Interpretation of a Listed Company’s Accounts (1/2)

Interpretation of a Listed Company’s Accounts (1/2)

In this lesson, you’re expected to learn about:
– intangible assets and amortization
– consolidated accounts for groups of companies
– accounting for subsidiaries

Intangible Assets 

To put it simply, intangible assets are things you can’t touch like computer software, patents, copyrights, trademarks etc.

If you buy an intangible asset from a third party, you capitalize it (i.e. treat it as a fixed asset) and then depreciate it over a number of years.

We use the word amortize to mean depreciate when talking about intangible assets. Amortization refers to the write-off of an asset over its expected period of life.

[Optional] What does amortization mean?
Check out this article to learn more:
https://www.accountingcoach.com/blog/amortization
[Optional] How Amortization Works
Check out this link to learn more:
http://bit.ly/2tVBGps
If you generate intangible assets internally, you capitalize them when certain strict conditions are met and then amortize them over their useful life. Otherwise, you have to expense the cost as incurred.
Groups of Companies

Just as an individual can, a company can also buy just a few of the shares in another company or it can buy all the shares. If you own a small percentage of the shares in a company, you don’t have any control over it and its business can’t really be considered to be a part of yours.

On the other hand, if you own 100% of a business, then it is clearly your business and the performance of that business should be reported in detail in your accounts.

Most investments in other companies are categorized as: 

1) Subsidiaries (Subsidiary Undertakings)

A company is a subsidiary of yours if you control it. This includes control by way of more than 50% of the voting rights but also by way of powers arising from contractual rights.

2) Associated Undertakings (Associates)

A company is usually an associate of yours if it is not a subsidiary but you exert a significant influence over the company. If you own 20% or more of the voting rights, you would normally be considered to exert significant influence over the company.

3) Investments

This includes any investment in another company’s shares that is not in one of the categories above.

Accounting for Subsidiaries
The objective is to present the accounts as if the investor company (also known as the parent company) and its subsidiaries were all actually just one company. This gives you the consolidated accounts (also known as the group accounts).

People often pay more than net asset value when buying shares in companies. Recall that we discussed this when we talked about the valuation of companies last week.

Why? 
A company has lots of valuable things that aren’t in the balance sheet. So if they were included as assets on the balance sheet, the net assets would be higher.

Goodwill 

When a company buys another company, the difference between what it pays and the net asset value of the company it’s buying is known as goodwill.

When we create consolidated accounts, we have to include this goodwill figure on the consolidated balance sheet in order to ensure that it balances.

Let’s use an example to better understand how this works. 

Assume that a company (the parent) buys another company (subsidiary) for €800k.

This subsidiary has no liabilities and the only asset on its balance sheet is a building. This building is recorded as €300k, which means that net assets of the subsidiary are €300k.

What would the overall effect of this transaction be on the accounts of the parent company in combination with its new subsidiary?  

Cash would decrease by €800k and fixed assets would increase by €300k. However, this leaves us with a balance sheet that doesn’t balance.

So we create an asset called goodwill valued at €500k. Essentially, goodwill is used to fill this gap that arises when a parent company buys a subsidiary.

Cash Generating Units (CGUs)

They are often cases in which companies buy subsidiaries that have lots of different businesses. In such a situation, the parent company has to split the goodwill up and apportion it between something called cash generating units or CGUs.

What happens to the goodwill in the years after you make an acquisition depends on the accounting standards that you follow in your country.

For example, under the UK GAAP, the goodwill is amortized like other intangible assets.

So you would pick an estimated life for the goodwill and decrease the value of the goodwill pro rata* in each year over that period.

Pro Rata: proportionately
Revaluation of assets on acquisition

We defined goodwill as the difference between the price the parent pays and the net assets of the subsidiary. However, this is not a complete definition.

The parent has to revalue to fair value all of the assets and liabilities of the subsidiary. It then uses those figures in its consolidated balance sheet. The parent also gives a value to various intangible assets of the subsidiary, even though those assets may not appear on the balance sheet of the subsidiary.

Thus, the goodwill figure then becomes the difference between what the parent paid and the net asset figure after the revaluations.

Since this revaluation figure will generally increase the net asset figure, the goodwill after this process is generally smaller than it otherwise would have been.

Let’s now go back to the building example. 

Assume that the fair value of the building at the time it was bought was actually €600k. The subsidiary owned a brand name that wasn’t included in its balance sheet but was established to be worth €50k.

Then what you get is the following:

Non-Controlling (Minority) Interests

Regardless of how much of a subsidiary a parent company owns, the consolidated accounts will always be prepared as if the parent company owned 100% of the subsidiary.

Thus, when the parent owns less than 100%, that would lead to overstating the parent shareholder’s claims over the assets so an extra line is added to the balance sheet to show the portion of the assets that is claimed by whoever owns the rest of the subsidiary. These are called the non-controlling interests (minority interests).

Similarly, the consolidated P&L and the statement of comprehensive income have a similar figure showing the portion of the consolidated profits that is attributable to the non-controlling interests, and thus, the profit that is attributable of the parent company’s shareholders.
On a balance sheet, the minority interest section refers to the equity of the minority shareholders in a company’s subsidiaries – which tends to occur when dealing with holding companies. Minority interests represent the minority stockholders’ share of the assets and liabilities of a subsidiary.
Let’s use an example to better understand the concept of minority interests.

One of the most well known holding companies in the world is Berkshire Hathaway, the investment vehicle of Warren Buffettwho has made minority interest a key strategic weapon in his acquisitions of companies.

Buffett looks for an attractive business to invest in – often family-owned or controlled by a few people – and then offers to acquire at least 80% of the stock. This percentage is important because that is the figure at which the current corporate tax rules in the US mean that the acquired business will be treated as a fully consolidated subsidiary and the parent holding company won’t have to pay taxes on dividends from that subsidiary.

[Optional] How to calculate minority interest
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