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Negotiation series

Acquiring a subsidiary in stages

The hidden consequences of the revised accounting model
September 2009

When negotiating a business acquisition, one of the furthest things from the negotiators mind may be the accounting consequences. However, it is the negotiation of the deal that establishes the method of accounting for the acquisition that will affect companies far into the future. This is a first in a series of publications looking at the issues to be considered when negotiating a business acquisition.

Acquiring subsidiaries has a bearing on the fortunes of the companies involved for years to come. While this is to be expected from combining the operations, accounting for the acquisition of a subsidiary that has been acquired in stages has different impacts on reported results and equity. An investment in a subsidiary is often acquired in stages both in the lead-up to gaining control and after control has been obtained. Sometimes this is because an initial strategic investment has been made as part of a long-term strategy leading to control. In some cases, it makes commercial sense to acquire part of a business, and leave part owned by the vendor executives for a period of time to ensure they have some skin in the game and are committed to the continued success of the business they are selling.

Accounting for step purchases has always been complex. The revised standards on accounting for business combinations (IFRS 3 Business Combinations) and consolidated financial statements (IAS 27 Consolidated and Separate Financial Statements) have introduced significant changes to the way these transactions are accounted for. Whilst in many ways the changes simplify the accounting, the new approach also creates new risks if the accounting impacts are not fully understood and planned for in advance. In this publication, we take a closer look at the changes to accounting for step acquisitions and the effects on reported profits and financial position, to help avoid surprises in the future.

Insights: considerations before entering into step acquisitions

The revised accounting model is effective for annual periods beginning on or after 1 July 2009. What does management need to do before entering into such transactions to avoid unwelcome surprises?
Understand the income statement impact fair value step-ups when obtaining

control in stages (and on loss of control) create gains/losses and recycling from equity and the consequential impact on subsequent reported results. All affect financial covenants, and management remuneration structures.
Understand the impact on equity effects on performance measures (return on

equity), financial covenants (gearing ratios) and sometimes tax (when tax is based on financial measures).
Consider involving accountants, lawyers and valuers to understand and plan for

the impact of the transaction.

Acquiring a subsidiary in stages the hidden consequences of the revised accounting model

Step acquisition accounting the new methodology

The old approach to accounting for the acquisition of a subsidiary in stages was a cost accumulation methodology. In contrast, the revised standard aims to fair value all of the elements of the business combination transaction at the date of acquisition including any existing ownership interests held by the acquirer. In effect, this results in accounting for any existing investment as if it had been sold in order for the business to be acquired. The accounting also reflects this the acquiree derecognises (i.e., disposes of) any existing investment together with the transaction proceeds paid (at their fair value) and recognises the acquired businesss net assets in return.

Table 1: Accounting for an existing investment on a step acquisition

Accounting for existing equity interests
1. Fair value through income statement 2. Available for sale 3. Equity accounted 4. Proportionately consolidated

Impact
None Recycle AFS reserve to income statement Recycle share of associates / JVs reserves to income statement1 Recycle share of JVs reserves to income statement1

1Applies to all recyclable reserves, i.e., available-for-sale reserve, cash flow hedge reserve and foreign currency translation reserve.

Where there is a change in the measurement of the existing interest (as in cases 3 and 4 in Table 1 above), we would normally expect this to give rise to a gain. However, there may be some instances where a loss occurs, as illustrated in Box 1.

Care will be needed in determining the fair value of the existing interest, particularly if it is unlisted its value will not necessarily be proportionate to the price paid for the controlling interest since that price may include a control premium.

Immediate impact
The effect of this sale accounting is that the acquirer recognises a gain or loss on any remeasurement of the existing investment. If the existing investment had already been carried at fair value with changes recognised in equity (because it was an available for sale (AFS) investment in accordance with IAS 39 Financial Instruments: Recognition and Measurement), the AFS reserve is recycled (or reclassified under the new terminology) to income. The same applies to other recyclable reserves, such as cash flow hedge reserves and foreign currency translation reserves, which would arise from an investment in an associate or joint venture. The impact of this fair value reassessment and the sales accounting is summarised in Table 1.

Box 1: Example of a loss arising on acquisition of a subsidiary

An investor has an equity-accounted interest in a listed associate comprising 1,000 shares with a carrying value of 1,000. The quoted price of the associates shares is 0.90 per share, i.e., 900 in total. As there is an impairment indicator, the investment is tested for impairment in accordance with IAS 36 Impairment of Assets. However, the investor determines that the investments value in use exceeds 1,000. Therefore, there is no impairment loss recognised. In the following period, the investor acquires all of the other outstanding shares in the associate following a takeover offer. The fair value of the shares is unchanged at 0.90 each. At the control date, the existing shares are remeasured to fair value and the loss of 100 is recognised in the income statement.

Acquiring a subsidiary in stages the hidden consequences of the revised accounting model

The tax consequences also need to be carefully considered. The gain or loss recognised may create additional deferred taxes, as it is unlikely that for tax purposes this will be considered an effective disposal. When the investment was carried as an AFS investment, giving rise to an AFS reserve, the deferred tax would already have been recognised. When the reserve is recycled to income, the tax is also recycled to income in the same period, therefore holding the effective tax rate static, and retaining the deferred tax liability. The deferred tax associated with this gain has no bearing on the calculation of goodwill associated with the subsidiary. In some jurisdictions where the tax treatment is based on the accounting treatment, the acquisition could give rise to an additional current tax payable on the gains generated, thereby potentially giving rise to real additional cash outflows, if tax planning is not also undertaken before the acquisition is completed. The gain or loss is easy to understand once you get used to reporting a profit as a result of a purchase transaction. Similarly, communication of the financial reporting impact should not be difficult to manage as it will usually be presented as a significant one-off gain or loss. Box 2 illustrates the impact of the new accounting and the effect on the profit.

As always, care needs to be taken to understand the impact on other accounting-based measures such as loan covenants. Many loan agreements are not clear on which significant items, if any, are excluded for covenant purposes. Therefore, questions will arise as to whether the gains/losses created from the fair value step-ups or recycling of equity items are taken into account or not. For some entities, it may be the difference between meeting a covenant or being in breach of the covenant. For example, an acquirer with earnings-based covenants may be at the points of meeting a covenant. Where it gains control of an investment and there are recyclable debit reserves, if these are to be included in the assessment, this may result in a breach of the covenant. It will therefore be critical to determine in advance whether the gain or loss is included for covenant purposes or, if it is unclear, obtain prior agreement from the financiers. Similarly, bonus and profit share arrangements are often based on accounting profit. However, it is not always clear from the terms whether the gain or loss arising at the date of acquisition should be included. If it is not clear, then it may be advisable to amend the terms of agreements before entering the transaction rather than risk the commercial disruption of a dispute later on. As the concept of a gain or loss arising on the acquisition of a subsidiary (because of the deemed disposal of the existing investment) is new, it is unlikely that this will be contemplated in borrowing and remuneration arrangements.

Acquiring a subsidiary in stages the hidden consequences of the revised accounting model

Box 2: Example of a step acquisition and the impact of the new requirements
Entity A acquires 25% of Entity B on 1 January 2007 for 225. Entity A acquires a further 75% of Entity B on 1 January 2010 for 910. Details about Entity B for these dates are as follows (ignoring tax effects): 1 January 2007 Fair value of the business Value of % acquired Fair value of the net assets Value of % acquired Equity accounted balance Fair value of interest held Change in fair value of assets (versus change from other activities) Profit since date of acquisition of first interest Share in profit since acquisition OCI since date of acquisition of first interest Share in OCI since acquisition 900 225 800 200 1 January 2010 1,200 900 1,000 750 258 300

70 80 20 50 13

Entity A accounts for the acquisition as if it had disposed of its equity accounted investment and acquired 100% of Entity B. The following table summarises the accounting result under both the current and new requirements. Old treatment Identifiable net assets of Entity B recognised Goodwill Asset revaluation reserve (25% of 70) Profit or loss (re-measurement of 25% interest from 258 to 300) OCI reclassified from equity to profit or loss for the period
* Goodwill is currently calculated for each tranche acquired: First 25% - Consideration (225) less 25% of net assets (200) = 25 Second 75% - Consideration (910) less 75% of net assets (750) = 160

New treatment 1,000 210** 42 13

1,000 185* 17

** Goodwill is calculated as consideration given (910) plus the fair value of the previous 25% interest (300) less 100% of net assets (1,000) = 210.

Acquiring a subsidiary in stages the hidden consequences of the revised accounting model

Future impact
The accounting consequences of step acquisitions will also affect subsequent reported profits compared with the current requirements. Firstly, there will be an increased risk of impairment losses in the future for:
Goodwill. The fair value step-up means

Other identifiable net assets. Although

that goodwill on an existing interest is effectively revalued to current fair value. Not only will the amount generally be larger, but any headroom over historical cost may also disappear. So there will be an increased risk of a future impairment loss.

these were also revalued under the former IFRS 3, those revaluations were taken to equity and the resultant reserves could have been used to absorb future impairments before affecting the income statement. Under IFRS 3R, there is no reserve to absorb any future impairments and so any such future charges will be recognised in the income statement. Secondly, because AFS and other reserves are recycled at the acquisition date, they are no longer available for recycling in the future. These effects are summarised in Table 2. This effect is illustrated in the example in Box 3.

Acquiring a subsidiary in stages the hidden consequences of the revised accounting model

Table 2: Impact of step acquisition accounting methodology on future reported profits

Components of gain or loss
1. Change in fair value of identifiable net assets: PP&E / intangibles future impact AFS instrument future impact Foreign currency translation reserve future impact 2. Change in value of goodwill future impact Create revaluation reserve May be used to absorb future impairment loss Create revaluation reserve Recycle upon future disposal Retained at the date of gaining control Recycle upon future disposal Not recognised Headroom mitigates risk of future impairment Profit / loss on acquisition No reserve to absorb future impairment Profit / loss on acquisition No reserve to recycle on future disposal Profit / loss on acquisition No reserve to recycle on future disposal Recognise revalued goodwill Increased risk of future impairment

Old treatment

New treatment

Box 3: Example illustrating the subsequent impact on the income statement

Using the example in Box 2, assume that the OCI within Entity B arose from the holding of an AFS instrument. Three years later (i.e., 1 January 2013) Entity B sells its investment in the AFS instrument for 200. At that date, Entity B had a value in OCI attributable to the AFS instrument of 80. Entity B therefore reclassifies 80 from OCI to the income statement. The table below illustrates the profit recognised on consolidation under the current and new requirements. Old treatment OCI existing at the date of sale reclassified to profit Made up of: 43 Change since acquisition plus ownership interest as an associate 80-50+13 New treatment 30 Change since acquisition 80-50

Acquiring a subsidiary in stages the hidden consequences of the revised accounting model

It is important to understand the reserve impact to avoid unwelcome surprises. An investor in an associate may have budgeted for profits from the associate that include recycled AFS reserves and the recycling of cash flow hedge reserves. When an investor takes control, these reserves will now flow into the calculation of the one-off gain or loss on obtaining control, and will not be available postacquisition. As a result, there could be significant changes to budgeted results from the acquired business. Again, where reported results are used for other purposes such as loan covenants and profit sharing arrangements it is important to consider in advance the potential effects of a step purchase and ensure that these are included in the due diligence process. For example, there may be potential anomalies whereby a gain on a step acquisition is excluded for profit-share purposes, but a subsequent impairment loss on the resulting goodwill is not.

Effect on equity
The fair value step-up also affects reported equity. This can be particularly significant where the acquiree was a longstanding associate (and not, therefore, already recorded at fair value). The step acquisition will typically result in a gain and an increase in reported equity. Reported equity is another measure often included in loan covenants and ratios and potentially profit sharing arrangements. Performance measures, such as return on equity, could be adversely affected by a significant increase in reported equity which may require careful management of the reporting of such measures or where they are used as performance hurdles adjustment or normalisation to avoid inequitable outcomes.

Acquiring a subsidiary in stages the hidden consequences of the revised accounting model

Some step purchases can have a negative impact on equity. Where an additional interest in an existing subsidiary is acquired, i.e., an acquisition of a non- controlling interest (NCI), the revised standards treat this as an equity transaction. Any difference between the consideration paid and the reduction in the NCI is charged directly against the parents equity. Previously, an entity that adopted the parent entity extension method would record this difference as additional goodwill.

The partial goodwill approach results in a larger reduction in equity because the goodwill attributable to the original NCI is never recorded it is effectively debited against equity. An example illustrating the effect of this new requirement is included in Box 4. This has implications for the subsequent goodwill impairment which we intend to explore further in a future publication. These reductions will have a flow-on impact for gearing ratios, returns on equity and other measures based on equity. Therefore,

it is vital to have an understanding of the likely future strategy regarding ownership of the acquiree when making the original choice of full or partial goodwill recognition. For combinations that occurred under the previous IFRS 3, only the partial goodwill method applies and any planned acquisition of the NCI for these will result in an erosion of equity, which could have consequences on equity based covenants. As noted above, this may require discussion with financiers to avoid a breach that may trigger repayment of any loans.

Box 4: Example of an increase in ownership interest of a subsidiary

Entity A has an 80% interest in a subsidiary which has net assets of 4,000. The carrying amount of the NCI share is 800. Entity A acquires an additional 10% interest from the NCI for 500. The following table summarises the impact of the accounting compared to current practice. Account New treatment Current treatments Parent extension method* Equity NCI Equity controlling interest Goodwill Cash Dr 400 Dr 100 Cr 500 Dr 400 Dr 100 Cr 500 Entity concept method Dr 400 Dr 100 Cr 500

* This method was commonly applied by entities in the absence of specific guidance in the existing standards.

Acquiring a subsidiary in stages the hidden consequences of the revised accounting model

Conclusion

The revised IFRS 3 and IAS 27 introduce significant changes to the way step acquisitions are accounted for that can significantly affect reported results and equity. Managing the impact of these changes requires a considerable planning effort and potentially involves a variety of experts such as accountants

(to understand the impact on reported results), lawyers (to evaluate the impact on loan covenants and bonus and sharebased payment agreements), and valuation professionals (to determine the value of the existing ownership interest). Renegotiations with financiers may also be required.

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Acquiring a subsidiary in stages the hidden consequences of the revised accounting model

Acquiring a subsidiary in stages the hidden consequences of the revised accounting model

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