Demystifying Financial Consolidation Part IV
In this blog we will be covering acquisition method, it was termed as purchase method in IFRS3 2004 there are some dissimilarities in both the methods ( purchase & acquisition) but essentially for the blog post we can consider them same.
To apply acquisition method, we need to have four facts with us.
Acquirer: we need to identify who is acquiring whom.
Date of acquisition: it is important to know date of acquisition as lot of calculations will depend on that. Income from subsidiary will be accumulated to the parent company from the date of acquisition prior income will automatically be counted in the fair value of assets/liabilities.
We need to identify assets acquired, liabilities inherited and Non controlling interest in the transaction.
Last step in purchase method is calculation of goodwill arising out of the transaction. As we have already covered goodwill in previous blogs, it is the excess amount paid over and above the fair value to acquire the stake.
Prior to 2001, we had two method of financial consolidation: pooling (pooling of interests) & purchase method. But in 2001, pooling method was not allowed to be used as a method of financial consolidation. In case of purchase method, we value the assets and liabilities at fair value while in case of pooling we only take into consideration book value of assets/liabilities. In pooling method also we take into consideration fair value of the company but we don’t report it in books of accounts. In it, we only consolidate book value of assets and liabilities. Since assets and liabilities are reported at book value, no goodwill gets created in pooling method.
Since we record assets and liabilities at book value in pooling method, depreciation is less compared to purchase method, thereby increasing income of the parent company. Similarly, we can deduce that Return on Assets will be higher as the asset base would be low in pooling method.
Return on Asset = Net Income/ Total Assets
As Assets are less in pooling compared to purchase method, therefore return on Asset is more in pooling than purchase method.
We apply acquisition method in case of subsidiary. One company is subsidiary of another company if that company is able to control first company. Control can be defined in many terms and the question arises how we quantify that one company is able to control another company. One of the simplest ways to see if acquirer company controls target company is to look at the share holding, if the holding is more than 50 percent stake in the target company then it can be presumed that the acquirer company controls target company unless acquirer company can prove that it doesn’t control target company.
There are certain circumstances where the equity held by company is less than 50 percent but it is able to govern target company as it has certain agreement with rest of the shareholders that it would be able to govern financial and operating policies of the company or it will have the right to select majority of directors or it has got more than 50 percent of the voting right.
Calculation of Equity
In purchase method, we don’t take into consideration Equity, excess capital paid in excess of par or retained earningsof Target Company. Only the fair value of shares issued by the acquirer company will be added to the equity of acquirer’s company.
While in case of pooling method we used to take into consideration retained earnings of the target company.
Assets and Liabilities of Target Company will be taken into consideration at fair value. In most of the cases liabilities will remain unchanged while in some cases we need to revalue liabilities also i.e. if market interest rates have changed then the value of bonds will increase/decrease accordingly. While calculating the fair values of assets we also need to take into consideration fair value of intangible assets. Sometimes, the target company may have internally generated intangible assets which they haven’t considered in Balance Sheet, they are also needed to put in Calculation of fair value of company like Brand Value.
If the liabilities are revalued, the premium amount will go into ‘Premium on bonds payable account’ or discount amount will go into ‘Premium on bonds payable account’.
Note: We do not take into consideration the goodwill on the Balance sheet of the target company while calculating the value of the company.
So, if there is goodwill present in the Balance Sheet of the target company, neglect it.
While preparing the income statement at the group level we can directly add the acquired firm’s income to the acquirer’s income from the date of acquisition, but in the case of pooling method we used to take into consideration the income of the target company for the whole financial year irrespective of the date of acquisition. Even if you have acquired the company on 31st March, in April- March financial year, still you would add the income of subsidiary for the whole year to the income of Acquirer Company.
Note: The expenses to issue the acquirer company shares will be charged against paid in capital in excess of par account.
In the next blog, we will cover one scenario where all the concepts discussed in this blog will be put to use.