Date of acquisition is the single most important date of consolidation. It is the date where:
- acquirer obtains control
- all assets and liabilities acquired are fair valued
- consolidations of results initiates, which also directly determines which financial year the acquisition sits in
Elements of consolidation
There are 4 main elements for consolidation at date of acquisition:
- Basic combination of financial statements
- Adjustments for the fair values of assets and liabilities
- Goodwill – Balance of cost of investment less fair value (FV) of net identifiable assets
- Non-controlling interest (NCI)
For the purpose of this post, we will assume 3 and 4 is negligible and focus our discussion on 1 and 2. What this means is that all examples provided in this post will have the cost of investment = acquiree’s equity, however in future posts, you will find that such assumptions are not realistic in real life applications.
Basic Combinations
Following is an example of how an investment cost of 120 is cancelled against acquiree’s equity for a 100% acquisition:
| A | B | DR | CR | Consolidated Bal. | |
| Land | 400 | 150 | 550 | ||
| Cost of Investment | 120 | – | 120 | – | |
| A/R | 200 | – | 200 | ||
| Bank | 40 | 20 | 60 | ||
| 760 | 170 | 810 | |||
| Share Capital | 500 | 100 | 100 | 500 | |
| Retained Earnings | 160 | 20 | 20 | 160 | |
| Loan | – | 50 | 50 | ||
| A/P | 100 | – | 100 | ||
| 760 | 170 | 810 |
If you notice from above, the “Cost of Investment” line has been zerorised. This is because every consolidation under the “Acquisition Method”, is combined at 100% basis, regardless of whether its a 100% subsidiary or 60% subsidiary. The allocation of profit base on holding% will be at a separate line and will be discussed in the future.
Hence from above, its also correct to say “Cost of Investment” line under the “Acquisition Method” will always be zero after consolidation. This is cancelled against subsidiary’s “Retained Earnings” and “Share Capital”. You can also visualize this entry as a way to prevent double counting since without this entry, the Gross Assets and Equity would be unfairly inflated.
Fair Value adjustments
There are 2 forms of fair value adjustments. The first form is when subsidiary’s liabilities or assets are not at fair value and thus during consolidation, it needs to be reflected as being part of the “Cost of Investment”. I see this as a necessary step to ensure the acquisition is base on a fair valuation that minimize overpayment or underpayment. Once you understand the reason behind the steps, its much more easier to remember why and how.
Following is an example on how a Land asset belonging to subsidiary is revalued from 150 to 200 at date of acquisition:
| A | B | DR | CR | Consolidated Bal. | |
| Land | 400 | 150 | 50 | 600 | |
| Cost of Investment | 170 | – | 170 | – | |
| A/R | 200 | – | 200 | ||
| Bank | 40 | 20 | 60 | ||
| 810 | 170 | 860 | |||
| Share Capital | 550 | 100 | 100 | 550 | |
| Retained Earnings | 160 | 20 | 20 | 160 | |
| Loan | – | 50 | 50 | ||
| A/P | 100 | – | 100 | ||
| 810 | 170 | 860 |
As you can see from above, the additional land adjustment of 50 has been included into the “Cost of Investment”. Without the fair value adjustment, the “Cost of Investment” would have stayed at 120.
The second form of fair value adjustment is to recognize any assets of liabilities that were not on subsidiary’s balance sheet at date of acquisition. This is because sometimes internally generated intangible assets such as brands, copyrights or R&D projects cannot be capitalized under FRS 38 Intangible assets but at consolidation level, this is allowed. Another accounting standard that has uneven treatment between consolidated level and entity level is FRS 37 Contingent Assets and Liabilities. Here, we have to be very careful since FRS 37 has 2 different types of contingent liabilities, one which can be upgraded from disclosure to a balance sheet item at consolidation level, one of which cannot. The first type of contingent liability defined by FRS 37 is possible obligation arising from past event that is subject to an uncertain event. An example would be compensation to CEO in event of dismissal. Its not appropriate to accrue for such an expense when the condition has not been triggered. This type of contingent liability will not be in the balance sheet, not even at consolidation level. What will be upgraded is the other type of contingent liability in FRS 37 that is defined as present obligation arising from past event but is not recognized because outflow of resources requirement is not probable. An example is a legal compensation that lawyers are of the opinion there’s a 20% chance of $100 payout. In the consolidated balance sheet, a $20 Provision for Legal Fee must be accrued.
Following is an example on how a the same $20 disclosure at subsidiary level is upgraded to a balance sheet item at date of acquisition:
| A | B | DR | CR | Consolidated Bal. | |
| Land | 400 | 150 | 50 | 600 | |
| Cost of Investment | 150 | – | 150 | – | |
| A/R | 200 | – | 200 | ||
| Bank | 40 | 20 | 60 | ||
| 790 | 170 | 860 | |||
| Share Capital | 530 | 100 | 100 | 530 | |
| Retained Earnings | 160 | 20 | 20 | 160 | |
| Provision | – | – | 20 | 20 | |
| Loan | – | 50 | 50 | ||
| A/P | 100 | – | 100 | ||
| 790 | 170 | 860 |
As always in accounting, timing and nature is a crucial consideration here. FRS 103 says that the assets and liabilities acquired must be part of the exchange between acquirer and acquiree in the business combination. This means that although its not abnormal for accruals such as provision for restructuring to be recognized as part of acquisition date entry, it can only do so if it’s not incidental to acquisition. If the restructuring plan was announced before the acquisition, then yes, it is allowed. However, if the restructuring plan wouldn’t have happened if there wasn’t any acquisition, then this is incidental and should not be part of the acquisition date entry. This is not something that is being “exchanged” since acquiree didn’t get paid to be restructured. Another issue to illustrate the scope of this requirement is due diligence fee paid by acquirer prior to the acquisition. This is clearly disallowed to be part of acquisition cost since its not for the benefit of subsidiary nor was the acquisition cost meant to cover the due diligence cost.
Just to re-emphasis my earlier opinion again, the purpose of the fair value adjustment exercise is to ensure the “Cost of Investment” is fairly accounted for. Afterall, the definition of fair value is:
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between knowledgeable market participants at the measurement date
The keyword here is “knowledgeable”, meaning both the acquirer and acquiree is fully aware of what is being paid for and what is the market value. This means undervalued land must be re-valued. This means internally generated assets must be included in the cost. This means legal fee, even if its less than 50% chance of being paid out, must be recognized. This also means they know what is NOT being paid for. Due diligence is most definitely not. FRS 103 is basically of the assumption that both the acquirer and acquiree are knowledgeable market participants. Any excess paid over the fair value of the net tangible assets is strictly voluntarily, known by both acquirer and acquiree and hence, known the name “Goodwill” which we will introduce briefly next.
Tax Effects on Fair Value Adjustments
The key takeaway of this section is to show that the deferred tax effect of fair value adjustment should be accounted for as an adjustment to the goodwill figure. There’s a lot to unpack here. Firstly, you need to understand that FRS 12 calls for any changes to future tax payment as a result of recovery or settlement of carrying amount of an asset and liability to be recognized as deferred tax asset or liability. To simplify further, basically if the fair value adjustment has any future tax consequence, then it needs to be adjusted for now. Second thing to unpack here is that FRs 12 also says the effect of deferred tax must be recognized in the same way the underlying assets or liability was accounted for. As a result of this principle, the tax figure is accounted as an adjustment to Goodwill because this is the line that represents the differences between Cost of Investment and fair value of net tangible assets. At this point, you may be very confused why is it that previous examples, the increase in fair value value of land or provision for legal fee went into the Cost of Investment line. That’s because previous examples were designed in such a way where Cost of Investment coincidentally equate to the value net tangible assets after the fair value adjustment exercise. The truth is, most of the time, the Cost of Investment and fair value of net tangible assets are 2 entirely different figures and any difference between the 2 is recorded as Goodwill because acquiree would want a premium over the fair value of net tangible assets. Goodwill will be discussed in further detail in the next post, but in the mean time, please see an example below where the fair value adjustment exercise produced a Provision for Legal fee of $20 that is tax deductible when it is subsequently paid. Statutory tax rate is 20%.
[Carrying amount $20 - tax base of $0] * 20% = $4 Deferred Tax Asset
| A | B | DR | CR | Consolidated Bal. | |
| Land | 400 | 150 | 50 | 600 | |
| Cost of Investment | 150 | – | 150 | – | |
| A/R | 200 | – | 200 | ||
| Bank | 40 | 20 | 60 | ||
| Deferred Tax Asset | – | – | 4 | 4 | |
| 790 | 170 | 864 | |||
| Share Capital | 530 | 100 | 100 | 530 | |
| Retained Earnings | 160 | 20 | 20 | 160 | |
| Provision | – | – | 20 | 20 | |
| Loan | – | 50 | 50 | ||
| A/P | 100 | – | 100 | ||
| Negative Goodwill | – | – | 4 | 4 | |
| 790 | 170 | 864 |
Another thing to note here is that if the fair value adjustment results in lesser tax payment now and more tax payment in future, its a deferred tax liability. If it results in more tax payment now and lesser tax payment in future, its a deferred tax asset.
All materials produced on this website, including this article, is based on author’s best interpretation of accepted accounting standards and his own experience. Any information bias, inaccuracies, misstatements, obsolesce are unintentional and should strictly not be held liable against the author. The author is not responsible for any losses, monetary or non-monetary, as a result of using these materials.
Derrick How 