsidiary that is now
accounted for in accordance with PFRs 9, the part of the gain or loss resulting
from the remeasurement at fair value of the investment retained in the former
subsidiary is æognised in full in the parent's profit or loss.

Illustration: Sale of a subsidiary to an associate

ABC Co. owns 100% interest in XYZ, Inc, On January l, 20xl, ABC

Co. sells 70% interest in XYZ, Inc. to DEF Co., an associate of ABC Co.
in which ABC Co. owns 2000 interest. Details on the sale are as follows:

Sale priœ

Carrying amount of the subsidiary's net assets 100,000

Fair value of investment retained in the former
subsidiary 90m
The investment retained in the former subsidiary (XYZ) is dassified as
investment in associate to be accounted for under the equity method.

Step 1: Computefor the total gain

The total gain before the required eliminations is computed as follows:
 Investment

C
ash
Excess of assets over liabilities (i.e. debit balana•). This is in derecognize it.

P200,000 gain above is the amount before the tions required by

PFRS 10.
Excess to be eliminated against carrying amount of ent
in the existing associate (140K — 112K)

28,om The elimination entries are as follows:

The total amount of gain recognized in ABC's profit or loss is (33,600

+ 112,000).

hportance of consolidation
l. Consolidated financial statements provide true and fair view of the
financial position and performance of the group. Users are provided
with a clearer view of the risks and rewards surrounding the group of
entities.
2 It would be burdensome for users to gather together all the
individual financial statements of a parent and its many
subsidiaries in order to get an idea of the financial position
and performanœ of the group, so parent entities are required
to prepare consolidated financial statements.
 Consolidated financial statements lessen the temptation of
hiding certain activities in the subsidiary's or special purpose
entitys (SPE) separate financial statements. Although, a Possible
loophole in consolidated financial statements is that Qrtain
activities Of subsidiaries or SPEs may be buried or Obscured in
the notes. SPEs will be discussed momentarily. COnsoIidated
financial statements eliminate the effects of
fi ons with related entities making the consolidated nanaal
statements more useful than the aggregate of each of e
members' separate financial statements.
Theories of consolidation
Consolidation accounting has evolved over the years. The
supporting thiš evolution are outlined below:
Proprietary theory — this theory focuses on the parent's legal interest
in the subsidiary. Advocates of this concept believe that since the
parent acquires only a portion of the subsidiary, only that portion
should be shown on the COnSOIidated financial statements,
Consequently, non-controlling interes« (NCI) are excluded from
the consolidated financial statements. This concept supports the
"proportionate consolidatiome wherein the consolidated financial
statements include the parent's net identifiable assets plus the
parent's share in the net identifiable assets of the subsidiary.
Similar procedure is applied for income and

b. Parent company theory — this theory focuses on the paren(s

ability to control the subsidiary as a whole and not only up to the
extent of its legal interest in the subsidiary. Advocates of this
concept believe that the subsidiary is an extension of th e parent
company. Therefore, the consolidated finandal statements should
be prepared from the viewpoint of the owners of the parent.
All of the subsidiary's net identifiable assets are included in
the consolidated financial statements, irrespective of the parent's
 ownership interest in the subsidiary. Accordingly' NCI is included
in the consolidated financial statements but not as part of equity.
The following are peculiar characteristics of the parat
company theory.
i. 100% of the subsidiary's net identifiable assets are includéd in
the consolidated financial statementS at carrying amounts plus
the parent's share in the fair adjustments (FVA) at acquisition
date. The NCI's share in FVA is not presented.
ii. NCI is measured at proportionate share and presented as
liability in the consolidated financial statementS•

The subsequent evolution of the parent company theory

changed the presentation from liability to a "mezzanine" line
item, i.e., between liabilities and equity, but neither part of
liabilities nor equity.

Goodwill pertains only to the owners of the parent (also called

'partial goodwill').
Consolidated profit includes only the parent's own profit
plus the parent's share in the subsidiary's profit. The NCI's share
in the subsidiary's profit is deemed an expense. In other words,
consolidated profit pertains only to the owners of the parent.
v. Unrealized gains and losses from upstream sales are eliminated
only up to the extent of the parent's ownership interest in the
subsidiary.

c. Entity theory (Contemporary theory) similar to the parent

company theory, the entity theory is also based on "control."
However, advocates of this concept believe that the parent and the
subsidiary are members of a group (the consolidated entity).
Therefore, consolidated financial statements should be prepared
from the viewpoint of the group rather than of the owners of the
parent.
All of the subsidiary's net identifiable assets are included in
the consolidated financial statements, irrespective of the parent's
ownership interest in the subsidiary, Accordingly, NCI is included
in the consolidated financial statements within equity but separate
from the equity of the owners of the parent.
The following are peculiar characteristics of the entity theory:

i. 100% of the subsidiary's net identifiable assets are included in the

consolidated financial statements at carrying amounts plus the total
FVA at the acquisition date.
NCI is measured at cither proportionate share or fair and
presented in the consolidated financial statemValle within
equity but separate from the equity of the of the parent, iii,
Goodwill pertains to both the owners of the parent NCI (also
called 'full goodwill'), particularly when NCI measured at fair
value,
Consolidated profit combines the parent's subsidiary's profits in
total, irrespective of the parent's ownership interest in the
subsidiary. The consolidated profit is then attributed to the
(a) owners of the parent and (b) NCI. Similar treatment is
made for comprehensive income. In other words,
consolidated profit or comprehensive income pertains to
both the owners of the parent and NCI.
v. Unrealized gains and losses from upstream sales are eliminated in
full.

d. Hybrid theory (Traditional theory) — like the parent company

and entity theories, the hybrid theory is also based on "control." As
the name implies, the hybrid theory incorporates characteristics of
both the parent company theory and the entity theory. However,
the hybrid theory has the following peculiarities:
i. 100% of the subsidiary's net identifiable assets are included
in the consolidated financial statements at carrying amounts
plus the total FVA at the acquisition date.
ii. NCI is measured at proportionate share (i.e., no fair
option) and presented in the consolidated financial
statements within equity but separate from the equity of the
owners of the parent.
 iii. Goodwill pertains only to the owners Of the parent (also called
'partial goodwill'). iv. Consolidated profit combines the parent's
and
subsidiary's profits in total, irrespective of the parent's
ownership interest in the subsidiary. However, the profit
attributable to the NCI is deducted from the combined
profits but not reported as expense. In other words,
Ñnsolidated profit pertains only to the owners of the parent.
Unrealized gains and losses from upstream sales are
eliminated in full.

The current standards require the use of the entity theory.

All our previous discussions are based on this theory.

Historical background
PAS 31 Interests in Joint Ventures, the predecessor of PFRS 11 Joint
Arrangements, required the use of the "proprietary theory" in accounting for
investments in jointly controlled entities. This theory was eliminated in PFRS 11
and PAS 28 Investments in Associates and Joint Ventures.
PAS 22 Business Combinations, which became, effective on
January 1, 1985, supported the "parent company theory." PAS 22 is the
predecessor of PFRS 3 which became effective on April 1, 2004.
The ori§nal PFRS 3 Business Combinations and PAS 27 Consolidated and
Separate Financial Statements initially supported the "hybrid theory."
However, on July 1, 2009, PFRS 3 and PAS 27 were revised. The revised
standards discarded the "hybrid theory" and requires the use of the
"entity theory."
PFRS 10 Consolidated Financial Statements and PFRS 12
Disclosure of interests in other entities which became effective on

January 1, 2013 also support the "entity theory.'

Accounting theories evolve primarily in response to user's

needs. This is in order for financial statements to continually Provide
useful information. Despite the various changes in COnsoIidation
accounting over time, the basic objective remains
the same, and that is to combine the assets, liabilities income, and
expenses of a parent and its subsidiaries. equity,

Advantages and disadvantages of the entity theory The

primary advantage of the entity theory over the other is that the
entity theory provides more relevant rq'resentationally faithful
information to users because of following reasons:
a. The entity theory focuses on the parent's ability to control
subsidiary as a whole and not only up to the extent of its
legal interest in the subsidiary (substance over form). This is
in contrast with the proprietary view.
b. The entity theory adheres better with fair value measurement
because all the-fair value adjustments are incorporated in the
consolidated financial statements. This avoids partial
measurement at fair value and partial measurement at book
value. This is in contrast with the parent company view.
c. Many critics believe that the consideration transferred by the
parent company for its controlling interest is not a valid basis in
valuing NCI. Thus, a measurement choice between
proportionate share and fair value. The entity theory is
consistent with this view. It supports the 'acquisition method
wherein control is obtained with or without any consideration
transferred and with or without the parent involved in the
transaction, The parent company and hybrid theories the
'purchase method,' wherein control is primarily obtained
through a purchase transaction.
d. In contrast with the other three theories, under the entity theory,
the consolidated financial statements pertain to the group and
not just primarily to the parent. Accordingly,
i. Assets, liabilities, equity, income and expenses in the
consolidated financial statements pertain to both controlling
interest and NCI.
ii. Profit or loss and comprehensive income in the consolidated
financial statements pertain to both
 controlling interest and NCI. These are attributed to the
controlling interest and NCI.

A disadvantage of the entity theory is that

m that measuring goodwill at fair value is

.10ant. Goodwill is an unidentifiable ase,«, which makes its
asurement inherently difficult.
illustrations:
illustrations aim to provide CPA 'ditmal learning
materials.

1: Intercompany receivables and payables

to
in Colt'S liabilities
to

¼gitmrnts; Compute for the tolls'S' tng

in Horse's immediately after the
combination,
T'Olasset5 in the consolidated
 in

la): Total
assets of
before the in
subsidiary of 'lone after
the
Answers to requirements:
a. 175,mo•'
b. 383,750"'

Consolidation of a reverse acquisition

The consolidated financial statements prepared after a acquisition
are issued under the name of the legal (accounting acquiree) but
described in the notes as a continualionf the financial statements of the
legal subsidiary (accounting acquirer However, the accounting
acquirer's legal capital is retrospectively adjusted to reflect the
accounting acquiree's legal capital.
Because the consolidated financial statements are continuation
of the accounting acquirer's financial statements except for the capital
structure, the consolidated financial statements reflect:
a. The accounting acquirer's assets and liabilities measured at
carrying amounts plus the accounting acquiree's assets and
liabilities adjusted for the fair value adjustments at acquisition
date.
b. The accounting acquireNs retained earnings and other equity
balances before the business combination.
c. The amount recognized as issued equity interests in the
consolidated financial statements determined by adding the
issued equity interest of the legal subsidiary (accounång
acquirer) outstanding immediately before the busines
 combination to the fair value of the legal parent (accounting
acquiree) determined in accordance with PFRS 3.
However, the equity structure (i.e., the number and type of
equity interests issued) reflects the equity structure Of the legal
parent (the accounting acquiree), including the interests the
legal parent issued to effect the combinatiOn•

Accordingly, the equity structure of the legal subsidiaq (the

accounting acquirer) is restated using the exchange established in
the acquisition agreement to reflect the
of shares or me Legal parent (accounting acquiree) issued in the reverse
acquisition.

d. The non-controlling interest's proportionate share of the legal

subsidiary's (accounting acquirer) preombination carrying
amountS of retained earnings and other equity interests.

Non-controlling interest
A non-controlling interest arises in a reverse acquisition when
some of the owners of the legal acquiree (accounting acquirer) do
not exchange their equity interests for equity interests of the legal
parent (accounting acquiree). Those owners are treated as NCI in
the consolidated financial statements after the reverse acquisition.
The owners of the legal acquiree (accounting acquirer) that do not
exchange their equity interests for equity interests of the legal acquirer
(accounting acquiree) have an interest in only the results and net assets
of the legal acquiree (accounting acquirer) and not in the results and
net assets of the combined entity.
On the other hand, even though the legal acquirer is the acquiree
for accounting purposes, the owners of the legal acquirer
(accounting acquiree) have an interest in the results and net assets of
the combined entity.
The assets and liabilities of the legal acquiree (accounting
acquirer) are measured and recognized in the consolidated financial
statements at their pre-combination carrying amounts. Therefore, in a
 reverse acquisition the NCI reflects the NCI's Proportionate interest in the
pre-combination carrying amounts of the legal acquiree's (accounting
acquirer) net assets.

Illustration: Reverse acquisition - NCI

On January 1, 20x1, Small Co. issues 2.5 shares in exchange for each
ordinary share of Big Co. The fair value of Big Co.'s shares on
January 1, 20x1 is P120 while the fair value of Small Co.'s shares is P48.
ac uisition vs. Reverse a uisition•
Conventional is
ac isition The
Issuer of shares as issuer of shares is the Reverse
consideration accountingacquiær, acquisitio
transferred n

the e
accountingIssuer
Reference to wmbining Accounting
of shares
d)nstituents acquirer/
Legal parent
acquiree
Accounting acquiree/
Legal subsidiary
Accounting
acquirer/ Legal
subsidiary
Accounting
Measurement of Fair value of
consideration acquiree/ Legal
consideration Faiparent
&ansferred
transferred by the r
accounting value of the
equity
notional number of
acquirer.
the
instruments that
(lega
accounting acquirer
l
subsidiary)
would
have had to to
issue
the accounting
acquire
e give (legal parent)
to the owners of
accounting acquiree
the
parent) the same
(leg
percentage
in ownership
althecombined enäty.
Consolidated In the name of the In the name of the
financial accounting acquirer accounting acquiree
statements (legal parent) with
and which is also the legal
 parent. disclosure in the
notes that the
financial
staten ents are a
continuation ofthe
accounting
acquirer's
(legal subsidiary) financial
Consolidated assets Accounting acquirer's statements.
liabilities assets and liabilities at
car in amounts lus Accounting acquire€s
assets and liabilities at
ca in amounts lus
 acquiree's adjusted
assets and liabilities
adjusted for FVAs.
for FVAR

Consolidated
acquirer
retained earnings
and other equity
balances

Consolidated equity The equity instruments The issued equity

instruments of the accounting
acquirer. accounting acquire
ouStanding business
combinnm plus the
fair value of the
consideraåm
effecòvely transferr¿

Non-controlling Arises if accounting Arises if not

inteÑsts acquirer acquires less all the
than 100% interest in accounting
the accounting acquirer's
acquiÑe. shares
exchanged for
accounting
Measured at the
acquiree's shares
NCI's proprtionate
share of accounting
acquire's net assets, NCI's share' of
or atfair value. accountigs
acquixr's net ass
at pNombinaåan
carrving
amounS
No fair value
Special purpose entities
A special purpose entity (SPE) (or special purpose vehicleaspV')Ð a
legal entity created by a sponsor (i.e., another entity on behalf the SPE
was created) to accomplish a narrow and lot defined objective (e.g., to
effect a lease, research and develop activities or a securitization of
 financial assets) for the SPEs are commonly created to isolate the
financial risk. However, SPEs are also used to, among
things hide liabilities, create "cookie jar reserves," obscure
Ñ1ationships between related entities, and avoid tax (when the SPE is
created in tax haven).
Normally, the sponsor frequently transfers assets to the spE,
obtains the right to use assets held by the SPE or performs services
for the SPE, while other parties ('capital providers') may provide the
funding to the SPE. The SPE will then perform tasks (e.g., to finance
a large project, enter into derivative transactions, etc.) for the sponsor;
thereby, reducing the risk to the sponsor

An entity that engages in transactions with an SPE (frequently

the sponsor) may in substance control the SPE This may be true
even if the sponsor owns little or none of the SPE's equity.
The sponsor shall use PFRS 10 in assessing the existence of control
and performing consolidation procedures.

Cha ter 6: Summa

• Impairment of goodwill is:

(a) attributed to the parent only, if NCI is measured at
proportionate share.
(b) attributed to both parent and NCI, if NCI is measured at
fair value.
• A change in the parenes ownership interest in the subsidiary
that:
(a) does not result to loss of control is accounted for as
equity transaction.
(b) results to loss of control is accounted for as
deconsolidation.
The gain or loss on the deconsolidation is computed as
follows:
 Xx
Cash or other assets (Consideration received) Xx Investment account (Int*stment retained) Xx

Xx
Liabilities of former subsidiary
Assets of former subsidiary
Goodwill
Gain on dis salo controllin interest(s ueeze) Xx

OR

Consideration received (atfair value) retained in the former

subsidiary (at fair value)
NCI (carving amount)
Total Xx
Lass Former subsidiary's net identifiable assets (carrying amount) (n)
Goodwill (currying amount) (xx)

Gain or loss on disposal of controllincinterest

• The consolidated financial statements after a reverse acquisition are in the

name of the accounting acquiree but described in the notes as a
continuation of the finandal statements of the accounting acquirer. The
consolidated accounts are computed in a manner similar to a conventional
acquisition except for equity. The number of shares is that Of the
accounüng acquiree but the monetary amount is equal to the accounüng
acquirer's share capital plus the fair value Of the effectively transferred.