9789144120188 by Smakprov Media AB

11 mm

This book presents an analytical method that helps the user form an opinion about the important consequences of a business combination. Group Accounting – An Analytical Approach has particular focus on the effects on profitability and financial position calculated from consolidated financial statements. Business transactions such as mergers, acquisitions of minority holdings, and disposals are also analysed. In this second edition there are chapters on step acquisitions and disposals and accounting for the cash flow effects of an acquisition. There is also an extended analysis of differences between amortisation of goodwill and impairment testing.

| GROUP ACCOUNTING

GROUP ACCOUNTING

An Analytical Approach

Walter Schuster

Walter Schuster is professor of accounting and managerial finance at the Stockholm School of Economics (SSE). He has been a teacher on the topic of mergers and acquisitions for many years, both in the bachelor and master programs at SSE and in executive education programs. In parallel to this he has worked with standard-setting as a member of the Swedish national standard-setter and in international groupings, such as the Joint International Group on Performance Reporting of the International Accounting Standards Board and the Financial Accounting Standards Board.

GROUP ACCOUNTING An Analytical Approach

The book discusses the most common methods in group accounting. However, the aim is to provide a general exposition of the issues since accounting rules tend to change over time and sometimes differ across jurisdictions. Numerical examples are used and important concepts are illustrated by excerpts from annual reports. Group Accounting – An Analytical Approach is intended for university students in accounting and is instrumental for understanding and analysing group accounting. Second Edition

2nd Ed.

Art.nr 31764

Walter Schuster

studentlitteratur.se

978-91-44-12018-8_01_cover.indd Alla sidor

2017-06-28 11:12

Copying prohibited This book is protected by the Swedish Copyright Act. Apart from the restricted rights for teachers and students to copy material for educational purposes, as regulated by the Bonus Copyright Access agreement, any copying is prohibited. For information about this agreement, please contact your course coordinator or Bonus Copyright Access. Should this book be published as an e-book, the e-book is protected against copying. Anyone who violates the Copyright Act may be prosecuted by a public prosecutor and sentenced either to a fine or to imprisonment for up to 2 years and may be liable to pay compensation to the author or to the rightsholder. Studentlitteratur publishes digitally as well as in print formats. Studentlitteratur’s printed matter is sustainably produced, both as regards paper and the printing process.

Art. No 31764 ISBN 978-91-44-12018-8 Edition 2:1 © The author and Studentlitteratur 2017 studentlitteratur.se Studentlitteratur AB, Lund Cover Design: Francisco Ortega Cover Illustration: Shutterstock/Onchira Wongsiri and Shutterstock/Stephen Coburn Printed by GraphyCems, Spain 2017

CONTENTS

Preface to the first edition 7 Preface to the new edition 9

Part I An analytical approach to group accounting

1 Introduction 13 1.1 1.2 1.3 1.4

Demand for group accounting 13 The use of accounting information 15 The basic principles of group accounting 16 Disposition 20

2 General effects of group organisation 23 2.1 2.2 2.3 2.4

Introduction 23 The timing issue 23 Disaggregation 26 Summary 27

Part II The effects of an acquisition when the whole firm is acquired

3 Effects of financing 35 3.1 3.2 3.3 3.4 3.5

Introduction 35 Financing with interest-bearing borrowings 35 Surplus cash 41 New shares 43 Summary 45

Contents

4 Effects of price 47 4.1 Introduction 47 4.2 The fair value of the indirectly acquired net assets exceed their book value in the subsidiary’s balance sheet 48 4.2.1 Assets that are not depreciated 50 4.2.2 Assets that are depreciated 52 4.2.3 Deferred taxes related to indirectly acquired assets 54 4.3 The fair values of indirectly acquired assets and liabilities equal their book values in the subsidiary. Goodwill 57 4.3.1 Expected abnormal profits 60 4.3.2 Synergies 63 4.4 Alternative accounting methods 65 4.4.1 A comparative analysis of amortization and impairment testing 65 4.4.2 Negative short-term effects 68 4.4.3 Long amortisation periods and immediate write-downs 72 4.5 Summary 75

Part III Other kinds of business transactions

5 Reverse acquisitions and mergers 81 5.1 5.2 5.3 5.4

Introduction 81 Reverse acquisitions 81 Mergers 85 Summary 89

6 The acquisition of a majority share of another company 91 6.1 6.2 6.3 6.4

Introduction 91 The price equals the acquired share of equity 91 The price exceeds the acquired share of equity 98 Summary 102

Contents

7 The acquisition of a minority share in another company 105 7.1 7.2 7.3 7.4 7.5

Introduction 105 Price equals acquired share of equity 105 A comparison of different consolidation methods 113 The price exceeds the acquired share of equity 117 Summary 119

8 Disposals 121 8.1 Introduction 121 8.2 Disposal of a company within the group. Price equals book value of sold assets 122 8.3 Disposal of a company within the group. Price exceeds book value of sold assets 125 8.4 The group’s holding gain in the presence of goodwill 127 8.5 Summary 129 9 Step transactions 131 9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8

Introduction 131 Step acquisition within the limit of control 132 Step acquisition within the limit of control. Price increase 135 Step acquisition crossing the limits of control. Constant price. 140 Step acquisition crossing the limit of control. Price increase 142 Partial disposal within the limit of control 146 Partial disposal crossing the limit of control 148 Summary 150

10 Cash flow effects of an acquisition 155 10.1 10.2 10.3 10.4 10.5 10.6

Introduction 155 Effects of financing 155 Alternative accounting methods 157 Purchase accounting effects and cash earnings 161 Cash flow effects using the equity method 161 Summary 162

Contents

Part IV Effects of operations abroad

11 The effects of exchange rate changes 167 11.1 11.2 11.3 11.4 11.5 11.6 11.7

Introduction 167 Effects of exchange rate changes: the closing-rate method 167 Effects of a weaker DCU 170 The price exceeds the net assets 180 Effects of a stronger domestic currency 181 Hedging equity or hedging the equity-to-assets ratio 182 Summary 188

12 Effects of exchange rate changes – extended analysis 189 12.1 12.2 12.3 12.4

Introduction 189 The monetary – non monetary method 189 A comparison between the two methods over time 198 Summary 202

13 Operations in highly inflationary economies 205 13.1 13.2 13.3 13.4 13.5 13.6

Introduction 205 Business conditions in highly inflationary economies 205 The monetary non-monetary method 207 The closing-rate method 208 Adjusting the closing-rate method for inflation 210 Summary 213

References 215 Index 217

CHAPTER 3

Effects of financing

3.1

Introduction

We start this chapter with a discussion of the effects on financial position and profitability of financing an acquisition with new interest-bearing borrowings of the acquiring firm (section 3.2). Then we proceed to the effects of financing with surplus cash in the acquiring firm (section 3.3). Finally, we cover the case of financing with new shares issued by the acquiring firm (section 3.4). We end the chapter with a summary of some important points related to different financing forms (section 3.5) 3.2

Financing with interest-bearing borrowings

Case I: Price MDCU 20. Financing with interest-bearing borrowings The focus of our analysis is on the effects on the new economic entity, i.e. the group. However, as a first step we will briefly discuss the effects on the parent company (we will skip this step in most analyses further on). Exhibit 3.1 represents the balance sheet of LARGE PLC, the parent company, immediately after the acquisition of the shares of SMALL and the financing of the acquisition: LARGE, the parent company Jan. 1, year 1 – after the acquisition Assets Shares in subsidiary

100 20

120

Equity Liabilities LiabilitiesNEW

40 60 20 120

Exhibit 3.1

3 Effects of financing

On the asset side there is a new item: “Shares in subsidiary” (SMALL). This item is recorded at cost. On the financing side there is also a new item: LiabilitiesNEW (the index NEW is to emphasize that this is the new interestbearing borrowings of the acquiring firm to finance the acquisition). However, we assume that the new group is the relevant economic entity on which interest is focused. Exhibit 3.2 represents the consolidated balance sheet of THE LARGE GROUP after the acquisition of all shares in SMALL PLC: THE LARGE GROUP Jan. 1, year 1 – After the acquisition AssetsLARGE AssetsSMALL

100 50

150

Equity LiabilitiesLARGE LiabilitiesNEW LiabilitiesSMALL

40 60 20 30 150

Exhibit 3.2

In contrast with the balance sheet of LARGE, the parent company, there is no item called “Shares in subsidiary”, but there are however two new items, AssetsSMALL and LiabilitiesSMALL . This is consistent with the basic principle for group accounting mentioned above, that an indirect acquisition of assets and liabilities in another company through the acquisition of the shares in the company should be reported in the same way as a direct acquisition of the assets and liabilities. Thus it is the individual assets and liabilities that are accounted for in the group’s balance sheet. Equity does not increase. This is hardly surprising. Equity in an enterprise increases when the enterprise is profitable or when the owners invest more capital; it does not increase through an acquisition of assets, regardless of whether the asset is a machine or another enterprise. In a purchase analysis, in a first step separately identifiable assets and liabilities are recorded at their fair values at the time of acquisition. In this case the fair values of the indirectly acquired assets and liabilities equal their book values in the subsidiary. The group’s acquisition cost of 20 is specified as indirectly acquired assets of 50 less liabilities of 30. (Naturally, the fair 36

3 Effects of financing

values of indirectly acquired assets and liabilities do not always equal their book values in the subsidiary. We will return to this issue in chapter 4.) Here we focus our interest on the effects of the acquisition on the financial position, and profitability, of the group. The E/A-ratio is approx. 27 % (40 / 150). The decrease in E/A-ratio from 40 % to 27 % is explained by the fact that the denominator in the ratio has increased, while the numerator is constant. When the denominator increases and the numerator is constant, the ratio will decrease. The question is how we should interpret this: Is the deterioration of the ratio only a consequence of accounting conventions – according to these conventions, acquired equity in a subsidiary should be eliminated in the consolidated balance sheet of the group – and thus without consequence? Or is the deterioration of the ratio a reflection of an increased financial risk in THE LARGE GROUP after the acquisition? It is the latter interpretation that is correct. The deterioration of the E/A-ratio is a reflection of an increased financial risk in the group after the acquisition. One way to explain this is to look at the equity of the firms as capital invested by the owners. Before the acquisition there is capital invested by the owners in LARGE and there is capital invested by the owners in SMALL. However, from the perspective of the owners of LARGE at the acquisition a sum corresponding to the capital invested by the owners of SMALL is paid out to them in return for their shares in SMALL and replaced by new interest-bearing borrowings (cf. exhibit 3.3). THE LARGE GROUP E LARGE

ALARGE LLARGE

E A

SMALL

ESMALL E

E L

ASMALL L

LNEW

LSMALL

Exhibit 3.3

3 Effects of financing

The only remaining capital invested by owners in the new LARGE GROUP is the equity in LARGE. After the acquisition this equity is a risk buffer to a substantially larger amount of assets. The financial risk has increased due to the acquisition. Actually, that is the very reason why the rules of group accounting are designed the way they are, which in an “elimination approach” means that acquired equity in a subsidiary should be eliminated in the consolidated balance sheet. Ideally, an assessment of the financial position of an enterprise should be made in the context of a comprehensive assessment of financial position, profitability, and growth. It is not sufficient to look at financial position independently of profitability or vice versa. Therefore, the next step of our analysis is to look at how profitability, in terms of ROE is affected by the acquisition. We do this by first looking at net profit. The expected net profit of LARGE, on a stand-alone basis was MDCU 4. This is the starting point of the analysis, which is then complemented by the effects of the acquisition and its financing: + Net profitLARGE

4.00

+ Net profitSMALL

2.00

− Interest expensea.t. = Net profitTHE LARGE GROUP

−0.70 5.30

Exhibit 3.4

As a consequence of the acquisition, the net profit in SMALL will be included in THE LARGE GROUP. Initially, we assume that the expected net profit of both LARGE and SMALL will be unaffected by the acquisition. However, the acquisition will also result in an interest expense on the new interest-bearing borrowings to finance the deal. It should be emphasized that since this is an after-tax analysis (the expected net profits of the companies on a stand-alone basis are after tax) it is the after-tax interest expense that should be deducted. For simplicity we assume that the pre-tax borrowing rate is 5 % and that the tax rate is 30 %. Then the after-tax interest expense will be MDCU 0.7 (20 × 0.05 × 0.70). The expected ROE of THE LARGE GROUP after the acquisition will be 13.25 % (5.3 / 40). This is higher than the expected ROE of LARGE on a stand38

3 Effects of financing

alone basis (and likewise higher than in SMALL before the acquisition), when expected ROE was 10 %. As a consequence of the acquisition, expected net profit in SMALL will be included in THE LARGE GROUP. The expected net profit in SMALL is higher than the after-tax interest expense because the expected ROE in SMALL (10 %) is higher than the after-tax borrowing rate (3.5 %) and the new interest-bearing borrowings is of the same amount as equity in SMALL. As mentioned above, the owners of THE LARGE GROUP have not invested any new capital at the acquisition. The profit increases while the invested capital is constant. An important follow-up question is how to interpret this increase in return. We have previously observed that an assessment of the profitability of an enterprise is incomplete without an assessment of the financial position. The conclusion of our analysis above was that the financial risk has increased. Thus the owners’ return has increased, but at the price of a higher risk. We illustrate this through a decomposition of ROE using the formula: ROE = ROCE + (ROCE – ROD) × D/E For definitions see the introduction to part II, pp. 31 − 33. Exhibit 3.5 represents the consolidated balance sheet of THE LARGE GROUP after the acquisition of all shares in SMALL PLC in terms of capital employed: THE LARGE GROUP Jan. 1, year 1 – After the acquisition Capital employedLARGE Capital employedSMALL

80 40

120

Equity DebtLARGE DebtNEW DebtSMALL

40 40 20 20 120

Exhibit 3.5

3 Effects of financing

Before the acquisition both LARGE and SMALL had a D/E-ratio of 1 (40 / 40 and 20 / 20 respectively). We make the additional assumption that both firms on a stand-alone basis had an expected ROCE of 6.75 %. This means that they had an expected profit before interest expenses (after tax) of MDCU 5.4 (0.0675 × 80) and MDCU 2.7 (0.0675 × 40) respectively. A further assumption is that both firms had an expected COD of 3.5 %. This means that they had expected after-tax interest expenses of MDCU 1.4 (0.035 × 40) and MDCU 0.7 (0.035 × 20) respectively. This is consistent with an ROE of 10 % for each firm on a stand-alone basis given the formula above: 6.75 + (6.75 – 3.5 ) × 1 = 10. The question is how THE LARGE GROUP’s expected ROE would change as a consequence of the acquisition. ROCE should be unaffected since the additional capital employed from SMALL has the same expected return as LARGE’s original capital employed. COD should also be unaffected since the average borrowing rate on the additional debt from SMALL equals the rate on LARGE’s original debt and the after-tax borrowing rate on the new debt to finance the acquisition is also at the same level. The only component that will change is the D/E-ratio, which would increase from 1 (40 / 40) to 2 (80 / 40). When we enter this into the ROE-formula, the result is: 6.75 + (6.75 – 3.5) × 2 = 13.25. This explains the higher level of ROE (13.25 %) that we calculated above as the ratio between net profit and equity. Return on capital employed is unaffected by the acquisition and so is the average borrowing rate. The only variable that changes is D/E and thus the explanation for the increased ROE is a higher financial risk. So far the only conclusion we have drawn is that the acquisition results in a higher financial risk. The next question is to assess the level of risk after the acquisition, to ask whether it is too high. The answer to that question depends upon the level of operating risk (e.g. as measured by the expected standard deviation in ROCE). If a low operating risk keeps the total risk at an acceptable level after the acquisition, it is positive that the risk has increased (at least from an owner’s perspective). This results in a higher expected ROE. Maybe the management of LARGE had been too careful previously. However, we will not explore this line of thought further here. We just note that the financial risk has increased and that the increase in expected ROE must be seen against this background. Of course, the expected net profit of the group could also increase due to synergies from the acquisition. So far such synergies have been left out of 40

3 Effects of financing

our analysis. At the moment our only comment is that there should be some relation between the size of the synergies and the price of the acquired firm and that a price equal to equity of the acquired company is not inconsistent with an absence of synergies. We will return to the issue of synergies in chapter 4 where we will analyse the case in which the price is higher than the equity of the acquired company.

3.3

Surplus cash

Case II: Price MDCU 20. Financing by surplus cash in the acquiring firm Our analysis of case I above showed that the acquisition resulted in a higher financial risk. In case I the acquisition was financed with new interestbearing borrowings. Our next question is whether a higher financial risk could be avoided if instead surplus cash is used to finance the acquisition. Exhibit 3.6 represents the consolidated balance sheet of THE LARGE GROUP after the acquisition of all shares in SMALL given this scenario: THE LARGE GROUP Jan. 1, year 1 – after the acquisition AssetsLARGE AssetsSMALL

80 50 130

Equity LiabilitiesLARGE LiabilitiesSMALL

40 60 30 130

Exhibit 3.6

There are two differences compared to case I. The first difference is that the item AssetsLARGE is MDCU 20 less. The reason for this is that in this case surplus cash in LARGE is assumed to have financed the acquisition. LARGE’s assets decrease by the amount paid. The other difference compared to case I is that there are no new interest-bearing borrowings (However, in this case too, the liabilities of the group have increased through the addition of the liabilities of SMALL). In case II the E/A-ratio after the acquisition is 31 % (40 / 130). This is © T h e au t h o r and S t u dentlitte r at u r

3 Effects of financing

higher than in case I, where the E/A-ratio was 27 %. The reason for this is that the assets are smaller in case II than in case I. Compared to the E/A-ratio of LARGE before the acquisition (40 %) there has been a substantial decrease in case II. The explanation for this is the same as in case I. From the perspective of LARGE’s owners the capital originally invested by the owners of SMALL, has been repaid in return for their shares. We could even argue that the risk in case II is as high as in case I. A fair comparison requires that after an acquisition financed through interest-bearing borrowings, MDCU 20 out of the total assets in LARGE is cash. Then the net debt (i.e. total interest-bearing liabilities less cash) is the same in both cases. (100 – 20 = 80 and 80 – 0 = 80 respectively.) Regarding profitability Case II is also rather similar to Case I. Exhibit 3.7 represents our analysis of the expected net profit after the acquisition: + Net profitLARGE − Lost interest incomea.t.

4.00 −0.70

+ Net profitSMALL

2.00

= Net profitTHE LARGE GROUP

5.30

Exhibit 3.7

There are two differences here compared to case I. The first is that there are no additional interest expenses when there are no new interest-bearing borrowings. The other difference compared to Case I is that the expected net profit in LARGE will be lower after an acquisition since LARGE in this case finances the acquisition with surplus cash (20). Because of that LARGE will not have any interest income from that amount (we must remember that the starting point of the analysis is the expected net profit of LARGE on a stand-alone basis). The magnitude of this decrease in net profit depends upon the opportunity cost. Here we assume that the cash could have earned an interest of 5 % before tax (3.5 % after tax). Assuming that, the net profit in case II will be the same as in case I. If on the other hand we assume that the opportunity rate of interest is slightly lower than the borrowing rate for new interest-bearing borrowings, the net profit in case II will be slightly higher than in case I. If we assume for some reason that the foregone interest rate on the cash is higher than the borrowing rate, the net profit will be somewhat 42

3 Effects of financing

lower in case II than in case I. Our overall conclusion is that apart from quite special circumstances case I and case II are rather similar in terms of both financial position and profitability. 3.4

New shares

Case III: Price MDCU 20. Financed by new shares issued by the acquiring company Our previous analyses show that the financial risk increases when an acquisition is financed through liabilities or through surplus cash. This changes when new shares issued by the acquiring firm are used as payment. We assume that the share issue is aimed directly at a specific group, the shareholders of SMALL, thus foregoing a potential right of the existing shareholders of LARGE to subscribe to new shares in proportion to their initial holdings. Furthermore this is not a cash issue since the new owners use their shares in SMALL as payment for their new shares in LARGE. A price of MDCU 20 means that LARGE has to issue new shares of a total value of MDCU 20. We assume that the issue price equals the fair value and that the issue results in an increase of equity of MDCU 20 in LARGE. Assuming a share price of DCU 40, 500,000 new shares will be issued. Exhibit 3.8 represents the consolidated balance sheet of THE LARGE GROUP: THE LARGE GROUP Jan. 1, year 1 – After the acquisition AssetsLARGE AssetsSMALL

100 50

150

Equity LiabilitiesLARGE LiabilitiesSMALL

60 60 30 150

Exhibit 3.8

In this case the equity in THE LARGE GROUP will amount to MDCU 60, which is also the equity of LARGE, the parent company, after the new issue. This results in an E/A-ratio of 40 % (60 / 150), i.e. of the same level as in LARGE before the acquisition. In case III the financial risk does not increase. © T h e au t h o r and S t u dentlitte r at u r

3 Effects of financing

One way for us to explain this is to say that the capital invested by the former owners of SMALL is not repaid to them, or to put it a little differently, an amount corresponding to the capital invested is offered to them at the acquisition, but by accepting payment in the form of new shares in LARGE, they invest the same amount in the new LARGE GROUP. The E/A-ratio of the group in this numerical example remains exactly the same as in the LARGE company before the acquisition because the E/A-ratio of SMALL was exactly the same as in LARGE and the price equals the equity of SMALL. If that had not been the case, the E/A-ratio would not have been exactly the same, but in the absence of any large deviations in these respects the E/A-ratio would not have been very different, and our conclusion is that the financial risk does not change much when an acquisition is financed by new shares (we must remember that our analysis so far rests upon the assumption that MDCU 20 is a fair price for acquiring SMALL). Finally we can add that the same consequences on equity and E/A-ratio would have followed from a share issue to the existing shareholders who then subscribed to new shares in proportion to their initial holdings and had paid cash for these, and that cash had then been used to buy the shares of SMALL. The difference is that in the approach we first discussed, LARGE’s owners do not have to invest any new capital. On the other hand, in that case there will be new owners in the group, a situation that would be avoided if the existing shareholders subscribe to the new issue and the cash proceeds are used to finance the acquisition. From now on it is assumed that the issue is directed at the former owners of SMALL. What are the effects on expected profitability in Case III? Exhibit 3.9 represents our analysis of the expected net profit after the acquisition: + Net profitLARGE

4.00

+ Net profitSMALL

2.00

= Net profitTHE LARGE GROUP

6.00

Exhibit 3.9

The net profit is MDCU 6, i.e. an increase of 50 %. However, there is also an increase of equity of the same relative magnitude. Consequently the ROE is the same as before the acquisition, 10 %. 44

3 Effects of financing

3.5

Summary

Our analysis rests upon the premise that accounting information is important to decision-makers. The consequences will depend on how this information is interpreted by the users. Regarding the effects of an acquisition in focus in this chapter, there should be no major interpretative problems: An acquisition that is financed through new interest-bearing borrowings (or surplus cash) results in a higher financial risk in the enterprise. This effect on financial risk is depicted clearly in the consolidated accounts. It is particularly evident when the price equals the equity of the target firm and when the book values of the assets and liabilities of the target equal their fair values, as we have assumed in this chapter. When that is not the case the effects will be intermingled with effects from the price in the financial reports (the effect of different prices is analysed in the next chapter). The expected return on a debt-financed acquisition will be higher, but this has to be seen against a higher required rate of return. A higher expected return exclusively due to an increase in risk could be expected to be offset by a higher required rate of return.

11 mm

| GROUP ACCOUNTING

GROUP ACCOUNTING

An Analytical Approach

Walter Schuster

GROUP ACCOUNTING An Analytical Approach

2nd Ed.

Art.nr 31764

Walter Schuster

studentlitteratur.se

978-91-44-12018-8_01_cover.indd Alla sidor

2017-06-28 11:12