Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Seven – An introduction to consolidation
Returns on capital
Now let us think about the balance sheet rather than measures of income. When
calculating return on capital, what do we do with goodwill? What about the
balance sheet? Well, when the company builds a new plant it is not going to build
goodwill as well, so when forecasting it is returns on capital excluding goodwill
that should drive our valuation. So is goodwill irrelevant? Is it irrelevant that
management spent lots of money and may not get a fair return on it? Clearly we
need both measures, but for different purposes.
4. Further issues in consolidation
The whole area of consolidated financials is full of complex issues. Although the
technical issues are important, for modelling purposes the key task is to deal with
the output reflected in the financials. Exhibit 7.5 addresses some other areas of
consolidation that may be useful for analysts.
Exhibit 7.5: Further issues in consolidation
Issue
Preference
stock shares
Mid-year
acquisitions
Inter-company
transactions
Income
statements
Acctg treatment
If the holding company owns both common stock and preferred then, unless it
holds the some percentage of both, this has an impact on our calculations in a
similar way to the calculation of minority interest on the consolidated balance
sheet. Therefore the company must disaggregate balance sheet and income
statement numbers into those ‘owned’ by the preference shareholders and the
balance residual amounts owned by the common stockholders.
A fundamental principle of consolidation is that only post acquisition profits are
reflected in the group financials. Therefore an income statement drawn up after a
mid-year acquisition will only include those sales, costs and other items that have
happened since consolidation.
The process of consolidation involves preparing an additional set of financial
statements that reflects the economic position that would exist if the holding and
subsidiary companies were a single economic entity. This, quite obviously, does
not reflect legal reality. Each entity is typically a separate legal entity. Such
companies trade with each other and this is reflected in their financial statements.
However, if we are assuming a single economic entity then it no longer makes
sense to reflect such transactions in the consolidated accounts
If a holding company and its subsidiaries trade then such transactions will
normally be on credit. Therefore in each set of financials there will be offsetting
balances. So if a parent company sold goods on credit to a subsidiary then there
would be a receivable in the parent balance sheet and an equal payable in the
financials of the subsidiary. As we are making the one entity assumption, both of
these numbers will be dropped out of the asset aggregation exercise on
consolidation.
Consolidated income statements are prepared on a similar basis to balance
sheets in that all profits under the control of management are consolidated. Also,
in a similar manner to balance sheet consolidations, income statements are
consolidated based on the single entity assumption. Therefore the sales of
subsidiaries are aggregated with the sales of the holding company in order to
calculate group sales. An income statement consolidation example is included in
Exhibit 7.6.
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