Acquisition, Equity and Proportionate Consolidation Method

CFA Level II
#1

I have found couple of discrepencies in these methods while discussing with couple of my friends. These may not be discrepencies, and may just be derivations of unsettled mind. Here are these discrepencies / confusions

1] I got to know that in the acquisition method, fair value of the subsidiary should be used, and I have seen this in the CFAI text (They have put it in asterisks) that appropriate method is use fair value of the subsidiary. The problem with this approach is first you have to find the fair value of each line item, which is going to be not only for the parent company but for subsidiary as well. I don’t know if balance sheet will look good if you mix book balue of the parent and fair value of the subsidiary. If this is not the case and if you consider FV for bot, your earnings will be 180 degree upside down because of the assets at old price on the balance sheet. If this is the case, who will get into acquisition in the first place? Schweser has only taken book values in the consideration regardless of the choice of the method – proportionate consolidation or acquisition.

2] Treatment of cash which the parent company pays to buy the subsidiary. In the schweser notes they mentioned that it has to be deducted from the cash and in the videos they have shown this amount needs to be added back to the minority shareholders portion of equity to bring the accounting equation in balance. Is this still true?

3] Amortization of fair value over book value of assets is different in partial and full goodwill approach the same is for goodwill from which you have to take off the % share of minority shareholders by any approach for any goodwill that is recorded on the balance sheet. I am assuming the deduction of fair market value that happens at the good will level in full good will approach should be for the value of the subsidiary not for the % share of the parent.

Can you please help me sort these things out?

#2

I’ll try for the cliffs, then come back later if still unclear.

1.) Always mark to fair value in acquisition. Yes, this will leave you with Book value of old assets + fair value of new assets.

2.) It has to be deducted, because it went out the door to the shareholders, not to the firms balance sheet… it should be a simple equation. Ive used this before, but think of case where you acquire a company with the following, all at fair value so no goodwill

Assets = 100; Liab = 70, Equity = 30. Net Assets = 30.

Pay 20 for 2/3 of the firm (66.6%).

Consolidation/Acquisition method: Assets + 100 - 20 in cash paid = 80. Liab + 70. Equity + 10 (which is 1/3 of the Net Assets that you didnt acquire, and also is 80 - 70.

In a situation where there is goodwill, this will be reflected in the full vs partial (ie, in full you will reflect the total amount of goodwill, partial strips the goodwill from the asset side attributable to minority interest)

3.) You need to be clearer on the question. 2 large run-on sentences = confusion.

#3

Thanks Kwalew! My apologied forf the terse email. But, I think you got what I was asking. This is a simple case where you don’t have any goodwill or may be you have. If you do, then it’s going to be a bit complicated case I guess either fair value will be less than book value or negative goodwill.

Let me get my screws tight for the simple case first, then we will go back to the complicated ones. Here are the revised numbers:

Subsidiary Details:

Assets = 1000, Liability =700, Net Assets = 300, Fair value of net assets = 400

Book value of PPE = 200, Fair Value of PPE = 250

Book Value of Inventory = 30, Fair Value of Inventory = 50

Share acquiring = 80%, Cash Paid = 500 to buy 80% share

Now I want to see all adjustments with respect to full vs partial goodwill for acquisition and proportionate consolidation. I will raise my doubts after I see how you are making adjustments.

Please adjust the numbers if those are not rounding to good values. Also assume numbers for parent if that makes it easier for you.

Do you know why schweser has not considered fair value of the subsidiary? Also, I would like to know how you derive the value for each line item on a question set. Are they given in the question or you simply assume that if a question is on acquisition, numbers will be fair values?

#4

Do you mean FVNA = 400 of identifiable net assets, or net assets in general? That will have a bearing on the problem. Basically we’ve said the assets at fair value are 400, but we can only identify 300 worth - its tough to make a distinction.

For now, we’ve got book value of other (lets assume cash & marketable secs) of 1000 - 230 = 770

Let’s assume for the sake of the problem that FV of net identifiable assets are 400, and that its all due to PPE & inventory. Book value of these assets = 230, fair value = 400. FV PPE = 300, FV Inventory = 100. SO, the fair value of our assets is actually 170 higher than book value.

Here we go:

Paying 500 for 80% assumes a fair firm value of 625. Now that we’ve marked the assets to fair value, we’ve got assets of 1,170 and liabilites of 700. FV Net Assets = 470.

We’ve paid (well, in theory, but we’ve got control with acquisition method so we take it as given) 625 for something worth 470: FULL goodwill = 625 - 470 = 155 goodwill.

On the balance sheet, we will show Assets of 1170 + 155 goodwill - 500 in cash = 825.

Liabilities = 700.

Minority interest? = .2 * Firm Value = .2 * 625 = 125. L + E = 700 + 125 = 825. Asset = L + E.

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Under partial goodwill, the calc is different (IFRS now). Now, we base it off of purchase price of 500. And the proportionate share of assets acquired. We paid 500 for 80%, that means we paid 80% for FV of net assets. FVNA hasn’t changed - its still 470. Except now, we take 80%. So 80% of 470 = 376.

500 - 376 is 124. This is goodwill under PARTIAL goodwill. Still take 1170 of Assets, + 124 of goodwill - 500 cash = 794 in Assets. Liabilities = 700. Equity? Minority interest is .2 * 470 = 94

Assets = 794 .Liabilities = 700, Equity = 94.

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Prop consolidation: assumes purchasing 50%, so without numbers will be hard to do. But, there is no minority interest ( just remember assets will decrease by the cash paid for the interest in the JV).

#5

^ And per your questions above: I dont know why Schweser has not considered FV. In general, they should tell you what the fair value of the assets are, because there is no way to pull them off of the balance sheet.

. Generally, the assets have to be identifiable - so PPE, Inventory, etc. So any other assets, like goodwill, will have to be taken at book value and transferred.

#6

I am not sure if, in the questions that I did, they had a distinction between “Fair value of net idenfiable assets” vs simply “Fair value of all assets”. Perhaps I wasn’t reading it closely. I thought I had a pretty good grasp on this one till I saw this post. Anyways, all good discussion.

Now I have these questions:

Usually, they list goodwill separately but you have incorporated that in the assets itself. Does that make any difference?

Also, since you have all the numbers ready, could you also demonstrate how you would calculate amortization of PPE and any other adjustments for Income statement? I also don’t how to deal with inventory but I think they have a different treatment for inventory right?

#7

I wanted to see how the calculation in Acquisition Method compares with Proportionate Consolidation method. So far, this is what I have in my mind – simply take the book value of both firms line by line, take appropriate percentage and that’s it, you have new balance sheet with new line items. But it seems like there is far more to it.

Let’s say rather than 80% in the previous example we were buying 50% interest. How would these calculations change for proportionate consolidation? Is it going to be simply replace .8 and .2 with .5 and .5 or are there any other considerations that we have to take into account?

Also, the way you have done here is that you have clubbed everything in one account assets, which I guess is not intended using this method, as you would not know whether these assets are because of the PPE, inventory or any other unidentifiable assets. If I wanted to calculate the effect on each line item say PPE or minority assets, should I simply to follow the same approach for each line item as you had done considering just one single asset?

#8

As I think a little more about it, I think i screwed up the first version in the calculation of goodwill. Bear with me

. We’ve still got a book value of all other assets of 770. PPE with a value of 230. Now, we’ve got PPE that has been marked up to 250 (+50), Inventory that has been marked up to 50 (+20)), so now we have 1000 + 70 worth of assets = 1070 and 700 in liabilities = 370 in fair value of net assets. But, we’re told its 400, so there has to be a $30 asset in fair value coming from somewhere. So, the 30 difference must have come from somewhere (perhaps some license that we didnt pay anything to develop, or maybe we marked up the value of a HTM bond). Either way, we know the extra 30 is not depreciable (ie, its not PPE, because they gave FV of that to us) and not amortizable.

At acquisition, we report these items at Fair Value:

Other assets: 770

PPE + Inventory: 300

Some other identifiable asset = 30

Total Assets = 1100. Total Liabilities = 700, So net assets = 400. Now, we’ve paid 500 for 80% of the firm, implying that the entire value of the firm is actually worth 625. The fair value of the net assets acquired = 400. FV subsidiary - FV net assets acquired = 625 - 400 = 225 = Full Goodwill.

Total Assets = 1100 Fair value of assets acquired + 225 goodwill - 500 cash paid = 825

Liabs = 700

Minority interest still = .2 * 625 = 125. Assets and L + E balances still

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Partial Goodwill: Goodwill = 500 - .8*400 = 500 - 320 = 180

1100 + 180 - 500 = 780 Assets

Liab = 700

Minority Interest = .2 * 400 = 80 => Assets = Liab + equity

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Now, for depreciation purposes, the only thing you can depreciate is the extra 50 in PP&E (assuming theres no land in there) -

#9

In addition - I also notices my assumption about prop consolidation is not 100% correct, as I guess it doesnt have to be just 50%. But since its mainly used for joint ventures in IFRS, I was assuming just 50%.

For prop consolidation, consolidate everything line by line but also remember you must remove the capital you acquire the firm with. Given the preferences of accounting treatments, ie prop consolidation is only used for joint ventures in IFRS, I’m not sure that goodwill exists (somebody else can prove me wrong if I am). Usually you enter into a JV with another firm, you dont really acquire one. So there is no need for goodwill to exist

Just remember that prop consolidation will report assets and liabilities that are in between those reported under equity method and acquisition method.