Consolidations

1
Consolidations

• Consolidation is currently considered to be the
  best means of accounting for business
  combinations internationally.

2
Consolidated Statements

• Present financial statements for single economic
  entity
• Balance Sheet
• Income Statement
• Statement of Cash Flows (in some countries)
• Statement of Retained Earnings (in some countries)

3
Consolidated Statements

• What users prefer consolidated statements?
• For what decisions?
• Are they relevant?
• Overall control and Evaluation Judgments
• By
• Managers (What level of manager?)
• Creditors
• Investors
• Employees

4
Consolidated Statements

• BUT! A multinational enterprise is a complex
  business entity.
• Are there situations where disaggregated
  statements might be useful?
• Who might prefer some form of disaggregation?
• What disaggregation might be appropriate?
• Business segment by line of business
• Geographical locations
• Geographical markets
• Parent
• Subsidiary
• Competitors?

5
Consolidated Statements

• Perhaps consolidated and disaggregated statements
  should be considered as complementary rather than
  an "either/or" situation.

6
Consolidated Statements

• 91 of companies surveyed provided world-wide
  consolidated statements
• As you might expect, different countries have
  different perspectives on the need for
  consolidated financial statements.

7
Consolidated Statements

• The quality and quantity of information reported
  varies considerably both within and between
  countries.
• UK and US require consolidated statements, and
  have some reporting requirements for segmental
  information
• UK requires a parent company balance sheet
• Germany normally has both parent-company and
  world-wide financials
• Italy and Switzerland--only summary consolidated
  information in addition to parent company
  financials.
• One issue is definition of a reportable segment.

8
Principles of Consolidation

• Full Consolidation
• Line-by-line aggregation of financial statement
  items, after intracompany transactions have been
  eliminated.
• Ownership by minority interest is reported in
  Stockholder's Equity section of the Balance
  Sheet.
• Proportional Consolidation
• Percentage ownership is used to add that fraction
  of assets and liabilities of a subsidiary.
• This is commonly used for joint ventures.

9
Principles of Consolidation

• Equity Accounting
• Investment is relegated to a single line on the
  balance sheet that includes the value of the
  initial investment, increased by the proportional
  share of net income, decreased by dividends
  received.
• Individual assets are not disclosed.
• Cost
• The investment is shown at historical cost.
• Market
• (US, FAS 115)
• Investment is shown at its current value on the
  stock market

10
Purchase vs. Pooling of Interest

• Differentiates between an ACQUISITION and a MERGER

11
Acquisition

• Buy a company, which implies buying the assets
  and taking responsibility for the liabilities.
• Previous owners get cash and cease to have
  ownership rights.
• Purchase price identifies the fair market value
  of the net assets of the purchased company.
• Purchase price is allocated to value specific
  assets and liabilities at the date of
  acquisition.
• The asset and liability accounts are entered into
  the purchasing company records at fair market
  value. (One asset may be goodwill).
• Only the purchased assets are at FMV. The book
  value of the assets previously owned remains
  unchanged.

12
Merger

• Implies interests of two companies are merged,
  and the owners of each of the companies in the
  transaction continue to have ownership rights in
  the new merged entity.
• Owners get shares of stock in the new merged
  entity in exchange for their old stock.
• Stock exchange may still imply a fair market
  value. However, the number of shares being
  traded in a single transaction may make share
  values prior to the merger less reliable.
• Assets and liabilities of the companies are
  merged at the book value, not the fair market
  value, of the assets of both companies.
• The results of operations for both companies are
  combined retroactively to present total income of
  the new, merged company.

13
Purchase vs. Pooling of Interest

• In practice, pooling is not widely used.
• In Canada, there are specific guidelines that
  dictate whether pooling or purchase must be used
  for a specific transaction.
• Pooling is not permitted in Australia or Japan.
  However, in Japan, book values are retained.
• Pooling may be used in many of the Common Market
  countries.
• Pooling is permitted under international
  standards.

14

• Pooling may show higher net income, as the income
  of the two companies is added together.
  Additionally, failure to write assets up to FMV
  means depreciation expense will be lower under
  pooling
• However, pooling also requires the acquiring
  company to issue shares of stock, so EPS may
  either increase or decrease as a result of the
  merger.

15
Joint Venture Accounting

• Relatively little is known about either the
  control processes employed or how to best measure
  the performance of joint ventures.
• Joint ventures (and virtual corporations) are
  increasingly important in international business,
  and accounting practices are necessary to
  distribute profits and losses and to evaluate the
  performance of the venture.

16
Joint Venture Accounting

• Three broad classifications
• Jointly-controlled operations
• recognition on the basis of share in operations
• Jointly-controlled assets
• recognition on the basis of share in assets
• Jointly-controlled entities
• Benchmark treatment proportional consolidation
• Equity method single line item

17
International Joint Ventures

• Shaughnessy points out that there is general
  acceptance of the idea that most joint ventures
  fail.
• Cultural differences are important.
• Can a quick course in Cultural Training improve
  the success rate?
• Cultural differences are important, but this
  concept is often used as an excuse for other
  problems the partners may not have considered.

18
Joint Ventures

• Joint ventures are by their nature perceived to
  be impermanent.
• Are there benefits to this perception?
• Are there problems with this perception?
• What are the management issues?
• What about career development?
• Traditional vs. emerging career development
  tracks.

19
Virtual Corporations

• When you hear this term, what do you think it
  might mean?

20
Virtual Corporations

• Temporary network of independent companies.
• Suppliers, customers, possibly even rivals linked
  by information or technology to share skills and
  access to each others markets.
• Technology Information networks allow linkages
• Excellence Core competencies
• "Best of Everything" corporation
• Opportunism less permanent, less formal business
  structure
• Trust more reliant on each other, "co-dependent"

21
Core Competencies

• What is meant by Core Competencies?
• Key capabilities of a company
• Companies will mix and match what it does best
  with the best from other companies and
  entrepreneurs.

22
Virtual Corporations

• No borders!
• Redefines traditional boundaries of company.
• More co-operation among competitors, suppliers,
  and customers
• Implications for financial reporting and
  financial information needs/uses.
• Where does one end and another begin?

23
Benefits of Virtual Corporations

• Develop and sell new products faster.
• Technologies are changing so fast that nobody
  can do it all alone anymore."
• Access to new markets or technologies.
• Market Power
• Flexibility
• Broaden offerings to customers
• Produce sophisticated products less expensively

24
Risks of Virtual Corporations

• Lose control of functions ceded to partners.
• New management techniques.

25
Virtual Corporations

• Commercial Logic
• Some say a virtual corporation defies common
  commercial logic, in that partners may be
  suppliers, customers, and competitors
• What factors might influence the success or
  failure of a virtual corporation?
• Shared objectives and shared goals...
• Are there differences between shared objectives
  and shared goals?

26
Cash Flows and Funds Statements

• How useful?
• Depends in part on amount of aggregation/disaggreg
  ation.
• Geographic location of sources and uses of funds?
• Segment funds flow?
• Even Direct vs Indirect method in US

27

• Significant voluntary disclosure because of wide
  variations in requirements within and across
  countries.
• Legally required France, Sweden, Brazil,
  Canada, Philippines
• Professionally required UK, Hong Kong, New
  Zealand, US
• IAS 7 Fiji, Malaysia, Nigeria, Singapore

28

• Increasingly provided on a voluntary basis
• Shift toward cash flow, as opposed to funds flow
  (i.e., working capital).

29

• Relatively new statement
• Growing pressure from UN, OECD, IASB
• Not a part of requirements of European Union
• Lots of variation in disclosure

30
Intangible Assets

• Non-monetary Assets lacking physical substance
  which are held for continuing benefit of the
  business
• Identifiable versus Unidentifiable
• Identifiable Capable of being acquired or
  disposed of separately without necessarily
  acquiring or disposing of the whole business.
• Unidentifiable Assets generally accounted for
  as part of goodwill.

31

• Dramatic growth in significance
• Wave of international mergers
• Pursuit of global leadership through acquisitin
  and brand names
• Expansion of service sector

32
Intangible Assets

• Information must be
• Reliable
• Relevant
• Consistent
• Comparable

33
Key Recognition Criteria

• IASC Framework (1989)
• Probable future economic benefit
  (Meets the definition of an asset)
• The item has a cost or value that can be measured
  reliably
• As well as meeting the definition of an asset,
  the asset also must be measurable and provide
  information which is relevant and reliable. to
  be reliable, the information must be sufficiently
  free of error and bias to be useful to users.

34

• UN Conceptual Framework (1989)
• Useful information for wide range of users,
  prudence, comparable and understandable
  information.

35

• Balance Sheet
• Information on financial strength of the company
  and its ability to meet its obligations.
• Should the values represent the purchase cost of
  the assets or their economic value?
• Intangibles are often internally-developed rather
  than purchased, and reliable measurement of
  intangibles is difficult.

36
Relevance Reliability

• Balance Between Relevance and Reliability
• Does the perceived relevance warrant a tolerable
  level of uncertainty?
• In certain cases, the measurement of the
  financial effects of items could be so uncertain
  that enterprises generally would not recognize
  them in the financial statements. (IASC)
• Relevance vs. Reliability is the key question
  when considering accounting for intangibles.

37
Unidentifiable Intangible Assets

• GOODWILL The excess of the purchase price of an
  ongoing business over the fair market value of
  the identifiable net assets.
• (Assumes purchased goodwill only)
• In effect, it is consideration given for
  above-normal earning power of the company being
  acquired.
• Goodwill may be positive or negative.

38

• Examples of goodwill

39
Goodwill

• Many different accounting practices
• Capitalize and amortize against revenues, with
  varying allowed useful lives
• Capitalize and write-off against stockholders'
  equity
• Capitalize and maintain as an asset indefinitely

40
Goodwill

• Is GOODWILL an asset?
• 1. Definition
• 2. Measurable
• Purchased goodwill
• Non-purchased, or internally generated goodwill

41
Goodwill - Immediate Write-Off ?

• Nature of goodwill differs from other assets.
• Not used up in earnings process
• Not possible to estimate periodic expense
• Relates to the business as a whole and cannot be
  independently identified or realized
• Value subject to wide fluctuations
• No predictable relationship to the costs paid on
  acquisition
• Preserves comparability

42
Goodwill - Immediate Write-Off ?

• BUT
• Immediate write-off has led to some companies
  showing a severely reduced net worth
• Difficult for users of financial statements to
  keep track of the resources expended for
  acquisition
• Calculation of gain or loss on disposal of
  segment at a later date could be misleading

43
Goodwill - Systematically Amortized ?

• Arguments PRO
• Purchased goodwill is valued with regard to
  particular circumstances at the time a business
  is acquired.
• Although total goodwill may not diminish,
  purchased goodwill is replaced by internally
  generated goodwill.
• Goodwill is an acquisition that represents future
  benefits, and is used up as those benefits are
  realized through earned profits.
• Since the life is indeterminate, systematic
  amortization is practical and prudent

44
Goodwill - Systematically Amortized ?

• Arguments ANTI
• Value of goodwill does not wear out if it is
  maintained by good management, and may lead to a
  "double counting" matched against earnings.
• Writing down goodwill only when there has been an
  impairment would more closely link accounting
  treatment to actual performance
• Goodwill is not consumed or used up to produce
  earnings, and amortization is arbitrary
• Possible inconsistency with parent financial
  statements subsidiary is not written down below
  cost.

45
Goodwill - Systematically Amortized ?

• Systematic Amortization
• Canada, Japan, Australia
• European Union, 7th Directive
• Systematic Amortization or Immediate Write-Off
• Developing Countries
• Most allow Systematic Amortization or Immediate
  Write-Off
• But
• A few still permit Goodwill to be Capitalized and
  Remain on the Balance Sheet without Amortization

46
EXAMPLE

• A target company has projected earnings of 10
  million per year, with the sales price having
  been negotiated to 140 million, representing a
  multiple of 14 times earnings.
• The target company is a service company with only
  identifiable net assets of 20 million, giving
  rise to goodwill of 120 million.
• Amortized over 40 years, this is a charge of 3
  million against earnings per year.
• 10 million - 3 million 7 million, which
  increases the earnings multiple from 14 to 20
  times the purchase price.

47
Goodwill

• Each Acquisition Reviews Separately
• Review Facts that Gave Rise to Goodwill
• Review Cash Flows
• Review Subsequent Events

48
Useful Life

• Legal Provisions
• Obsolescence or Other Economic Facts
• Service Life
• Competitors Actions
• Unlimited?
• 40 years Max? 20 years Max? 5 years minimum?
• May be a Composite of Many Factors

49
Identifiable Intangibles

• Acquired
• Meet definition and measurement criteria
• Internally Generated
• Some costs are reliable
• legal fees, registration costs, etc.
• Lives
• Indeterminate vs. Determinate

50
Identifiable Intangibles

• US
• All Intangibles Acquired are Recorded as Assets
  and Amortized except Goodwill, which is subject
  to an impairment test (unique!)
• Few Internally Generated Intangibles Appear on
  the Balance Sheet
• UK
• During 1980s, Some Companies Included Brand
  Names as Material Assets on their Balance Sheets
• 4th Directive -- True and Fair Value
• Considerable Debate

51
Deferred Charges

• Research and Development
• Definition?
• Measurement?
• Research
• Investigation directed towards the advancement of
  knowledge in general or in a specific area, with
  the aim of developing a new product or service.
• Development
• Translation of research findings towards the
  introduction or improvement of specific
  commercial products or processes.

52
Capital Expenditures

• Capitalize and amortize over life
• Research Expenditures
• Expense as Incurred
• Development Costs
• Capitalize and amortize
• Expense as incurred
• FAS Statement 2
• RD is expensed as incurred
• IAS 9
• Development costs, under certain criteria, should
  be capitalized and amortized

53
Software Development Costs

• United States
• Establish technological feasibility
• Completion of a detail program design
• Completion of a working model
• How does this compare to development costs for
  other types of internally generated assets?
  Hardware? Should there be differential
  accounting?