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loss making subsidiaries – consolidation

1 September 2010 10,177 views 14 Comments

Hi,

my company has a subsidiary which is loss making. The capital has been fully consumed with accumulated losses. In consolidation, we have accounted for the losses. Now we are closing the company. What is the accounting treatment for the investment? in consolidation, this is offset against capital. How to account fo the write-off of the investment in consolidation?

thank you for your suggestion

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14 Comments »

  • ifrslist
    ifrslist said:

    Loss making subsidiaries – consolidation – http://www.ifrslist.com/2010/09/loss-mak...
    via Twitoaster

  • Mladek said:

    Is the “subsidiary” a cash generating unit / group of units, or is it a part of cash generating unit?

    If the “subsidiary” is a cash generating unit (group of units), has it been tested for impairment as required by IAS 36?

    If it has, then IFRS 5.30-37 provides fairly clear, step-by-step instructions on how to deal with discontinued operations.

    Also, based on your question, it is not clear that “subsidiary” has been consolidated in a manner consistent with IFRS.

    In the past, has the following procedure been used:

    The entity combined the financial statements of the parent and the subsidiary line by line by adding together like items of assets, liabilities, equity, income and expenses.

    The carrying amount of the parent’s investment in each subsidiary and the parent’s portion of equity of each subsidiary was eliminated.

  • xavier (author) said:

    dear,
    the subsidiary is a cash generating unit and has been consolidated line by line as per IFRS requirements. The carrying amount of investement and portion of equity were eliminated.
    All assets of the subsidiary were fully depreciated.

  • Mladek said:

    I guess I don’t understand the question.

    If all the assets are fully depreciated (to zero, I assume), there shouldn’t be anything left to consolidate or write off.

  • patriciawalters said:

    We need more information, but in the meantime, I’ll make some assumptions.

    Assumption 1: This is a wholly owned subsidiary. Therefore, you could either sell the shares or you could sell any remaining assets. It’s possible that there are liabilities that a buyer would need to assume. Or you could abandon it.

    Assumption 2: You are going to sell the subsidiary. Therefore, you need to assess under IFRS 5 whether you have a discontinued operations, are eligible to classify assets (or disposal group) as held for sale. If either is true, you need to test the assets for impairment (as suggested by previous commenter) and reclassify to the lower of carrying value or fair value less cost to sell. If any assets are depreciable, you stop recording depreciation.

    So, we need to know whether this is really a subsidiary (separate legal entity and you own all shares or a controlling interest) or is this simply an operation and you have assets to dispose of.

    Regards
    Patricia Walters

  • Mladek said:

    Xavier, if you choose to responded to the previous comment, please bear in mind that being a separate “legal” entity is not a prerequisite to being a subsidiary as per IFRS. Since IFRS seeks to address the economic substance of transactions (rather than merely their legal form) it explicitly avoids reference to “legal entities”, “juristic persons” or other non-human entities regarded to have the status of a person by the particular law of a particular country.

    Also, you stated: “All assets of the subsidiary were fully depreciated”. Since, in most countries, this means their carrying amount is zero, an impairment test is not relevant. But, please correct me if you meant something else by the term “fully depreciated”.

    The reason I mention it is that, if the above is true and if the subsidiary were sold (rather than abandoned), this would be evidence of fraud or (more likely) error.

    In other words, selling a subsidiary whose assets have no value is (without false representation) quite difficult. On the other hand, selling a subsidiary whose assets (including intangible assets) have not been depreciated properly is fairly easy.

    Problem is, doing so allows the company to recognize the hidden reserve it created by using unrealistic depreciation assumptions.

    Thus, if the subsidiary were sold, the first step would not be an impairment test (since there is nothing left to impair) but rather a correction of a mistake in applying accounting policies (primarily IAS 16.50, 51 and 56, and possibly IAS 16.60 and 61, or IAS 38.97 and 104, etc.) as per IAS 8.42.

    Therefore, there are two possibilities.

    One, the subsidiary is to be abandoned.

    Since its assets are (as stated) fully depreciated (carrying amount zero) there are no line-by-line assets to add up. Since its capital has been “fully consumed”, there is nothing left eliminate against the parent’s investment in the subsidiary.

    I suppose that the parent could keep operating the subsidiary so keep generating more losses, but that would not make much sense.

    As to IFRS 5, paragraph IAS 5.13 states: “An entity shall not classify as held for sale a non-current asset (or disposal group) that is to be abandoned.” …

    So, about the only thing left that could be disclosed on the consolidated balance sheet are the liabilities that parent has to assume, if it has to assume any (though no liabilities were mentioned).

    Two, the subsidiary is to be sold.

    In this case, the consolidated entity would correct its prior period error(s), by restating those periods. Then it would “disclose:

    “(a) a single amount in the statement of comprehensive income comprising the total of:

    “(i) the post-tax profit or loss of discontinued operations and

    “(ii) the post-tax gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of the assets or disposal group(s) constituting the discontinued operation. …”

  • patriciawalters said:

    My first comment is a response to Mladek’s comment of “fully depreciated assets.”

    “Fully depreciated” and “Having no value” are not the same.

    Residual values are estimates. Estimates are adjusted prospectively.

    The best estimate of residual value ex ante might be greater than or equal to zero. Regardless, the amount someone else is willing to pay for the asset can be different. This isn’t fraud or an error (in the sense of “retrospective correction of an error). The selling price itself essentially corrects the estimate.

    Let’s say we had an asset with an estimated useful life of 5 years and a estimated residual value of 0. If we continue to use the asset for 3 more years, its carrying value in each of those years is 0.

    It obviously still has value to us, but unless we are measuring the asset on a model other than cost, its carrying value will stay 0.

    It we happen to sell it for more than zero, we’ll recognize a gain.

    No fraud, no error. Otherwise, one would claim fraud or error every time an entity recorded either gains or losses.

    On the subject of separate legal entity: I did not mean to imply that being a separate legal entity is a sufficient condition for a subsidiary. It is a necessary condition.

    Definition from IAS 27: A subsidiary is an entity, including an unincorporated entity such as a partnership, that is controlled by another entity (known as the parent).

    If it’s not a legal entity, you only have control of assets and liability, not an “investment”. Consolidation of a subsidiary presumes that there are equity accounts to be eliminated as well as assets and liabilities to be consolidated.

    If there is a “non-legal” such entity, I’d be interested in knowing about its form.

    Xavier: Would you let us know what the form of this subsidiary is and whether there are liabilities as well as assets? Are you trying to sell the assets or not (regardless of their carrying value)?

    Patricia Walters

  • Mladek said:

    Allow me to retort.

    Assets are depreciated for two reasons. First, the depreciation expense is supposed to approximate how an asset contributes to earnings (irrespective of cash flows). Second, the carrying amount (net book value) is supposed to approximate the asset’s remaining economic value.

    Form the user’s perspective both pieces of information are useful. The first allows the user to evaluate how the company generates earnings and make forecasts based on this evaluation. The second allow the user to estimate the company’s approximate liquidation value.

    Now if I were a capital provider trying to make investment decisions based on accounting data, I think I would prefer data that was not significantly distorted. Wouldn’t you?

    Obviously, no one expects accounting to be perfect. If it were, assets would be depreciated exactly for the period they were used, the pattern (depreciation expense) would exactly correspond to the contribution to earnings and the assets would be sold for their residual value at the exact moment they ceased to useful to the enterprise.

    But, while such high expectations are unrealistic, dismissing such obvious distortions of economic reality not only does a disservice to the user, but makes accountants look like bean counters only concerned with ticking boxes.

    After all, what’s the point in paying an accountant his salary if one has to wait 3 years (60% of the assets claimed useful life) for the error to “correct itself”.

    And disappear on the I/S as a gain no less!

    Allow me to demonstrate with a simple (though extreme) example.

    Assume the only expense was depreciation and the company depreciated its manufacturing assets for 5 years but used them for 8. During the first five years its COS would be 38% higher. Worse, over the last 3, its return on assets would be infinite.

    Now lets assume the company’s management realizes this and intentionally manipulates its depreciation to, for example, manage earnings.

    Now managing earnings with a cash (or near cash) expense like material or wages is pretty darn hard. Managing them with depreciation, which has to be estimated for years into the future, child’s play.

    As to “Fully depreciated” and “Having no value” being unrelated.

    When was it exactly that accounting terminology and economic reality diverged so completely?

    I’m actually hoping this is just a cultural thing. In the US, assets are commonly depreciated to a salvage value, so fully depreciated does not mean 0. In the EU, the opposite is the case. Here “fully depreciated” generally means zero.

    Not that I’m letting you off the hook that easily. Even if a non-zero salvage value was set, how can you justify distorting not only COS but net income and EPS by continuing to use an asset for years while not not recognizing the related expense?

    How can you, in good conscience, claim that this is a faithful representation of economic reality?

    And if were such a trifle, why would IAS 16 explicitly (and in bold lettering!) require companies to review their depreciation methods, periods and residual values annually?

    If they could just flush a gain through their income statement three years after the fact, what’s the point of having depreciation at all.

    As far as I’m concerned, distorted data dressed up to look legitimate is even worse than no data at all. It harms investors, it harms company’s and, in the end, it discredits our profession.

    BTW you (probably inadvertently) proved my point: “It obviously still has value to us, but unless we are measuring the asset on a model other than cost, its carrying value will stay 0.”

    Obviously it does still have value. And, after 5 years, the only way to recognize that it does is to admit our mistake in making the original estimate (which we compounded by ignoring our obligation to perform an annual review for 5 consecutive years) and restate.

    Had we acted sooner, maybe it could have been dealt with as a change in estimate. Now, with its value at zero, the only choice left: IAS 8.42.

  • patriciawalters said:

    Depreciation is a cost allocation process and cannot result (except by chance) in the carrying value of the asset approximating market value.

    Question for you Mladek:

    Hypothetical situation:

    Company X incorporates in 1920 and builds a headquarters building in the City of London. What should the estimate of useful life and residual value on that building be? What depreciation method should be used?

    It is now, 2010, Company buys the above building from Company X. What should the estimate of useful life and residual value be? What depreciation method should be used?

    In my view, an estimate of useful life of 90 years by Company X would not have been reasonable. Why not 100, 200? Company X would have no way of predicting that it wouldn’t sell the building until 2010 and it couldn’t estimate that it would sell it in 2010 either.

    Regardless of the estimate of useful life, residual value (even if the entire cost of the building without depreciation), or depreciation method selected, Company X would likely (I might even say highly likely) that it would record a gain on the sale.

    I personally prefer an estimate of useful life to be the time over which the company expects to recover the depreciable base of the asset. I also expect few assets to have high residual values. To me all that looks like is earnings manipulation.

    Just like changing from straight line depreciation to units of production when production slows.

    Patricia

  • patriciawalters said:

    Meant to say, Company Y buys the building in 2010.

    Hate typos!

    Patricia

  • Mladek said:

    I realize that a straw man is easier than attack than the argument presented, but I never said carrying amount approximates market value. I said “carrying amount (net book value) is supposed to approximate the asset’s remaining economic value.”

    Obvious, under the historical cost model, everyone knows that, that value was originally established in a past, arm’s-length transaction and all depreciation does is allocate it over the asset’s useful life (in some, more or less, arbitrary fashion).

    That is why I also said it allows “the user to estimate the company’s approximate liquidation value” not than base it on the B/S.

    I also realize you are trying to be clever with that building example. But, buildings are special. Like art, they can have (for all intents and purposes) indefinite lives.

    For example, XYZ built a stylish, concrete and steel, 40-story office building in 1920. Since then the city capped new buildings at 20 stories. What is its useful life? 50 years? 100 years? 500 years? Does anyone really know? Probably not, since no such building has ever fallen down by itself. Its useful life ends when someone in the future decides to end it. When will that be? I haven’t a clue. Nor does anyone else.

    But most assets are neither buildings nor art.

    BTW, that’s also why, as an investor, I prefer buying stock in companies that rent and decorate with Ikea (unless I want to take them over to get their real estate or art collections), but that is a different issue.

    So, unless I want to take a chance on revaluation (which I don’t), I have no choice but to disclose some assets at values that are grossly unrealistic. But, as long as I disclose them on the balance sheet at a value not zero and provide adequate footnote disclosure, I’m still doing a better job than if I pretend they have no value at all.

    Thus, I am not opposed to high salvage values, per se. Quite the opposite. In certain situations, I’m a fan.

    What I am opposed to (and what has been the point of my posts all along) is the European specialty of depreciating assets down to zero and continuing to use them for years on end.

    Finally, I realize that you “prefer an estimate of useful life to be the time over which the company expects to recover the depreciable base of the asset.”

    Just one problem with that (two actually).

    First, this opens the door to the exact kind of manipulation I described earlier.

    Two, it is in direct violation of IAS 16 which states:

    Useful life is:

    (a) the period over which an asset is expected to be available for use by an entity; or

    I don’t know about you, but when I set accounting policy, I prefer policy that is not in violation of the accounting standards I am trying to apply.

    As to changing depreciation methods when productions slows?

    As long as a proper impairment test is performed and as long as adequate footnote disclosure is made, I don’t see the problem.

    Where I do see a problem is management hiding assets by pretending they have no value (and accountants turning a blind eye, or even helping out).

  • xavier (author) said:

    dear all,

    thank you for your interesting comments. The situation is relatively simple. The company is owned 60% by my company. It was not successul and the Board decided to close. We did an impairement test of the assets of the subsidiary and they were fully depreciated. As a result, the company has a negative equity. In consolidation, the subsidiary was consolidated as discontinued operations, and the investment is offset against our share in the capital of the subsidiary and the losses are consolidated. When I close the company, I will need to write off the investment through P&L. But I have already consumed all the capital injected with accumulated losses. I therefore don’t want to have already accounted for the losses and again have the P&l impact of the write-off. Should I reduce the accumulated losses for an amount equivalent to the write-off?

    thank you again for your comments.

  • Mladek said:

    Hate to say, but based on your description I’m still not clear on the substance of your question/problem.

    It’s probably a terminology issue so maybe, if you posted summarized balance sheets for the two entities (including the line items that have a zero net balance), I might be able to provide a reasonable reply (just don’t use their real names or balances).

  • patriciawalters said:

    First, I promise Mladek that I’ll get back to our conversation on depreciation, but just don’t have time right now.

    On the closing of the subsidiary issue. Let’s leave consolidation out of the question for a minute. Consolidation is an financial reporting issue that is required because the parent controls the sub.

    Your parent entity has on its books an investment in this sub. Did you impair this investment? Is so, you have restated the value of the investment in S to 0 and potentially written off other intercompany (parent and sub) loans and receivables, correct?

    The assets of the sub are not on the books of the parent. They are only presented in the consolidated financial statements.

    Your task is to complete the dissolution of the sub. Record any additional effects on your investment account (again just because the book value of the assets are 0, doesn’t mean you won’t sell them for more than 0.)

    Once all of these activities are complete and you’ve sold or abandonned all of the subs assets, from the sub’s books.

    The parent is going to remove any remaining value of the investment from its books, recognize any consideration it has received in respect of that investment and recognize a loss (or gain) as appropriate.

    This is not a consolidation issue, at this point. Afterwards, there is no sub to consolidate. If I remember correctly, you have already classified these assets as discontinued operations, so any additional gain or loss from removing your investment from the books would be shown in that section of the income statement.

    Pat

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