For ACCA candidates studying Financial Reporting (FR), consolidated financial statements are a key topic. A central part of this syllabus area is accounting for the acquisition of a subsidiary and this will test the concept of fair value. Fair value relates to both the value of the consideration paid for the subsidiary and the fact that the assets, liabilities and contingent liabilities of the subsidiary must also be consolidated at their fair value. This article considers these values in each element of the goodwill calculation.
1. Fair value of consideration
It makes logical sense that the amount to be paid for the subsidiary must be recorded at its fair value. Accounting for a payment of cash is simple. However, complexities arise when a parent company pays for the subsidiary in a number of different ways. For the FR exam, it is vital that candidates are able to account for each of these and arrive at the correct total consideration.
(a) Payments in cash
These are the most straightforward types of consideration to deal with. In the FR exam, this amount is likely to have already been recorded in the parent company’s non-current assets as ‘Investment in subsidiary’.
(b) Deferred payment
In addition to cash paid immediately, there may be an element of deferred cash, being cash payable at a later date. For this to be accounted for as deferred cash, there must be no conditions attached to the payment (or this becomes contingent consideration – discussed further below). For deferred cash, the amount payable needs to be discounted to its present value. This reflects the time value of money and represents the amount of money that the parent would have to put aside at the date of acquisition in order to be able to pay for the subsidiary on the due date. If this aspect has been excluded when calculating and recording goodwill by the parent company, this is adjusted with the entry of Dr Goodwill, Cr Liability for deferred payment. As the liability represents the present value of the consideration, this needs to be increased to the full amount over time. This process is called ‘unwinding the discount’. Each year, the liability is increased by the interest rate used in the discounting calculation. This subsequent increase is expensed to interest expenses on unwinding of discounts, making the double entry Dr Interest expenses on unwinding of discounts, Cr Liability for deferred payment. Effectively, the liability is increasing as it approaches the actual payment date. Note that goodwill is not affected by the unwinding of the discount as goodwill is calculated at the date of acquisition.
EXAMPLE
Pratt Co acquired 80% of Swann Co on 1 January 20X1. As part of the consideration, Pratt Co agreed to pay the previous owners of Swann Co $10m on 1 January 20X2. Pratt Co has a cost of capital of 10%. This was not accounted for when the consolidation adjustment for goodwill was recorded.
Solution
As Pratt Co gained control of Swann Co on 1 January 20X1, the goodwill needs to be calculated on this date. Part of this calculation is the $10m payable in 1 year. The present value of $10m in one year is $9.091m ($10m ÷ 1.101 year). This is recorded in the goodwill calculation, with an equivalent liability set up within current liabilities, as the amount is payable in 12 months.
By the 31 December 20X1, the amount is now payable in one day. The previous owners of Swann Co will be contacting Pratt Co in one day requesting the payment of $10m. Therefore, Pratt Co is required to show a liability of $10m in its financial statements at this date. Currently, Pratt Co is showing a liability of $9.091m. Therefore, this needs to be increased by 10% (the interest). This increase of $909,100 ($9.091m × 10%) is added to the liability and recorded as an interest expense in the statement of profit or loss.
It is important to repeat that the interest expenses on unwinding of discounts do not affect the goodwill calculation in any way. Goodwill is calculated at the date of acquisition (using $9.091m as the deferred payment element of the consideration).
(c) Contingent consideration
Contingent consideration also relates to amounts payable to the previous owners in the future. However, the key difference is that the payment of these amounts is conditional upon certain events, such as the subsidiary performance hitting certain targets after acquisition.
Therefore, when the contingent consideration will be paid in cash, this will be recorded as a provision as the amount payable is likely to have an element of uncertainty (remember that a provision is a liability of uncertain timing or amount). This is where it is important to tread carefully. While this is recorded as a provision in the financial statements, the criteria of IAS 37 Provisions, Contingent Liabilities and Contingent Assets do not apply here. When we are producing consolidated financial statements, we must apply the principle of using the fair value of consideration, as stated by IFRS 3 Business Combinations.
The fair value of the contingent consideration payable will be a mix of the likelihood of the event and a reflection of the time value of money. The fair value of the contingent consideration will be given to you in the exam. Assuming that no amounts have been recorded by the parent company, this needs to be included in the goodwill calculation on the date of acquisition with the double entry Dr Goodwill, Cr Provision for contingent consideration.
Again, the fair value of the contingent consideration is likely to have changed by the year end. This is treated as a subsequent movement in the provision, with the subsequent increase or decrease being taken through the consolidated statement of profit or loss (CSPL). Just like with the deferred consideration, subsequent measurement of the provision does not affect the calculation of goodwill in any way.
EXAMPLE
Pratt Co also commits to paying $10m to Swann Co two years after the acquisition date if the results of Swann Co continue to grow by 5% over that period. An external valuer has assessed that this is not likely so estimates the fair value of this to be $4m at 1 January 20X1. At 31 December 20X1, the likelihood has increased and now the valuer assesses the fair value to be $6m. No accounting has taken place for the deferred consideration.
Solution
Many candidates fall into the trap of stating that as this is not likely, no liability should be recorded. In the individual financial statements this would be true but, when there is a conflict between the treatment in consolidated financial statements and the individual financial statement reporting treatment, the requirements of IFRS 3 should be applied. Therefore, while the outflow may not be probable, IFRS 3 states that the consideration must be recorded at fair value.
Therefore, on 1 January 20X1 the fair value of $4m is added to the consideration in the goodwill calculation and included as a provision within non-current liabilities (as payment is due in more than one year).
At 31 December 20X1, this has increased from $4m to $6m. This increase of $2m is not added to goodwill but is, instead, expensed to the CSPL to reflect the increase in the provision with the double entry Dr Operating expenses, Cr Provision for contingent consideration. As the amount is now potentially payable in one year, this will be moved from non-current liabilities to current liabilities. Note that, for simplicity, we will not separately consider unwinding of a discount from an increase in the expense and will simply take the fair value movement to operating expenses.
(d) Paying in shares
In addition to the potential cash payments outlined above, the parent company may also decide to pay for the subsidiary by giving the subsidiary’s previous owners new shares in the parent company. The double entry for this is similar to the double entry for a normal share issue.
The issue of shares at market value usually results in the receipt of cash, the nominal value being taken to share capital and the excess being recorded in share premium/other components of equity. This is similar to what is happening here but no cash is changing hands. Instead of the parent company receiving cash for the shares, they are gaining control of a subsidiary.
The double entry for this is, assuming no accounting has been performed, to debit the full market value to the goodwill calculation, credit the share capital figure in the consolidated statement of financial position (CSFP) with the nominal amount and to credit the excess to share premium/other components of equity.
EXAMPLE
Pratt Co acquired 80% of Swann Co’s $5m share capital, which consisted of $1 ordinary (equity) shares only. As part of the consideration for Swann Co, Pratt Co gave the previous owners of Swann Co two $1 shares in Pratt Co for every five shares it acquired in Swann Co. At 1 January 20X1, Pratt Co’s shares had a market value of $3.50.
Solution
Pratt Co has acquired 80% of Swann Co’s shares, meaning it has acquired 4m shares (80% of the 5m shares in Swann Co). Therefore, it issued 1.6m Pratt Co shares, being 4m × 2/5. These 1.6m shares had a fair value of $5.6m (1.6m × $3.50).
To record this, Pratt Co must add the full fair value of $5.6m as part of the consideration in the calculation of goodwill. $1.6m must be added to the parent's share capital, being 1.6m shares × $1 nominal value. This means that the excess of $4m is added to the parent's share premium/other components of equity.
2. Fair value of net assets
In addition to recording the consideration paid at fair value, the fair value of the net assets of the subsidiary at acquisition must be assessed as part of the consolidation process, in order to give an accurate picture of the goodwill arising on the acquisition.
If a parent company was to buy an individual asset from the subsidiary, say an item of property, this would be done at whatever the market price of the asset is, irrespective of its carrying amount in the selling entity’s statement of financial position. This same principle is applied to the acquisition of the entire entity. Upon selling the entity, the previous owners would base the selling price on the fair value of the assets, rather than their carrying amounts. Therefore, the consolidated financial statements must adjust the subsidiary’s assets and liabilities to fair value at the date of acquisition. In the FR exam, this could occur in three different ways:
(a) Fair value adjustments to recognised assets
Assets such as property, plant and equipment or inventories will be recognised in the subsidiary’s financial statements at their carrying amounts. Adjustments must be made to reflect the fair value of these assets.
For example, inventories must be held in the financial statements of the subsidiary at the lower of cost and net realisable value but must be recognised in the consolidated financial statements at fair value on acquisition. Similarly, the subsidiary may hold property under the cost model but this must be accounted for at fair value in the consolidated financial statements.
In terms of depreciable non-current assets, a fair value adjustment is applied at the date of acquisition, similar to applying the revaluation model under IAS 16 Property, Plant and Equipment. However, during the consolidation process, a revaluation surplus is not created. The effect of adding a fair value adjustment to the asset is that the value of goodwill will decrease. This is because goodwill is the difference between the consideration paid and the identifiable net assets of the entity. Therefore, as the fair value adjustment increases the net assets, it produces a lower, more accurate goodwill in the subsidiary.
As the group must make these fair value adjustments at acquisition, there is also an additional depreciation adjustment to be made to depreciable assets. The increase to fair value is not recorded in the subsidiary’s individual financial statements but is a consolidation adjustment and so the additional depreciation is a consolidation adjustment too. This means that the subsidiary’s depreciation in its financial statements is based on the carrying amount of the asset before the fair value adjustment has been made. As the fair value adjustment increases the value of the asset, the additional depreciation on this must also be accounted for.
In the CSPL, the current year’s depreciation expense on the fair value adjustment must be included. In the CSFP, it is the cumulative depreciation in all the years since acquisition that must be adjusted. In both cases, the subsidiary’s post-acquisition profits to be consolidated will reduce following the adjustment for this fair value depreciation. This means that both the parent’s share and the non-controlling interests’ (NCI) share of the post-acquisition profits will also be affected and must be reduced.
(b) Internally generated assets
The subsidiary may also have internally generated assets that are not recognised in its individual financial statements. This is correct, particularly in relation to internally generated intangibles as most are prohibited from being capitalised under IAS 38 Intangible Assets. In the consolidated financial statements these will need to be recognised at fair value if they are identifiable, meaning they could either be separated from the subsidiary or arise from contractual or other legal rights.
This means that items such as internally generated brands or research expenditure could be capitalised in the CSFP, despite not meeting the criteria for capitalisation per IAS 38. Here, we can see again that the requirements of IFRS 3 are applied rather than the ‘usual’ rules for individual company accounting treatment.
The process of recording the fair value adjustment will be almost identical to that noted above. The only difference is that it may lead to the creation of a new intangible asset which is currently not recognised. It will still have the effect of increasing non-current assets and reducing goodwill in the CSFP. As this asset has a limited useful life, it must be amortised over that remaining life. If it is deemed to have an indefinite life, it will be subject to an annual impairment review.
(c) Contingent liabilities
This is often the area that candidates find most difficult in the exam. Many candidates have correctly learned the rule per IAS 37 that contingent liabilities are only disclosed in the notes to the financial statements and are not recognised in the financial statements themselves as a liability. For individual financial statements, this is true. For consolidated financial statements, this is not the case. In this case, where the contingent liability assumed in a business combination is a present obligation that arises from past events, it must be included in the CSFP at fair value.
These contingent liabilities must be recognised in the consolidated financial statements at their fair value as they will have affected the price that a parent company is willing to pay for the subsidiary. This is because the parent company will have offered a lower price for the subsidiary knowing that the subsidiary may need to make a payment in the future, even if it is not probable that a payment will be required.
These contingent liabilities need to be consolidated at fair value as a liability at the date of acquisition. This will reduce the net assets at acquisition and, therefore, increase the goodwill. Any subsequent fair value movements in this contingent liability are recognised in the CSPL rather than affecting the goodwill calculation. In the FR exam, you will be told the fair value of any contingent liability and you just need to remember to include it as a decrease in net assets acquired (in the goodwill calculation) and as an increase in liabilities on the CSFP.
Summary
As we have seen, both the consideration paid and the net assets of the subsidiary need to be included at fair value at the date of acquisition. More often than not, the fair value of items will be provided in the FR exam, such as the fair value adjustment required to net assets, or the fair value of contingent consideration. For the calculation of items such as a deferred payment or an issue of shares, the information will be given which allows candidates to calculate the entries.
The key is to not confuse the rules for accounting for items in a consolidation with the rules for individual accounting standards. As we have seen above, IFRS 3 and its fair value adjustments will take precedence over the usual accounting treatment, so this is a vital area to be aware of in order to score well within a consolidation question. Fair value adjustments are very common in the exam.
Written by a member of the FR examining team
