4: Fair Value Adjustments (Date of Acq.) Part II

To recall the learnings in my immediate prior post, there are 4 main elements for consolidation at date of acquisition:

1. Basic combination of financial statements
2. Adjustments for the fair values of assets and liabilities
3. Goodwill – Balance of cost of investment less fair value (FV) of net identifiable assets
4. Non-controlling interest (NCI)

For the purpose of this post, we will now focus on discussion on point number 3 and 4. While previous examples often equate Cost of Investment (COI) to be same value of acquiree’s Fair Value of Net Identifiable Assets (FVNIA), even after performance of the fair value adjustment exercise, this is not realistic. Often, when an acquisition or merger happens, acquirer or merger partners are expecting synergy to happen, which is when the combined entity is greater than the sum of all parts. For that, the acquirer is willing to pay a premium above acquiree’s FVNIA. For the purpose of consolidation, this is called “Goodwill”. FRS 103 defines “Goodwill” as ‘an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized’. From acquiree’s point of view, they also want a price as high as possible to give up control. On the flip side, its also entirely possible acquirer underpays for the acquisition that results in “Negative Goodwill”. A possible scenario for this to happen is when acquiree is in distress and owners are willing to cash out at a bargain to acquirer.

Goodwill

An important thing to note about Goodwill is it is subject to FRS 36 Impairment of Assets but not subject to amortisation. Following is an example of an acquisition in which the COI is 200 but acquiree’s FVNIA is only 170.

	A	B	DR	CR	Consolidated Bal.
Goodwill on Conso	–	–	30		30
Land	400	150	50		600
Cost of Investment	200	–		200	–
A/R	200	–			200
Bank	10	20			30
	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

Another important thing to note about Goodwill on acquisition date is if acquiree has any prior Goodwill not related to the acquisition, the treatment of this unrelated Goodwill should be to:

• Ignore it during calculation of Goodwill on Consolidation.
• Offset it against the reserves of the subsidiary before cancellation against COI

The net effect of doing this is to hide or pretend the unrelated subsidiary Goodwill isn’t there and refresh the Goodwill calculation back to zero for the purpose of calculating the present acquisition Goodwill at acquisition date. Following is a demonstration of how this pans out:

	A	B	DR	CR	Consolidated Bal.
Goodwill on Conso	–	–	30		30
Subsi Goodwill	–	50		50	–
Land	400	150	50		600
Cost of Investment	200	–		200	–
A/R	200	–			200
Bank	10	20			30
	810	220			860
Share Capital	550	100	100		550
Retained Earnings	160	70	50		160
			20
Loan	–	50			50
A/P	100	–			100
	810	220			860

As you can see from the example above, acquiree’s prior Goodwill of 50 is offset against the reserves first, then the acquiree’s FVNIA comes down to 170 which is then compared against the COI of 200 to get the Goodwill of Consolidation of 30.

Non-Controlling Interest (NCI)

We are now ready to move on to our next discussion, Non-Controlling Interest (NCI). NCI occurs when the acquisition is not a full 100% but acquirer has control. (How acquirer can gain control has been discussed before, but to simplify our discussion, we will assume any shareholding >50% is enough to gain control.) If for example, the acquisition is only for 80%, then the 20% belongs to shareholders outside of acquirer, also defined as Non-Controlling Interest (NCI). The consolidation exercise will still be on 100% basis as before, but 20% of net assets and profits will need to be allocated to NCI. FRS 110 governs the presentation of the NCI, which indicates that it must be presented as equity.

An important discussion of NCI is measurement. FRS 103 gives us 2 choices on how to measure NCI:

• Base on fair value (market price of shares)
• Proportionate share of acquisition date FVNIA

The main difference between these 2 methods is that the first method gives the entire consolidation exercise an additional NCI goodwill, calculated by taking the (market price of share * number of NCI share) and net against (NCI % * FVNIA). The second method just assumes NCI does not have a NCI Goodwill. In summary, the first method inflate the Goodwill on Consolidation and the NCI with an arbitrary figure derived from share price while second method don’t.

In current industry practice, most people use the second method and don’t use the first and for very good reasons.

• Firstly, NCI’s Goodwill really doesn’t add much value to calculations. On the contrary, it makes the entire consolidation exercise more complex that it should be by introducing share price as a variable. This makes any consolidation proof to require a record of the share price that was used.
• Secondly, not every company is listed and thus the choice of share price value used can be highly contentious and quite frankly, difficult to justify.

For simplicity (cause I am lazy), I will demonstrate how NCI is calculated using the second method. For this example, the acquisition is for 80% @ COI of 180. Land was fair valued to 250 from 200 with any future sale of land attracting a 20% tax rate.

	A	B	DR	CR	Consolidated Bal.
Goodwill on Conso	–	–	28		28
Land	–	200	40		250
			10
Cost of Investment	180	–		180	–
A/R	100	10			110
Bank	60	10			70
	340	220			458
Share Capital	200	100	80		200
			20
Retained Earnings	60	50	40		60
			10
A/P	80	70			150
Deferred tax	–	–		8	10
				2
NCI	–	–		38	38
	340	220			458

Breakdown of consolidation working as follows:

Fair Value Adj. Exercise	Amt	P%/NCI%	P/NCI
Increase in Land FV	50	80%	40
		20%	10
20% Deferred Tax on Land FV	(10)	80%	(8)
		20%	(2)
Total FV adjustment	40
Add on:
Acquiree’s FVINA at acq. date	150
Acquiree’s FVINA after FV exercise	190	80%	152*
NCI’s share of FVINA		20%	38
Thus to derive Acquirer Goodwill:
Acquirer COI	180
Acquiree’s share of FVINA	152*
Goodwill on consolidation	28

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