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Examination Preparatory Course CMGA/CGA Associates and Joint Ventures

Examination Preparatory Course CMGA/CGA Associates and Joint Ventures. Dr. Gary Leung www.garyleung.hk. IAS 28 Investments in Associates. Introduction Definition Identifying associates Equity method Transactions between parent and associate Share of losses of the associates

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Examination Preparatory Course CMGA/CGA Associates and Joint Ventures

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  1. Examination Preparatory Course CMGA/CGA Associates and Joint Ventures Dr. Gary Leung www.garyleung.hk CMGA/CGA Sept 2010

  2. IAS 28 Investments in Associates • Introduction • Definition • Identifying associates • Equity method • Transactions between parent and associate • Share of losses of the associates • Impairments losses • Dissimilar accounting policies • Different reporting dates • Main defects of equity accounting • Disclosure CMGA/CGA Sept 2010

  3. Introduction • Where one company has a controlling investment in another company, a parent subsidiary relationship is formed and accounted for as a group. Companies may also have substantial investments in other entities without actually having control. Thus, a parent-subsidiary relationship does not exist between the two. • If the investing company can exert significant influence over the financial and operating policies of the investee company, it will have an active interest in its net assets and results. • The nature of the relationship differs from that of a simple investment, i.e. it is not a passive interest. • Including the investment at cost in the company's accounts would not fairly present the investing interest. • So that the investing entity (which may be a single company or a group) fairly reflects the nature of the interest in its accounts, the entity’s interest in the net assets and results of the company, the associate, needs to be reflected in the entity’s accounts. This is achieved through the use of equity accounting CMGA/CGA Sept 2010

  4. Definitions of Key Terms • An associate is an entity, including an unincorporated entity such as a partnership, over which the investor has significant influence and that is neither a subsidiary nor an interest in a joint venture. • The equity method is a method of accounting whereby the investment is initially recognised at cost and adjusted thereafter for the post-acquisition change in the investor’s share of net assets of the investee. The profit or loss of the investor includes the investor's share of the profit or loss of the investee. • Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies. CMGA/CGA Sept 2010

  5. Significant Influence • If an investor holds, directly or indirectly (eg through subsidiaries), 20 per cent or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case. • If the investor holds, directly or indirectly (eg through subsidiaries), less than 20 per cent of the voting power of the investee, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated. CMGA/CGA Sept 2010

  6. Significant Influence • The existence of significant influence by an investor is usually evidenced in one or more of the following ways: • (a) representation on the board of directors or equivalent governing body of the investee; • (b) participation in policy-making processes, including participation in decisions about dividends or other distributions; • (c) material transactions between the investor and the investee; • (d) interchange of managerial personnel; or • (e) provision of essential technical information. CMGA/CGA Sept 2010

  7. Potential voting rights • The existence and effect of potential voting rights that are currently exercisable or convertible, including potential voting rights held by other entities, are considered when assessing whether an entity has significant influence. Potential voting rights are not currently exercisable or convertible when, for example, they cannot be exercised or converted until a future date or until the occurrence of a future event. CMGA/CGA Sept 2010

  8. Illustration 1 • X Owns 60% of the voting rights of Y,Z owns 19% of the voting rights of Y, and the remainder are dispersed among the public. Z also is the sole supplier of raw materials to Y and has a contract to supply certain expertise regarding the maintenance of Y’s equipment. • Required: • What is the relationship between Z and Y ? CMGA/CGA Sept 2010

  9. Illustration 1 • Z may be able significant influence over Y, and therefore it may have to be treated as an associate. Although Z owns only 19% of the voting rights, it is the sole supplier of raw materials to Y and provides expertise in the form of maintenance of Y’s equipment. CMGA/CGA Sept 2010

  10. Separate financial statements of the investor • Issues consolidated accounts • An investments in an associate should be either • A) cost or in accordance with IAS 39. • B) Under IFRS5 if classified as held for sale; • Not issues consolidated accounts (e.g. no subsidiary) • Equity method CMGA/CGA Sept 2010

  11. Consolidated accounts • Relationship to a group • A group is defined as being a parent and all of its subsidiaries. An associate is not part of a group as it is not a subsidiary, i.e. it is not controlled by the group. • As such, the accounting treatment of the associate is different to that of subsidiaries. • Basic rule • An investment in an associate should be accounted for using the equity method. • Associates must be accounted for using the equity method regardless of the fact that the investor may not have investments in subsidiaries and does not therefore prepare consolidated financial statements. CMGA/CGA Sept 2010

  12. Equity accounting • The investment in an associate is initially recognised at cost and the carrying amount is increased or decreased to recognise the investor’s share of the profit or loss of the investee after the date of acquisition. • This is equivalent to taking the investor’s share of the net assets of the associate at the date of the financial statements plus goodwill. • Distributions received from the associate reduce the carrying amount of the investment. • Adjustments to the carrying amount may also be necessary for changes in the investor’s proportionate interest in the associate arising from changes in the associate’s equity that have not been recognised in the profit or loss. CMGA/CGA Sept 2010

  13. Equity accounting • Such changes include those arising from the revaluation of property, plant and equipment and from foreign exchange translation differences. • The investor’s share of the current year’s profit or loss of the associate is recognised in the investor’s profit or loss. • The associate is not consolidated line-by-line. Instead, the group share of the associate’s net assets is included in the consolidated statement of financial position in one line, and share of profits (after tax) in the consolidated statement of comprehensive income in one line. CMGA/CGA Sept 2010

  14. Treatment in a consolidated statement of financial position • The methods described below apply equally to the financial statements of a non-group company that has an investment in an associate as they do to group accounts. • In group investments, replace the investment as shown in the individual company statement of financial position with: • the group’s share of the associate’s net assets at the end of the reporting period, • plus • the goodwill arising on acquisition, less any impairment losses. • Do not consolidate line-by-line the associate’s net assets. The associate is not a subsidiary, therefore the net assets are not controlled as they are for a subsidiary. CMGA/CGA Sept 2010

  15. Treatment in a consolidated statement of financial position • In group reserves, include the parent’s share of the associate’s post-acquisition reserves (the same as for subsidiary). • Cancel the investment in associate in the individual company’s books against the share of the associate’s net assets acquired at fair value. The difference is goodwill. • Negative goodwill is required to be taken to income in the period the associate was acquired and included in the investor’s share of the associate’s post acquisition after tax result. • The fair values of the associate’s assets and liabilities must be used in calculating goodwill. Any change in reserves, depreciation charges etc due to fair value revaluations must be taken into account (as they are when dealing with subsidiaries). • Where the share of the associate’s net assets acquired at fair value are in excess of the cost of investment, the difference is included as income in determining the investor’s share of the associate’s profits or losses. CMGA/CGA Sept 2010

  16. Treatment in a consolidated statement of financial position • To calculate amounts for net assets and post-acquisition reserves, use a net assets working for the associate (the same as for the subsidiary). • Where the equity method is used for associates in a consolidated statement of financial position, the carrying value of the associate is made up as follows: • Either: share of equity at the balance sheet date (plus fair value adjustments at acquisition) , PLUS any unimpaired goodwill remaining at the balance sheet date, • Or: cost PLUS share of post-acquisition reserves at the balance sheet date LESS goodwill impaired and written off since acquisition. CMGA/CGA Sept 2010

  17. Illustration 2 • P owns 80% of S and 40% of A. A statement of financial position of the three companies at 31December 2008 are: • P S A • $ $ $ • Investment: shares in S 800 – – • Investment: shares in A 600 – – • Other non-current assets 1,600 800 1,400 • Current assets 2,200 3,300 3,250 • ——— ——— ——— • 5,200 4,100 4,650 • ——— ——— ——— • Issued capital – $1 O.S. 1,000 400 800 • Retained earnings 4,000 3,400 3,600 • Liabilities 200 300 250 • ——— ——— ——— • 5,200 4,100 4,650 • ——— ——— ——— CMGA/CGA Sept 2010

  18. Illustration 2 • P acquired its shares in S seven years ago when S’s retained earnings were $520 and P acquired its shares in A on the 1 January 2008 when A’s retained earnings were $400. •  The goodwill in S was fully written off after five years. • There were no indications during the year that the investments in S or A were impaired. • Non-controlling interest is valued at the proportionate share of the subsidiary’s identifiable net assets, it is not credited with its share of goodwill. • Required: •  Prepare the consolidated statement of financial position at 31 December 2008. CMGA/CGA Sept 2010

  19. Illustration 2 • P Consolidated statement of financial position as at 31 December 2008 •   $ • Investment in associate 1,880 • Non-current assets (1,600 + 800) 2,400 • Current assets (2,200 + 3,300) 5,500 • ——— • 9,780 • ——— • Issued capital 1,000 • Retained earnings (W5) 7,520 • ——— • 8,520 • NCI (W4) 760 • Liabilities 500 • ——— • 9,780 • ——— CMGA/CGA Sept 2010

  20. Illustration 2 • WORKINGS • (1) Group structure • P • 80% 40% • S A CMGA/CGA Sept 2010

  21. Illustration 2 • (2) Net assets working • Balance Acquisition sheet date • $ $ • Issued capital 400 400 • Retained earnings 3,400 520 •   ——— —— •   3,800 920 •   ——— —— • A Balance Acquisition • sheet date • Issued capital 800 800 • Retained earnings 3,600 400 • ——— ——— • 4,400 1,200 • ——— ——— • (3) Goodwill • S $ Cost of investment 800 • Net assets acquired (80% X 920 (W2)) (736) • —— • 64 • —— • A $ • Cost of investment 600 • Net assets acquired (40% × 1,200 (W2))(480) • —— • 120 • —— CMGA/CGA Sept 2010

  22. Illustration 2 • (4) NCI • $ • S only – (20% X 3,800) 760 • —— • (5) Retained earnings • $ • P – from question 4,000 • Share of S [80% X (3,400 – 520) (W2)] 2,304 • Share of A [40%X (3,600 – 400) (W2)] 1,280 • Less Goodwill impaired (W3) (64) • ——— • 7,520 • ——— CMGA/CGA Sept 2010

  23. Illustration 2 • (6) Investment in associate • $ Share of net assets (40% × 4,400) 1,760 • Goodwill 120 • ——— • 1,880 • ——— •  OR • Cost 600 • Share of post acquisition profits 1,280 • ——— • 1,880 • ——— CMGA/CGA Sept 2010

  24. Treatment in a consolidated statement of comprehensive income • Treatment is consistent with consolidated statement of financial position and applies equally to a non-group company with an associate: • Include group share of the associate’s profits after tax in the consolidated statement of comprehensive income. This replaces dividend income shown in the investing company’s own statement of comprehensive income. • Parent’s % the associate’s profit for the year X • Less: any impairment loss in the current year (X) • Less: the parent’s % of additional depreciation on fair value adjust. (X) • X • Do not add in the associate’s revenue and expenses line-by-line as this is not a consolidation and the associate is not a subsidiary. • Time-apportion the associate’s results if acquired mid-year. • Note that the associate statement of financial position is NOT time apportioned as the statement of financial position reflects the net assets at the period end to be equity accounted. CMGA/CGA Sept 2010

  25. Illustration 3 • P has owned 80% of S and 40% of A for several years. Statements of comprehensive income for the year ended 31 December 2008 are: • P S A • $ $ $ • Revenue 14,000 12,000 10,000 • Cost of sales (9,000) (4,000) (3,000) •   ——— ——— ——— • Gross profit 5,000 8,000 7,000 • Administrative expenses (2,000) (6,000) (3,000) • ——— ——— ——— • 3,000 2,000 4,000 •  Dividend from associate 400 – – •   ——— ——— ——— • Profit from ordinary activities before taxation 3,400 2,000 4,000 • Income taxes (1,000) (1,200) (2,000) • ——— ——— ——— • Profit from ordinary activities after taxation 2,400 800 2,000 • ——— ——— ——— •  Dividends (paid) (1,000)–(1,000) •  Retained earnings for the period 1,4008001,000 •  Goodwill was fully written off three years ago. • Required: •  Prepare the consolidated Statements of comprehensive income for the year ended 31 December 2008. CMGA/CGA Sept 2010

  26. Illustration 3 • P Consolidated profit and loss account for the year ending 31 December 2008 • $ • Turnover 26,000 • Cost of sales (13,000) • ——— • Gross profit 13,000 • Administrative expenses (8,000) • ——— • Operating profit 5,000 • Income from associate 800 • ——— • Profit before taxation 5,800 • Income taxes (2,200) • ——— • Profit after taxation 3,600 • ——— • Profit attributable to:- • Owner of the parent 3,440 • NCI (W3) 160 • 3,600 • Dividends (paid) (1,000) CMGA/CGA Sept 2010

  27. Illustration 3 • 1) Consolidation schedule • P S 40% A Consolidation • Revenue 14,000 12,000 26,000 • Cost of sales (9,000) (4,000) (13,000) • Administration expenses (2,000) (6,000) (8,000) • Income from associate 40% × 2,000 800 800 • Tax – group (1,000) (1,200) (2,200) • (2) NCI • S only 20% × 800 $160 CMGA/CGA Sept 2010

  28. Impairments losses • Impairment indicators in IAS 36 apply to investments in associates. • Because the goodwill that forms part of the carrying amount of the investment in an associate and is not separately recognzied, it cannot be tested for impairment separately by applying IAS 36. Instead the entire carrying amount of the investment is tested for impairment under IAS 36 by comparing the recoverable amount with the carrying amount. • An impairment loss recognised in those circumstances is not allocated to any asset, including goodwill, that forms part of the carrying amount of the investment in the associate. Accordingly, any reversal of that impairment loss is recognised in accordance with IAS 36 to the extent that the recoverable amount of the investment subsequently increases. CMGA/CGA Sept 2010

  29. Impairments losses • In determining the value in use of the investment, an entity estimates: • its share of the present value of the estimated future cash flows expected to be generated by the associate, including the cash flows from the operations of the associate and the proceeds on the ultimate disposal of the investment; or • the present value of the estimated future cash flows expected to arise from dividends to be received from the investment and from its ultimate disposal. CMGA/CGA Sept 2010

  30. Illustration 4 • A acquired 30% of the issued capital of B for $1 million on 31 Dec 2007. The accumulated profit and the share capital at that date were $2 million and $ 1 million (share capital @ $1) respectively. • Financial information of B Ltd at 31 Dec 2008 is • Share capital $1 million • Retained profit $3 million • Recoverable amount is $ 6 million • Required: • What amount should be shown in A’s consolidated balance sheet at 31 Dec 2008, for the investment in B ? CMGA/CGA Sept 2010

  31. Illustration 4 • Goodwill = 1 million – (30% X 3 million)=0.1 million. • Interest in associate at 31 Dec 2008 • Cost 1 • Add: profit acq. Profits. ( 3-2)X 30% 0.3 • 1.3 • RA ( 6 X 30%) 1.8 • An impairment test would prove that the carrying amount of the investment is not impaired. CMGA/CGA Sept 2010

  32. Illustration 5 • The following are the summarised accounts of India, New and Delhi for the year ended 30 June 2009. • Statements of financial position • India New Delhi • Tangible assets 90,000 80,000 60,000 • Investment in New 92,000 • Investment in Delhi 30,000 • Current assets 88,00050,00010,000 • 300,000130,00070,000 • Share capital ($1 share) 175,000 75,000 40,000 • Accumulated profits 114,00051,00029,000 • Equity 289,000 126,000 69,000 • Liabilities 11,0004,0001,000 • 300,000130,00070,000 CMGA/CGA Sept 2010

  33. Illustration 5 • Income statement • India New Delhi • Revenue 500,000 200,000 100,000 • Operating costs (400,000)(140,000)(60,000) • Profit before tax 100,000 60,000 40,000 • Tax (25,000)(20,000)(14,000) • Profit for the year 75,00040,00026,000 • Additional information i) New • 1. India acquired 60,000 shares in New three years ago when the accumulated profits were $15,000. • 2. At the date of acquisition the fair value of New’s non current assets, which at that time had a remaining useful life of ten years, exceeded their book value by $5,000. • 3. The group policy is to calculate the goodwill arising on the consolidation of a subsidiary gross with the NCI at fair value. At acquisition the fair value of the NCI of New was $24,000. • 4. Impairment reviews reveals that no impairment losses have arisen. • ii) Delhi • 5. India acquired 12,000 shares in Delhi three years ago when the accumulated profits were $5,000. • 6. At the date of acquisition the fair value of Delhi’s non-current assets, which at that time had a remaining useful life of four years, exceeded the book value by $20,000. • 7. The impairment review reveals the recoverable amount of Delhi at their year-end to be $103,333. • Required: • Prepare the consolidated income statement and the consolidated statement of financial position for the India Group 2009. CMGA/CGA Sept 2010

  34. Illustration 5 • W1) Group • India • 80% 30% • New Delhi CMGA/CGA Sept 2010

  35. Illustration 5 • W2 Net Assets • New Delhi • DOA 2009 DOA 2009 • Share Cap. 75,000 75,000 40,000 40,000 • Acc. Profits 15,000 51,000 5,000 29,000 • Fair value • adjustment 5,000 5,000 20,000 20,000 • Less: add. • dep. (1,500) # (15,000) *95,000129,50065,00074,000 • % of Post acq. profits of New 80% (129,500 – 95,000) = $27,600 • % of Post acq. Profits of Delhi 30% ( 74,000 – 65,000) = $2,700 • # $5,000 X 1/10 X 3 years = $1,500 • * $20,000 X ¼ X 3 years = $15,000 CMGA/CGA Sept 2010

  36. Illustration 5 • W3) Investment in associate • Cost of investment 30,000 • Plus Post acq. Profits (30% X 9,000) 2,700 • Less: impairment loss (1,700) • 31,000 • W4) Impairment review • Carrying value before impairment 32,700 ? • Recoverable amount (30% X 103,333) (31,000) • Impairment loss 1,700 CMGA/CGA Sept 2010

  37. Illustration 5 • W 5) Goodwill • Cost of the New investment 92,000 • Fair value of the NCI 24,000 • Net assets (95,000) • Gross goodwill at acquisition 21,000 • W6) NCI • Fair value of the NCI at DOA 24,000 • Plus NCI % of the post acq. Profits • ( 20% X 34,500) 6,900 • 30,900 • OR • NCI % of the net assets at 2008 25,900 • ( 20% X 129,500) • Plus goodwill ( 24,000 – 20% X 34,500) 5,000 • 30,900 CMGA/CGA Sept 2010

  38. Illustration 5 • W7) Accumulated profits • Parent 114,000 • New - Post acq. Profits (80% X 34,500) 27,600 • Delhi-Post acq. Profits ( 30% X 9,000) 2,700 • Impairment loss on the associate –Delhi (1,700) • 142,600 • W8) Income from associate • Parent’s % of the associate’s profit for the year (30% X 26,000) 7,800 • Less: additional deprecation ( 30% X 5,000) (1,500) • Less: the impairment loss arising in the year (1,700) • 4,600 • W9) NCI in the subsidiary’s profits for the year • NCI % of the subsidiary’s profits ( 20% X 40,000) 8,000 • Less: the NCI % of the deprecation of FVA ( 20% X 500) (100) • 7,900 CMGA/CGA Sept 2010

  39. Illustration 5 • India group income statement • Revenue ( 500,000 + 200,000) 700,000 • Operating costs (540,500) • (400,000 + 140,000 + 500 dep. (5,000 X 1/10)) • Operating profit 159,500 • Income from associate (W8) 4,600 • Tax ( 25,000 + 20,000) (45,000) • Profit for the year 119,100 • Attributable: • Owner 111,200 • NCI (W9) 7,900 • 119,100 CMGA/CGA Sept 2010

  40. Illustration 5 • India group statement of financial position • $ • Goodwill 21,000 • Tangible ( 90,000 + 80,000 + 5,000- 1,500) 173,500 • Investment in associate (w3) 31,000 • Current assets 138,000 • 363,500 • Ordinary shares ($1) 175,000 • Accumulated profits (w7) 142,600 • NCI (w6) 30,900 • Equity 348,000 • Liabilities 15,000 • 363,500 CMGA/CGA Sept 2010

  41. Inter- company items with associate • Inter-company trading • Dividends • Unrealised profit CMGA/CGA Sept 2010

  42. Inter-company trading • Members of the group can sell to or make purchases from the associate. This trading will result in the recognition of receivables and payables in the individual company accounts. • Do not cancel inter-company balances on the statement of financial position and do not adjust sales and cost of sales for trading with associate. • In consolidated statement of financial position, show balances with associate separately from other receivables and payables. • The associate is not part of the group. It is therefore appropriate to show amounts owed to the group by the associate as assets and amounts owed to the associate by the group as liabilities. CMGA/CGA Sept 2010

  43. Dividends • Consolidated statement of financial position: • Ensure dividends payable/receivable are fully accounted for in individual companies’ books. • Include receivable in the consolidated statement of financial position for dividends due to group from associates. • Do not cancel inter-company balance for dividends. • Consolidated statement of comprehensive income: • Do not include dividends from the associate in the consolidated statement of comprehensive income. Parent’s share of the associate’s profit after tax (hence before dividends) is included under equity accounting in the income from associate. CMGA/CGA Sept 2010

  44. Unrealised profit • If parent sells goods to associate and associate still has these goods in stock at the year end, their carrying value will include the profit made by parent and recorded in its books. Hence, profit is included in inventory value in associate’s net assets (profit is unrealised); and parent’s revenue. • If associate sells to parent, a similar situation arises, with the profit being included in associate’s revenue and parent’s inventory. • To avoid double counting when equity accounting for associate, this unrealised profit needs to be eliminated. • Unrealised profits should be eliminated to the extent of the investor’s interest in the associate. • To eliminate unrealised profit, deduct the profit from associate’s profit before tax and retained earnings in the net assets working before equity accounting for associate, irrespective of whether sale is from associate to parent or vice versa. CMGA/CGA Sept 2010

  45. Unrealised profit • Unrealised inter-company profits and losses resulting from ‘upstream’ and ‘downstream’ transactions are to be eliminated, but on partial rather than full elimination basis, i.e. only the investor’s proportionate interest in the inter-company profit and losses is adjusted for. • ‘Upstream’ transactions are, for example, sales of goods from an associate to the investor. • Dr. Retained earning • Cr. Inventory • ‘Downstream’ transactions are, for example, sales of goods from the investor to an associate. • Dr. Retained earning • Cr. Investment in associate CMGA/CGA Sept 2010

  46. Illustration 6 • Company A sells inventory to its 30% owned associate, B. The inventory had cost A $200,000 and was sold for $300,000 to B. • B also has sold inventory to A. The Cost of this inventory to B was $100,000, and it was sold for $120,000. • Required: • How would the inter company profit on these transactions be dealt with in the financial statements if none of the inventory had been sold at year-end ? CMGA/CGA Sept 2010

  47. Illustration 6 • Solution • Company A to Company B $000 • The inter group profit is $(300 -200) 100 • Unrealised Profits would be 100X 30/100 30 • The unrealised profit would be deferred until the sale of the inventory • Consolidated Journal : • Dr. Retained profits 30 • Cr. Interest in Associate 30 CMGA/CGA Sept 2010

  48. Illustration 6 • Company B to Company A $000 • The inter group profit is $(120 -100) 20 • Unrealised Profit would be (20X 30/100) 6 • The unrealised profit would be deferred until the sale of the inventory . • Consolidated Journal : • Dr. Retained profits 6 • Cr. Inventory (B/S) 6 CMGA/CGA Sept 2010

  49. Unrealised profit • IAS 28 requires that the share of the provision for unrealised profit of parent has to be accounted for. What IAS 28 investments in Associates does not do is to precisely inform us how to account for the adjustment and over the years, I have seen a variety of approaches used. • The adjustment may be always to deduct the unrealised profit away from the income from the associates and the investment in the associates is the seller or the buyer. In this way cost of sales and inventory are never adjusted. This has the advantage of simplicity. CMGA/CGA Sept 2010

  50. Shares of losses of the associates • If the investor’s share of losses of an associate equals or exceeds its interest in the associate – i.e. the CV of the associate – the investor discontinues recognising its share of further losses. • Note that the CV of the associate for this purpose includes any long-term interests that, in substance form part of the investor’s net investment in the associate – for example, long-term receivables, loans (unless supported by adequate collateral) and preference shares. • If the associate subsequently reports profits, the investor resumes recognising its share of those profits only after its share of the profits equals the share of losses not recognzied. CMGA/CGA Sept 2010

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