Lecture 9 notes

Question 1

What will we learn today?

Answer 1

How to account for mergers and accquistions

Question 2

Why do firms accquire other firms?

Answer 2

Growth by accqusition

diversification

Take advantage of limited liability

Vertical and horizontal intergration

Synergies = EOS and scope

Question 3

What does horizontal intergration mean?

Answer 3

eliminate/reduce competition i.e google did this.

Question 4

What does vertical intergration mean?

Answer 4

accquire new sources of supply ( e.g. lets say you have a supplier and they do not provide things on time, thus you think its time to make your supplier chain better, hence you accquire a supply chain yourself, accquiring another firm in the same industry.

Question 5

What does diversification mean in the context of firms accquiring other firms?

Answer 5

if you want to move into a new industry but don’t have an established prescence in the industry, what you do is you accquire and established firm and diversify in a different operation.

Question 6

What does taking advantage of limited liability mean?

Answer 6

(If there is a financial failure of one subsidiary, neither the assets of other subsidiaries nor those of the parent could be legally demanded by any unsatisfied claimants (such as lenders) )

Question 7

What is a Parent or holding company?

Answer 7

Company that owns the shares of the ‘subsidiary’ company.

Question 8

What is a subsidary?

Answer 8

Company whose sharees are partly or wholly owned by the parent.

Question 9

What does the parent have to show their shareholders, with their accquistions?

Answer 9

A consolidated B/S of the parent and subsidary together, presenting an overview to investors of whole group.

A consolidated I/S to.

They do not care about internal transcations.

Question 10

What are 3 types of group structures that parent companies are in?

Answer 10

1) Parent accquiring one subsidary
2) Parent accquiring many subsidaries e.g. 4
3) Indirect control

Question 11

What is the group structure of a Parent accquiring subsidary?

Answer 11

The parent creates a new company to operate some part of its business. For example, the would-be parent company forms a new company to undertake the work that has previously been done by the parent’s industrial division.

Question 12

What is the group structure of parent having multpile subsidaries?

Answer 12

The parent has multpile subsidaries e.g. 4 in each, they have atleast 50% direct holdings, or control of atleast 50%, this means that you can for example have voting rights. ( change CEO)

Question 13

What is the group structure of indirect control?

Answer 13

Here the Parent owns 1 and 3 directly but 2 indirectly, It has majority shareholdings in 1, thus it means in 2.

Question 14

What does control mean in terms of Parent owing a subsidary?

Answer 14

 The power to govern the financial and operating policies

 Control is presumed when P owns more than 50% of the voting rights of S.

Question 15

Is it possible that the parent can have less than 50% and still have control of S?

Answer 15

yes it is possible, through an agreement, allowing the parent company to change policies etc. ( e.g. big pension fund investing in sainsburys, this pension fund owns ownly 40%, but through some agreement, they have given this pension fund voting rights, thus the pension fund has control)

Question 16

What happens when the parent company has control over the subsidary?

Answer 16

When P has effective control over S, P needs to prepare consolidated financial statements (or group accounts) as if the group was a single entity. ( e.g. M&S create a subsidary called M&S clothing , you the investor are shareholders of M&S, so you are interested in how well the parent is doing as well as the subsidary.

Question 17

Why does the parent company make consolidated B/S for investors in parent?

Answer 17

Lets say the parent receives some dividend income from the subsidary and the parent has paid money to accquire the subsidary. To the investors of the parent, these look like internal transcations, these shareholders do not care about internal transcations, they care about how the group as a whole perfoms, in relationship to external world.

So it is important to remove any internal transcation that have occured, whilst consolidating.

Question 18

To prepare for consolidated balance sheet she are going to look at how many cases?

Answer 18

7

Question 19

What is the first case we will look at when creating a consolidated balance sheet?

Answer 19

1) Case 1: P(parent) accquires 100% of Subsidary equity

Question 20

Give an example of case 1?

Answer 20

Assume Parent (P) acquires 100% of Subsidiary (S)’s equity for £100m

• Investment in S = £100m
• P acquires S’s equity = assets – liabilities (net assets) = £80m (the parent gets the equity secton) Why pay more than its net assets’ worth?

Market premium = £20m

Question 21

What is Market premium of 20m also known as?

Answer 21

Goodwill.

Question 22

When preparing consolidated b/s for the simple case 1 what do you do?

Answer 22

You first ADD

then elimanate Equity of Subsidary and Investment in S ( entire equity section of S), AS these look like internal trasncations to the outside shareholder, so you cancel this out, but this only happensn when you pay the exact amount for the firm as the equity section

When you pay more for the firm, whatever extra you pay, you note down as Goodwill which is a non current asset, as the benefit will be long term.

Question 23

Sprint plc bought 100% of the shares of Sport Ltd on 31 December 2011 for a consideration (purchase price) of £10 million. The statements of financial position of the two companies as of 31 Dec 2011 are as follows: How would CBS look like?

Answer 23

1) You add like items, you remove investment in subsidary and equity section.
2) Calculate the good will ( you paid 10 and got the equitiy section so goodwill is 2.)

Question 24

What are the benefits that arise from Goodwill?

Answer 24

Cost synergies

Sales syneries ( technological and innovative skills)

Question 25

What is the Goodwill calculation ?

Answer 25

Goodwill = purchase price - fair value of Subsidary's net assets ( equity section)

Question 26

Do you calculate goodwill every year?

Answer 26

You calculate goodwill every year, you calculate once, at the time of accquistion, then every year, you ask do you still except the same benefit, if no then you do the goodwill impairment test.

Question 27

What is the goodwill impairment test?

Answer 27

Goodwill (NBV) = Goodwill - Impairment e.g. You except to get 2 mil benefit but some employees have left, so we will not get that much benefit, so in subsquent year, you reduce value

Question 28

A. 0, 1, 31 B. 1, 0, 30 C. 0, 1, 30 D. What is goodwill? E. I’m tired prepping for Mid-term

Answer 28

First investment in Sports ltd gets cancelled out Then calculate goodwill Then Share capital is 30 as you cancel equity section of Sprint PLC. The answer is C

Question 29

What is Case 2?

Answer 29

P (parent) acquires less than 100 % of S’s (subsidiary) equity The remaining x percentage is calle minority interest or Non controlling interest.

Question 30

When preparing consolidated CBS how do you take care of NCI?

Answer 30

NCI is the minority of shares of S held by outsiders. NCI % C net assets of S at the balance sheet date. It is posted below equity section of CBS.

Question 31

IS good will different here than the one we saw in case 1?

Answer 31

Yes Goodwill = Purchase price - %share owned X equity section of subsidary S

Question 32

E.g Calculate goodwill and NCI In the example above, assume that Sprint plc acquired only 80% of the shares of Sport ltd, everything else remaining unchanged (i.e. purchase price still £10 m) Equity section ( 8) and calculate NCI

Answer 32

Goodwill = 10 - (80% of 8) = 10 - 6.4 = 3.6 The remaining 20% claims on net assets of Sprint LTD is NCI = 20% X 8 = 1.6

Question 33

So how does Case 2 look like on CBS?

Answer 33

Question 34

Complete the CBS

Answer 34

Question 35

Find XYZ A. 0, 5, 30, 1 B. 0,6, 30, 1 C. 10, 6, 33, 2 D. 10,5, 30, 1

Answer 35

Answer b Cancel investment to give X = 0 Good will= purchase - ( % of shared owned X equity section) 10 - ( 80% X 5) = 6 Z = 30 as you cancel equity section of Sport LTD

Question 36

So so far what have we done?

Answer 36

So far, we assumed for simplicity that the statement of financial position of the subsidiary reflects all assets and liabilities at their fair values.However, in practice things are not usually that simple, so lets introduce the case of revaluation adjustement.

Question 37

With previous lectures when the value of land goes up what do we do?

Answer 37

Dr Land ( this increases land asset) Cr Revaluation gain ( this goes in equity section)

Question 38

What is Case 3?

Answer 38

Revaluation Adjustment in subsidary. ( Subsidaries assets to be revalued before being included on the consolidated balance sheet)

Question 39

What is the revaluation Adjustment calculation and where is it posted?

Answer 39

Revaluation Adjustment = S’s fair value of assets − S’s book value assets The value of the asset has gone up so 1) There will be an increase in the Non current asset 2) Goodwill of Subsidarys net assets required will be ( investment - ( Percentage of parent share X (Equity section + revaluation adjustment) 3) NCI would be (NCI X RA+ Equity section)

Question 40

When preparing consolidated financial statements how does RE affect it.

Answer 40

Question 41

Make a Consolidated balance sheet for Case 3 in this example

Answer 41

First of all RA = 400 add on the asset As revaluation adjustment = Subsidary fair value assets - Subsidary book value = 12400 - 12000 ( Add the NCA and Equity section) 2) Goodwill = 12800 - ( 80% of 15400) = 480 ( Investment - ( percentage share OF Equity section + RA) NCI = 20% of ( 15400) = 3,080

Question 42

What is X, GW and NCI A. X=175,GW = 6, NCI = 1 B. X=174,GW = 5.2, NCI = 1.2 C. X=174,GW = 6, NCI = 1 D. X=175,GW = 5.2, NCI = 1.2

Answer 42

The RA is plus 1 so you add this to equity section and the NCA which is land in this case so X = 175 Good will = 10 - ( 80% X 6) = 5.2 Investment in Sport LTD - ( %Purchase of Sport LTD x Equity section + RA) Non controlling interest = 20% of 6 = 1.2 Minority interest % X equity section So the Answer is D

Question 43

So far from case 1 -3 what have we looked at?

Answer 43

Consolidation at the date of accquistion.

Question 44

What does the case 4-7 look at?

Answer 44

Consolidation after accqustion.

Question 45

What is Case 4?

Answer 45

Post accqusition profit

Question 46

Lets say accquistion happened in 2016, after 2016 the subisdary has earned new profits, so parent brought 80% of subisdary in 2016, between 2016 and now, the subsidary earned profits, so to whom does these profits belong to?

Answer 46

Any new profits generated by the subisdary after accqustion, i.e 80% if it goees to the parent and 20% of it would go to minority shareholders, if that is the share of equity.

Question 47

When preparing Consolidated B/S how does it look like?

Answer 47

Question 48

Example: Consolidation after the date of acquisition On 1 January 2010 ABC plc acquired 80% of the 20,000 £10 shares of XYZ plc for £15 per share in cash and gained control. Total cost of the investment is £240,000 (= 80% x 20,000 shares x £15). The retained earnings of XYZ at the date of acquisition amounted to £80,000. The fair value of XYZ’s PPE was £12,000 above the book value. An impairment test carried out at the end of 2010 revealed a loss of £1,280 for goodwill. Prepare consolidated B/S

Answer 48

1) Note all values@ accqustion ( by adding RA) 2) Find post accqustion profit = 40000 ( as in question at accqustion the Retained earnings was £80000 and now it is £120000. We find percentage of profit that belongs to parent so 700000 + 80% of 400000 = 730720 3) Canvel investment and subsidary equity section. 4) calculate Goodwill = Investment @ accquistion - ( percentage shares X equity section at accquistion) = 240000 - [80% of (200000 +80000 + 120000) = 6400. 5) NCI @ accquistion 20% of (20000 + 80000 + 120000) + NCI after accquistion 20% of 40000 which is post accqustion proift. It doesn't say anything about share premium so don't touch it. Now there is an impariement test and a loss in value, there is a double aspect effect so you reduce RE and Good will

Question 49

What is the corrrect answer for this question for case 5 A. GW = 6.6, RE= 30.6, NCI = 1 B. GW = 6.8, RE= 30.8, NCI = 1 C. GW = 5.8, RE= 30, NCI = 1 D. GW = 6, RE= 29.8, NCI = 0.8

Answer 49

1) First of all there is profit of 1 as at accqustion it is 1 and now its 2. 2) Calculate good will which is always @starting cost 10 - (80% of 3+1) = 6.8 and as there is an impairment you take away 0.2 so the answer is 6.8. ( the impairement was after accquisiton ) 3) RE = 30+ ( 80% of 1 mil ) = 30.8mil - 0.2 impairment = 30,6 4) NCI @ accqusition 20% of 3+1 = 4 = 0.8and NCI after aquestion is 20% of profit = 20% of 1 = 0.2 which the total is 1 A is the answer

Question 50

What is Case 5?

Answer 50

Intercompany balances; Receivables and payables

Question 51

Lets take the example where the subsidary has to pay a payable to the parent and the parent has a receivable from subsidary, does shareholders of parent care ?

Answer 51

No they do not, you eliminate this from consolidated B/S as this is an internal transcation

Question 52

Lets say the subsidary owes the parent £1000 as aat 31 dec 2010 doe sales made by P ON credit during 2008? How do you show this on a consolidated B/S?

Answer 52

It should be eliminated

Question 53

There is a special case for which lets say the balances do not cancel out ie the subsidary has sent a check but has not been received, so V has sent P £500 to P in which P has not received yet, what do you do?

Answer 53

Create a new account

Question 54

What is case 6?

Answer 54

Unrealised profit on inter comany sales

Question 55

What does case 6 ( unrealised profit on inter company sales entail)?

Answer 55

Lets think of this case, the parent sells something to subsidary, the original cost of product is £100, the paretn sells to subsidary at £125, the extra £25 is called markup ( you increase value beyond cost price), so markup was 25%. Now the subsidary has not sold this product to the outside world, thhe parent shareholders care bout the transcations in the outside world, if products are not sold the extra profit is called unrealised profit. (PUP) So inventory would of went up for subsidary and when sell RE goes up, but as this is not happened, the profit that was generated by Parent from susidiary is reduced and value of inventory should be reduced to.

Question 56

How do you calculate pup ( Proivision for unrealised profit)

Answer 56

Question 57

Example: P sells goods to S for £12,000. Selling prices are set by marking up the cost of goods by 50%. S sells half of those goods to a third party. What is the PUP and where is it posted.

Answer 57

PUP = 1/2 X 12000 x 50/150 = 2000 where is it posted? ↓ CBS: Inventory(of subsidiary) £2,000 ( as you havent sold inventory you should value it at original cost that it was on parent balance sheet) ↓ CBS RE (for the parent) £2,000

Question 58

IN the I/S consolidated, unrealised profit is what?

Answer 58

Unrealised profit on inter company sales increase cost of sales

Question 59

What happens when subsidary sells to parent and parent doesnt have full control of company?

Answer 59

In this case the non-controlling interest will have to be adjusted for the amount that it is sold from subsidary to parent.

Question 60

Example: Balance sheet of P at 31/12/2010 includes goods bought for £5,000 which cost £3,000. P owns 60% of shares in S.

Answer 60

The unrealised profit is £2000 for subsidary ↓ CBS: Inventory £2,000 ↓ CBS RE (for the group) £1,200 (60%\*£2,000) ↓ CBS NCI £800 (40%\*£2,000)