Equity Accounting And Consolidations

Chapter 14 Equity accounting and consolidations

Second edition update, June 2005.

Fair value adjustments and goodwill [p. 435 et seq.]

A parent company rarely acquires a subsidiary at a price equal to the book value of the latter's net assets. The price it pays reflects its assessment of the cash flows those net assets are expected to generate. The amount may be more or less than book value. As a result, a positive or negative 'consolidation difference' arises. How is this difference accounted for?

In most countries, the difference is accounted for in two steps. First, the investor company revalues the individual assets and liabilities of the acquired company to fair value at the date of acquisition. (In countries which observe historical cost accounting strictly, this is a consolidation exercise only: the subsidiary's books are not altered.) 'Fair value' means market value or a current valuation. The reason for this adjustment is clear. If the investor company purchased assets from the investee on an individual basis, it would record them at their fair value at the date of exchange.

Any remaining excess of purchase price over fair value of net assets at acquisition is described as 'goodwill'. Goodwill represents the capitalised value of the 'above-normal' earnings attributable to an acquired company or collection of assets. In the second of the two steps, the goodwill is recognised as an intangible asset on the consolidated balance sheet. This is now a universal practice. However, until recently companies in certain countries were allowed to write off goodwill against reserves. Although this practice is no longer permitted, the impact on corporate balance sheets - in the form of low shareholders' equity relative to assets - is still evident today.

Sometimes the purchase price is less than the value of net assets acquired - after the initial fair valuation is carried out. This indicates the values of the individual assets and liabilities acquired are probably misstated. The investor company then reassesses those values, correcting any overstatement of assets or understatement of liabilities and, in the process, minimising any reported negative goodwill on acquisition.

The fair valuation of individual assets and liabilities will affect consolidated income in later periods. For example, an upward valuation of inventory and tangible fixed assets at the time of acquisition will result in higher cost of sales and depreciation charges and will lower consolidated income. As for goodwill, most companies now argue - and regulators support them - that the asset has an indeterminate life and thus there is no need to amortise it. However, as with other intangibles, management must assess the value of goodwill periodically and write it down if its value has been impaired, recording the write-down as a charge in the consolidated income statement.

* Illustration 4: Fair value adjustments and goodwill

We now illustrate the accounting for fair value adjustments and goodwill. Let us suppose that Danilo pays 8 per share, or 1.6 million, for the net assets of Glawari which on 1 January have a book value of 1 million. (Danilo's 'other assets' fall to 3.4 million as a result.) We also assume that, of the positive consolidation difference of 600,000:

 200,000 is attributable to a revaluation of Glawari's tangible fixed assets to fair value; and

 the balance of 400,000 represents goodwill.

Exhibit 14.8 shows how the start-year 1 consolidated balance sheet of the Danilo group is derived. Panel (a) assumes goodwill capitalisation, the dominant method of accounting for goodwill today. Panel (b) assumes immediate write-off of goodwill, a method rarely used now but the balance sheet effects of which are still evident in some companies' accounts. Under capitalisation, goodwill is recorded as an intangible asset. Unlike other intangibles, it appears only in the consolidated balance sheet. Under immediate write-off, group reserves are reduced by the amount of the goodwill. Thus in panel (b), the consolidation adjustment to shareholders' equity of 1.4 million includes the goodwill of 400,000 arising from the purchase of Glawari.

Exhibit 14.8 Danilo Group & group companies: summary balance sheets at 1 January year 1, assuming (a) capitalisation and (b) immediate write-off of goodwill

Now let's look at the impact of the Glawari acquisition on Danilo's accounts in the following period. Exhibit 14.9 shows the consolidated accounts of the Danilo Group for year 1, prepared under the assumption that Danilo capitalises the goodwill arising on the purchase of Glawari Industries. We also assume Danilo's and Glawari's operating results are the same as those illustrated in Exhibits 14.6 and 14.7 but, for simplicity's sake, we exclude intercompany transactions (other than the dividend payment from Glawari to Danilo).

Exhibit 14.9 Danilo Group & group companies: summary year 1 accounts, assuming goodwill capitalisation

Danilo makes two additional adjustments during year 1. First, depreciation is charged on the revalued assets. The assets are assumed to have a remaining life of eight years and are depreciated on a straight-line basis. This results in additional depreciation expense of 25,000 (200,000 / 8 years). (To keep things simple, we assume the revaluation and additional depreciation are consolidation entries.) Second, goodwill is assumed to be impaired during the year. The end-year 1 recoverable amount of the asset is estimated at 320,000, 80,000 less than the initial carrying amount of 400,000, and Danilo records an impairment charge of 80,000 in its year 1 consolidated accounts. As a result of these adjustments, year 1 consolidated income and end-year 1 shareholders' equity are 595,000 and 3,975,000 respectively - or 105,000 less than the amounts reported in Exhibits 14.6 and 14.7. As before, we assume that the liabilities' balance is unchanged and therefore the increase in shareholders' equity from the companies' profitable operations is reflected in 'Other assets'.

Consolidation and acquisition accounting under international standards

* Consolidation requirements

International standards lay down simple rules to ensure consolidated accounts