(a) Level of control and ownership level

The level of control⁶ measures the strength of direct or indirect dependence that exists between the parent company and its subsidiaries, joint ventures or associates. Although control is assessed in a broader way in IFRS (see page 71), the percentage of voting rights that the parent company controls (what we call here “level of control”) will be a key indication to determine whether the subsidiary is controlled or significantly influenced.

To calculate the level of control, we must look at the percentage of voting rights held by all group companies in the subsidiary provided that the group companies are controlled directly or indirectly by the parent company.

Control is assumed when the percentage of voting rights held is 50% or higher or when a situation of de facto control exists at each link in the chain.

It is important not to confuse the level of control with the level of ownership. Generally speaking, these two concepts are different. The ownership level⁷ is used to calculate the parent company’s claims on its subsidiaries, joint ventures or associates. It reflects the proportion of their capital held directly or indirectly by the parent company. It is a financial concept, unlike the level of control, which is a power-related concept.

The ownership level is the sum of the product of the direct and indirect percentage stakes held by the parent company in a given company. The ownership level differs from the level of control, which considers only the controlled subsidiaries.

Consider the following example:

A controls 60% of B, B controls 70% of D, so A controls 70% of D. D and B are therefore considered as controlled and thus fully consolidated by A. But A does not own 70%, but 42% of D (i.e. 60% × 70%). The ownership level of A over D is then 42%: only 42% of D’s net income is attributable to A.

Since C owns just 10% of E, C will not consolidate E. Neither will D as it only owns 15% of E. But since A controls 20% of C, A will account for C under the equity method and will show 20% of C’s net income in its income statement.

The ownership level of A over E is 20% × 10% + 60% × 70% × 15% = 8.3%. The percentage of control of A over E is 15%.

How the ownership level is used varies from one consolidation method to another:

• with full consolidation, the ownership level is used only to allocate the subsidiary’s reserves and net income between the parent company and minority interests in the subsidiary;
• with the equity method of accounting, the ownership level is used to determine the portion of the subsidiary’s shareholders’ equity and net income attributable to the parent company.

(b) Changes in the scope of consolidation

It is important to analyse the scope of consolidation, especially with regard to what has changed and what is excluded. A decision not to consolidate a company means:

• neither its losses nor its shareholders’ equity will appear on the balance sheet⁸ of the group;
• its liabilities will not appear on the balance sheet of the group.

Certain techniques can be used to remove subsidiaries still controlled by the parent company from the scope of consolidation. These techniques have been developed to make certain consolidated accounts look more attractive. These techniques frequently involve a special-purpose vehicle (SPV). The SPV is a separate legal entity created specially to handle a venture on behalf of a company. In many cases, from a legal standpoint the SPV belongs to banks or to investors rather than to the company. That said, the company must consolidate the SPV if it controls it, as explained in the first paragraph of Section 6.1. These rules make it very difficult to use this type of scheme under IFRS or US GAAP.

Changes in the scope of consolidation require the preparation of pro forma financial statements. Pro forma statements enable analysts to compare the company’s performances on a consistent basis. In these pro forma statements, the company may either:

• restate past accounts to make them comparable with the current scope of consolidation; or
• remove from the current scope of consolidation any item that was not present in the previous period to maintain its previous configuration. This latter option is, however, less interesting for financial analysts.

(a) What does this difference represent?

In other words, why should a company agree to pay out more for another company than its book value? There are several possible explanations:

• the assets recorded on the acquired company’s balance sheet are worth more than their carrying cost. This situation may result from the prudence principle, which means that unrealised capital losses have to be taken into account, but not unrealised capital gains;
• it is perfectly conceivable that assets such as patents, licences and market shares that the company has accumulated over the years without wishing to, or even being able to, account for them, may not appear on the balance sheet. This situation is especially true if the company is highly profitable;
• the merger between the two companies may create synergies, either in the form of cost reductions and/or revenue enhancement. The buyer is likely to partly reflect them in the price offered to the seller;
• the buyer may be ready to pay a high price for a target just to prevent a new player from buying it, entering the market and putting the current level of the buyer’s profitability under pressure;
• finally, the buyer may quite simply have overpaid for the deal.

(b) How is goodwill accounted for?

When first consolidated, the identifiable assets of the new subsidiary, joint venture or associate are valued at their fair value and are recorded on the group’s balance sheet in these amounts. Intangible assets in particular are valued even if they weren’t recognised on the acquired company’s balance sheet: brands concerned, patents, software, emissions permits or landing rights, customer lists, etc. Accordingly, the equity capital of the newly consolidated company will be revalued.

The difference between the price paid by the parent company for its shares in the acquired company and the parent company’s share in the revalued equity of the acquired company is called goodwill. It appears on the asset side of the new group’s balance sheet as intangible assets.

Under IFRS and US GAAP, goodwill is assessed each year to verify whether its value is at least equal to its net book value as shown on the group’s balance sheet. This assessment is called an impairment test. If the market value of goodwill is below its book value, then goodwill is written down to its fair market value and a corresponding impairment loss is recorded in the income statement.⁹ This impairment loss cannot be reversed in the future.

To illustrate the purchase method, let’s analyse now how Holcim accounted for the acquisition of Lafarge in 2015.

Prior to the acquisition, Holcim’s balance sheet (in millions of CHF) can be summarised as follows:

While Lafarge’s balance sheet (in millions of EUR) was as follows:

Holcim acquired 100% of Lafarge for CHF19 483m paid for in shares (CHF18 590m) and cash (CHF893m). Therefore, Holcim paid CHF1920m¹⁰ more than Lafarge equity. This amount is not equal to goodwill, as Holcim proceeded to a revaluation of assets and liabilities of Lafarge as follows:

Total adjustments amount to −CHF4553m (−10 382 + 7315 + 909 – 424 − 1971). 
Consequently, the amount of goodwill created was CHF1920m – (–CHF4553m) = CHF6473m. The simplified balance sheet of the combined entity was therefore as follows:

Finally, transactions may give rise to negative goodwill under certain circumstances. Under IFRS, negative goodwill is immediately recognised as a profit in the income statement of the new groups.

(c) How should financial analysts treat goodwill?

From a financial standpoint, it is sensible to regard goodwill as an asset like any other, which may suffer sudden falls in value that need to be recognised by means of an impairment charge. We advise our readers to treat impairment charges as non-recurring items and to exclude them for the computation of returns (see Chapter 13) or earnings per share (see Chapter 22).

Can it be argued that goodwill impairment losses do not reflect any decrease in the company’s wealth because there is no outflow of cash? We do not think so.

Granted, goodwill impairment losses are a non-cash item, but it would be wrong to say that only decisions giving rise to cash flows affect a company’s value. For instance, setting a maximum limit on voting rights or attributing 10 voting rights to certain categories of shares does not have any cash impact, but definitely reduces the value of shareholders’ equity.

Recognising the impairment of goodwill related to a past acquisition is tantamount to admitting that the price paid was too high. But what if the acquisition was paid for in shares? This makes no difference whatsoever, irrespective of whether the buyer’s shares were overvalued at the same time.

Had the company carried out a share issue rather than overpaying for an acquisition, it would have been able to capitalise on its lofty share price to the great benefit of existing shareholders. The cash raised through the share issue would have been used to make acquisitions at much more reasonable prices once the wave of euphoria had subsided.

It is essential to remember that shareholders in a company which pays for a deal in shares suffer dilution in their interest. They accept this dilution because they take the view that the size of the cake will grow at a faster rate (e.g. by 30%) than the number of guests invited to the party (e.g. by over 25%). Should it transpire that the cake grows at merely 10% rather than the expected 30% because the purchased assets prove to be worth less than anticipated, then the number of guests at the party will unfortunately stay the same. Accordingly, the size of each guest’s slice of the cake falls by 12% (110/125 − 1), so shareholders’ wealth has certainly diminished.

(d) How should financial analysts treat “adjusted income”?

Some groups (particularly in the pharmaceutical sector) like Pfizer or Sanofi, following an acquisition, publish an “adjusted income” to neutralise the P&L impact of the revaluation of assets and liabilities of its newly acquired subsidiary. Naturally, a P&L account is drawn up under normal standards, but it carries an audited table showing the impact of the switch to adjusted income on operating income and net income.

As a matter of fact, by virtue of the revaluation of the target’s inventories to their market value, the normal process of selling the inventories generates no profit. So how relevant will the P&L be in the first year after the merger? This issue becomes critical only when the production cycle is very long and therefore the revaluation of inventories (and potentially research and development capitalised) is material.

We believe that for those specific cases, groups are right to show this adjusted P&L.

(a) The problem

The translation of the accounts of foreign companies is a tricky issue because of exchange rate fluctuations and the difference between inflation rates, which may distort the picture provided by company accounts.

For instance, a parent company located in the eurozone may own a subsidiary in a country with a soft currency.¹²

Using year-end exchange rates to convert the assets of its subsidiary into the parent company’s currency understates their value. From an economic standpoint, all the assets do not suffer depreciation proportional to that of the subsidiary’s home currency.

On the one hand, fixed assets are protected to some extent. Inflation means that it would cost more in the subsidiary’s local currency to replace them after the devaluation in the currency than before. All in all, the inflation and devaluation phenomena may actually offset each other, so the value of the subsidiary’s fixed assets in the parent company’s currency is roughly stable. On the other hand, inventories, receivables and liabilities (irrespective of their maturity) denominated in the devalued currency all depreciate in tandem with the currency.

If the subsidiary is located in a country with a hard currency (i.e. a stronger one than that of the parent company), then the situation is similar but the implications are reversed.

To present an accurate image of developments in the foreign subsidiary’s situation, it is necessary to take into account:

• the impact on the consolidated accounts of the translation of the subsidiary’s currency into the parent company’s currency;
• the adjustment that would stem from translation of the foreign subsidiary’s fixed assets into the local currency.

(b) Methods

Several methods may be used at the same time to translate different items in the balance sheet and income statement of foreign subsidiaries, giving rise to currency translation differences.

The most frequently used method is called the closing rate method: all assets and liabilities are translated at the closing rate, which is the rate of exchange at the balance sheet date.¹³ Revenues and charges on the income statement are translated at the average rate over the fiscal year.¹⁴ Currency translation differences are recorded under shareholders’ equity, with a distinction being made between the group’s share and that attributable to minority investors. This translation method is used under IFRS and it is relatively comparable to the US standard.

The temporal method consists of translating:

• monetary items (i.e. cash and sums receivable or payable denominated in the foreign company’s currency and determined in advance) at the closing rate;
• non-monetary items (fixed assets and the corresponding depreciation and amortisation,¹⁵ inventories, prepayments, shareholders’ equity, investments, etc.) at the exchange rate at the date to which the historical cost or valuation pertains;
• revenues and charges on the income statement theoretically at the exchange rate prevailing on the transaction date. In practice, however, they are usually translated at an average exchange rate for the period.

Under the temporal method, the difference between the net income on the balance sheet and that on the income statement is recorded on the income statement under foreign exchange gains and losses.

(c) Translating the accounts of subsidiaries located in hyperinflationary countries

A hyperinflationary country is one where inflation is both chronic and out of control. In such circumstances, the previous methods are not suitable for translating the effects of inflation into the accounts.

Hence the use of a specific method based on restatements made by applying a general price index. Elements such as monetary items that are already stated at the measuring unit at the balance sheet date are not restated. Other elements are restated based on the change in the general price index between the date those items were acquired or incurred and the balance sheet consolidation. A gain or loss on the net monetary position is included in net income. IFRS prescribes this method, which is not allowed in the US where the temporal method is applied.