Financial Operations

Where a newly acquired subsidiary has previously always recorded its net assets at historical cost, the consolidated statements have to be adjusted to reflect their fair value at the time of the acquisition

Historical cost is one of the most fundamental concepts followed in accounting. It simply means that assets are recorded by the amount of cash paid for them, or the fair value of the consideration given to acquire them, at the time of their acquisition. This concept applies both in single-company accounts and in consolidated accounts.

Confusion can arise when a company follows a policy of recognising its assets at historical cost, rather than a policy of revaluation. This approach is set out in IAS16, “Property, plant and equipment”, and the choice between cost and fair value (revaluation) is available for all organisations. Once a company has chosen this policy, it may continue to carry its assets at historical cost (less accumulated depreciation and impairment losses), no matter how much they increase in value. But in consolidated accounts the historical cost of the net assets of a newly acquired subsidiary is their fair value at the acquisition date. If the subsidiary doesn’t make adjustments for this in its own financial statements – and it usually won’t – there needs to be an adjustment on consolidation.

To illustrate this point, let’s look at question four from the May 2012 F1 paper. Here is the relevant information it provides:

   LochRiver Stream 
 Non-current assets     
 Property, plant and equipment(iv)1,193767670 
 Equity and liabilities     
 Equity shares of $1 each 3,500600520 

   LochRiver Stream 
 Revenue 1,500693227 
 Cost of sales (865)(308)(84) 
 Gross profit 635385143 

Additional information (extract):
(ii) Loch acquired all of River’s equity shares on 1 April 2011 in a share-for-share exchange. The agreed purchase consideration was $950,000, but Loch has not yet recorded the acquisition in its accounting records. On 1 April 2011, Loch’s shares had a market value of $2 each. River’s retained earnings were $130,000 on 1 April 2011.

(iv) The fair value of River’s property, plant and equipment on 1 April 2011 exceeded its carrying value by $144,000. This excess was attributed to buildings owned by River. At the acquisition date these had a remaining useful life of 12 years. Loch’s accounting policy is to depreciate buildings on a straight-line basis with no residual value.

(v) Loch conducted an impairment review of the goodwill arising on its River acquisition and found that as at 31 March 2012 the goodwill had been impaired by $20,000. (NB: Stream is an associate.)

In this question the figure of $767,000 represents the carrying value of the property, plant and equipment in River’s financial statements. This represents the historical cost to River minus the accumulated depreciation and impairment losses up to 31 March 2012.

When Loch decides to acquire control of River, the financial statements will be reviewed, the goodwill will be wrapped up in the business considered and a figure for the consideration to be paid for the equity shares will be decided. But when this decision is made it will be based not on the carrying value of $767,000, but on what the assets are worth: the carrying value of $767,000 plus the fair-value adjustment given in note (iv) of $144,000, which comes to $911,000. Why would River accept anything less than what the business is worth?

We need to allocate the amount paid for the shares in River to its identifiable net assets in the consolidated accounts. We do this based on their air values at the date of acquisition. Loch will have included $911,000 to cover the fair value of the property, plant and equipment of River in the overall acquisition. This becomes historical cost to the Loch group – i.e. what was paid on acquisition and what we call its fair value. This is an important concept to grasp.

When the goodwill is calculated, the fair value of the consideration paid is included, so this must be matched with the fair value of the net assets acquired if the goodwill figure is to be accurate. The goodwill calculation will be as follows:

Cost   950note (ii)
Fair value of net assets at acquisition:     
Equity shares 600  from SFP
Retained earnings 130  note (ii)
Fair-value adjustment 144  note (iv)
Goodwill at acquisition   76 
Impairment to date   (20)note (v)
Goodwill at 31 March 2012   56 

When the property, plant and equipment is consolidated, it must be included in the consolidated financial statements based on its fair value at the date of acquisition. The consolidated property, plant and equipment will therefore now be as follows:

 Non-current assets    
 Property, plant and equipment (1,193 + 767 + 144 fair-value adjustment)    

Having considered the cost to the group of the net assets, we must now bring depreciation up to date, too. In the question, the figure of $767,000 is the historical cost depreciated up to 31 March 2012, which to River is the appropriate figure. But in the consolidated financial statements, depreciation of the buildings must be based on their fair value at the acquisition date. This is $144,000 higher than the carrying value in the individual financial statements of River.

The extra $144,000 must now be depreciated over the remaining useful life of the buildings, which note (iv) of the question has told us is 12 years from the date of River’s acquisition. The amount of depreciation calculated needs to be based on the exact period from acquisition to the reporting date. In this case that’s one year, from 1 April 2011 to 31 March 2012.

So we have $144,000 ÷ 12 years = $12,000 of additional depreciation to be accounted for in the consolidated accounts as follows:

Dr Group depreciation expense: $12,000.
Cr Group accumulated depreciation: $12,000.

Note the use of the word “group” in front of each line of the journal. This shows that the extra depreciation is a consolidation adjustment made when the two entities are combined and not an adjustment to be put through River as an individual company.

It’s important to remember that River will continue reporting the buildings at their historical cost, minus the accumulated depreciation – and that’s fine.

The next consideration is where in the comprehensive income statement the additional depreciation should be charged. First, follow any instructions in the question concerning which cost category to use. In this case it’s cost of sales or expenses. Alternatively, think about how the asset would be used. In this case buildings would be used to conduct the business, so cost of sales would be an appropriate category. The extracts of the consolidated financial statements based on the above adjustments only will be as follows:

 Non-current assets    
 Property, plant and equipment    
 1,193 + 767 + 144 – 12 extra depreciation  2,092 
 Goodwill  56 

 Revenue 1,500 + 693...    
 Cost of sales 865 + 308 + 12 extra depreciation...    
 Gross profit    

The rest of the question requires further adjustments to both revenue and cost of sales. To see the complete question and the model answers, visit

The final consideration is the link between increased costs in the statement of comprehensive income and the reduction of profit. This reduction must also be shown in consolidated, retained earnings. In the comprehensive income statement the charge for the year is used – i.e. $12,000. But in consolidated retained earnings the depreciation to date must be used – in this case it’s also $12,000, as there has been only one full year between the date of acquisition (1 April 2011) and the reporting date (31 March 2012).

It is possible, of course, that more than one year has elapsed since the acquisition. If this is the case, the accumulated extra depreciation will pass through the consolidated statement of financial position and the charge for the year will go through the consolidated statement of comprehensive income. Say, for instance, that River was acquired on 1 April 2010: we calculate the annual charge as before: $144,000 ÷ 12 years = $12,000 a year. This is charged to cost of sales in the consolidated statement of comprehensive income as above. For property, plant and equipment there must be extra depreciation on the fair value for two years from the acquisition date to the current reporting date – i.e. $12,000 x 2 years = $24,000, which is matched by the charge to group retained earnings:

 Non-current assets    
 Property, plant and equipment    
 1,193 + 767 + 144 – 24 extra depreciation  2,080 







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