IFRS Foundation - The Acquisitive Case Study - Business Combinations and Consolidated Financial Statements Assessment Answer

Assessment Task:

Business Combinations and Consolidated Financial Statements Assessment Answer

Background

Jane Doe is the recently appointed Group Accountant at Acquisitive—a company listed on the Antarctican Stock Exchange. 1 She is preparing to deliver ‘her’ first press release and investor conference call—to announce Acquisitive’s preliminary consolidated results for the year ended 31 December 20x5, and she anticipates receiving a number of questions from existing and potential shareholders and the financial press about some significant issues that are mentioned in the forthcoming release.

Jane is aware that Acquisitive has operated successfully in the Antarctican manufacturing sector for more than fifty years and for many years has prepared its financial statements in accordance with International Financial Reporting Standards (IFRS). In accordance with the listing requirements of the Antarctican Stock Exchange, Acquisitive also prepares half-yearly interim financial statements in accordance with IAS 34 Interim Financial Reporting.

Issue 1—goodwill

On 1 July 20x5 Acquisitive gained control of Introspective when it purchased all of Introspective’s issued equity for CU25 billion cash.

Jane observes that the forthcoming release includes a statement that a CU2 billion goodwill asset is, in accordance with IFRS 3, recognised in Acquisitive’s accounting for the acquisition of Introspective. Her examination of the due diligence reports that informed the acquisition decision identifies, in support of recognising CU2 billion goodwill:

•  CU1 billion—significant synergies between Acquisitive’s pre-existing operations and Introspective’s operations;
• CU0.4 billion—synergies between the assembled collection of net assets that make up Introspective’s business; and
• CU0.6 billion—premium paid solely to entice the last remaining pre-existing Introspective shareholders to sell their shares to Acquisitive.

For the six-month period ended 31 December 20x5 Introspective’s operations decreased the Acquisitive group’s profit by CU1 billion. The loss related primarily to the three months’ production lost at its Antarctican ice lolly plant, which was due to sustained industrial action. Introspective’s other businesses all performed in line with, or better than, management’s forecasts made on the basis of the due diligence reports that informed the acquisition decision.

Issue 2—controlling shareholder buys out the non-controlling interests

On 1 July 20x5 Acquisitive increased its equity interest in its subsidiary Booming from 75 per cent to 100 per cent in exchange for CU10 billion cash. While Jane is aware that this transaction is between equity holders (and consequently, in accordance with IFRS, has no effect on reported earnings) she recalls last night reading a related issue in Warren Buffett’s letter to Berkshire Hathaway Inc. shareholders (see extract reproduced below) and consequently she expects that some might ask her about the effects of Acquisitive’s purchase of Booming’s non-controlling interests on Acquisitive’s soon-to-be-released preliminary consolidated financial information. 

“Last year we invested $3.5 billion in the surest sort of bolt-on: the purchase of additional shares in two wonderful businesses that we already controlled. In one case—Marmon—our purchases brought us to the 100% ownership we had signed up for in 2008. In the other instance—Iscar—the Wertheimer family elected to exercise a put option it held, selling us the 20% of the business it retained when we bought control in 2006. These purchases added about $300 million pre-tax to our current earning power and also delivered us $800 million of cash. Meanwhile, the same nonsensical accounting rule that I described in last year’s letter required that we enter these purchases on our books at $1.8 billion less than we paid, a process that reduced Berkshire’s book value. (The charge was made to “capital in excess of par value”; figure that one out.) This weird accounting, you should understand, instantly increased Berkshire’s excess of intrinsic value over book value by the same $1.8 billion.”

Jane is aware that, unlike Acquisitive (which reports its financial information in accordance with IFRS), Berkshire Hathaway uses US GAAP3 . However, she recalls that IFRS 3 Business Combinations is the product of a joint FASB4 and IASB5 project, so she expects that the same (or similar) issues would exist for Acquisitive. This is confirmed when she reads a UBS Research Footnotes Compendium issued by Dennis Jullens, former UBS Accounting and Valuation Analyst (8 December 2010)—an extract from which is set out below.'

“In 2009, Swiss company Roche increased its stake in US group Genentech from 56% to 100% by buying out the minority interest. As Roche already fully consolidated Genentech, the transaction from the accounting perspective was viewed as a transaction between shareholders that does not give rise to goodwill.

In the case of the Roche/Genentech transaction, the difference between purchase price and net asset value of minority interest of CHF 43.8bn was charged to Roche’s shareholders’ equity. This accounting adjustment caused return on equity to increase from 17% in 2008 to 119% in 2009... (p68) However, the principal reason for Roche’s return on equity is accounting rather than underlying economics.

The rationale here is that the wealth-generating ability of business assets is unaffected by the acquisition of the minority interest. That is to say, the parent is not investing in more or new assets. It is simply acquiring more rights to income from the assets it already controls, but to which non-controlling interests previously had rights...”

Jane’s preparations for the forthcoming release also led her to an article by Dr Alan Teixeira (2014): The International Accounting Standards Board and Evidence-Informed StandardSetting, Accounting in Europe, DOI: 10.1080/17449480.2014.900269. In particular, her attention is drawn to the following extract:

‘When the IASB developed IFRS 3 Business Combinations we faced significant opposition from lobby groups. One of the issues was the proposed treatment when non-controlling (minority) interests were acquired by the controlling interest. Opponents claimed that most of the equity of listed European companies would be wiped out. As part of the analysis of the effects for this Standard, I examined reported equity for the largest 600 European and the largest 600 US-listed entities (IASB, 2008). The analysis found that less than 1% of these entities had economically significant non-controlling interests. An analysis of the individual cases provided the IASB with evidence that non-controlling interests were less economically significant than had been asserted by our detractors. And the reasons for the high proportion of non-controlling interests in the few cases we did observe made economic sense.[ 6 ] We also ran a series of calculations to estimate the likely effect on financial reports of various buy-out scenarios. The analysis suggested that the assertions and claims against us were without foundation.’

Jane is aware that Acquisitive’s soon-to-be-released preliminary consolidated financial information makes much of Acquisitive’s purchase of the 25 per cent non-controlling interests in Booming for CU10 billion, which results in non-controlling interests declining by CU4 billion and equity attributable to Acquisitive’s shareholders declining by CU6 billion. She re-examines the due diligence reports prepared before making the decision to purchase the non-controlling interests and is satisfied that the valuations set out therein support her understanding that the transaction was priced ‘at the market’. She is also aware that Booming’s financial performance in the six months since this transaction has greatly exceeded expectations and has thus contributed greatly to the impressive performance of Acquisitive for the six months ending 31 December 20x5, thereby providing good value to Acquisitive’s shareholders for the CU10 billion cash spent to buy out the non-controlling interests in Booming.

Issue 3—reorganisation

On 31 December 20x5 Acquisitive acquires all the equity of Action from Conglomerate in exchange for CU20,000 million in cash. Mrs C owns all the equity of Conglomerate and controls both Conglomerate and Acquisitive.

Issues for class discussion How would you advise Jane Doe to explain the financial effects of this transaction in Acquisitive’s consolidated financial statements to Acquisitive’s non-controlling shareholders at the forthcoming earnings release?

What other accounting, if any, in accordance with IFRS could Acquisitive have adopted for this reorganisation in its consolidated financial statements?

Which method of accounting for the reorganisation do you believe best serves the objective of IFRS financial reporting (and why)?

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