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Interpretation of non controlling interests and effect on EPS and EV

Analysing companies' finances and value from their financial statements using ratios and formulae
TheMotorcycleBoy
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Interpretation of non controlling interests and effect on EPS and EV

#165233

Postby TheMotorcycleBoy » September 9th, 2018, 8:49 am

I'm currently researching what is meant by a firm reporting "non-controlling" interests in their financial statements, that is, in their income statement and equity/balance sheets, and of course the financial impact of those interests.

The rationale for my latest research, is firstly to understand their effect on EPS/dividend calculation (i.e. how much the share holder of the parent company is awarded), and to understand the equity effect and how and why this effects EV (enterprise value, which is another topic on my radar.)

The background behind non-controlling (NC) interests, also known as minority interests, was explained to me before, and I believe it relates to when a company (which becomes known as the parent) buys the bulk (>50%) of the shares of another company, which is then known as a "subsidiary". When this occurs the parent effectively takes control of the subsidiary, and then includes the subsidiary's earnings along with it's own in the "Consolidated Accounts". (I believe these are also known as "Group Accounts".)

The contribution which the subsidiary makes to the Consolidated Income Statement, is that all of the profit/loss generated by the subsidiary is added to that of the parent (I think!!), so as an example if we have a situation where CompanyA generates 60 GBP million profit after tax, and it owns 80% of CompanyB which itself made 10 GBP million PAT, then the accounts will presented as follows:

Profit for the Year           68 (after tax)
Attributable to:
Equity shareholders of Parent 70 (all Profits and losses of parent and subsidiaries summarised)
Non-controlling interests 2 (20% of the subsidiary is not owned by parent)
--------------------------------
68

So although the Consolidated accounts includes CompanyB's earnings, the percentage of CompanyB's earnings, equal to the percentage of equity of the CompanyB which CompanyA does not own, is returned the CompanyB and hence cannot be used for CompanyA, for example it cannot be used in any dividend payment for CompanyA's shareholders.

Hence in the above scenario, if the CompanyA currently has 1 billion shares in the market, the Earnings per share (EPS) value will be 68/1000, i.e. 6.8p per share.

This is what I have learnt so far regards non-controlling interests, feel free to correct/comment/add etc. as I'm not totally sure on whether I have it right.

Now an example of how this looks for shareholders in a firm with a reasonable amount of non-controlling interests reported, GlaxoSmithKline (GSK). Looking at their income statement for 2017 (page 158 of https://www.gsk.com/media/4751/annual-report.pdf), all figures in million GBP:

Profit for the year        2169 
Attributable to:
Shareholders 1532
Non-controlling interests 637
-------------------------------
2169

So as there were approximately 4,941M shares (including dilutive effects), the earnings per share (EPS) can be calculated as 1532/4941 = 0.31, i.e. 31p per share, in agreement with the reported figure. So it looks as if a residual part of the earnings of the group are withheld from the owners of the parent.

Whilst I find the effect of NC interests quite explicable regards the statement of income, I find it harder to understand in terms of equity. Returning again to the example of GSK in the 2017 report, this time the equity section of their balance sheet:

Share capital	          1343
Share premium account 3019
Retained earnings -6477
Other reserves 2047
------------------------------
Shareholders' equity -68
Non controlling interests 3557
------------------------------
Total equity 3489

Whilst I'm ok with the maths side of things, I'm less sure about exactly what all the numbers themselves represent.

It seems clear that the first 4 rows imply that a "big part of the company" is "in the red", i.e. the shareholders equity is negative, however, the Total equity figure is positive, by virtue of the contribution from the NC interests. Now seeing as the above comprises the balance sheet, then things have to balance, right? That is, the Total equity = Net Assets, so what exactly does the "Non controlling interests=3557" mean?

Presumably the NC interests have contributed substantially to the non-current asset position? i.e. the PPE, goodwill, intangibles etc.

So what does the non-controlling interest part in the equity (and it's implied shadow in the NC assets) relate to in terms of the subsidiaries and the parent? In other words if, for example, GSK own 80% of each of their subsidiaries (to keep the example simple), then does this imply that 80% of those subsidiaries equity and assets are included in the Consolidated accounts?

thanks
M&M

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Re: Interpretation of non controlling interests and effect on EPS and EV

#165254

Postby PinkDalek » September 9th, 2018, 10:00 am

Melanie wrote:… So what does the non-controlling interest part in the equity (and it's implied shadow in the NC assets) relate to in terms of the subsidiaries and the parent? In other words if, for example, GSK own 80% of each of their subsidiaries (to keep the example simple), then does this imply that 80% of those subsidiaries equity and assets are included in the Consolidated accounts?


It is years since I studied Consolidated Financial Statements in such depth but if you look at Notes to the financial statements ... 2. Accounting principles and policies, on page 162 onwards, you'll see the basis of consolidation:

The consolidated financial statements include:

the assets and liabilities, and the results and cash flows, of the company and its subsidiaries, including ESOP Trusts
– the Group’s share of the results and net assets of associates and joint ventures
– the Group’s share of assets, liabilities, revenue and expenses of joint operations.


Thus, broadly, the full 100% of those subsidiaries' assets and liabilities etc would be consolidated into the Consolidated balance sheet. The not owned 20% (or whatever the figures are) would be reflected in the Non-controlling interests 3,557 you've already extracted.

I'm sure you've seen the list and percentages of the Subsidiaries where the effective interest is less than 100% but, if not, it commences on page 182. The audit report (page 234) includes:

As a result of our work, we agreed with management that the carrying values of the investments held by the parent company are supportable in the context of the parent company financial statements taken as a whole.

Further down the auditors talk about Carrying value of goodwill and intangible assets and the Accounting principles and policies have a number of sections where Goodwill is mentioned, such as under Business combinations, Impairment of non-current assets and Goodwill itself.

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Re: Interpretation of non controlling interests and effect on EPS and EV

#165271

Postby Alaric » September 9th, 2018, 10:37 am

PinkDalek wrote:Thus, broadly, the full 100% of those subsidiaries' assets and liabilities etc would be consolidated into the Consolidated balance sheet.


Something of a minefield. If you think the quoted Group is a going concern, I suppose it's the attribution of the aggregate profit that's of interest. If you are reviewing the break-up value or solvency of the Group, the break up value will be of interest. If you are looking for hidden value, as to whether the subsidiaries are correctly or fairly valued may be of interest.

Legislation both in the UK and elsewhere has forced a lot of disclosure. It can often force so much detail as to act to obscure salient points.

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Re: Interpretation of non controlling interests and effect on EPS and EV

#165291

Postby Gengulphus » September 9th, 2018, 12:30 pm

Melanie wrote:The contribution which the subsidiary makes to the Consolidated Income Statement, is that all of the profit/loss generated by the subsidiary is added to that of the parent (I think!!), so as an example if we have a situation where CompanyA generates 60 GBP million profit after tax, and it owns 80% of CompanyB which itself made 10 GBP million PAT, then the accounts will presented as follows:

Profit for the Year           68 (after tax)
Attributable to:
Equity shareholders of Parent 70 (all Profits and losses of parent and subsidiaries summarised)
Non-controlling interests 2 (20% of the subsidiary is not owned by parent)
--------------------------------
68

No - you've got the figures 70 and 68 the wrong way around. The profit for the year will be £70m - i.e. the consolidated profits of the parent and the subsidiary - and the amount attributable to the parent's shareholders will be £68m - i.e. the sum of the parent's profits and 80% of the subsidiary's. And the "Attributable to:" breakdown will use addition to get the profit for the year, not subtraction.

Basically, the parent has full control of the subsidiary - it can do anything it likes with it, within the constraints imposed by company law such as treating all of its shareholders equivalently and having to act in those shareholders' interests, just by using its 80% ownership of the subsidiary's shares to propose and pass a shareholder resolution (of the subsidiary) to put it into effect (*). But the parent only has economic ownership of 80% of the subsidiary - i.e. it's only entitled to 80% of whatever benefits that belong to the subsidiary's owners. (It's similar to the legal distinction between legal and beneficial ownership, where a trustee has legal ownership of a trust's assets but the beneficiaries of the trust have beneficial ownership, if you're familiar with that.)

(*) Because it owns more than 75% of the subsidiary's shares, that applies to any valid shareholder resolution at all. If it owned under 75% but more than 50%, it would only be able to pass ordinary resolutions, not special resolutions. That would prevent it from doing some things without getting enough votes from the other shareholders to get over the 75% majority needed to pass a special resolution, such as delisting the company. But fairly routine matters generally only require ordinary resolutions and it could put those through without trouble - this is sometimes known as having full operational control. And for completeness, if it doesn't own more than 50% of the subsidiary's shares, then it's not a subsidiary at all, and will be treated quite differently in the accounts.

Melanie wrote:So although the Consolidated accounts includes CompanyB's earnings, the percentage of CompanyB's earnings, equal to the percentage of equity of the CompanyB which CompanyA does not own, is returned the CompanyB and hence cannot be used for CompanyA, for example it cannot be used in any dividend payment for CompanyA's shareholders.

That's the overall effect, yes, but it might help to understand the legal technicalities. Those are that CompanyA doesn't directly control the £10m earnings of CompanyB at all - it only controls CompanyB itself. So it cannot simply take any of the £10m out of CompanyB's bank accounts and pay them as a dividend to its own shareholders. What it can do is use its control of CompanyB to get CompanyB to declare a dividend, for instance one that will use all £10m to fund the dividend payment. If it does that, it will receive £8m from that dividend and companyB's other shareholders will receive the other £2m between them, and so it will end up with £68m that it can hand out to its own shareholders. If it doesn't, it will only have £60m that it can hand out to them.

And while the other shareholders of CompanyB cannot prevent CompanyA from doing that by voting down such a dividend declaration, they can take legal action against CompanyB and its directors if they try doing something that's against company law - for example, paying unequal dividends-per-share to different holders of the same class of share, or changing the class of some but not all shares of one class, or making a straight gift of the £10m to CompanyA. (If CompanyA does try such things, CompanyB's directors are placed in a decidedly awkward position, by the way: CompanyA can appoint and remove them as it wishes, so they'll want to remain in CompanyA's good books - but company law will oblige them to act contrary to what CompanyA wants... That's where it's a very good idea for them to take legal advice, just in order to be able to say something to CompanyA along the lines of "Sorry, we'd like to help, but we've asked our legal advisers and their advice is that what you're asking is beyond our powers." But CompanyA probably won't even try them, since if it's got competent legal advisers, they should have advised against them...)

Note though that they do control the entire £10m within the constraints of company law. For instance, if they want to invest it all in expanding CompanyB in a particular way, and CompanyB's other shareholders want it paid out as a dividend, then as long as it's a judgement call whether the expansion or the dividend is better for shareholders (rather than a really clear-cut decision, enough so to get a court to decide that expanding instead of paying the dividend is definitely not in shareholders' interests), CompanyA can get its way and the other shareholders of CompanyB have no ability to ensure that £2m of the money is paid out to them.

Melanie wrote:Whilst I find the effect of NC interests quite explicable regards the statement of income, I find it harder to understand in terms of equity. Returning again to the example of GSK in the 2017 report, this time the equity section of their balance sheet:

Share capital	          1343
Share premium account 3019
Retained earnings -6477
Other reserves 2047
------------------------------
Shareholders' equity -68
Non controlling interests 3557
------------------------------
Total equity 3489

Whilst I'm ok with the maths side of things, I'm less sure about exactly what all the numbers themselves represent.

It seems clear that the first 4 rows imply that a "big part of the company" is "in the red", i.e. the shareholders equity is negative, however, the Total equity figure is positive, by virtue of the contribution from the NC interests. Now seeing as the above comprises the balance sheet, then things have to balance, right? That is, the Total equity = Net Assets, so what exactly does the "Non controlling interests=3557" mean?

Presumably the NC interests have contributed substantially to the non-current asset position? i.e. the PPE, goodwill, intangibles etc.

Have had a look at this, I think I can give you some pointers. The main one is to have a look at the parent-company balance sheet on page 239 of the report: that is after all the company you actually have (or are contemplating having) shares in. It shows considerable net assets and retained earnings (the latter being why the parent company can pay dividends), with the biggest part of its assets being "Fixed assets – investments", and note F detailing those shows that the biggest part of that part is its ownership of its direct subsidiary GlaxoSmithKline Holdings Limited.

Taking that further would involve quite a bit more delving into what the accounts say about GSK's subsidiaries, and quite possibly going to the Companies House website to get what it has on the accounts of the main direct subsidiaries. But it looks as though their book value for the parent company (which contributes to the parent company balance sheet) must be quite a bit higher than their net asset value (which is what contributes to the consolidated balance sheet). I.e. what the parent company has down for them as the value that it paid for them and it reckons they're still worth is more than the total of what they have on their balance sheets as the book value of their assets. That's very common - most profitable quoted companies are valued more highly by the stockmarket than the total book value on their balance sheets, for example. And the basic reason for that is that profitable companies are generally valued more highly on a "whole thing as a going concern" basis than on a "sum of the parts" break-up basis. (Finding exceptions to that is the basis of an investment strategy, though one that is more easily used by big players who can force the break-up or make it more likely to happen than by small investors who can only take a stake and either just wait or try to get bigger players interested. The big players who do that are frequently referred to as "asset strippers".)

The difference between the "whole thing as a going concern" and "sum of the parts" values is the general concept of 'goodwill', but that's not to be confused with the accounting concept, which only takes acquired goodwill into account - i.e. when a company acquires another, the difference between what the acquirer paid for it and what its identifiable net asset value is becomes accounting goodwill on the balance sheet, but when a company simply builds up its business organically, any resulting increase in its general-sense goodwill does not go on to its balance sheet. So essentially, the difference between net asset values on the consolidated and parent-company balance sheets is due to goodwill the direct subsidiaries have built up organically - though the issue is further complicated by the general fact that book values may well not be realistic current values...

Anyway, I would need to delve more deeply into it and very possibly mull it over to understand just what those numbers mean, especially as I don't think I've ever properly looked at the question of how minority interests are dealt with in consolidated balance sheers. I might do that sometime, but I've other things to get done and so have run out of time to put into the question right now. So all I can do is offer you the above as pointers about how I would go about the job, not anything like a full answer! Hope it helps.

Gengulphus

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Re: Interpretation of non controlling interests and effect on EPS and EV

#165354

Postby TheMotorcycleBoy » September 9th, 2018, 5:19 pm

PinkDalek wrote:It is years since I studied Consolidated Financial Statements in such depth but if you look at Notes to the financial statements ... 2. Accounting principles and policies, on page 162 onwards, you'll see the basis of consolidation:

The consolidated financial statements include:

the assets and liabilities, and the results and cash flows, of the company and its subsidiaries, including ESOP Trusts
– the Group’s share of the results and net assets of associates and joint ventures
– the Group’s share of assets, liabilities, revenue and expenses of joint operations.


Thanks. Worthy of note, I think, is that the word "share" is used for joint ventures/operations, but not for the subsidiaries, suggestive that the one "entirety" is relevant in their case?

PinkDalek wrote:Thus, broadly, the full 100% of those subsidiaries' assets and liabilities etc would be consolidated into the Consolidated balance sheet. The not owned 20% (or whatever the figures are) would be reflected in the Non-controlling interests 3,557 you've already extracted.

Yes, and owned (70, 80, whatever%) contributions somehow blending into the whole Group - resulting in the -ve earlier (i.e. in the report) equity situation.

PinkDalek wrote:I'm sure you've seen the list and percentages of the Subsidiaries where the effective interest is less than 100% but, if not, it commences on page 182.

I think you must've meant page 282. But thanks.

Also "44. Principal Group companies" on page 226.

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Re: Interpretation of non controlling interests and effect on EPS and EV

#165360

Postby TheMotorcycleBoy » September 9th, 2018, 6:05 pm

Gengulphus wrote:No - you've got the figures 70 and 68 the wrong way around. The profit for the year will be £70m - i.e. the consolidated profits of the parent and the subsidiary - and the amount attributable to the parent's shareholders will be £68m - i.e. the sum of the parent's profits and 80% of the subsidiary's. And the "Attributable to:" breakdown will use addition to get the profit for the year, not subtraction.

Aha. Thanks for correcting me. I drafted some of my post last night, and I guess the figures were starting to jump around on the screen a bit! :lol:
I just double checked with the breakdown from the GSK sheet - and yes you're dead right.

Gengulphus wrote:Basically, the parent has full control of the subsidiary - it can do anything it likes with it, within the constraints imposed by company law such as treating all of its shareholders equivalently and having to act in those shareholders' interests, just by using its 80% ownership of the subsidiary's shares to propose and pass a shareholder resolution (of the subsidiary) to put it into effect (*). But the parent only has economic ownership of 80% of the subsidiary - i.e. it's only entitled to 80% of whatever benefits that belong to the subsidiary's owners. (It's similar to the legal distinction between legal and beneficial ownership, where a trustee has legal ownership of a trust's assets but the beneficiaries of the trust have beneficial ownership, if you're familiar with that.)

Thanks again. That bit is very interesting. Since as you point out later it leads on to this:

Gengulphus wrote:Note though that they do control the entire £10m within the constraints of company law. For instance, if they want to invest it all in expanding CompanyB in a particular way, and CompanyB's other shareholders want it paid out as a dividend, then as long as it's a judgement call whether the expansion or the dividend is better for shareholders (rather than a really clear-cut decision, enough so to get a court to decide that expanding instead of paying the dividend is definitely not in shareholders' interests), CompanyA can get its way and the other shareholders of CompanyB have no ability to ensure that £2m of the money is paid out to them.


Gengulphus wrote:Have had a look at this, I think I can give you some pointers. The main one is to have a look at the parent-company balance sheet on page 239 of the report: that is after all the company you actually have (or are contemplating having) shares in. It shows considerable net assets and retained earnings (the latter being why the parent company can pay dividends), with the biggest part of its assets being "Fixed assets – investments", and note F detailing those shows that the biggest part of that part is its ownership of its direct subsidiary GlaxoSmithKline Holdings Limited.

I have to say that at this moment in time, understanding the difference/interaction between the consolidated and the parent balance sheets represents a quantum leap. I'm going to park the full enquiry for now, but may start another thread sometime, once I've done some background research first.

Gengulphus wrote:Taking that further would involve quite a bit more delving into what the accounts say about GSK's subsidiaries...But it looks as though their book value for the parent company (which contributes to the parent company balance sheet) must be quite a bit higher than their net asset value (which is what contributes to the consolidated balance sheet). I.e. what the parent company has down for them as the value that it paid for them and it reckons they're still worth is more than the total of what they have on their balance sheets as the book value of their assets. That's very common - most profitable quoted companies are valued more highly by the stockmarket than the total book value on their balance sheets, for example. And the basic reason for that is that profitable companies are generally valued more highly on a "whole thing as a going concern" basis than on a "sum of the parts" break-up basis....

I have to say that the above really freaks me out. My first thought was "well that sounds like Creative Accounting" if ever I've seen it! So the contribution of subsidiary (and presumably whole) purchases to the parent's BS is the actual sum spent at acquisition?

Hmm....aha, after reading this:
Gengulphus wrote:The difference between the "whole thing as a going concern" and "sum of the parts" values is the general concept of 'goodwill', but that's not to be confused with the accounting concept, which only takes acquired goodwill into account - i.e. when a company acquires another, the difference between what the acquirer paid for it and what its identifiable net asset value is becomes accounting goodwill on the balance sheet, but when a company simply builds up its business organically, any resulting increase in its general-sense goodwill does not go on to its balance sheet. So essentially, the difference between net asset values on the consolidated and parent-company balance sheets is due to goodwill the direct subsidiaries have built up organically - though the issue is further complicated by the general fact that book values may well not be realistic current values...

Yes, maybe the penny is starting to drop. The value assigned to the purchased assets on the parents BS, relates to the actual sum exchanged, and hence includes the purchased thing's organic goodwill, whereas when the value of purchase is included in the consolidated sheet it is based on estimates of the working book value (which is very subjective), and if there is a remainder, this is bunged in the "accounting" goodwill column in the consolidated accounts to make the books balance. (Hmm... I definitely need to do some background reading on this sometime).

Gengulphus wrote:Anyway, I would need to delve more deeply into it and very possibly mull it over to understand just what those numbers mean, especially as I don't think I've ever properly looked at the question of how minority interests are dealt with in consolidated balance sheers. I might do that sometime, but I've other things to get done and so have run out of time to put into the question right now. So all I can do is offer you the above as pointers about how I would go about the job, not anything like a full answer! Hope it helps.

No worries. Your post has been very helpful, and given me food for thought into further research.

many thanks
M&M

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Re: Interpretation of non controlling interests and effect on EPS and EV

#165513

Postby Gengulphus » September 10th, 2018, 4:28 pm

Melanie wrote:
Gengulphus wrote:The difference between the "whole thing as a going concern" and "sum of the parts" values is the general concept of 'goodwill', but that's not to be confused with the accounting concept, which only takes acquired goodwill into account - i.e. when a company acquires another, the difference between what the acquirer paid for it and what its identifiable net asset value is becomes accounting goodwill on the balance sheet, but when a company simply builds up its business organically, any resulting increase in its general-sense goodwill does not go on to its balance sheet. So essentially, the difference between net asset values on the consolidated and parent-company balance sheets is due to goodwill the direct subsidiaries have built up organically - though the issue is further complicated by the general fact that book values may well not be realistic current values...

Yes, maybe the penny is starting to drop. The value assigned to the purchased assets on the parents BS, relates to the actual sum exchanged, and hence includes the purchased thing's organic goodwill, whereas when the value of purchase is included in the consolidated sheet it is based on estimates of the working book value (which is very subjective), and if there is a remainder, this is bunged in the "accounting" goodwill column in the consolidated accounts to make the books balance. (Hmm... I definitely need to do some background reading on this sometime).

No, definitely not. "Estimates of the working book value (which is very subjective)" are not involved in producing accounting goodwill - they're occasionally involved in getting rid of it, but not in producing it. Let me give an extended example of how it works:

Company P wants to set up two businesses. It's uncertain about their prospects, and doesn't want its other businesses exposed to either of them going bust, nor either of them to be exposed to the other going bust. That sort of protection is the basic purpose of limited companies, so it sets up two limited companies S1 and S2, putting £5m into each and owning 100% of their shares. They each buy £2m of equipment, etc, employ a few staff and set about developing their businesses, retaining the remaining £3m cash to pay their staff and other costs until they can get their businesses going. At this point, company P's parent balance sheet has its shares in its subsidiaries S1 and S2 each down with a book value of £5m, and its consolidated balance sheet instead has the subsidiaries' book values consolidated in: non-cash assets with a book value of £2m and cash of £3m. Total £10m for the two on both balance sheets.

A couple of years go by while S1 and S2 get their businesses going, and as they've chosen a depreciation period of 4 years for the equipment, in that time half the book value of the subsidiaries' non-cash assets depreciates away, so now £1m each. Also, their expenditure on salaries, etc, has pulled their cash down to £1m each. Company P's shares in them still have a book value on its balance sheet of £5m each, as all is going to plan and P's directors reckon there's no need to treat them as having lost value: the £3m reduction in their non-cash assets is balanced by the fact that they are now going concerns and can easily be reckoned to be worth £5m as such. I.e. it's fair to reckon that they are still worth what they're on the books at. But company P's consolidated balance sheet instead consolidates in the subsidiaries' book values of their assets, and that's just £1m each for non-cash assets and £1m cash each. So the subsidiaries are on the parent company balance sheet for a total of £10m and the consolidated balance sheet for a total of £4m. No goodwill entry appears in the accounts: the fact that the directors reckon the subsidiaries are each worth £3m more of going-concern value than their identifiable asset value might be the general concept of goodwill, but it is not recognised in the accounts, i.e. it is not the accounting concept of goodwill.

Over the next several years, the subsidiaries' businesses do very well, and they expand rapidly, ploughing all their profits back into the businesses. This includes buying a lot more equipment, much more than is needed to make up for their old equipment wearing out, becoming obsolete, etc (which is what depreciation of those assets is meant to roughly model in accounting terms, without the cost of having to re-value all the equipment every year), and so their non-cash assets expand a great deal, to say £10m each. Their cash doesn't rise, because although they're making good cash profits, they're spending them - not just on that increase in their equipment, but also in a bigger sales force, more stocks, etc - all things required to support their greater level of business. So their cash remains at £1m each. So by the end of that period, their identifiable assets are worth £11m each: the directors of their parent company P might reckon that each of them is easily worth £50m, i.e. another £39m of going-concern value, but that does not affect its balance sheets at all: the parent company balance sheet still shows them at their book value of £5m each; the consolidated balance sheet instead shows their non-current assets of £11m each. I.e. again, the general concept of 'goodwill' does not get reflected in the accounts at all.

By then, each of the subsidiaries has saturated its natural market, and can no longer make good use of all the cash profits it's making, so they have maybe £5m per year surplus profits each. Neither has an obvious new business area to break into, so their parent company P has them pay their profits (minus what's needed to replace worn out equipment, etc) out as dividends, which all go to P. As a result, the parent company balance sheet still has them at their book value of £5m each, but now has its cash rising at £10m per year from those dividends, specifically going up when each dividend is paid. The consolidated balance sheet instead still has the subsidiaries' assets at £11m each, now no longer rising as the new expenditure on them is merely balancing their deprecation. But its cash too is rising at £10m per year, though with a timing difference: the consolidated cash balance rises as the money comes into the subsidiaries and does not change when it is later paid to the parent as a dividend, because the rise in the parent's cash then is matched by the fall in the subsidiaries' cash.

While all that was going on, a different parent company Q happens to have been going through a very similar story with its subsidiaries T1 and T2. Around this time, though, Q develops an urgent need for a lot of cash and finds itself having to sell assets to get it. P has been wanting to get into the business areas of T1 and T2 for some time but hasn't been able to, e.g. because T1 and T2 hold patents on key technology in their areas. And so after some negotiation, P and Q agree that P will buy T1 and T2 off Q for £50m each. That improves Q's parent company balance sheet by removing T1's and T2's book values of £5m each from it and adding £100m cash to it (making a balance-sheet gain of £90m in the process), and Q's consolidated balance sheet by removing the £11m each of T1's and T2's assets from it and adding £100m cash to it (making a balance-sheet gain of £78m in the process).

But what about P's balance sheets? It's pretty clear that as far as its parent company balance sheet is concerned, its shareholdings in T1 and T2 have book values of £50m each, and the appearance of those book values on the balance sheet is balanced by the disappearance of £100m cash from it. This is the normal situation when a company buys an asset: the cash spent on the asset is the book value put down for it, so value shifts on the balance sheet from cash to it, but the two balance out and so there's no change to the total. The total may change afterwards, e.g. because an asset which will wear out is depreciated, but this is generally done according to fixed accounting rules and not by using the directors' opinions about what they are worth or trying to decide what it is valued at in any other way. This might well differ from the asset's real market value or value to the company - for instance, computer equipment is usually depreciated quite quickly, typically over three years, but when I was employed, I had a computer on my desk that was over 10 years old, would still have had some market value (though probably not a lot) and was still the best one I had for some tasks (though the more modern PC I also had on my desk was better for most jobs). It's only when an asset is professionally re-valued (typically for property assets, as they are held for long periods, typically rise in value over time, and are valuable enough for it to be worth an occasional professional valuation fee to get greater accounting accuracy), or has obviously suffered a bad loss of value (known as being 'impaired') that the book value is adjusted. Usually, it's only if and when the asset is sold that the balance sheet total is changed by the gain or loss between the sale proceeds and the asset's book value, as happened to Q's balance sheet values above (note that the increase in the value of its shareholdings of T1 and T2 from £5m each to £50m each will really have happened spread out over many years - but in balance sheet terms, it will have all appeared abruptly at the point of sale).

The same is generally true of the consolidated balance sheet, but purchases of companies (or of enough shares in a company to change a <= 50% holding to a > 50% holding, so that it becomes a consolidated subsidiary) are an exception. That's because the consolidated balance sheet 'looks inside' subsidiaries to see their underlying assets. So what happens when P buys T1 and T2 off Q is that £100m of cash comes off P's consolidated balance sheet and only two lots of £10m non-current assets and two lots of £1m cash go on to it - and if that were all that happened, its total would therefore drop by £78m. That's when the accounting concept of goodwill comes into play. It basically assumes that because P's directors were willing to actually pay £39m above the identifiable asset value of each of T1 and T2, and not just say they thought they had that much extra going-concern value, that they really do each have that much extra going-concern value, and so the consolidated balance sheet also has £39m each of goodwill added to it, neatly making the additions to and subtractions from it balance out, so that as for any other purchase, purchases of subsidiaries don't themselves change either balance sheet value (though what happens subsequently to the purchased asset might well do so).

Some years later, it becomes clear that while S1's and T1's businesses are still going strong, S2's and T2's businesses are now declining, and the directors conclude that they cannot be revived, only have that decline managed (for example, it might be that competitors have invented far superior products for the needs addressed by S2's and T2's products, have managed to get patent protection for those inventions that the directors feel cannot be effectively challenged, and are asking far more to license the patents than the directors feel they can economically pay). As a result, S2 and T2 are clearly no longer worth anything like as much as the £50m each that they were - maybe only £15m each. As far as P is concerned, its shareholdings in S2 and T2 are on the parent company balance sheet with book values of £5m and £50m respectively. They reckon the shareholding in S2 is still worth at least about book value, but that in T2 is now clearly worth much less than book value, and so they impair the book value of T2 by £40m from £50m to £10m. The consolidated balance sheet has £1m cash and £10m book value of non-cash assets other than goodwill for each of them, and additionally has £39m of goodwill for T2, so no change happens to it for S2's clearly reduced value, but T2 clearly no longer has anything like as much going-concern value as it once had, so they declare the goodwill to be impaired and take its book value down to £4m (or indeed they might write it off entirely to reduce the risk of having to declare further impairments in future years). Such impairments (or complete write-offs) is the one circumstance in which the directors' opinions on the value of goodwill (or indeed other assets) are taken into account, and they generally reduce book values rather than increase them - and they are done fairly formally, not casually. In particular, companies with goodwill on their balance sheets are required to do an annual goodwill impairment review.

As they manage the subsequent decline of S2 and T2, there will probably be further balance sheet changes. For example, both ought to run down their stocks as the decline continues, so the £10m of non-cash assets other than goodwill for each of S2 and T2 will probably drop - and if the decline happens too fast to be able to use all the stocks, some of them are likely to have to be written off. But I think I've covered all the main points by now, so I'll stop the example at this point!

I should also say that I only intend the example as a broad-brush picture, to illustrate the basic principles without going into huge amounts of detail. That's partly because some of the detail will just obfuscate that broad-brush picture (for instance, that there's generally a lot more items on balance sheets than the few I've actually mentioned) and partly because I don't actually know anything like all the detail of the accounting rules (so I cannot guarantee that there aren't any exceptions to what I've said in various special circumstances...).

Finally, to relate this to your original question about minority interests, you might try working out how things go if each of the four subsidiaries S1, S2, T1 and T2 was actually started in response to someone external having invented a product and patented the invention approaching P or Q for help with bringing the invention to market, and the subsidiaries being set up as a result of agreements by which the company would put £10m and the inventor their invention into the company, getting 80% and 20% respectively of its shares in return, and the inventors having resisted subsequent attempts by the company to buy out their 20% minority shareholdings.

Gengulphus

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Re: Interpretation of non controlling interests and effect on EPS and EV

#165523

Postby Charlottesquare » September 10th, 2018, 5:00 pm

Melanie wrote:Yes, maybe the penny is starting to drop. The value assigned to the purchased assets on the parents BS, relates to the actual sum exchanged, and hence includes the purchased thing's organic goodwill, whereas when the value of purchase is included in the consolidated sheet it is based on estimates of the working book value (which is very subjective), and if there is a remainder, this is bunged in the "accounting" goodwill column in the consolidated accounts to make the books balance. (Hmm... I definitely need to do some background reading on this sometime).



many thanks
M&M


Do remember that whilst the goodwill is in effect the missing X (What was paid for company Y less what net assets were acquired) it is not quite that blunt an instrument, the board , once it is calculated, do need to consider the fair value and consider of the goodwill and whether its impairment would be appropriate.

If you actually try working your way through an accounting textbook consolidation example the steps will be simpler to follow, but in essence:

1. Add the assets and liabilities of the two companies together.

2. Eliminate reserves and share capital of sub (at purchase) against investment carrying cost of the parent re its investment in subsidiary; in effect difference goes to goodwill in consolidated Balance Sheet

3. Consider goodwill impairment and subsequent amortisation.

Whilst I do not think it really covers consolidation (wonder if there is a book 2) something like

https://www.amazon.co.uk/Financial-Acco ... 1292086696

would be a useful book to use to get comfortable with the accounting building blocks, or even a cheaper older secondhand version (whilst required disclosures will not be up to date the essence will still be there in the earlier publication)

Disclosure- Whilst I have no financial interest in Prof Weetman's publications I am one of her former students from the 1980s, if you pick up a cheap earlier edition for a couple of pounds plus postage it may be a useful addition to your library, imho she writes very clearly and the book is squarely aimed at first year UGs or those where accounting is not the core part of their course but need an understanding how accounts get put together and even sometimes why.

OFF TOPIC

Whilst not dealing with consolidations I can also recommend

https://www.amazon.co.uk/Management-Com ... 1861522290

re financial theory, I used its earlier successor in the first term at university from a standing start (no prior accounting knowledge) PG Cert in Accountancy Studies at Aberdeen and it is useful background re looking at dividend theories and capital cost issues re company finance.

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Re: Interpretation of non controlling interests and effect on EPS and EV

#165602

Postby TheMotorcycleBoy » September 11th, 2018, 7:22 am

Thanks for this!

Gengulphus wrote:At this point, company P's parent balance sheet has its shares in its subsidiaries S1 and S2 each down with a book value of £5m, and its consolidated balance sheet instead has the subsidiaries' book values consolidated in: non-cash assets with a book value of £2m and cash of £3m. Total £10m for the two on both balance sheets.

So at this point, right after the formation of S1 and S2, I assume that Consolidated balance sheet looks the same as for the last period. However, how (if at all) will the parent's balance sheet actually record the flow of money at this point? Whilst I do realise that the net position will be the same (providing no external funding was used), so will it merely be the Fixed assets entry in the statement increases by £10m whilst the Cash on hand entry decreases in a similar fashion?

Gengulphus wrote:A couple of years go by while S1 and S2 get their businesses going...... No goodwill entry appears in the accounts: the fact that the directors reckon the subsidiaries are each worth £3m more of going-concern value than their identifiable asset value might be the general concept of goodwill, but it is not recognised in the accounts, i.e. it is not the accounting concept of goodwill..

Gengulphus wrote:Over the next several years, the subsidiaries' businesses do very well,....the general concept of 'goodwill' does not get reflected in the accounts at all.

Yes, what you have written so far makes for a very clear example. I'm starting to understand the different areas in which accounting and economic goodwill are actually referring to. (I did find this a while ago, which I've only partially read but it seems to focus on this area and maybe of interest to some: https://www.valuewalk.com/2015/11/econo ... -goodwill/)

Gengulphus wrote:By then, each of the subsidiaries has saturated its natural market, and can no longer make good use of all the cash profits it's making, so they have maybe £5m per year surplus profits each.

The picture I'm starting to get is that up until this point P's parent balance sheet, sees no adjustments due to the happenings of S1 and S2.

Gengulphus wrote:Neither has an obvious new business area to break into, so their parent company P has them pay their profits (minus what's needed to replace worn out equipment, etc) out as dividends, which all go to P. As a result, the parent company balance sheet still has them at their book value of £5m each, but now has its cash rising at £10m per year from those dividends, specifically going up when each dividend is paid. The consolidated balance sheet instead still has the subsidiaries' assets at £11m each, now no longer rising as the new expenditure on them is merely balancing their deprecation. But its cash too is rising at £10m per year, though with a timing difference: the consolidated cash balance rises as the money comes into the subsidiaries and does not change when it is later paid to the parent as a dividend, because the rise in the parent's cash then is matched by the fall in the subsidiaries' cash.

Ok. So it's at this point - when S1 and S2 start to pay divs to P, that the parent's BS's cash entry starts to record an increase. I assume that from the limited company aspect that you touched upon earlier, that in simple terms, P, S1, S2 have separate bank/cash-holding accounts for legal purposes, and so it's only when S's bank actually pays into P's bank account that the parent's balance sheet entry needs to record this.

Gengulphus wrote:But what about P's balance sheets? It's pretty clear that as far as its parent company balance sheet is concerned, its shareholdings in T1 and T2 have book values of £50m each, and the appearance of those book values on the balance sheet is balanced by the disappearance of £100m cash from it. This is the normal situation when a company buys an asset: the cash spent on the asset is the book value put down for it, so value shifts on the balance sheet from cash to it, but the two balance out and so there's no change to the total......

Gengulphus wrote:The same is generally true of the consolidated balance sheet, but purchases of companies (or of enough shares in a company to change a <= 50% holding to a > 50% holding, so that it becomes a consolidated subsidiary) are an exception. That's because the consolidated balance sheet 'looks inside' subsidiaries to see their underlying assets. So what happens when P buys T1 and T2 off Q is that £100m of cash comes off P's consolidated balance sheet and only two lots of £10m non-current assets and two lots of £1m cash go on to it - and if that were all that happened, its total would therefore drop by £78m. That's when the accounting concept of goodwill comes into play. It basically assumes that because P's directors were willing to actually pay £39m above the identifiable asset value of each of T1 and T2, and not just say they thought they had that much extra going-concern value, that they really do each have that much extra going-concern value, and so the consolidated balance sheet also has £39m each of goodwill added to it, neatly making the additions to and subtractions from it balance out, so that as for any other purchase, purchases of subsidiaries don't themselves change either balance sheet value (though what happens subsequently to the purchased asset might well do so).

Ok. Yes, the accounting goodwill is a balance sheet entity, whereas economic goodwill is an abstract/subjective entity, which is the compact term for why one firm seems particularly attractive, i.e. people seem prepared to pay extra for it's products, and probably for it's shares too.

Incidentally does accounting goodwill only appear on Consolidated Balance Sheet then? It seems to me, from the picture you've painted above, that the Parents sheet deals only in more tangible items, e.g. cash and book value.

Gengulphus wrote:Some years later, it becomes clear that while S1's and T1's businesses are still going strong, S2's and T2's businesses are now declining, and the directors conclude that they cannot be revived....written of.....

Hereby introducing us to the topic of write-downs.

Gengulphus wrote:But I think I've covered all the main points by now, so I'll stop the example at this point!

Of course, thanks again.

Gengulphus wrote:Finally, to relate this to your original question about minority interests, you might try working out how things go if each of the four subsidiaries S1, S2, T1 and T2 was actually started in response to someone external having invented a product and patented the invention approaching P or Q for help with bringing the invention to market, and the subsidiaries being set up as a result of agreements by which the company would put £10m and the inventor their invention into the company, getting 80% and 20% respectively of its shares in return, and the inventors having resisted subsequent attempts by the company to buy out their 20% minority shareholdings.

Yes, will do. And some more background reading.

thanks for all your time and patience,
M&M

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Re: Interpretation of non controlling interests and effect on EPS and EV

#165666

Postby TheMotorcycleBoy » September 11th, 2018, 1:29 pm

Thanks for the book suggestions, Charlottesquare, I did buy this book, a couple of months ago,

https://www.amazon.co.uk/Accounts-Demys ... 0273744704

I must admit that I found it a very good intro. I might purchase another book sometime but I'm holding back on too many amazon purchases currently, at least until I can get my sellers account working again!

M&M

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Re: Interpretation of non controlling interests and effect on EPS and EV

#165757

Postby Charlottesquare » September 11th, 2018, 10:27 pm

Melanie wrote:
Incidentally does accounting goodwill only appear on Consolidated Balance Sheet then? It seems to me, from the picture you've painted above, that the Parents sheet deals only in more tangible items, e.g. cash and book value.


M&M


No, it can arise on the individual company balance sheet when the acquirer purchases a business (assets and liabilities) from another business rather than acquiring the shares in the other business. In such a case it has no investment in subsidiary as it has not acquired a subsidiary.

Where it say pays £1,000,000 for net assets valued at £600,000 it needs to account for the difference, it does this by generating an intangible asset on its own balance sheet, goodwill. (in this case initially £400,000)

Now this may not remain on its balance sheet, it may determine it needs impaired (it has overpaid) but initially before this it has the following postings, as every debit has a credit and it has spent £1,000,000

Dr Net assets £600,000
Dr Goodwill £400,000
Cr Bank £1,000,000 (what it paid)

However I would suggest this is far less common in the world of quoted shares , usually business combinations are done by the purchaser buying shares in the target company (soon to be subsidiary) and if the relevant assets/liabilities are not already conveniently enclosed in their own corporate shell very often the selling company will first hive into a subsidiary all the bits it is selling and then sell the shares in that subsidiary, it then becomes a subsidiary of the acquirer. But sometimes (especially when buying parts of a distressed business) the asset/liability acquisition route is done.

Thought even more infrequent in the world of quoted shares, if a company was to say purchase a business that was not itself a company then obviously what it paid over and above the net assets would have to initially be goodwill, it has no route to have an investment,so re our business with £600,000 net assets if that business say generated £150,000 profits a year our company might well be happy to pay £1,000,000 notwithstanding the net assets needed to generate that profit were only £600,000, the difference is evidently the goodwill (in effect the business value beyond merely its net assets)

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Re: Interpretation of non controlling interests and effect on EPS and EV

#166008

Postby TheMotorcycleBoy » September 13th, 2018, 6:46 am

Charlottesquare wrote:
Melanie wrote:
Incidentally does accounting goodwill only appear on Consolidated Balance Sheet then? It seems to me, from the picture you've painted above, that the Parents sheet deals only in more tangible items, e.g. cash and book value.


M&M


No, it can arise on the individual company balance sheet when the acquirer purchases a business (assets and liabilities) from another business rather than acquiring the shares in the other business. In such a case it has no investment in subsidiary as it has not acquired a subsidiary.

All I really understand from what I've just quoted above is that an acquirer can acquire tangible parts of business by, what seems to me, a direct financial transaction, i.e. without any equity purchase. (Which seems reasonable).

But what you have written here

Charlottesquare wrote:Where it say pays £1,000,000 for net assets valued at £600,000 it needs to account for the difference, it does this by generating an intangible asset on its own balance sheet, goodwill. (in this case initially £400,000)

confuses me, if you are actually referring to the parent's balance sheet. Not that I don't understand the difference in the figures. But because of Geng's earlier example:

Gengulphus wrote:While all that was going on, a different parent company Q happens to have been going through a very similar story with its subsidiaries T1 and T2. Around this time, though, Q develops an urgent need for a lot of cash and finds itself having to sell assets to get it. P has been wanting to get into the business areas of T1 and T2 for some time but hasn't been able to, e.g. because T1 and T2 hold patents on key technology in their areas. And so after some negotiation, P and Q agree that P will buy T1 and T2 off Q for £50m each. That improves Q's parent company balance sheet by removing T1's and T2's book values of £5m each from it and adding £100m cash to it (making a balance-sheet gain of £90m in the process), and Q's consolidated balance sheet by removing the £11m each of T1's and T2's assets from it and adding £100m cash to it (making a balance-sheet gain of £78m in the process).

But what about P's balance sheets? It's pretty clear that as far as its parent company balance sheet is concerned, its shareholdings in T1 and T2 have book values of £50m each, and the appearance of those book values on the balance sheet is balanced by the disappearance of £100m cash from it.

In Geng's example the acquirer pays more than book (i.e. the selling firms net asset value attributable to T1 and T2) for T1 and T2, but accounts for the entirety of the transaction as an asset in it's parent balance sheet.

And it's in the consolidated accounts where the accounting goodwill concept is raised:
Gengulphus wrote:So what happens when P buys T1 and T2 off Q is that £100m of cash comes off P's consolidated balance sheet and only two lots of £10m non-current assets and two lots of £1m cash go on to it - and if that were all that happened, its total would therefore drop by £78m. That's when the accounting concept of goodwill comes into play. It basically assumes that because P's directors were willing to actually pay £39m above the identifiable asset value of each of T1 and T2, and not just say they thought they had that much extra going-concern value, that they really do each have that much extra going-concern value, and so the consolidated balance sheet also has £39m each of goodwill added to it, neatly making the additions to and subtractions from it balance out, so that as for any other purchase, purchases of subsidiaries don't themselves change either balance sheet value (though what happens subsequently to the purchased asset might well do so).

However, I believe that in your example, the acquirer is choosing to account for some of the difference in values as accounting goodwill in the parent balance sheet, contrary to my earlier quote to which I believe that your reply relates.

My common sense suggests to me that the reason for the accounting difference is not due to Gengs transaction example being due to equity purchase, where as what you site (in the first of your writings that I quote) is a transaction without equity changing hands. But perhaps I have this wrong.

So, it seems to be a little arbitrary, to me, at this point, how an acquirer is choosing to account for a purchase. In my naive view, I'm back to where I started: a large part of the accounting procedure is subjective, based on determination of book value. It's like in Gs example the acquirer is thinking "the original owner has valued these assets at 11m each, I appreciate that, but because we can do much with them, I'm happy to pay and book 50m for the purchase of each". But in your example, the acquirer seems to be arriving at an identical logical conclusion, i.e "the seller values these assets at 0.6m but to me they are worth 1m".

So, in my opinion, we have on one hand the addition of "economic goodwill", i.e. something is apparently worth X in book (which of course is not a totally precise measure itself) but is worth to the market place when managed correctly X + Y where Y is additional value. (I.e. why Apple and Tesla etc. shares are highly priced). But it Gengs example X+Y are both subsumed in a book asset on the parent's BS, but in your example, the acquirer actually account for the amount Y - i.e. accounting goodwill appears at this point.

(I apologise in advance if you were referring to the accounting goodwill appearing in the consolidated accounts.)

M&M

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Re: Interpretation of non controlling interests and effect on EPS and EV

#166043

Postby Gengulphus » September 13th, 2018, 11:14 am

Melanie wrote:All I really understand from what I've just quoted above is that an acquirer can acquire tangible parts of business by, what seems to me, a direct financial transaction, i.e. without any equity purchase. (Which seems reasonable).

But what you have written here

Charlottesquare wrote:Where it say pays £1,000,000 for net assets valued at £600,000 it needs to account for the difference, it does this by generating an intangible asset on its own balance sheet, goodwill. (in this case initially £400,000)

confuses me, if you are actually referring to the parent's balance sheet. Not that I don't understand the difference in the figures. But because of Geng's earlier example:

Gengulphus wrote:While all that was going on, a different parent company Q happens to have been going through a very similar story with its subsidiaries T1 and T2. Around this time, though, Q develops an urgent need for a lot of cash and finds itself having to sell assets to get it. P has been wanting to get into the business areas of T1 and T2 for some time but hasn't been able to, e.g. because T1 and T2 hold patents on key technology in their areas. And so after some negotiation, P and Q agree that P will buy T1 and T2 off Q for £50m each. That improves Q's parent company balance sheet by removing T1's and T2's book values of £5m each from it and adding £100m cash to it (making a balance-sheet gain of £90m in the process), and Q's consolidated balance sheet by removing the £11m each of T1's and T2's assets from it and adding £100m cash to it (making a balance-sheet gain of £78m in the process).

But what about P's balance sheets? It's pretty clear that as far as its parent company balance sheet is concerned, its shareholdings in T1 and T2 have book values of £50m each, and the appearance of those book values on the balance sheet is balanced by the disappearance of £100m cash from it.

In Geng's example the acquirer pays more than book (i.e. the selling firms net asset value attributable to T1 and T2) for T1 and T2, but accounts for the entirety of the transaction as an asset in it's parent balance sheet.

And it's in the consolidated accounts where the accounting goodwill concept is raised:
Gengulphus wrote:So what happens when P buys T1 and T2 off Q is that £100m of cash comes off P's consolidated balance sheet and only two lots of £10m non-current assets and two lots of £1m cash go on to it - and if that were all that happened, its total would therefore drop by £78m. That's when the accounting concept of goodwill comes into play. It basically assumes that because P's directors were willing to actually pay £39m above the identifiable asset value of each of T1 and T2, and not just say they thought they had that much extra going-concern value, that they really do each have that much extra going-concern value, and so the consolidated balance sheet also has £39m each of goodwill added to it, neatly making the additions to and subtractions from it balance out, so that as for any other purchase, purchases of subsidiaries don't themselves change either balance sheet value (though what happens subsequently to the purchased asset might well do so).

However, I believe that in your example, the acquirer is choosing to account for some of the difference in values as accounting goodwill in the parent balance sheet, contrary to my earlier quote to which I believe that your reply relates.

My common sense suggests to me that the reason for the accounting difference is not due to Gengs transaction example being due to equity purchase, where as what you site (in the first of your writings that I quote) is a transaction without equity changing hands. But perhaps I have this wrong.

I think (having now seen and thought about Charlottesquare's example) that the difference is due to my example involving equity purchase and Charlottesquare's not involving it. The key point is that shares in a company are an asset in accounting and legal terms - a distinct asset from the assets owned by that company. For instance, if I own shares in a company, it's purely my choice whether to sell the shares and other shareholders generally don't get any say in whether I sell them (*) - but my rights to force the sale of the company's assets are limited by what I can get a shareholder resolution passed for. On the other hand, if I own an unincorporated business, I own its assets directly and have the same legal rights to sell them as I do for any of my other assets. (And this can be very relevant if someone else has legal rights over my property, e.g. because I'm going bankrupt.)

So basically, when a company is acquired, the shares in it are a separate asset and the amount paid is the book cost on the acquirer's parent company balance sheet. But when an unincorporated business is acquired, there is no such separate asset, so the business's assets have to go directly on to the acquirer's balance sheet. And if those assets are clearly worth less than the acquisition cost, they basically cannot go on to the acquirer's balance sheet at values totalling the acquisition cost (or possibly they can but one or more of them would immediately have to be declared as being impaired, which is pretty much equivalent!).

And by the way, that difference is not just a notional accounting difference with nothing much to do with reality - it does reflect the very real fact that a limited-liability company is protected from having its assets having to be sold out from under it to deal with the bankruptcy of any of its shareholders as well as the shareholders being protected from having their directly-owned assets sold to deal with the bankruptcy of a company whose shares they own.

One other thing I should add is that I do say things like (from near the end of my last post):

Gengulphus wrote:I should also say that I only intend the example as a broad-brush picture, to illustrate the basic principles without going into huge amounts of detail. That's partly because some of the detail will just obfuscate that broad-brush picture (for instance, that there's generally a lot more items on balance sheets than the few I've actually mentioned) and partly because I don't actually know anything like all the detail of the accounting rules (so I cannot guarantee that there aren't any exceptions to what I've said in various special circumstances...).

for a very good reason. In this case, it looks very much as though this is a case where Charlottesquare knows more about the accounting detail / special cases than I did. (Thank you, Charlottesquare!)

(*) Just to note that that's only about whether I sell, not details of the sale. In the case of private companies, there are often 'pre-emption rights' in their articles of association, which say that if I want to sell the shares to someone who isn't an existing shareholder, all the existing shareholders get the chance to say "no, I'm willing to pay the price you're getting for the shares and I'm making use of my right to pre-empt the sale - i.e. I'll buy (this number of) them instead" (if multiple existing shareholders do that and the numbers they want total more than are being sold, I believe they typically get the numbers they requested, scaled down pro rata so that together they get all the shares being sold).

Gengulphus

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Re: Interpretation of non controlling interests and effect on EPS and EV

#166099

Postby Charlottesquare » September 13th, 2018, 2:09 pm

Melanie wrote:
So, it seems to be a little arbitrary, to me, at this point, how an acquirer is choosing to account for a purchase. In my naive view, I'm back to where I started: a large part of the accounting procedure is subjective, based on determination of book value. It's like in Gs example the acquirer is thinking "the original owner has valued these assets at 11m each, I appreciate that, but because we can do much with them, I'm happy to pay and book 50m for the purchase of each". But in your example, the acquirer seems to be arriving at an identical logical conclusion, i.e "the seller values these assets at 0.6m but to me they are worth 1m".

So, in my opinion, we have on one hand the addition of "economic goodwill", i.e. something is apparently worth X in book (which of course is not a totally precise measure itself) but is worth to the market place when managed correctly X + Y where Y is additional value. (I.e. why Apple and Tesla etc. shares are highly priced). But it Gengs example X+Y are both subsumed in a book asset on the parent's BS, but in your example, the acquirer actually account for the amount Y - i.e. accounting goodwill appears at this point.

(I apologise in advance if you were referring to the accounting goodwill appearing in the consolidated accounts.)

M&M


You have to just consider what is being purchased.

When you buy a business wrapped in a company by buying the shares in the company, the parent, as discussed, shows that as an investment, the goodwill then only arises when you consolidate because on consolidation you are effectively adding the two balance sheets together (and the I & E stats post acquisition) when reporting the consolidated results and the book carrying net value of the subsidiary's assets and liabilities does not total the price you were willing to pay.

When though, you buy a business rather than a company (and the accounting standards describe attributes that will determine whether it is a business rather than a mere bunch of assets and liabilities) there is not going to be an investment on your balance sheet, the actual assets/liabilities will slot in, the excess you paid over these amounts has to go somewhere.

The accounting options would be (This is not what companies can do per the Standards but what might be possible to do re double entry) :

1.Treat as goodwill (you paid more than the asset value for the business) to reflect this "value" you acquired- what the Accounting Standards currently say you ought to do re a business combination. (caveated by impairment reviews)

2.Write off through I & E, perfectly possible but somewhat distorts results for the year, in addition in future years distorts ratios like ROCE as you have (in accounting terms) devalued the capital employed, this then flatters , in percentage terms, how hard the net business assets are being seen to work. It also would make comparing relative performance between two companies tricky, company A makes its profits due to long term organic growth, its relative return is based on earnings over capital retained, company B could squander millions on buying another business, have the earnings, write the acquisition cost against its capital employed reducing the denominator and on paper show itself a far better employer of capital, but that perception would be false as the cost of acquiring that extra business would have been ignored.

3. Write off against reserves, avoids the in year I & E hit, but the other issues in 2 remain.

4. Argue the extra paid was re the assets, but that wholly distorts those assets either carried in the balance sheet (Fixed) or say stock (which will impact cost of sales and gross profit in later I & E accounts)

There is a subjectivity but the difference does have to go somewhere, if you follow the Debits and Credits the extra Debit has to go somewhere, so treating the excess as goodwill is a solution, not perfect, but near enough acceptable.

It is still not perfect, in my example suppose company A paid out most of its past earnings in dividends but gradually it grew its customer base and earnings organically, it then shows a very high ROCE because the internally generated goodwill that exists (but is not shown in its balance sheet) is not recognised so its capital employed in economic terms is understated (though not in accounting terms due to internally generated goodwill not being included in the accounts per the Accounting Standards).

These discussions in accountancy have raged for years (since my apprenticeship in the 1980s , probably longer), accounting thought does morph and it is important to be comfortable enough with the debits and credits and standards to appreciate that a lot of what "economically exists" in accounts is not shown. Accountancy is far more complicated today than in the past, but that is because how business operates is also more complicated.

Consolidations, Mergers, Business Combinations is not Accounting 101, student first learn and get very comfortable dealing with individual accounts for single companies/other business entities and then consolidation etc gets added in Acccountancy 102, the catch for you is you want to learn re quoted companies and they do, for myriad reasons, use groups/combinations as the way they operate, so I appreciate it is a steep learning curve especially if the underlying guidance re valuation issues is not firmly grounded.

I will also caveat that these days my knowledge of consolidation, mergers etc is not great, I work in the SME market re accounting and it is a fair few years since I studied or applied this knowledge. (Am a bit better at tax but that will not be much use on this board)

You point re subjectivity may not be that well covered in basic textbooks which more tend to concentrate on what we do per current standards rather than what we ought to do. Years ago accounting magazines used to discuss journal articles re these issues (Students reading into the why as against the how) but these days it is tricky for me to point where you ought to go if you want to delve into the arguments re why. One possible useful source is say International GAAP 2018, I have not got it or read it but the old EY UK GAAP book I do have did touch on the whys as well as detailing and showing examples of the how, but it is a massive book (5360 pages-a reference not a read) and it assumes some existing knowledge re the basic debits and credits and is not cheap.

https://www.amazon.co.uk/International- ... +gaap+2018

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Re: Interpretation of non controlling interests and effect on EPS and EV

#166128

Postby TheMotorcycleBoy » September 13th, 2018, 5:29 pm

Gengulphus wrote:I think (having now seen and thought about Charlottesquare's example) that the difference is due to my example involving equity purchase and Charlottesquare's not involving it. The key point is that shares in a company are an asset in accounting and legal terms - a distinct asset from the assets owned by that company. For instance, if I own shares in a company, it's purely my choice whether to sell the shares and other shareholders generally don't get any say in whether I sell them (*) - but my rights to force the sale of the company's assets are limited by what I can get a shareholder resolution passed for. On the other hand, if I own an unincorporated business, I own its assets directly and have the same legal rights to sell them as I do for any of my other assets. (And this can be very relevant if someone else has legal rights over my property, e.g. because I'm going bankrupt.)

So basically, when a company is acquired, the shares in it are a separate asset and the amount paid is the book cost on the acquirer's parent company balance sheet. But when an unincorporated business is acquired, there is no such separate asset, so the business's assets have to go directly on to the acquirer's balance sheet. And if those assets are clearly worth less than the acquisition cost, they basically cannot go on to the acquirer's balance sheet at values totalling the acquisition cost (or possibly they can but one or more of them would immediately have to be declared as being impaired, which is pretty much equivalent!).

And by the way, that difference is not just a notional accounting difference with nothing much to do with reality - it does reflect the very real fact that a limited-liability company is protected from having its assets having to be sold out from under it to deal with the bankruptcy of any of its shareholders as well as the shareholders being protected from having their directly-owned assets sold to deal with the bankruptcy of a company whose shares they own.

Yes, Geng. Indeed upon reading Charlottesquare's this does seem to be case, but thanks for coming to this conclusion first......since reading this post of yours has served me well as a primer prior to reading Charlottesquare's!

M&M

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Re: Interpretation of non controlling interests and effect on EPS and EV

#166130

Postby TheMotorcycleBoy » September 13th, 2018, 5:34 pm

Charlottesquare wrote:You have to just consider what is being purchased.

When you buy a business wrapped in a company by buying the shares in the company, the parent, as discussed, shows that as an investment, the goodwill then only arises when you consolidate because on consolidation you are effectively adding the two balance sheets together (and the I & E stats post acquisition) when reporting the consolidated results and the book carrying net value of the subsidiary's assets and liabilities does not total the price you were willing to pay......

Thank for you very much for this, alas I've only got about half way through this. I just want to clarify something before I plough on however, and that is, when you state "I & E", are you referring to "Income and Earnings"? In other words the Income/Profit and Loss statement?

I'll chew on the rest of your post in the next couple of days, and hopefully I'll understand it fully by the weekend.

thanks again for your time,
M&M

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Re: Interpretation of non controlling interests and effect on EPS and EV

#166151

Postby Charlottesquare » September 13th, 2018, 8:11 pm

Melanie wrote:
Charlottesquare wrote:You have to just consider what is being purchased.

When you buy a business wrapped in a company by buying the shares in the company, the parent, as discussed, shows that as an investment, the goodwill then only arises when you consolidate because on consolidation you are effectively adding the two balance sheets together (and the I & E stats post acquisition) when reporting the consolidated results and the book carrying net value of the subsidiary's assets and liabilities does not total the price you were willing to pay......

Thank for you very much for this, alas I've only got about half way through this. I just want to clarify something before I plough on however, and that is, when you state "I & E", are you referring to "Income and Earnings"? In other words the Income/Profit and Loss statement?

I'll chew on the rest of your post in the next couple of days, and hopefully I'll understand it fully by the weekend.

thanks again for your time,
M&M


Income and Expenditure (Aka Profit and Loss, Statement of Comprehesive income or whatever label is the current fad) I actually prefer profit and loss but can no longer remember which standard calls it what these days.

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Re: Interpretation of non controlling interests and effect on EPS and EV

#166175

Postby Charlottesquare » September 13th, 2018, 9:05 pm

Melanie wrote:
Charlottesquare wrote:You have to just consider what is being purchased.

When you buy a business wrapped in a company by buying the shares in the company, the parent, as discussed, shows that as an investment, the goodwill then only arises when you consolidate because on consolidation you are effectively adding the two balance sheets together (and the I & E stats post acquisition) when reporting the consolidated results and the book carrying net value of the subsidiary's assets and liabilities does not total the price you were willing to pay......

Thank for you very much for this, alas I've only got about half way through this. I just want to clarify something before I plough on however, and that is, when you state "I & E", are you referring to "Income and Earnings"? In other words the Income/Profit and Loss statement?

I'll chew on the rest of your post in the next couple of days, and hopefully I'll understand it fully by the weekend.

thanks again for your time,
M&M


Re goodwill in parent by chance came across this excellent little video from ICAEW covering hive ups (I actually was pretty unfamiliar with the process)

This is where in effect the goodwill that would arise on consolidation becomes the goodwill of the parent, it is easy to follow and well described.

The caveat is it looks about three years old and not sure if the various accounting standards would be on point re all companies you are looking at, but it is more the entries that arise in the books of parent and sub showing goodwill turning up in the parent balance sheet that were interesting.

Quite strange as I was not looking at it re this discussion I looked at it because of a discussion on another (accounting) forum but it seemed it might be useful to this discussion re parent company balance sheet goodwill and the slides are easier to follow than my rambling posts.

Hope it makes sense, enjoy.

https://vimeo.com/148633056

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Re: Interpretation of non controlling interests and effect on EPS and EV

#166224

Postby Gengulphus » September 14th, 2018, 9:22 am

Charlottesquare wrote:When you buy a business wrapped in a company by buying the shares in the company, the parent, as discussed, shows that as an investment, the goodwill then only arises when you consolidate because on consolidation you are effectively adding the two balance sheets together ...

I know what you mean, but it's actually a bit more complicated than just an addition of the balance sheets. What you're doing is replacing the investment in the subsidiary on the parent company balance sheet with the subsidiary's balance sheet, so you're effectively subtracting the investment-in-subsidiary entry as well as adding in the subsidiary's balance sheet.

Also, if the subsidiary itself has subsidiaries, you're repeating that subtract-and-add process "all the way down". And there's the additional detail (which comes back to the actual subject of this thread!) that if the subsidiary is not 100% owned, you still add in its entire balance sheet, and account for that later with a minority-interests item.

I have incidentally occasionally seen companies report additional information in the form of financial statements done on the basis that e.g. an 80% owned subsidiary causes the investment in it to be subtracted and 80% of its balance sheet added, described as "proportionally consolidated" or some such phrase. On the fairly infrequent occasions that I have seen that done, it's always been an addition to the statutory statements - though that's in the sense that the statutory statements are a legal requirement and the addition something that the company is saying presents a fairer and/or alternative view for shareholders. The order and emphasis of the report may well present the additional statements look like the most important ones and the statutory statements the addition... (This is basically the same phenomenon as company reports highlighting what has happened to adjusted EPS and relegating basic EPS to the detail.)

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Re: Interpretation of non controlling interests and effect on EPS and EV

#166246

Postby Gengulphus » September 14th, 2018, 10:18 am

Charlottesquare wrote:... One possible useful source is say International GAAP 2018, I have not got it or read it but the old EY UK GAAP book I do have did touch on the whys as well as detailing and showing examples of the how, but it is a massive book (5360 pages-a reference not a read) and it assumes some existing knowledge re the basic debits and credits and is not cheap.

https://www.amazon.co.uk/International- ... +gaap+2018

Something I will add is that the photograph on that Amazon page must give a pretty misleading impression about just how massive it is. Getting 5360 pages into that thickness of book must involve the use of very thin paper - so much so that I was rather suspicious about the photograph actually being of the product (especially as the listed product dimensions of 18.8 x 15.5 x 26.2 cm clearly don't match the photograph - but that might be a matter of them being the dimensions of the boxed product). But a check of the publisher's page about it does indicate that it is indeed a photograph of the correct book.

If judging how much text it contains by the standards of more normal paperback books, I would judge (from looking at page counts of various technical paperbacks on my own bookshelves) one should think in terms of something 2-3 times as thick as that photograph would suggest to most users of such paperbacks.

Gengulphus


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