FSA 1 – Intercorporate Investments
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An intercorporate investment is simply one company putting money into the securities of another. The reasons are ordinary commercial ones: spreading the asset base across more than one business, buying a way into a new market, securing a competitive advantage, putting idle cash to work, and adding to profit. What makes the topic difficult is not the motive but the accounting. The same cash outflow can land on the investor balance sheet as a single line carried at market price, as a single line carried at cost plus accumulated profits, or as an entire second set of assets and liabilities folded in line by line. Two companies with economically similar positions can therefore report very different totals.
The securities themselves fall into two families. On the debt side the list runs from commercial paper through corporate and government notes and bonds to redeemable preferred stock and asset-backed securities. On the equity side it is common stock together with preferred stock that carries no redemption feature. How much equity an investor ends up holding depends on the resources available to it, on whether the shares can actually be bought, and on how much influence or control the investor wants.
Five categories, one organising principle
Marketable debt and equity holdings are sorted into categories that run along a single axis: how much say the investor has over the investee.
- Investments in financial assets. The investor has neither significant influence nor control over the operations of the investee.
- Investments in associates. The investor can exert significant influence, but not control.
- Joint ventures. Control is shared between two or more entities.
- Business combinations, including investments in subsidiaries. The investor obtains a controlling interest.
- Special purpose and variable interest entities. Control does not run through voting rights at all, so a separate test is needed.
The percentage of shares held is a presumption, not the test. Below a 20% equity interest the usual presumption is that no influence exists. From 20% up to 50% the usual presumption is significant influence. Above 50% the presumption is control. Each of those presumptions can be rebutted by the facts. A 19% holder with two board seats and a technology licence that the investee cannot operate without may have significant influence; a 25% holder frozen out of every decision may not.
Where the rules live
The IASB and the FASB worked to narrow the differences in the standards that govern classification, measurement and disclosure of intercorporate investments, and the resulting standards did improve relevance, transparency and comparability. Convergence was not completed for financial instruments, however, so differences remain. The terminology used here follows IFRS; US GAAP terminology is similar in most cases but not identical.
| Feature | Financial assets | Associates | Business combinations | Joint ventures |
|---|---|---|---|---|
| Degree of influence | None that is significant | Significant | Controlling | Joint, that is shared |
| Equity interest usually seen | Usually < 20% | Usually 20% to 50% | Usually > 50% or other indications of control | |
| Financial reporting | Amortized cost, or fair value with the movement taken either to profit or loss or to other comprehensive income | Equity method | Consolidation | IFRS: equity method |
| Governing IFRS | IFRS 9 alone | IAS 28 | IAS 27 with IFRS 3 and IFRS 10 | IFRS 11 with IFRS 12 and IAS 28 |
| Governing US GAAP | ASC Topic 320 | ASC Topic 323 | ASC Topics 805 with 810 | ASC Topic 323 again |
The standards referenced are IFRS 9, on financial instruments; IAS 28, which covers investments in associates and in joint ventures; IAS 27, on separate financial statements; IFRS 3, on business combinations; IFRS 10, on consolidated financial statements; IFRS 11, on joint arrangements; and IFRS 12, on the disclosure of interests held in other entities. On the US side, Topic 320 deals with investments in debt and in equity securities, Topic 323 with the equity method and with joint ventures, Topic 805 with business combinations, and Topic 810 with consolidations.
How the categories read in a real accounting policy note
GlaxoSmithKline, a British pharmaceutical and healthcare company, sets out the same ladder in its 2017 accounting policies. Entities whose relevant activities the group can direct, so as to affect the returns flowing back to the group, and which it generally does through control over financial and operating policies, are treated as subsidiaries. Where the group shares control and has rights to the net assets of an arrangement, the arrangement is a joint venture. Where the group shares control but has rights to specified assets and obligations for specified liabilities rather than to net assets, the arrangement is a joint operation, and the group brings in its own rights and obligations directly. Where the group can exercise significant influence, the entity is an associate. Associates and joint ventures both come into the consolidated statements through the equity method.
That last distinction, between a joint venture and a joint operation, is worth holding on to. It shows that the classification depends on what the investor has rights to, not on the label attached to the contract.
IFRS 9, Financial Instruments, replaced IAS 39 and became effective for annual periods beginning on 1 January 2018. The comparable US guidance sits in ASC 825, Financial Instruments, which has been updated several times and became effective for periods after 15 December 2017. The two are broadly consistent, with some differences that survive.
The design idea behind IFRS 9 is that measurement should follow two things: the contractual characteristics of the asset cash flows, and the way management actually runs the portfolio. Labelling a whole portfolio as held for trading, as available-for-sale, or as held-to-maturity is gone. Those last two descriptions have been struck out of the standard entirely. The second major change concerns loan impairment. An incurred loss model gave way to a model built on expected credit losses, which forces a company to weigh what it expects to happen next alongside the historical and current record of how its loans have performed.
The two tests for amortised cost
To be measured at amortised cost, a financial asset must pass both of the following, which together resemble the old management intent to hold to maturity but are drafted much more tightly:
- A business model test. The assets have to be held for the purpose of collecting the cash flows the contract promises. Business model here describes the way an entity runs its financial assets so as to generate cash, whether that is by collection, by sale, or by a mixture of the two.
- A cash flow characteristic test. The contractual cash flows are solely payments of principal and interest on principal.
Three measurement categories
IFRS 9 divides all financial assets into those measured at amortised cost and those measured at fair value, which produces three measurement categories in practice: amortised cost, fair value through profit or loss (FVPL), and fair value through other comprehensive income (FVOCI). Every financial asset is measured at fair value when it is first acquired, which will generally equal the cost basis on the acquisition date. After that the paths diverge.
A debt instrument that passes both tests is generally carried at amortised cost. If it passes both tests but may also be sold, which is a hold-to-collect-and-sell business model, it may be carried at FVOCI. Management may nonetheless elect FVPL to avoid an accounting mismatch, meaning an inconsistency that arises when related assets and liabilities are measured on different bases, some at amortised cost and some at fair value. So the measurement of a debt instrument depends on the business model applied to it.
Equity instruments have only the two fair value routes open to them, and amortised cost is closed off completely. Anything held for trading goes to FVPL with no election attached. For the rest, a company may designate the holding at FVOCI, but the designation cannot be undone, and once it is made the only thing reaching profit or loss is the dividend. The requirements for reclassifying gains and losses previously recognised in other comprehensive income also differ between debt and equity instruments.
Financial assets that are derivatives are measured at FVPL, with hedging instruments excepted. An embedded derivative stays inside its hybrid contract, rather than being stripped out, whenever the asset sits within the scope of the standard and is itself carried in full at FVPL.
The following illustration is constructed to isolate the mechanics of the three categories. An investor buys a bond at par for 100,000 with an annual coupon of 4%, and separately buys shares for 50,000. At the end of the year the bond has a fair value of 103,000 and the shares have a fair value of 58,000. Cash dividends of 1,500 were received on the shares. Ignore taxes and credit losses.
Amortised cost. Carrying amount 100,000. Profit or loss 4,000. The gain is not recognised at all.
FVOCI. Carrying amount 103,000. Profit or loss 4,000, with the 3,000 gain reported in other comprehensive income.
FVPL. Carrying amount 103,000. Profit or loss 4,000 + 3,000 = 7,000.
Under FVOCI and FVPL total comprehensive income is 7,000 in both cases, and all that changes is how it splits between profit or loss and other comprehensive income. Under amortised cost the gain is never recognised anywhere, so total comprehensive income is 4,000 and the balance sheet stays at 100,000.
FVPL. Carrying amount 58,000. Profit or loss 8,000 + 1,500 = 9,500.
FVOCI, elected. Carrying amount 58,000. Profit or loss 1,500, the dividend only, with the 8,000 gain in other comprehensive income. Amortised cost is not permitted for an equity instrument, so there is no third column.
Reclassification
Reclassification of equity instruments is not permitted, because the initial choice between FVPL and FVOCI is irrevocable. Reclassification of debt instruments is permitted only when the business model for the financial assets, meaning the objective for holding them, has changed in a way that significantly affects operations. Such changes require judgement and are expected to be very infrequent.
When reclassification is appropriate, prior periods are not restated at the reclassification date. If an asset moves from amortised cost to FVPL, it is then measured at fair value and any gain or loss is recognised immediately in profit or loss. If it moves from FVPL to amortised cost, the fair value at the reclassification date becomes the new carrying amount.
What changed, in summary
- A business model approach to the classification of debt instruments.
- Three classifications for financial assets: FVPL, FVOCI and amortised cost.
- Debt instruments may be reclassified only where the business model itself changes, while for equity investments the choice between FVOCI and FVPL can never be revisited.
- Provisioning was redesigned across financial assets, financial guarantees, loan commitments and receivables under leases, with an incurred loss basis giving way to an expected loss basis. Recognition therefore comes earlier, with expected losses for the coming twelve months taken upfront on assets that are performing, and expected losses across the whole remaining life taken on assets that are not.
Under US GAAP the equivalent credit impairment requirements sit in ASC 326, effective for most public companies beginning 1 January 2020.
How a large bank described the transition
Deutsche Bank explained in its 2017 statements that under IFRS 9 the business model and the contractual cash flows of an instrument together determine its classification and measurement, with every financial asset classified on initial recognition as fair value through profit or loss, amortised cost, or fair value through other comprehensive income. Because the IFRS 9 requirements differ from the IAS 39 assessments, some classification and measurement outcomes changed, including decisions about electing the fair value option. Classification and measurement of financial liabilities were left largely unchanged.
The sequence is instructive. An initial determination of business models and an assessment of contractual cash flow characteristics were made in 2015; a population of assets destined for amortised cost or FVOCI, and therefore subject to the impairment rules, was identified in 2016; the business model assessments were updated and the outstanding classification decisions completed in 2017. On the equity side the bank noted an option, exercisable investment by investment and never reversible, to route later fair value changes on an equity holding not held for trading into other comprehensive income, and recorded that it had taken up none of them. Where debt it has issued is designated at fair value, the part of the movement caused by changes in its own credit standing belongs in other comprehensive income rather than in the income statement, and the bank chose not to adopt that presentation early.
The analyst adjustment
Analysts normally evaluate operating and investing performance separately. An assessment of operating performance should exclude items that belong to investing activity: interest income, dividends, and realised and unrealised gains and losses. For comparability, non-operating assets should be excluded when computing a return on net operating assets. Both IFRS and US GAAP require disclosure of the fair value of each class of investment in financial assets, so the raw material for these adjustments is available. Using market values and adjusting pro forma statements for consistency improves performance ratio comparisons across companies.
Under both IFRS and US GAAP, an investor holding 20% to 50% of the voting rights of an investee, either directly or indirectly through subsidiaries, is presumed to have significant influence but not control over the investee business activities. Below 20% the presumption reverses: the investor is presumed unable to exercise significant influence unless such influence can be demonstrated. IAS 28 under IFRS and FASB ASC Topic 323 under US GAAP govern most investments carrying significant influence and set out the equity method.
Evidence of significant influence
The standards list the indicators that can confirm or rebut the percentage presumption:
- a seat, or several seats, on the board of directors;
- a hand in the process by which policy is set;
- transactions of a material size flowing between the two companies;
- managerial staff moving from one company to the other; or
- dependence by the investee on technology the investor supplies.
One difference between the frameworks is worth memorising. IFRS also count instruments the investor already holds that are currently exercisable or convertible, meaning warrants, call options and convertible securities, where exercising them would either add to the voting power of the investor or cut back the voting power another party holds over financial and operating policy. US GAAP look only at the voting shares in issue on the date of purchase, so potential voting rights play no part at all.
Where significant influence exists, the financial and operating performance of the investee is partly shaped by the management decisions and operational skills of the investor. The equity method reflects that economic reality and gives a more objective basis for reporting investment income than waiting for dividends, because the investor can potentially influence the timing of dividend distributions.
Joint ventures
Joint ventures are ventures undertaken and controlled by two or more parties. They are a convenient way to enter foreign markets, conduct specialised activities and take on risky projects, and they come in many legal forms: partnerships, limited liability companies, and unincorporated associations among them. Some are primarily contractual relationships and others involve common ownership of assets. IFRS pick out two common features: there is a contract between two or more venturers, and joint control is established by it. The equity method is required for joint ventures under both frameworks, and proportionate consolidation is permitted only in rare circumstances.
The mechanics of the equity method
The investment is initially recorded on the investor balance sheet at cost. In later periods the carrying amount is adjusted for the investor proportionate share of the investee earnings or losses, and that share is reported in income. Distributions coming back from the investee, dividends included, count as a return of capital. They pull down the carrying amount and never reach the profit or loss of the investor. The method is often called one-line consolidation, because the investor proportionate interest in the assets and liabilities of the investee shows up as a single net assets line on the balance sheet and its share of revenues and expenses as a single line on the income statement. Equity method investments are classified as non-current assets, and both the share of profit or loss and the carrying amount must be separately disclosed.
Losses are handled asymmetrically. The recorded value can fall because of investee losses or a permanent decline in the investee market value. If the investment is written down to zero, the investor usually discontinues the equity method and records no further losses. If the investee later reports profits, the method resumes once the investor share of those profits equals the share of losses that went unrecognised while the method was suspended.
Branch, a fictitious company, purchases a 20% interest in Williams, also fictitious, for €200,000 on 1 January 2016. Williams reports income and dividends as follows.
| Year | Income | Dividends |
|---|---|---|
| 2016 | EUR 200,000 | €50,000 |
| 2017 | EUR 300,000 | 100,000 |
| 2018 | EUR 400,000 | 200,000 |
| Total | EUR 900,000 | €350,000 |
Initial cost €200,000.
Equity income 2016: €40,000 (20% of €200,000).
Dividends received 2016: (€10,000) (20% of €50,000).
Equity income 2017: €60,000 (20% of €300,000).
Dividends received 2017: (€20,000) (20% of €100,000).
Equity income 2018: €80,000 (20% of €400,000).
Dividends received 2018: (€40,000) (20% of €200,000).
Balance in the equity investment: €310,000, which is €200,000 + 20% × (€900,000 − €350,000).
The shortcut in that last line works only because this example implicitly assumes the purchase price equalled the purchased 20% share of the book value of the Williams net assets. Section 4 removes that assumption.
What the disclosures look like
Deutsche Bank describes an associate as an entity over whose operating and financial management policy decisions the group has significant influence but not a controlling interest, with significant influence generally presumed between 20% and 50% of voting rights. Potential voting rights that are currently exercisable or convertible are considered, as are board representation, which in German stock corporations means the supervisory board, and material intercompany transactions. The bank is explicit that these factors can require the equity method even where the holding is below 20% of the voting stock.
Its aggregated disclosure for individually immaterial associates and joint ventures is a compact illustration of the equity method output.
| Item | Dec 31, 2017 | Dec 31, 2016 |
|---|---|---|
| Carrying amount of all associates that are individually immaterial to the group | EUR 866 | 1,027 |
| Share of profit (loss) from continuing operations | EUR 141 | 183 |
| Share of post-tax profit (loss) from discontinued operations | EUR 0 | 0 |
| Share of other comprehensive income | EUR (36) | 11 |
| Share of total comprehensive income | EUR 105 | 194 |
The group held interests in 77 associates in 2017 against 92 in 2016, and in 13 jointly controlled entities against 14. The comprehensive income line reconciles in both years: 141 + 0 − 36 = 105 for 2017, and 183 + 0 + 11 = 194 for 2016.
Two features of the equity method show through in that table. First, everything arrives net: one carrying amount, one profit share, one comprehensive income share, no assets and no liabilities of the associates themselves. Second, the group applies the method to holdings below 20% where board representation or other measures give it significant influence, which is precisely the substance-over-percentage principle at work.
For practical reasons the results of associates are sometimes included in the investor accounts with a time lag, normally not more than one quarter. Dividends from associates stay out of investor income, since counting them would count the same profit twice: the full share of associate income has already been recognised, and a dividend does no more than turn part of that equity interest into cash. On the consolidated balance sheet the book value of the holding rises with the share of net income and falls with both the amortisation of surplus values and the dividends taken.
What it costs to buy shares in an investee will often exceed what those shares are worth on the books. The main reason is that a good deal of what the investee owns and owes is carried at historical cost rather than at fair value. IFRS allow a company to measure property, plant and equipment using either historical cost or a revalued amount, less accumulated depreciation. US GAAP require historical cost less accumulated depreciation. There are also economic reasons for paying a premium: a successful company should generate economic value through the productive use of its assets in excess of the resale value of those assets, so a buyer may pay for future benefits arising from market conditions, from the ability to exert significant influence, or from other synergies.
How the premium is split
Suppose the cost of the investment runs above the proportionate share the investor is buying of the book value of the identifiable tangible and intangible assets of the investee, a population that includes inventory, property, plant and equipment, trademarks and patents. The gap is pushed first onto specific assets, or onto categories of assets, at their fair values. Whatever has been allocated in that way is then written off against the share of investee profit that the investor recognises, spread over the economic life of each asset that carried a fair value above its book value.
Any remaining difference between the acquisition cost and the investor share of the fair value of the net identifiable assets is goodwill under both IFRS and US GAAP. Goodwill is not amortised. It is reviewed for impairment regularly and written down when impairment is identified, and it stays inside the carrying amount of the investment because the investment is reported as a single line.
Two mechanical points cause most of the confusion. The allocation is never recorded formally in the accounts: what appears in the investment account on the acquisition date is simply the cost. And the allocated amounts are not reflected in the investee financial statements either, so the investee income statement will not contain the periodic adjustments. The investor must record the effects directly, by reducing the carrying amount of its investment and by reducing the investee profit it recognises. Amounts landing on assets that are never systematically amortised, land being the obvious one, simply stay at whatever fair value they carried on the day the stake was bought.
Blake Co. and Brown Co. are hypothetical companies. Blake acquires 30% of the outstanding shares of Brown. At the acquisition date the book values and fair values of the recorded assets and liabilities of Brown are as follows.
| Item | Book value | Fair value |
|---|---|---|
| Current assets | EUR 10,000 | €10,000 |
| Plant and equipment | EUR 190,000 | 220,000 |
| Land | EUR 120,000 | 140,000 |
| Total assets | EUR 320,000 | €370,000 |
| Liabilities | EUR 100,000 | 100,000 |
| Net assets | EUR 220,000 | €270,000 |
Blake believes the value of Brown is higher than the book value of its identifiable net assets and offers €100,000 for the 30% interest.
Purchase price €100,000.
30% of the book value of Brown (30% × €220,000) = 66,000.
Excess purchase price = €34,000.
Fair value exceeds book value across the identifiable net assets by €50,000 (€270,000 − 220,000). The 30% share of that gap is €15,000, allocated as follows:
Plant and equipment (30% × €30,000) = €9,000.
Land (30% × €20,000) = 6,000.
Goodwill (residual) = 19,000.
The three components sum to €34,000.
Goodwill is whatever is left after the identifiable assets and liabilities have absorbed what they can. On the acquisition date the Blake books show one non-current line, Investment in Brown, at €100,000.
| Account | Excess price (€) | Useful life | Amortisation per year (€) |
|---|---|---|---|
| Plant and equipment | EUR 9,000 | 10 years | 900 |
| Land | EUR 6,000 | Indefinite | 0 |
| Goodwill | EUR 19,000 | Indefinite | 0 |
On 1 January 2018 Parker Company acquired 30% of the common shares of Prince Inc. for a cash price of €500,000. Both companies are fictitious. Parker has the ability to exert significant influence over the financial and operating decisions of Prince. The following information about the assets and liabilities of Prince on 1 January 2018 is provided.
| Item | Book value | Fair value | Difference |
|---|---|---|---|
| Current assets | EUR 100,000 | €100,000 | €0 |
| Plant and equipment | EUR 1,900,000 | 2,200,000 | 300,000 |
| Total assets | EUR 2,000,000 | €2,300,000 | €300,000 |
| Liabilities | EUR 800,000 | 800,000 | 0 |
| Net assets | EUR 1,200,000 | €1,500,000 | €300,000 |
Depreciation on the plant and equipment is straight-line, with 10 years still to run. For 2018, Prince reports net income of €100,000 and pays out dividends of €50,000.
Purchase price €500,000.
Less the equity bought in the book value of the Prince net assets (30% × €1,200,000) = 360,000.
Excess purchase price = €140,000.
Attributable to plant and equipment (30% × €300,000) = (90,000).
Goodwill (residual) = €50,000.
Purchase price €500,000.
Share of the Prince net income (30% × €100,000) = 30,000.
Dividends received (30% of €50,000) = (15,000).
Amortisation of the excess purchase price attributable to plant and equipment (€90,000 ÷ 10 years) = (9,000).
Balance in investment in Prince at 31 December 2018 = €506,000.
2018 beginning net assets €1,200,000.
Plus net income 100,000.
Less dividends (50,000).
2018 ending net assets = €1,250,000.
Proportionate share of the recorded net assets of Prince (30% × €1,250,000) = €375,000.
Unamortised excess purchase price (€140,000 − 9,000) = 131,000.
Investment in Prince = €506,000.
The unamortised excess is a cost incurred by Parker, not by Prince, which is why the whole of it sits in the Parker investment account and none of it appears anywhere in the Prince accounts.
The reverse case is possible. Where the investor share of the fair value of those net assets, meaning identifiable assets, liabilities and contingent liabilities, comes out above what was actually paid, the surplus stays out of the carrying amount altogether. It goes into income instead, as part of the associate profit or loss recognised in the period in which the stake was bought.
The fair value option
Both IFRS and US GAAP allow an investor to account for an equity method investment at fair value instead. Under US GAAP the option is available to all entities. IFRS restrict it to venture capital organisations, to mutual funds, to unit trusts and to similar entities, investment-linked insurance funds among them. Under both frameworks the election is made when the investment is first recognised and can never be reversed.
After initial recognition the investment is reported at fair value, with unrealised gains and losses from changes in fair value, together with any interest and dividends received, included in the investor profit or loss. The consequences are worth listing, because a candidate who forgets them will double count. Under the fair value option the investment account does not reflect the investor proportionate share of the investee profit or loss, dividends or other distributions. The excess of cost over the fair value of the investee identifiable net assets is not amortised. And no goodwill is created.
Impairment of an equity method investment
Both frameworks require periodic reviews for impairment. If fair value falls below carrying value and the decline is other than temporary, an impairment loss must be recognised. The details differ.
| Feature | IFRS | US GAAP |
|---|---|---|
| Trigger | Objective evidence of impairment from one or more loss events occurring after initial recognition, with an impact on future cash flows that can be reliably estimated | A decline in fair value below carrying value that is determined to be permanent |
| Unit of account | The entire carrying amount of the investment, because goodwill is inside it and is not separately tested | The investment as a whole, reduced to its fair value |
| Measurement | Compare the recoverable amount with the carrying amount | Write the carrying value down to fair value |
| Reversal | Permitted, in line with IAS 36, to the extent the recoverable amount of the net investment subsequently increases | Prohibited, even if fair value later increases |
Recoverable amount is the higher of value in use and net selling price. Value in use means the present value of the cash flows an asset is expected to throw off while it remains in use, together with whatever it fetches when it is finally disposed of. Net selling price means fair value after the costs of selling have been taken off. The loss is recognised on the income statement, and the carrying amount is reduced either directly or through an allowance account.
Keep this test separate in your mind from the goodwill impairment test applied to a consolidated subsidiary, covered later in this lesson. Here the whole investment is tested as one number. There, goodwill is disaggregated to units and tested at that level.
Because an investor with significant influence can affect the terms and the timing of transactions with its associate, profit on those transactions cannot be treated as realised until it is confirmed through use or through sale to a third party. The investor share of any unrealised profit is therefore deferred by reducing the amount recorded under the equity method. In a later period, when the profit is considered confirmed, it is added back to equity income, and from that point equity income is once again based simply on the recorded values in the associate accounts.
The direction of the sale determines where the profit was recorded, but not whether it must be eliminated.
- Upstream means associate to investor. The profit on the intercompany transaction sits on the associate income statement, so the investor share of the unrealised profit is already inside equity income on the investor income statement.
- Downstream means investor to associate. The profit sits on the investor own income statement.
Under both frameworks the unearned profit has to be removed as far as the investor interest in the associate extends, and whichever way the goods travelled, the correction lands on equity income in the investor income statement.
Wicker Company bought a 25% interest in Foxworth Company on 1 January 2018, both companies being fictitious, paying €1,000,000 and applying the equity method. Foxworth net assets stood at a book value of €3,800,000 that day. Fair values matched book values right across the assets and liabilities with one exception, a building carried €40,000 below its fair value and having 20 years of life left. Straight-line depreciation is used for the building. Foxworth paid dividends of €3,200 during 2018 and its reported net income for the year came to €20,000. Foxworth also sold inventory to Wicker in that year. Sitting inside the reported figure at the year end was €8,000 of profit on that upstream sale, and Wicker had not yet passed the goods on to anyone outside.
Share of the reported income of Foxworth (25% × €20,000) = €5,000.
Amortisation of the excess purchase price attributable to the building (€10,000 ÷ 20) = (500).
Unrealised profit (25% × €8,000) = (2,000).
Equity income 2018 = €2,500.
Note that the amortisation base is the €10,000 share of the building undervaluation, not the €40,000 undervaluation itself, because Wicker paid for only 25% of it.
Purchase price €1,000,000.
Acquired equity in the book value of the Foxworth net assets (25% × €3,800,000) = 950,000.
Excess purchase price = €50,000, of which the building takes 25% × €40,000 = €10,000 and goodwill takes the residual €40,000.
Then roll the account forward.
Purchase price €1,000,000.
Equity income 2018 = 2,500.
Dividends received (25% × €3,200) = (800).
Investment in Foxworth at 31 December 2018 = €1,001,700.
The same balance from its composition: the Wicker proportionate share of the Foxworth net equity at book value, 25% × [€3,800,000 + (20,000 − 8,000) − 3,200] = €952,200, plus the unamortised excess purchase price (€50,000 − 500) = 49,500, giving €1,001,700. The €8,000 unrealised profit is stripped out of the net assets of Foxworth in this calculation because it has not been earned from the group point of view.
Jones Company owns 25% of Jason Company, both fictitious, and applies the equity method appropriately. Assets that were undervalued when the stake was bought give rise to amortisation of excess purchase price of €8,000 a year. In 2017 Jones sold inventory costing it €96,000 to Jason for €160,000. Of that, Jason passed €120,000 on to outside buyers during 2017 and the balance during 2018. Income from the operations of Jason was €800,000 in 2017 and €820,000 in 2018.
Share of the reported income of Jason (25% × €800,000) = €200,000.
Amortisation of excess purchase price = (8,000).
Unrealised profit (25% × €16,000) = (4,000).
Equity income 2017 = €188,000.
Building the €16,000: the profit Jones made on the sale to Jason was €160,000 − 96,000 = €64,000. Jason sold on 75% of the goods (€120,000 ÷ 160,000), leaving 25% unsold. Total unrealised profit is therefore €64,000 × 25% = €16,000, and the Jones share of it is €16,000 × 25% = €4,000.
The same answer by the margin route: the Jones profit margin on the sale was 40% (€64,000 ÷ €160,000). The Jason inventory of Jones goods at 31 December 2017 was €40,000. The Jones margin on that was 40% × 40,000 = €16,000, and its share of the profit on the unsold goods is €16,000 × 25% = €4,000.
Share of the reported income of Jason (25% × €820,000) = €205,000.
Amortisation of excess purchase price = (8,000).
Realised profit (25% × €16,000) = 4,000.
Equity income 2018 = €201,000.
During 2018 the last quarter of the goods bought from Jones is sold on, so the deferral unwinds and the €4,000 returns as a positive item. The deferral shifts profit between periods; it does not destroy it.
Issues for the analyst
Equity method accounting creates several analytical problems, and none of them is solved by the disclosures alone.
- Is the equity method even appropriate? A 19% holder may in truth wield significant influence and yet resist the equity method so as to keep associate losses off its own income statement. A 25% holder may wield none, and may be unable to reach the cash flows at all, and yet prefer the equity method so as to capture associate income.
- The balance sheet is incomplete. The investment account stands for a percentage of the net assets of the investee and for nothing else. Sizeable assets, and more to the point sizeable borrowings, can sit inside the investee without ever reaching the balance sheet of the investor, which distorts every debt ratio. Net margin can be flattered too, since associate income lifts net income while contributing nothing to sales.
- Structure can be chosen for effect. An investor may in substance control an investee with less than 50% ownership yet prefer the financial results that the equity method produces. Careful analysis can reveal financial performance that is driven by accounting structure rather than by economics.
- Earnings quality. The equity method assumes that a fraction of each unit of currency earned by the investee, equal to the fraction of the company owned, is earned by the investor, even when no cash is received. Analysts should therefore look at potential restrictions on dividend cash flows in the statement of cash flows.
A business combination brings two or more entities together into a larger economic entity. The motive is normally a belief that the combination will be worth more than the parts: revenue neither party could win alone, duplicated cost bases that can be stripped out, tax advantages, a production process that can be run end to end, and assets that can be managed more efficiently.
IFRS draw no distinction between combinations according to the structure the enlarged entity ends up with. In every case one party is identified as the acquirer, and the classification question stops there. US GAAP also identify an acquirer, but then sort combinations into mergers, acquisitions and consolidations according to the legal shape that results.
| Type | Distinctive feature | Result |
|---|---|---|
| Merger | Just one entity survives. The target is absorbed whole by the acquirer, which may hand over common stock, preferred stock or bonds, or simply pay cash, in return for the net assets. | Company A + Company B = Company A |
| Acquisition | Legal continuity of both entities, connected through a parent–subsidiary relationship. Each keeps separate financial records and the parent provides consolidated statements each period. The acquirer does not need 100%, and in some cases may acquire less than 50% and still exert control. | Company A + Company B = (Company A + Company B) |
| Consolidation | A fresh legal entity is created to take over the net assets of both, and neither predecessor survives. | Company C alone, formed from Company A plus Company B |
| Special purpose or variable interest entity | Voting control is usually beside the point, because the equity investors have too little at risk for the entity to fund what it does without subordinated support from elsewhere, and may hold no controlling financial interest at all. The sponsor builds the entity for one narrow purpose. | Consolidated by the party that controls it in substance |
Where an acquisition stops short of complete ownership, the interests belonging to minority shareholders outside the group are reported within the consolidated statements.
Under IFRS 10, Consolidated Financial Statements, and SIC-12, Consolidation of Special Purpose Entities, the definition of control extends across a broad range of activities. Control exists where two conditions hold together: the investor is able to influence the financial and operating policy of the entity, and it is either exposed to, or holds rights over, returns from that involvement which vary. The consolidation criteria apply to every entity meeting that definition. US GAAP instead runs a two-component consolidation model with a variable interest component and a voting interest component; under the variable interest component the primary beneficiary of a variable interest entity must consolidate it regardless of voting interests or decision-making authority, the primary beneficiary being the party that will absorb the majority of the expected losses, receive the majority of the expected residual returns, or both.
There was once a choice between treating a combination as a purchase and treating it as a uniting, or pooling, of interests. Pooling has gone. The acquisition method developed jointly by the IASB and the FASB replaced the purchase method, and it substantially reduced the differences between the two frameworks. Both now require the acquisition method for business combinations, with a few specific exemptions.
What the acquisition method requires
The measurement basis is the fair value of what the acquiring company gives up, and any contingent consideration enters at its fair value on the acquisition date as well. Costs run up directly on the deal, meaning the fees of lawyers, accountants, valuation specialists and consultants, are never capitalised into that price; they are expensed as they arise. The method then settles three questions: how assets and liabilities of the combined entity get recognised and measured, how goodwill is first recognised and then carried afterwards, and how any interest belonging to outside shareholders is recognised and measured.
- Identifiable assets and liabilities. The acquirer measures the identifiable tangible and intangible assets and liabilities of the acquiree at fair value as of the acquisition date, and must also recognise assets and liabilities the acquiree had never recognised itself. Internally developed brand names, patents and technology are the standard examples.
- Contingent liabilities. A contingent liability assumed in the acquisition is recognised if it is a present obligation arising from past events and it can be measured reliably. It must be recognised even if an outflow of resources to settle it is not probable. Costs the acquirer expects but is not obliged to incur are not liabilities at the acquisition date; expected restructuring costs on exiting an acquiree business are recognised in the period they are incurred. IFRS include contingent liabilities whose fair values can be reliably measured; US GAAP include only those that are probable and can be reasonably estimated.
- Indemnification assets. Where the seller contractually indemnifies the acquirer for the outcome of a contingency or an uncertainty related to a specific asset or liability, or against losses above a specified amount, the acquirer recognises an indemnification asset at the same time it recognises the indemnified liability, measured on the same basis. If the indemnified item is recognised at acquisition-date fair value, the indemnification asset is too.
- Financial assets and liabilities. These are classified in accordance with the applicable standards at the acquisition date, with the acquirer reclassifying them based on contractual terms, economic conditions and its own operating or accounting policies as they exist at that date.
Full goodwill and partial goodwill
IFRS allow two options for recognising goodwill at the transaction date, chosen transaction by transaction. Partial goodwill starts from the fair value of the acquisition, meaning the fair value of what was handed over, and deducts the acquirer share of everything identifiable that came with it: tangible assets, intangible assets, liabilities, and contingent liabilities. Full goodwill starts instead from what the whole entity is worth at fair value and deducts the fair value of all those same identifiable items. US GAAP take the entity as a whole and insist on full goodwill. Neither framework amortises goodwill, since its life is indefinite; instead it faces an impairment test each year, and sooner if events or circumstances point that way.
An acquirer pays $800,000 for an 80% interest in an acquiree. Identifiable net assets are worth $900,000 at fair value, and the entity taken as a whole is valued at $1 million.
Partial goodwill (IFRS option).
Fair value of consideration $800,000.
80% of the fair value of identifiable net assets = 720,000.
Goodwill recognised = $80,000.
Full goodwill (IFRS option and required under US GAAP).
Fair value of entity $1,000,000.
Fair value of identifiable assets 900,000.
Goodwill recognised = $100,000.
The gap of $20,000 is exactly the goodwill attributable to the 20% the acquirer does not own. Partial goodwill leaves it out; full goodwill brings it in and then hands the same amount back to the non-controlling shareholders inside equity.
Now and then a company runs into trouble severe enough to push its market value under what its net assets are worth at fair value. Buying such a company for less than the fair value of its net assets is a bargain purchase. Both frameworks then require the shortfall, being the amount by which the fair value of the net assets acquired exceeds the price paid, to go straight into profit or loss as a gain, recognised at once. Any contingent consideration must be measured and recognised at fair value at the time of the combination, and subsequent changes in its value are recognised in profit or loss.
Franklin Company, a hypothetical company, took over the whole of Jefferson, Inc., also fictitious, by issuing 1,000,000 of its own €1 par common shares, which carried a market value of €15 each. The two companies compiled the following information immediately before the transaction. Jefferson holds no identifiable intangible assets.
| Line | Franklin, on the books | Jefferson, on the books | Jefferson, at fair value |
|---|---|---|---|
| Cash and receivables | EUR 10,000 | €300 | €300 |
| Inventory | EUR 12,000 | 1,700 | 3,000 |
| PP&E (net) | EUR 27,000 | 2,500 | 4,500 |
| Total assets | EUR 49,000 | €4,500 | €7,800 |
| Current payables | EUR 8,000 | 600 | 600 |
| Long-term debt | EUR 16,000 | 2,000 | 1,800 |
| Total liabilities | EUR 24,000 | 2,600 | 2,400 |
| Net assets | EUR 25,000 | €1,900 | €5,400 |
| Capital stock (€1 par) | EUR 5,000 | €400 | |
| Additional paid in capital | EUR 6,000 | 700 | |
| Retained earnings | EUR 14,000 | €800 |
Stock issued, at fair value (1,000,000 shares at €15) = €15,000,000.
Less the book value of what Jefferson brings, €1,900,000, leaves an excess purchase price of €13,100,000.
Taking the same €15,000,000 and deducting instead the €5,400,000 of identifiable net assets measured at fair value leaves goodwill of €9,600,000.
Spreading the excess over each gap between fair value and book value gives inventory €1,300,000, PP&E (net) €2,000,000, long-term debt €200,000 and goodwill €9,600,000, which together come to €13,100,000. The long-term debt contributes because its fair value of €1,800,000 is below its book value of €2,000,000.
| Item | Amount |
|---|---|
| Cash and receivables | EUR 10,300 |
| Inventory | EUR 15,000 |
| PP&E (net) | EUR 31,500 |
| Goodwill | EUR 9,600 |
| Total assets | EUR 66,400 |
| Current payables | EUR 8,600 |
| Long-term debt | EUR 17,800 |
| Total liabilities | EUR 26,400 |
| Capital stock (€1 par) | EUR 6,000 |
| Additional paid in capital | EUR 20,000 |
| Retained earnings | EUR 14,000 |
| Total stockholders equity | EUR 40,000 |
| Total liabilities and stockholders equity | EUR 66,400 |
The equity side reflects the stock Franklin issued. Par value issued was €1,000,000, but the stock is measured at fair value under both frameworks, so the consideration exchanged is €15,000,000. Franklin had 5,000,000 shares of €1 par outstanding beforehand, so combined capital stock is €6,000,000. Additional paid in capital of €6,000,000 rises by €14,000,000, being €15,000,000 less the €1,000,000 par, to €20,000,000. Only the retained earnings of the acquirer survive the acquisition date, so the €800,000 belonging to Jefferson simply vanishes. Earnings of the target start feeding consolidated income, and consolidated retained earnings, only once the acquisition is behind them.
Consolidated statements take the separate accounts of legally distinct companies, a parent and the subsidiaries beneath it, and present them as though one economic unit had produced them. Assets, liabilities, revenues and expenses of the subsidiaries are added to those of the parent. Anything transacted between parent and subsidiary is then stripped out, so that nothing is counted twice and no income is booked before the group has earned it from outside. The presumption is that statements built this way are the more faithful representation, but an analyst still has to weigh the differences between the two frameworks, the valuation bases in use, and anything else that could undermine a comparison.
In a merger or a consolidation the acquirer buys 100% of the target equity. In a transaction structured as an acquisition it need not, because control does not require complete ownership. The acquirer may be constrained by resources or unable to buy every outstanding share. Both frameworks presume control where more than 50% of the voting shares are owned. Each of them normally keeps its own records, with the parent preparing consolidated statements on top of that in every reporting period. Those consolidated statements are what investors and analysts actually work from.
Non-controlling interests on the balance sheet
A non-controlling, or minority, interest is the portion of the subsidiary equity, its residual interest, held by third parties. It arises whenever the parent acquires less than a 100% controlling interest. IFRS and US GAAP classify it the same way, as a separate component of stockholders equity on the consolidated balance sheet. They differ on measurement. IFRS let the parent carry that interest either at fair value, which is the full goodwill method, or at the share of the identifiable net assets of the acquiree that belongs to it, which is the partial goodwill method. US GAAP leave no choice: the parent applies full goodwill and carries the outside interest at fair value.
On 1 January 2018 Parent Co., a hypothetical company, took 90% of the shares outstanding in Subsidiary Co., also hypothetical, paying with its own no par common stock worth €180,000. On the day of the exchange the shares of the subsidiary carried a fair market value of €200,000 in total. Selected financial information for the two companies just before the exchange, and before the parent had recorded anything, is given below.
| Item | Parent book value | Subsidiary book value | Subsidiary fair value |
|---|---|---|---|
| Cash and receivables | EUR 40,000 | €15,000 | €15,000 |
| Inventory | EUR 125,000 | 80,000 | 80,000 |
| PP&E (net) | EUR 235,000 | 95,000 | 155,000 |
| Total assets | EUR 400,000 | €190,000 | €250,000 |
| Payables | EUR 55,000 | 20,000 | 20,000 |
| Long-term debt | EUR 120,000 | 70,000 | 70,000 |
| Total liabilities | EUR 175,000 | 90,000 | 90,000 |
| Net assets | EUR 225,000 | €100,000 | €160,000 |
| Capital stock (no par) | EUR 87,000 | €34,000 | |
| Retained earnings | EUR 138,000 | €66,000 |
Fair value of the subsidiary €200,000.
Fair value of the identifiable net assets of the subsidiary 160,000.
Goodwill = €40,000.
The non-controlling interest equals its proportionate share of the subsidiary fair value: 10% × €200,000 = €20,000.
Acquisition price €180,000.
90% of fair value 144,000.
Goodwill = €36,000.
The non-controlling interest equals its proportionate share of the fair value of the identifiable net assets: 10% × €160,000 = €16,000. Whichever method is used, goodwill is not amortised under either framework, and it is tested for impairment at least annually.
| Item | Full goodwill | Partial goodwill |
|---|---|---|
| Cash and receivables | EUR 55,000 | €55,000 |
| Inventory | EUR 205,000 | 205,000 |
| PP&E (net) | EUR 390,000 | 390,000 |
| Goodwill | EUR 40,000 | 36,000 |
| Total assets | EUR 690,000 | €686,000 |
| Payables | EUR 75,000 | €75,000 |
| Long-term debt | EUR 190,000 | 190,000 |
| Total liabilities | EUR 265,000 | €265,000 |
| Non-controlling interests | EUR 20,000 | €16,000 |
| Capital stock (no par) | EUR 267,000 | €267,000 |
| Retained earnings | EUR 138,000 | 138,000 |
| Total equity | EUR 425,000 | €421,000 |
| Total liabilities and shareholders equity | EUR 690,000 | €686,000 |
Non-controlling interests on the income statement
On the income statement the non-controlling interest appears as a line item that allocates the profit or loss for the period. Where transactions between the group companies exist, they come out in full. Assumed data consistent with Example 9, and ignoring income taxes, produce the subsidiary amounts shown below. In practice the figure shown on that line is the share of subsidiary income, measured after tax, that belongs to the outside shareholders.
| Item | Full goodwill | Partial goodwill |
|---|---|---|
| Sales | EUR 250,000 | €250,000 |
| Cost of goods sold | EUR 137,500 | 137,500 |
| Interest expense | EUR 10,000 | 10,000 |
| Depreciation expense | EUR 39,000 | 39,000 |
| Income from continuing operations | EUR 63,500 | €63,500 |
| Non-controlling interest (10%) | EUR (6,350) | (6,350) |
| Consolidated net income to parent shareholders | EUR 57,150 | €57,150 |
| Ratio | Full goodwill (%) | Partial goodwill (%) |
|---|---|---|
| Return on assets | 8.28 | 8.33 |
| Return on equity | 13.45 | 13.57 |
Both ratios use net income to parent shareholders of €57,150 over the totals in the comparative balance sheet: €690,000 and €425,000 under full goodwill, €686,000 and €421,000 under partial goodwill.
Goodwill impairment after consolidation
Goodwill escapes amortisation but not scrutiny. It has to be tested at least once a year, and sooner if anything happens that suggests its value has fallen. Where it becomes probable that profitable operation of the combined business will not recover some or all of it, the unrecovered part is charged to expense, whether in part or in full. Such a write-down is permanent: goodwill once reduced can never be put back. Both frameworks show the resulting loss on its own line within consolidated income.
The frameworks differ on the level at which goodwill is assigned and on the mechanics of the test.
| Feature | IFRS | US GAAP |
|---|---|---|
| Level of allocation | Cash-generating units expected to benefit from the synergies of the combination. Such a unit is the smallest identifiable group of assets whose cash inflows are largely independent of those from other assets, and it is the finest level at which goodwill gets monitored anywhere in the combined entity. | Reporting units. A reporting unit is an operating segment, or a component of an operating segment one level below the segment as a whole. |
| Approach | One step: compare the recoverable amount of the unit with its carrying value. | Two steps: identify impairment, then measure the loss. |
| Measurement | The loss is the excess of carrying value over recoverable amount. | The loss is whatever gap separates implied goodwill in the unit from the goodwill carrying amount. |
| Allocation of the loss | Goodwill sitting in the unit absorbs the loss first. Anything still outstanding after goodwill reaches zero is spread pro rata over the remaining non-cash assets. | Applied to the goodwill allocated to the reporting unit. After that goodwill is eliminated, no automatic adjustments are made to other assets or liabilities, although testing them for recoverability may be prudent. |
Recoverable amount for a unit means the higher of two measures: net selling price, being fair value after selling costs, and value in use, being the present value of the cash flows the unit is expected to generate. Carrying value means the carrying value of the assets and liabilities inside the unit, goodwill allocated to it included. US GAAP derive implied goodwill exactly as in a combination, by taking what the reporting unit is worth at fair value and deducting the fair value of its assets and liabilities.
A French company has a cash-generating unit carrying €1,400,000 on the books, of which €300,000 is goodwill allocated to it. Recoverable amount for the unit is assessed at €1,300,000. The identifiable net assets inside it are estimated to be worth €1,200,000 at fair value.
Recoverable amount of the unit €1,300,000.
Carrying amount of the unit 1,400,000.
Impairment loss = €100,000.
That €100,000 goes to the income statement, and the goodwill sitting in the unit drops by the same €100,000, from €300,000 to €200,000. Note that the fair value of the identifiable net assets plays no part in the IFRS calculation. That is the whole point of the one-step approach.
A division of a US corporation counts as a reporting unit. Its fair value is $1,300,000, while its carrying value of $1,400,000 has $300,000 of recorded goodwill inside it. On the test date the identifiable net assets of the unit are estimated to be worth $1,200,000 at fair value.
Step 1, is there a loss at all. Fair value of $1,300,000 sits below the carrying book value of $1,400,000, so a potential impairment has been flagged.
Step 2, measurement of the impairment loss.
Fair value of the reporting unit $1,300,000.
Less net assets 1,200,000.
Implied goodwill = $100,000.
Current carrying value of goodwill $300,000.
Less implied goodwill 100,000.
Impairment loss = $200,000.
That $200,000 goes to the income statement, and the goodwill sitting in the reporting unit drops by the same $200,000, from $300,000 to $100,000. Compare this with Example 10: identical carrying value, identical goodwill, identical recoverable or fair value, and yet a loss twice as large, purely because US GAAP measures the shortfall at the goodwill level while IFRS measures it at the unit level.
Presentation of consolidated statements is similar under IFRS and US GAAP. Each income statement line, turnover, cost of sales and the rest, includes 100% of the parent and subsidiary transactions after eliminating any upstream transactions, where the subsidiary sells to the parent, or downstream transactions, where the parent sells to the subsidiary. The portion of income accruing to non-controlling shareholders is shown as a separate line. Net income would be the same under IFRS and US GAAP, although differences can still arise through the application of different accounting rules such as the valuation of fixed assets, so an analyst comparing specific line items across frameworks will need to adjust.
The consolidated statements of GlaxoSmithKline make a good reading exercise, because almost every category covered in this lesson appears somewhere on the face of them.
| Line | 2017 | 2016 |
|---|---|---|
| Property, plant and equipment | GBP 10,860 | 10,808 |
| Goodwill | GBP 5,734 | 5,965 |
| Other intangible assets | GBP 17,562 | 18,776 |
| Investments in associates and joint ventures | GBP 183 | 263 |
| Other investments | GBP 918 | 985 |
| Deferred tax assets | GBP 3,796 | 4,374 |
| Derivative financial instruments | GBP 8 | nil |
| Other non-current assets | GBP 1,413 | 1,199 |
| Total non-current assets | GBP 40,474 | 42,370 |
| Inventories | GBP 5,557 | 5,102 |
| Current tax recoverable | GBP 258 | 226 |
| Trade and other receivables | GBP 6,000 | 6,026 |
| Derivative financial instruments | GBP 68 | 156 |
| Liquid investments | GBP 78 | 89 |
| Cash and cash equivalents | GBP 3,833 | 4,897 |
| Assets held for sale | GBP 113 | 215 |
| Total current assets | GBP 15,907 | 16,711 |
| Total assets | GBP 56,381 | 59,081 |
| Short-term borrowings | GBP (2,825) | (4,129) |
| Contingent consideration liabilities | GBP (1,076) | (561) |
| Trade and other payables | GBP (20,970) | (11,964) |
| Derivative financial instruments | GBP (74) | (194) |
| Current tax payable | GBP (995) | (1,305) |
| Short-term provisions | GBP (629) | (848) |
| Total current liabilities | GBP (26,569) | (19,001) |
| Long-term borrowings | GBP (14,264) | (14,661) |
| Corporation tax payable | GBP (411) | nil |
| Deferred tax liabilities | GBP (1,396) | (1,934) |
| Pensions and other post-employment benefits | GBP (3,539) | (4,090) |
| Other provisions | GBP (636) | (652) |
| Contingent consideration liabilities | GBP (5,096) | (5,335) |
| Other non-current liabilities | GBP (981) | (8,445) |
| Total non-current liabilities | GBP (26,323) | (35,117) |
| Total liabilities | GBP (52,892) | (54,118) |
| Net assets | GBP 3,489 | 4,963 |
| Share capital | GBP 1,343 | 1,342 |
| Share premium account | GBP 3,019 | 2,954 |
| Retained earnings | GBP (6,477) | (5,392) |
| Other reserves | GBP 2,047 | 2,220 |
| Shareholders equity | GBP (68) | 1,124 |
| Non-controlling interests | GBP 3,557 | 3,839 |
| Total equity | GBP 3,489 | 4,963 |
The word nil replaces the dash used in the original for a zero balance. Every subtotal in the 2017 column reconciles: non-current assets of 40,474 plus current assets of 15,907 give total assets of 56,381, and total liabilities of 52,892 leave net assets of 3,489, which equals shareholders equity of negative 68 plus non-controlling interests of 3,557.
Reading the balance sheet as a catalogue of investment types
- Financial assets. Other investments of £918m and liquid investments of £78m in 2017.
- Associates and joint ventures. £183m, one line, equity method. During 2017 the group invested £15m of cash in associates and disposed of two associates for cash consideration of £198m.
- Business combinations. No companies were acquired in 2017, but a number of small business disposals were made for net cash consideration of £342m, including contingent consideration receivable of £86m. The decline in goodwill from £5,965m to £5,734m reflects exchange adjustments recognised because of the weakness of the functional currency of the parent, the pound sterling, rather than impairment.
- Contingent consideration. £6,172m of contingent consideration liabilities, split £1,076m current and £5,096m non-current, relating to future events such as development milestones or sales performance for acquired companies. The £1,076m expected within one year relates to the Novartis Vaccines business, which reached its sales milestone. The rest relates to the Shionogi–ViiV Healthcare joint venture and to Novartis Vaccines, and is expected to be paid over a number of years. The balance sheet amount is the present value of the expected payments, discounted at 8.5%.
- Non-controlling interests. £3,557m in the equity section, the share of the combined entity accruing to shareholders outside the group. GlaxoSmithKline is therefore a parent in a less than 100% acquisition.
| Line | 2017 | 2016 |
|---|---|---|
| Turnover | GBP 30,186 | 27,889 |
| Cost of sales | GBP (10,342) | (9,290) |
| Gross profit | GBP 19,844 | 18,599 |
| Selling, general and administration | GBP (9,672) | (9,366) |
| Research and development | GBP (4,476) | (3,628) |
| Royalty income | GBP 356 | 398 |
| Other operating income | GBP (1,965) | (3,405) |
| Operating profit | GBP 4,087 | 2,598 |
| Finance income | GBP 65 | 72 |
| Finance costs | GBP (734) | (736) |
| Profit on disposal of interests in associates | GBP 95 | nil |
| Share of after tax profits of associates and joint ventures | GBP 13 | 5 |
| Profit before taxation | GBP 3,525 | 1,939 |
| Taxation | GBP (1,356) | (877) |
| Profit after taxation for the year | GBP 2,169 | 1,062 |
| Profit attributable to non-controlling interests | GBP 637 | 150 |
| Profit attributable to shareholders | GBP 1,532 | 912 |
| Basic earnings per share (pence) | GBP 31.4p | 18.8p |
| Diluted earnings per share (pence) | GBP 31.0p | 18.6p |
Figures are reproduced exactly as reported. In the 2016 column the items from operating profit down add to the reported profit before taxation of 1,939. In the 2017 column the same items add to 3,526 against the reported 3,525, a presentational rounding difference of £1m. Below the tax line the split reconciles in both years: 637 plus 1,532 gives 2,169, and 150 plus 912 gives 1,062.
Two lines on that statement come straight from this lesson. The share of after tax profits of associates and joint ventures, £13m in 2017 against £5m in 2016, is the equity method output, arriving net of tax and net of everything else. The profit on disposal of interests in associates, £95m in 2017, is the gain recognised when the group ceased to have significant influence, measured as the difference between the sum of the fair value of any retained investment plus the disposal proceeds and the carrying amount of the investment.
The method changes the statements far more than it changes the economics
This is the point the examiner returns to most often. Consider an investor with the same economic exposure to the same investee reported three different ways.
| Item shown by the investor | Financial asset at fair value | Equity method | Consolidation |
|---|---|---|---|
| Balance sheet presentation | One line at fair value | One line at cost plus share of post-acquisition profit less dividends | Every asset and liability of the investee, line by line, at acquisition-date fair value |
| Revenue reported | None from the investee | None from the investee | 100% of investee revenue |
| Income recognised | Dividends, plus fair value changes if the FVPL route applies | Share of investee profit, adjusted for excess purchase price amortisation and unrealised intercompany profit | 100% of investee profit, with the outside share removed on a separate non-controlling interest line |
| Liabilities reported | None of the investee liabilities | None of the investee liabilities | 100% of investee liabilities |
| Typical effect on net margin | Comparable to standalone | Overstated, because associate income is in net income but not in sales | Broadly representative, because income and sales rise together |
| Typical effect on leverage and asset turnover | Understates the assets and debt behind the exposure | Understates the assets and debt behind the exposure | Shows them in full |
Three practical conclusions follow. First, an investor that can choose the equity method over consolidation, by keeping control ambiguous, will report lower total assets and lower total liabilities for identical economics, which flatters leverage and asset turnover. Second, when a joint venture is reported by the equity method rather than by proportionate consolidation, total income and total net assets are unchanged but every ratio built on sales, assets or liabilities moves. Third, even within consolidation, the choice between full and partial goodwill under IFRS moves total assets and total equity while leaving net income to the parent alone, so cross-border comparisons of return on assets and return on equity need the goodwill basis checked before the numbers are trusted.
Special purpose entities are enterprises created to accommodate a specific need of a sponsoring entity. The sponsor, on whose behalf the entity is created, frequently transfers assets to it, obtains the right to use assets it holds, or performs services for it, while other parties, the capital providers, supply the funding. They can be a perfectly legitimate financing mechanism, allowing a company to segregate certain activities and thereby reduce risk. They take the form of a limited liability company, a trust, a partnership or an unincorporated entity. Very often the legal documentation caps what the board or the management of the vehicle is allowed to decide, and those caps can be strict and permanent. IFRS use the term special purpose entity; US GAAP use both variable interest entity and special purpose entity.
A beneficial interest in such a vehicle can take the form of debt, of equity, of a participation right, or of a residual interest in a lease. Some deliver no more than a fixed or stated rate of return. Others open up the future economic benefits thrown off by whatever the vehicle does. In most cases the creator or sponsor retains a significant beneficial interest even though it may own little or none of the voting equity of the entity, and that mismatch between economic interest and voting interest is the whole reason a separate consolidation test is needed.
How the structure was abused
In the past, sponsors avoided consolidating these entities because they did not have control in the narrow sense of owning a majority of the voting interest. They were deliberately built so that financial control over the assets, or over the operating activities, stayed with the sponsor while a majority of the voting interest sat with third parties. Those outside equity participants often funded their investments with debt that the sponsor guaranteed directly or indirectly, and the sponsor was then able to avoid disclosing many of those guarantees or their economic significance. Many sponsors also used the structures to move assets and liabilities off their own balance sheets, recognising large amounts of revenue and gains because the transfers were accounted for as sales.
The reporting benefit arrived as a package: asset turnover looked better, both operating and financial leverage measures looked lower, and profitability looked higher, with nothing in the underlying economics having changed at all. Because consolidation was avoided, the assets and the liabilities of the entity were never reported, and financial performance measured on the unconsolidated statements was potentially misleading. Enron is the standard illustration, having used such vehicles for off-balance sheet financing and to flatter its reported performance artificially. Part of what brought the company down was the guarantee it had given over borrowings of the vehicles it created.
The two consolidation tests
IFRS 10 revised the definition of control so that it encompasses many special purpose entities, and a structured financial transaction involving such an entity requires an evaluation of purpose, design and risks. The FASB reached for the broader label of variable interest entity, catching anything under the financial control of one or more parties without a voting majority, so the US population takes in entities that are not special purpose vehicles at all.
FASB ASC Topic 810 classifies a special purpose entity as a variable interest entity if either of the following holds:
- the equity at risk in total falls short of what is needed to fund its activities without support from outside parties; or
- the equity investors lack any one of the following: the ability to make decisions, the obligation to absorb losses, or the right to receive returns.
Vehicles set up to lease out real estate or other property, to securitise financial assets, or to house research and development work are the usual examples. Whoever qualifies as the primary beneficiary must consolidate the vehicle as a subsidiary, no matter how small its equity investment in it may be. That beneficiary, frequently the sponsor itself, is whichever party is expected to take most of the losses, to collect most of the residual returns, or to do both. Where one entity will absorb a majority of the expected losses and a different, unrelated entity will receive a majority of the expected residual returns, the entity absorbing the losses consolidates. Non-controlling interests in the entity, if any, appear on the consolidated balance sheet and income statement of the primary beneficiary, and Topic 810 requires disclosure about relationships with variable interest entities even where the reporting company is not the primary beneficiary.
Odena, a fictional Italian auto manufacturer, wants to raise €55M of capital by borrowing against its financial receivables. It can either borrow directly against the receivables (Alternative 1), or create a special purpose entity, invest €5M in it, have the entity borrow €55M, and use the funds to purchase €60M of receivables from Odena (Alternative 2). Odena meets the definition of control and will consolidate the entity.
| Item | Amount |
|---|---|
| Cash | EUR 30,000,000 |
| Accounts receivable | EUR 60,000,000 |
| Other assets | EUR 40,000,000 |
| Total assets | EUR 130,000,000 |
| Current liabilities | EUR 27,000,000 |
| Noncurrent liabilities | EUR 20,000,000 |
| Total liabilities | EUR 47,000,000 |
| Shareholder equity | EUR 83,000,000 |
| Total liabilities and equity | EUR 130,000,000 |
Assets in total become €85,000,000 + 60,000,000 + 40,000,000 = €185,000,000.
The current figure stays at €27,000,000 and the noncurrent figure becomes €75,000,000, so liabilities reach €102,000,000, which alongside shareholder equity of €83,000,000 gives the same €185,000,000.
Because Odena consolidates the vehicle, none of that survives into the reported statements. Total assets come to €185,000,000, made up of €85,000,000 of cash, €60,000,000 of receivables and €40,000,000 of other assets. Against them stand liabilities of €102,000,000, being €27,000,000 current and €75,000,000 noncurrent, and shareholder equity of €83,000,000.
Accounting for business combinations is a complex topic, and convergence removed most but not all of the differences. Four remaining areas matter for comparability.
Contingent assets and liabilities
IFRS spread the acquisition cost across assets, liabilities and contingent liabilities at fair value, recording contingent liabilities separately during that exercise wherever their fair values can be established reliably. From then on a contingent liability sits at whichever is higher, the amount first put on the books or the best estimate of what settling it will take. Contingent assets are not recognised at all. The GlaxoSmithKline balance sheet shows the scale this can reach: approximately £6 billion of contingent liabilities relating to a number of purchases for the year ended 31 December 2017, which the notes describe as the expected value of those contingent payments once discounted at a suitable rate.
US GAAP bring contractual contingent assets and liabilities onto the books at fair value on the acquisition date. Where the item is non-contractual, it comes in only when it is more likely than not that the definition of an asset, or of a liability, is satisfied at that date. Afterwards a contingent liability is held at the higher of the amount first recognised and the best estimate of the loss, whereas a contingent asset is capped at the lower of its fair value on the acquisition date and the best estimate of whatever is eventually settled.
Contingent consideration
Extra payments can be negotiated into the price itself. The buyer may promise the former shareholders of the target more money if agreed events come to pass, typically the target, or the combined business, hitting a specified level of sales or of profit. Both frameworks measure such consideration at fair value on day one and classify it as an asset, a liability or equity. Movements in the fair value of the liabilities, and under US GAAP of the assets as well, then run through consolidated income in later periods. Neither framework remeasures the portion classified as equity; settlement of that portion is dealt with inside equity.
In-process research and development
Research and development already under way inside the target is treated by both frameworks as an intangible asset in its own right, carried at fair value wherever a reliable measurement is possible. Later on it is amortised if the work is completed successfully and a marketable product emerges, or written down for impairment if no product emerges, or if the product turns out not to be viable technically or financially.
Restructuring costs
Neither framework recognises restructuring costs associated with a business combination as part of the cost of the acquisition. They are recognised as an expense in the periods in which they are incurred. This closes the loop on a point made earlier: an acquirer cannot bury the cost of reorganising the target inside goodwill.
| Topic | IFRS | US GAAP |
|---|---|---|
| Potential voting rights in the significant influence test | Currently exercisable or convertible warrants, options and securities are considered | Only voting shares outstanding at the time of purchase are considered |
| Fair value option for equity method investments | Confined to venture capital organisations, to mutual funds, to unit trusts and to similar vehicles, investment-linked insurance funds included | Available to all entities |
| Reversal of an impairment of an equity method investment | Permitted in line with IAS 36 | Prohibited |
| Goodwill at acquisition | Full or partial goodwill, chosen transaction by transaction | Full goodwill only |
| Measurement of the non-controlling interest | Fair value, or the proportionate share of identifiable net assets | Fair value |
| Goodwill impairment | One step, at the cash-generating unit | Two steps, at the reporting unit |
| Contingent liabilities in an acquisition | Included when fair value can be measured reliably | Included when probable and reasonably estimable |
| Contingent assets in an acquisition | Not recognised | Recognised, contractual ones at fair value and non-contractual ones on a more likely than not basis |
| Consolidation of structured entities | IFRS 10 control definition applied to all entities | Two-component model: variable interest component and voting interest component |
Set against those differences, the shared ground is now large. Both frameworks require the equity method for associates and joint ventures, both require the acquisition method for business combinations, both expense acquisition costs, both refuse to amortise goodwill, both require an immediate gain on a bargain purchase, and both require the party that in substance bears the risks and reaps the rewards of a structured entity to consolidate it. The analytical work has moved on from finding the differences to judging whether the reported structure matches the economic one.