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Demystifying Financial Consolidation Part I

In this blog series, we will be covering concepts related to financial statements consolidation. As the topic is bit complex for people from non-finance background, I will start from the basics covering each and every term, what it means, and relevant context and so on. In this series I won’t be covering how these things are implemented in BOFC or BPC but the functional knowledge required to implement it.

Before moving on to this topic we need to understand why we are required to consolidate financial statements.

We observe lot of merger/acquisitions happening around us every day, recently we have seen Google acquiring Motorola mobility for $ 12.5 Billion, Microsoft acquiring Skype for $ 8.5 Billion and the list is endless.

These acquisitions were friendly acquisitions, means the management of Target Company wanted to sell the company to the acquirer, whereas in a hostile takeover Target Company management does not want to sell the company to the acquirer.

Hostile takeover are portrayed in negative shade, than friendly acquisitions but both create and destroy value to the shareholders in long term depending on the post acquisition scenarios/synergy and on lot of other factors.

Management of Target Company takes lot of steps to prevent acquisition in hostile takeover. If the company is owned more than 51 percent by one individual or group of people then hostile takeover can’t happen. Even if the acquirer company acquires 49 percent stake in the company it won’t be able to govern it or control it as rest of the 51 percent stake is with other party. We can take the case of Wipro, in it approx. 70 percent equity stake of the company is owned by Azim Premji and members of his family, therefore acquirer can’t acquire more than 30 percent in Wipro so hostile takeover can’t happen.

Hostile takeover happens when the management of the target is not willing to sell the company, or if there is difference in the valuation of Target Company between target & Acquirer Company and lastly sometimes because of vested interests of management in the company.

To prevent hostile takeover, the management of Target Company can takes lot of steps:

Poison Pill: In it, the management of target company gives right to the existing shareholders to get more shares of the company at price far below than fair value. Current shareholders will get this option only when other company acquirers a certain percentage stake in the company. This way target company increases the cost of acquisition for the acquirer company and is beneficial for the shareholders. These again can be divided further, but we won’t be going deep in it. In 2004, News Corporation used this method to ward off acquisition from US cable group Liberty Media. It allowed its shareholders to increase stakes in the company at half the price if some acquirer buys more than 15 percent of the company i.e. company offered to its existing shareholders to buy new shares at half the price. 

White Knight: Management of the target company which is currently looked for hostile takeover looks for some other company whom they can sell their company at friendlier terms. Sometimes, management of the target company puts his own interest first, as in a hostile takeover most of the management is removed while in friendly acquisition it depends on the negotiation and sometimes current management is allowed to continue. Around three months back Teva acquired Cephalon by outbidding hostile acquirer Valeant. Teva offered 12 % percent premium to Valeant’s offer.

Staggered Board of Directors: Instead of electing all the directors every year, in staggered boards only a fraction of the members of board of directors are selected every year. In this case, even though the acquirer company acquires majority stake in the target company, it takes 1-2 year to get actual representation in Board of members depending on the fraction of the members of boards of directors selected every year.

Selling the crown jewels: management of the target company sells vital assets to make the target less attractive

Greenmail or greenmailing is the practice of purchasing enough shares in a firm to threaten a takeover and thereby forcing the target firm to buy those shares back at a premium in order to suspend the takeover.

There are lots of other tactics to discourage acquisitions by Target Company in case of hostile takeover; we can’t cover all of them in detail. These tactics are normally used in combinations instead of only one technique. We have seen normally staggered board of directors being applied along with Poison pill provisions.

From the view point of Acquirer, it looks at the earning potential of the company, if it makes economic sense for it to acquire target company (Financial Analysis & Modeling), if it is in line with its strategic vision, if it will be able to realize synergy between both the companies, if it will be able to gain tax benefits out of it and so on.

Whenever one company acquires another company, we need to write it in our books of accounts the money we paid to acquire the company, the assets we acquired and the liabilities we inherited. There are various methods of consolidating financial statements depending on the equity one holds in the target company. The basic rule is if acquirer holds between 0-20 percent, the stake will be valued at fair value, in case of 20-50 percent stake we opt for equity method and in case of 50-100 percent stake we go for acquisition method (purchase method in IFRS3 2004).

According to new IFRS guidelines, if the company owns more than 50 percent stake in the target company it will be called as subsidiary and if the percentage stake lies in between 20 to 50 i.e. significant influencer it will be an associate. These guidelines also covers lot of scenarios like if the acquirer company owns more than 50 percent stake in the company but is not able to govern the company because of some reasons than we can opt for equity method and vice-versa i.e. if the acquirer owns between 20-50 percent but it is able to govern the policies of the target company then it can opt for purchase method.

In the next blog, we will look at the various terms used in consolidating financial statements, their utility and how they are calculated like fair value, goodwill, ownership, control etc. Once we are clear with the basics, we will further look in detail acquisition method (purchase method), equity method and proportional method of consolidating financial statements

Prior to 2001, we used to have one more method of consolidating financial statements i.e. pooling method, but the same was discontinued by regulatory bodies. We will also cover some of the differences between both the methods (Purchase and Pooling), though it is not required to understand it but knowing it will help us to appreciate the purchase method.


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