Group accounting - associated companies and negative goodwill

Figure 1 is an adaptation of a question from Paper 10 (equivalent to Paper 2.5 under the previous syllabus) at the December 1998 session. Although the syllabus of Paper 2.5 differs to that of the old Paper 10, many of the Paper 10 questions are still very useful as practice for Paper 2.5 (with the exception of the auditing aspects of Paper 10 questions). In Paper 2.5 at the June 2002 session, there was a consolidation question containing a subsidiary and an associate. Answers to the associate company aspects of the question were particularly poor and it appeared that the topic had not been studied adequately by a significant number of candidates. In addition, the question in Figure 1 contains aspects of negative goodwill. Several tutors have asked me about the level of understanding that would be expected from candidates in this specific area.

The terminology of the question attempts to cover both International- and UK-based terminology. Its format is based on IAS 1 Presentation of Financial Statements (including the use of the $ symbol), but it should be readily understandable by candidates sitting UK-based papers. Where the workings differ they are presented separately. See Figure 1.

Note: Augment has not recorded the acquisition of the above investments nor the issue of the new shares.

Summarised balance sheets at 30 September 2002 are:

The following information is relevant:

1. The book values of the net assets of Caldershaw and Debut, at the date of acquisition, were considered to be a reasonable approximation to their fair values with the exception of Caldershaw’s land and plant. These were considered to have fair values of $1 million and $2 million in excess of their book values respectively. The plant had a remaining life of four years at the date of acquisition.
   
   
2. The profits of Caldershaw and Debut, for the year to 30 September 2002, as reported in their entity financial statements, were $8 million and $2 million respectively. No dividends have been paid by any of the companies during the year.
   
   
3. Goodwill is to be written off on a straight-line basis over a ten-year life. Negative goodwill is to be treated in accordance with IAS 22 Business Combinations / FRS 10, Goodwill and Intangible Assets. Under IAS 22 the average remaining life of the depreciable non-monetary assets at the date of acquisition can be taken as four years.
   
   For the purposes of crediting any negative goodwill to realised profits at the date of acquisition under FRS 10, $600,000 of the negative goodwill relates to the stock at the date of acquisition (all sold by 30 September 2002), $1.4 million relates to land and the balance relates to the other non-monetary assets. The average remaining life of the other non-monetary assets can be taken as five years.
   
   
4. All depreciation / amortisation is on a straight-line basis.

Required:

1. Prepare the journal entries (ignoring narratives) to record the acquisition of Caldershaw and Debut in the accounting records of Augment as at 1 October 2001. Show your workings.
   (4 marks)
   
   
2. Prepare the Consolidated Balance Sheet of Augment as at 30 September 2002
   (16 marks)
   Note: ignore the additional disclosures relating to material associates. Under International Accounting Standards the allowed alternative treatment for fair value adjustments in IAS 22 Business Combinations should be used.
3. Explain the nature and circumstances in which negative goodwill may arise, and discuss its required accounting treatment in IAS 22 / FRS 10. (5 marks)
   25 marks
   

The name ‘T’ accounts is actually a misnomer, because no consolidated ledger accounts actually exist – they are no more than workings. Despite this, my own view is that ‘T’ accounts help students to better understand the process of consolidation as they follow the principles of double entry accounting. However, advocates of using schedules point out that they often provide a quicker answer.

From a marking perspective no one method is considered superior to another and, provided they give the correct answer, each method is marked equally. It is also worth mentioning that all markers are very experienced in terms of the different approaches used. For illustration, I have given answers based on both approaches.

The 80% holding in Caldershaw is likely to give Augment control and means it is a subsidiary and should be consolidated. The 40% holding in Debut is likely to give Augment influence rather than control and thus it should be accounted for under the equity method. Note: Paper 2.5 will not contain consolidation questions that have more than one subsidiary. See Figure 2.

Figure 2
a Journal entries in Augment’s accounting records 1 October 2001

The total purchase consideration for both investments is $45 million. Of this, $15 million is settled by issuing the loan and the balance is settled by issuing ordinary shares at a value of $2.50 each. Therefore, Augment will issue a total of 12 million shares for the acquisition of Caldershaw and Debut. This would be recorded as $12 million of ordinary share capital and $18 million (i.e. 12 million x $1.50) share premium.

b Consolidated Balance Sheet of Augment as at 30 September 2002:

Tutorial note: if the question had required the use of the Benchmark treatment in IAS 22, only the group share (80%) of the fair value adjustments would be included in non-current assets, and the minority interest would not contain any of the fair value adjustments.

In this example the effect is that both non-current assets and minority interest would be $500,000 lower. This is calculated as $3 million fair value adjustments x 20% = 600, less the reduction in additional depreciation of 100 (500 x 20%). Note that the benchmark and alternative treatments always give the same figure for goodwill / negative goodwill.

Workings:
Note: all figures in $000.

i Cost of control in Caldershaw:

The fair value adjustment of $2 million to plant will be realised evenly over the next four years in the form of additional depreciation at $500,000 per annum. In the year to 30 September 2002 the effect of this is $500,000 charged to profits (as additional depreciation); and a net of $1.5 million added to the carrying value of the plant.

ii Accumulated profits:

Alternative method:
Accumulated profits

International standards: As the question does not refer to any anticipated reorganisation costs or expected future losses (refer to part (c)), the whole of the negative goodwill should be released to the income statement over the remaining weighted average lives of the depreciable non-monetary assets, which is given as four years. Thus $1 million (4,000 / 4 years) would be taken to realised profits in the year to 30 September 2002 leaving $3 million for negative goodwill in the balance sheet.

UK Standards:

The question is designed so that the same amount of negative goodwill is taken to realised profits in the year to 30 September 2002 under both answers, but it is calculated differently. The amount of negative goodwill taken to realised profits in future years would be different under each answer.

iii Minority interest

iv Investment in associate

c Negative goodwill arises where the cost of an acquisition is less than the acquirer’s interest in the fair values of the identifiable net assets at the date of acquisition. For many people this is an unusual concept to grasp as it appears that the selling company (or its shareholders) is accepting, presumably at arms length, an amount of consideration that is less than the company’s underlying net assets are individually worth (based on their fair values). If this is the case, the acquiring company has purchased the business at a bargain price. This view is reflected by the IASB / ASB as they appear rather sceptical about the existence of negative goodwill. They say the apparent existence of negative goodwill may indicate that identifiable assets have been overvalued or some identifiable liabilities have been omitted.

Where negative goodwill has been identified, a careful check of the value of the assets acquired and whether any liabilities have been omitted is required. It is also possible that an understatement of the purchase consideration could lead to negative goodwill. This is possible for share and stock issues but not for cash consideration. Contingent or deferred consideration is particularly difficult to value and therefore such consideration must be evaluated very carefully.

Negative goodwill indicates that there has been a bargain purchase. This may occur for several reasons:

• the vendor is in a poor financial position and needs to realise assets quickly
• the vendor’s share price may be depressed because of a poor profit record (or in expectation of future losses) and the offer price seems reasonable in comparison to the stock market price
• the vendor’s assets may be worth more than their carrying value if put to a different use or simply that the vendor does not realise how much the assets are really worth
• the acquirer may have good negotiating skills.

Negative goodwill may also arise where an acquiring company, in determining the amount of consideration it is willing to pay for a business, takes into account the cost of post acquisition reorganisation expenditure and estimated future operating losses that it believes will occur.

The effect of this is that the acquirer would reduce the consideration offered / paid. In most circumstances these reorganisation costs and expected operating losses do not qualify as identifiable liabilities at the date of acquisition and this leads to the consideration being lower than the identifiable net assets. It seems ironic that both the IASB and ASB caution against omitting liabilities at the date of acquisition, but do not allow reorganisation costs and future losses to be treated as liabilities. To acquisitive managers, these costs are very real and have to be taken into account when determining an offer price.

Accounting treatment of negative goodwill under International Accounting Standards
IAS 22 Business Combinations requires the accounting treatment of negative goodwill to reflect its nature. To the extent that it represents reorganisation expenses and expected future operating losses that were not allowed to be recognised as liabilities at the time of the acquisition, this amount should be released to the income statement as these expenses and losses arise. Any remaining negative goodwill (which would include any amount attributable to the previous expenses and losses that did not arise) up to the value of the acquired non-monetary assets should be released to income over the weighted average useful lives of the acquired depreciable non-monetary assets.

Only the non-monetary assets are taken into account in this exercise because it is these that may be overvalued (despite IAS 22 cautioning against this). Monetary assets are, by definition, objectively valued in money terms. Any negative goodwill in excess of these amounts (which should be very rare) is effectively attributable to the acquired monetary assets and this should be recognised in income immediately.

The reasoning behind the above treatment is that, to the extent that negative goodwill relates to non-monetary assets, it is realised as those assets are consumed. A slight weakness in this reasoning is that any amount of negative goodwill that may be attributable to land is realised over the average life of the depreciable non-monetary assets, and, of course, land is not normally a depreciable asset. Negative goodwill should be presented under the assets section of the balance sheet in the same classification as goodwill.

Accounting treatment of negative goodwill under UK Accounting Standards (FRS 10)
FRS 10 states that negative goodwill should first be matched to the fair value of the non-monetary assets acquired. It should be released to the profit and loss account in the periods in which the non-monetary assets are recovered through use (depreciation) or sale. Any negative goodwill in excess of this should be released to the periods which are expected to benefit. The first part of the above is capable of at least two interpretations. Stock is a non-monetary asset and is normally realised very quickly. At the other extreme is land, which is not normally realised through depreciation, only on its eventual sale. My first interpretation of the requirement is that negative goodwill should be proportionately matched to the non-monetary assets, i.e. some is attributed to the stock, some to the land, and say, the rest to the remaining non-monetary assets. The negative goodwill is then credited to the profit and loss account as those specific assets are realised. This is the approach taken in the illustrative question above.

A second alternative interpretation would be that when the stock (acquired at the date of acquisition of the subsidiary) has been sold, then an amount of negative goodwill equal to the fair value of the whole of this stock can be released to the profit and loss account (not just the proportional amount that may have been attributable to it). Further negative goodwill would be released up to the total amount of the depreciation of the acquired non-monetary assets until the negative goodwill is exhausted. Clearly, under this interpretation negative goodwill would be realised very quickly.

My personal view is that the first method is more appropriate as it complies with the matching principle and is more prudent than the second interpretation. Any question in a future Paper 2.5 examination will be based on the method used in this illustrative question (i.e. the first method referred to above).

There is also some ambiguity as to what the expression ‘any negative goodwill in excess of that matched to the non-monetary assets should be released to the periods which are expected to benefit’ actually means. Fortunately it is thought that occurrence of negative goodwill in excess of the value of non-monetary assets would be quite rare. Most commentators believe that any such negative goodwill is probably attributable to future reorganisation expenses or future estimated losses. It would seem reasonable to release such negative goodwill to the profit and loss account as these expenses are incurred or losses realised. Negative goodwill should be presented as a negative asset immediately after any positive goodwill.

Steve Scott is Examiner for Paper 2.5