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A public listed company X owns two subsidiary company investments. It owns 100% of the equity shares of A and 55% of equity shares of B. During the year ended 31st May 2009 B made several sales of goods to A. These sales totalled $15m and had cost B $14m to manufacture. B made these sales on the instruction of the Board of X. It is known that one of the directors of B, who is not a director of X, is unhappy with the parent company’s instruction as he believes the goods could have been sold to other companies outside the group at the far higher price of $20m. All directors within the group benefit from a profit sharing scheme.
Describe the financial effect that X’s instruction may have on the financial statements of the companies within the group and the implications this may have for other interested parties. (8 marks)
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I have a similar example in my course notes to my students (see below for the case, requirements, and solution). I cannot remember where I get it. You should be able to transfer it to your case easily. I also put “my added remark” at the solution to show the structure of the answer. ACCA has a standard approach to the answer.
Scenario:
Able Limited, which is a public listed company, owns investments in its two subsidiaries, Benny Limited and Candy Limited. Able Limited owns 100% of the equity shares of Benny Limited and 60% of the equity shares of Candy Limtied
The following information is also available
All companies of Able Group have a financial year end of 30 June
The Able Group adopts a profit sharing basis when calculating the director’s bonus
The Board of Able Limited instructed Candy Limited, to charge Benny Limited at a price that is lower than the market. As a result, only a 7% profit margin is obtained by Candy Limited for sales to Benny Limited; Candy Limited is able to sell the goods at a 30% profit margin in the market
During the year ended 30 June 20×6, Candy Limited made several sales of goods to Benny Limited totaling $40 million.
One of the directors of Candy Limited, who is not a director of Able Limited, is not satisfied with the instructions received from Able LimitedRequirements:
Describe the implications that Able Limited’s instructions may have on the users of the financial statements. (You are required to consider both the financial effect on the financial statements of the companies involved and also the non-financial implications on the economic decisions of users of the financial statements)Solution (Key words are shown in capital letters. You should demonstrate in examination your competency in using the key terms in the accounting standards to explain the situation and your judgments):
My added remark: To establish the relevance of the accounting standards to the case
Both Benny Limited and Candy Limited are the subsidiaries of Able Limited
In accordance with IAS 24, Benny Limited and Candy Limited are related parties to each other and to Able Limited as they are UNDER COMMON CONTROL.
In this case, one of the important aspects of related party relationship emerges because Candy Limited has its INTERESTS SUBORDINATED; in particular, it may not be able to act in its own best interest when selling goods to Benny Limited.My added remark: To specify the financial implications
The Board of Able Limited instructed Candy Limited to charge Benny Limited at a price that is lower than the market
The sales of goods from Candy Limited to Benny Limited will also affect reported revenue and cost of sales and working capital in the individual financial statements of Benny Limited and Candy Limited
The sale of goods from Candy Limited to Benny Limited has not been made at an arm’s length and such transactions have moved profits from Candy Ltd to Benny Ltd
In this case, Candy Ltd would have made a profit on these transactions of $12 million (40 million x 30%) rather than $2.8 million (40 million x 7%) that it made
As a result, the user of financial statements, such as investors, may be misled by the contributions made by different individual companies to the group.
There may have been no real overall financial effect because intra-group transactions are eliminated in preparing the consolidated financial statements.My added remark: To specify the non-financial implications
There are not only financial implications of these related party sales to the users of the financial statements, but also non-financial implications:
Candy Limited has minority interests of 40% and these shareholders have been deprived of their shares of the [$3.68 million (12 million – 2.8 million) x 40%] distributable profits. This is unfairly prejudicing to the minority shareholders in Candy Limited.
The directors of Candy Limited may be unfavourably prejudiced under the group profit sharing policy as Candy Limited’s profit are effectively $9.2 million (12 million – 2.8 million) lower than they should be.
Shareholders, financial analysts and institutional investors would find it difficult to appraise the performance of both Candy Limited and Benny Limited. This is because the related party transaction gives the impression that Candy Limited is under performing and Benny Limited is over performing.
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