Acquisition method, Equity method, and Proportionate consolidation: sample questions

Acquisition

		Acquirer	Target
Accounting		U.S.GAAP	U.S.GAAP
Purchase price		-	$185 million in cash (20% stake)

Pre-Acquisition Balance Sheets (12/31/2010)

in million $		Acquirer	Target
Current assets		13,900	716
PP&E		26,977	108
Total assets		40,877	824
Current liabilities		10,363	220
Other liabilities		11,121	8
Common stock		6,127	108
Retained earnings		13,266	488
Total liabilities and equity		40,877	824

Pro-Forma (i.e. projected) Income Statement (for the year ending 12/31/2011)

in million $		Acquirer	Target
Revenue		66,176	2,176
Expenses		63,515	2,068
Net Income		2,661	108
Dividends		1,525	0

---

(Questions and Answers)

1. Assuming the acquisition goes through at the beginning of 2011, and that Acquirer will have a significant influence on Target, the total assets after acquisition would be:
• 40,877
• The accounting for an ownership interest of between 20% and 50% in an associate is handled using the equity method. Acquirer also have a significant influence (NOT control) on Target.
• Under the equity method, the initial investment is recorded at cost and reported on the balance sheet as a noncurrent asset.
• Because the acquisition in this case is fully funded by cash, there will be no change to total assets for Acquirer.
2. The fair value of Target's other assets PP&E is $250 million. The amount allocated to goodwill would be:
• 37.4
• (Partial) goodwill = Purchase price (cash) - Pro-rata book value of Target - Amount of excess purchase price allocated to PP&E = 185 - (108+488)*20% - (250-108)*20% = 37.4
• Full goodwill = 185/20% - (108+488) - (250-108) = 187.0 = 37.4/20%
3. For this question only, assume that as a result of the acquisition, Acquirer must depreciate an additional $50 million over a 10-year period to zero salvage value. Target's contribution to Acquirer's EBT for 2011 is projected to:
• 16.6
• Equity income: 108*20% - (50-0)/10 = 16.6
4. For this question only, assume that the acquisition occurs on December 31, 2010, and that there is no additional depreciation expense as a result of the acquisition. Compared to its beginning of year investment balance, the balance for Acquirer's investment in Target on December 31,2011, will be lower, higher, or unchanged?
• Higher
• No calculations are required to solve this problem.
• Acquirer's investment balance = Investment balance at the beginning of year + equity income - dividend paid (under no additional depreciation assumption)
• Increase/Decrease to Acquirer's investment balance = Target's equity income - Target's dividend paid (under no additional depreciation assumption)
• The equity income is positive Target had positive net income, and there is no additional depreciation expense to subtract. Additionally, Target is not expected to make any dividend payments for 2011.
• Based on this, Acquirer's investment balance will increase.
5. "Since Target is profitable and pays no dividends, the equity method will result in higher net income than proportionate consolidation. Additionally, the equity method will result in lower return on assets (ROA) than the acquisition method with partial goodwill." Is this stament correct for both net income and ROA?
• Under the condition above, the equity method, proportionate consolidation, and the acquisition method all report the same net income.
• ROA is higher under the equity method than under proportionate consolidation because the equity method does report lower assets than proportionate consolidation.
6. If an analyst were to follow IFRS instead of U.S. GAAP, the accounting method predescribed for this type of investment would most likely be (A) the equity method, (B) the acquisition method, or (C) proportionate consolidation?
• Equity method
• When the investment constitutes 20% to 50% of the associate, and the investor has significant influence on the associate, IFRS prescribes the equity method for accounting for the invesment.