Companies are continuously reshuffling their business portfolio by either spinning off assets (GlaxoSmithKline, Vivendi) or increasing their share in existing businesses (BMW, Siemens Energy). However, the M&A accounting applied to these transactions can produce some unusual and potentially confusing effects.
In 2022, German luxury car manufacturer BMW increased its stake in its Chinese joint venture BMW Brilliance from 50% to 75%. Surprisingly, this produced a gain in profit and loss (even though nothing had been sold), a cash inflow (even though BMW paid cash for the additional investment), and recognition of an asset that BMW already owned.
Recently, we have seen several examples of IFRS reporting companies reshuffling their portfolio of activities. GlaxoSmithKline and Vivendi have spun off or sold part of their business, whereas BMW and Siemens Energy are increasing their share of already partially owned businesses. In some cases these transactions result in companies losing or obtaining control of the business, which triggers a change in classification of the equity stake, and consequently a different accounting treatment.
M&A accounting can produce some confusing effects in financial statements. In this article, we explain how the accounting for a change in ownership works, focusing on the accounting consequences when BMW increased its ownership stake in its Chinese venture BMW Brilliance. This transaction resulted in:
- A profit reported in the BMW income statement even though nothing had been sold – the only transaction was a purchase of an asset at (we assume) a fair price.
- A cash inflow reported in the BMW cash flow statement even though BMW paid cash for their additional investment.
- A new intangible asset reported in the BMW balance sheet even though this asset represents rights to BMW technology that the company already owned.
We return to BMW later.
M&A accounting – changes in equity ownership
An equity interest in another company is accounted for in one of 3 ways:
- Full consolidation – control: If the equity stake gives the investor control, the investee is classified as a subsidiary and full consolidation is applied. The subsidiary’s assets, liabilities, income, expenses and cash flows are included in the consolidated financial statements on a line-by-line basis. If the investor (parent company) does not own 100% of the subsidiary, it recognises a non-controlling interest for the share held by other investors.
- Equity method – significant influence: Where an equity stake gives the investor significant influence over the investee, the investment is classified as an associate and the equity accounting method is applied. On acquisition, the investor recognises the investment at the purchase price. Subsequently, the carrying value of the investment increases with the share of retained profit and other changes in equity. The investor recognises its share of earnings in the income statement with dividends received in the cash flow statement. Equity accounting is often regarded as ‘one-line consolidation’.1There is of course much more to equity accounting. For example, we recently wrote about the impairment of associates in our article ’Associate impairments may not reflect underlying economics’.
- Financial investment: If an equity stake gives neither control nor significant influence over the investee, it is measured at fair value in the balance sheet, with changes in fair value reported in profit and loss. Under IFRS (but not US GAAP) there is an option to reflect changes in fair value in Other Comprehensive Income (which are not subsequently recycled into the income statement).2We think that the application of the OCI option to equity investments is confusing for investors and prefer the US GAAP approach. See our article ‘Ignore this recycled profit – Ping An’ for more about OCI and recycling, and ‘IFRS 17 Insurance – More comparability and new insights’ for our explanation of why the OCI option is bad for investors in insurance companies.
Investors generally seem to have a good understanding of these different methods of accounting. However, in our view, this does not always extend to how changes in equity ownership are reflected in financial statements and the impact these transactions have on key metrics.
The following table shows the different permutations for purchases and sales of equity investments and whether you can expect to see a gain or loss in the consolidated statement of profit and loss for different transactions that involve a change in equity ownership.The shaded cells show the effects when a sale (green) or purchase (blue) of an equity stake results in a change in classification and therefore accounting treatment.
IFRS gain or loss on a change in equity ownership
Note: This table is a brief summary of how changes in equity ownership may produce gains and losses in profit and loss. Most of the accounting is clear, even if not always intuitive. However, in the case of changes in equity stake of associates, where equity accounting applies before and after the transaction, the accounting is less clear, and you may find differences in application.
As you might expect, gains and losses arise in each of the three situations where a reduction in equity stake changes the accounting. Under equity accounting and full consolidation, equity investments are not measured at fair value. When, as a result of a sale, these investments are replaced by cash and an investment that is measured at fair value, a gain or loss is reported. If a holding is retained these gains are not fully ‘realised’. This includes the disposal of a stake in a subsidiary but where significant influence is retained such that equity accounting is subsequently applied. In this case the retained interest is remeasured to fair value (even though fair value is not used subsequently) with the resulting ‘gain’ included in profit and loss.
Interestingly, no gain or loss arises for transactions that reduce the holding in a subsidiary if full consolidation continues to apply after the disposal. In this case the transaction is regarded as a transfer between two classes of equity shareholders – the controlling and non-controlling interests – which in accounting terms does not result in a gain or loss.
No gain or loss for acquisitions – except when associates become subsidiaries
For acquisitions of an additional equity stake that result in a change in accounting, no gain or loss arises if the stake was previously measured at fair value; the prior carrying value simply becomes part of the purchase price for what is now classified as an associate or subsidiary. However, when full consolidation is first applied to an investment that was previously equity accounted, gains (and sometimes losses) will be reported – this is the highlighted blue cell in the table. It would seem odd to recognise a gain given that nothing has been sold, but this is exactly what happened in the case of BMW.
BMW – Equity accounting to full consolidation
In March 2003, German luxury car manufacturer BMW and the Chinese company Brilliance China Automotive Holdings agreed to form a joint venture called BMW Brilliance to produce BMW cars for the Chinese market. As BMW owned a 50% stake in the joint venture and had significant influence (but not control), it applied the equity method.
In October 2018, BMW announced it would pay €3.6bn to take control of its BMW Brilliance joint venture by acquiring an additional 25% shareholding. The deal would only close in 2022 because Chinese rules capping foreign ownership of joint ventures would then be lifted. In February 2022, BMW paid €3.7bn for the 25% of BMW Brilliance. This difference with the €3.6bn previously announced is due to exchange rate changes.
With 75% ownership, BMW now controls the joint venture. As of February 2022, BMW therefore applies full consolidation to BMW Brilliance, together with recognising the 25% non-controlling interest owned by Brilliance. . Increasing the share of businesses already partially owned is common practice. The transaction, however, does produce some confusing items in BMW’s financial statements.
Confusion in profit and loss – Reporting a profit without a sale
When BMW acquired the additional 25% stake in BMW Brilliance it reported an unrealised gain of €7,649m in profit and loss. The gain arises from the remeasurement of the prior equity accounted stake (which was essentially reported at cost) to fair value for the purpose of applying full consolidation.
BMW profit and loss statement (extract) and net financial result note
BMW 2022 financial statements. The BMW Brilliance gain of €7,649m is a the major component of the €7,949m ‘income from investment in subsidiaries and participations’ (i.e. associates).
Unrealised (nothing is sold) gains can arise when equity assets are reported at fair value; this represents a change in value during the period and is not triggered by a change in equity stake. For assets reported at cost (which is effectively the measurement approach for BMW Brilliance under equity accounting) it is usual to only report a profit if the assets are sold at a price above cost. Neither of these situations apply to BMW.
BMW’s transaction with Brilliance reflects a change in control because BMW moves from equity accounting to full consolidation. In financial reporting the date at which the investor obtains control is significant – it is the point from which the results of the subsidiary are fully consolidated and it is also when the purchase price allocation (PPA) takes place.
The purchase price allocation involves measuring the purchase price for the subsidiary and allocating that amount to the individual assets and liabilities acquired (measured at their fair value3However, not all assets and liabilities are measured at fair value, as we explain in our article ‘Goodwill accounting – Investors need something different’. on the acquisition date) with the remainder being goodwill. The purchase price includes the fair value of any existing holding – in the case of BMW Brilliance the prior 50% stake.
The difference between the equity accounted share of net assets and the fair value of the equity holding that is included in the purchase price allocation is recognised as a gain in profit and loss. BMW reports this remeasurement gain of €7,649m as part of financial result.
Calculation of BMW Brilliance remeasurement gain
BMW 2022 financial statement data
Obtaining control of a subsidiary produces a gain for BMW
The remeasurement gain of €7,649m is the cumulative change in value of BMW’s stake in BMW Brilliance since inception of the joint venture, after allowing for the recognition under equity accounting of the share of profit retained in the business. We believe this change in fair value should not be included when assessing the performance for BMW for 2022. However, the gain should not be ignored because it is part of the cumulative value creation for BMW from the investment in BMW Brilliance. The problem is that the share of profit recognised by BMW for its BMW Brilliance joint venture in the past decade does not capture the overall value created.
The rationale for remeasuring the equity accounted stake to fair value, for the purpose of the purchase price allocation, is to derive a meaningful measure for the goodwill arising on consolidation. The full amount of goodwill is the excess of the value of the business at the time of acquisition compared with the value of the underlying individual assets and liabilities acquired, including intangible assets separately recognised.
However, in the case of BMW, the goodwill amount is incomplete because only part of the purchase price – the value of the prior 50% holding – is measured at fair value when control was obtained. Neither the 25% acquired in 20224Because the payment of €3,735m made in 2022 was fixed in 2018, the price agreed was not equal to the value of the 25% stake at the time control was obtained. The value attributed to the 50% prior holding suggests that the purchased 25% was worth €6,171m at the time of settlement in 2022.
In effect, the agreement to purchase the stake for a fixed price in 2018 created a derivative forward position. Arguably this should have been remeasured to fair value in the intervening years, with the value of the 25% stake in 2022 included in the purchase price for the PPA. The fact that BMW did not remeasure the agreement reached in 2018 resulted in an understatement of goodwill.
We are not saying the BMW accounting is flawed. IFRS seems to be unclear regarding what happens in this specific situation. nor the 25% non-controlling interest5Under US GAAP any non-controlling interest must be measured at fair value for the purchase price allocation. Under IFRS there is an option to alternatively measure NCI at the share of the underlying net assets acquired (excluding goodwill). The difference is simply in the measurement of NCI and goodwill in the consolidated balance sheet. All options in financial reporting are unfortunate in that they reduce comparability – in this case in invested capital and ROIC measures. (NCI) still held by Brilliance is included in the purchase price allocation at fair value.
Confusion in the cash flow statement: Cash paid but a cash inflow reported
A further confusing aspect of the BMW Brilliance transaction is the presentation of the transaction in the cash flow statement. As you can see below, even though BMW paid €3,735m for the additional 25% stake, the acquisition results in a cash inflow being reported in the cash flow statement of €3,587m. The clue to the apparent contradiction is the label for this item – ‘Expenditure for acquisitions, net of cash acquired’.
BMW cash flow statement extract
BMW financial statements 2022
The cash balance of a new subsidiary is reported as a cash inflow when first consolidated
Because the cash balance of BMW Brilliance is now incorporated in the group financial statements, this represents an increase in group cash balances in the year. However, part of the BMW Brilliance cash was already included in the group financial statement prior to the acquisition due to cash deposits made by BMW Brilliance to BMW’s financial services companies in China.
The reported €3,587m inflow is the net of the purchase price (€3,735m) and the cash held by the subsidiary at the time of the acquisition (€8,746m), reduced by the intra-group cash and cash equivalents of €1,424m.
BMW net cash inflow arising from the acquisition of BMW Brilliance
BMW financial statements 2022
We do not believe netting these separate ‘cash flow’ items into one line in the cash flow statement provides useful information to investors. The components of the €3,587m above are very different and it seems confusing to net them off. Only the purchase price is an actual outflow, the offsetting amount simply arises from a change in the scope of the consolidation.
Cash ‘inflow’ from a change in scope of consolidation is not a real cash flow
In our view, it would have been better to present the cash paid as an investing outflow with the other related changes in cash included as part of the reconciliation of the opening and closing cash position in the balance sheet. The current presentation in the cash flow statement makes it difficult for investors to gauge the investments in other businesses because the actual cash outflow from the (partial) purchase of a subsidiary can be offset by the cash held by the target company.
A further common problem with the cash flow effects of purchasing businesses arises when part of the purchase price is non-cash – usually where equity is issued as consideration. In this case nothing appears in the cash flow statement in respect of the equity element of the purchase. This does not affect BMW, but it is common problem when using cash flow statement data. Some transactions that result in a zero cash flow in fact comprise two offsetting ‘effective’ flows which, had they been done separately, would have appeared in the cash flow statement. Whether the purchase is a single transaction or a separate equity issue followed by a cash purchase does not affect the underlying economics but does produce very different cashflows in the cash flow statement.
We have argued in previous Footnotes Analyst articles that investors need to factor effective cash flows into their analysis. This applies to several situations in addition to business combinations, including leasing and supplier finance arrangements.6See ‘When cash flows should include non-cash flows’ and ‘New supplier finance disclosures will affect operating cash flow’. Considering just cash flows reported in the cash flow statement can lead to metrics, such as free cash flow, that are incomplete and unsuitable for use in equity valuation.
We believe that cash flow statement reporting should better incorporate so called effective cash flows, either through improved footnotes or by including a separate ‘non-cash’ column next to the cash flow statement itself.
Confusing intangibles – Reacquired rights dominate purchase price allocation
BMW performs a purchase price allocation of BMW Brilliance as part of the acquisition. This involves recognising the ‘purchase’ of BMW Brilliance’s individual assets and liabilities in the consolidated financial statements. The purchase price is the fair value of assets and liabilities at the transaction date.
Extract from ‘Increased shareholding in BMW Brilliance’ disclosure
BMW financial statements 2022
The most significant intangible recognised on acquisition are reacquired rights. BMW, in its 2022 Annual report, explains as follows:
“Reacquired rights were recognized as a separate intangible asset if they were contractually granted to Brilliance before control was obtained by the BMW Group. More specifically, they relate to rights granted by the BMW Group to the BMW Brilliance joint venture prior to the acquisition, allowing the latter to use specified vehicle production technologies and trademark rights.”
The confusing thing about recognising reacquired rights as an asset in consolidated financial statements is that it could be regarded as the recognition of an asset which the purchasing entity already owns, and therefore double counting.
BMW clearly owns vehicle production technologies and trademark rights related to its products, although most of these will not have previously been recognised in its financial statements due to the lack of recognition of most internally generated intangibles. However, granting the right to use these assets to the Brilliance joint venture diminished the value of the assets for BMW. Now that BMW Brilliance has been acquired and consolidated this ‘right of use’ asset has been returned to the BMW group and must be capitalised due to the differing recognition requirements for intangibles ‘purchased’ in a business combination.
Previously unrecognised internally developed intangible now appears in the balance sheet
The net effect is that what was part of inherent goodwill (or an unrecognised intangible) for BMW returns as a recognised intangible because it has been ‘reacquired’. While it may seem odd, the effect is consistent with the principles of consolidated financial statements. It is simply another example of the problems caused by the lack of recognition of internally generated intangibles.
These acquired intangible assets are reported as having a relatively short estimated useful life of 6 to 7 years and will therefore produce a not insignificant amortisation charge going forward. We think that investors should exclude amortisation of intangibles from performance metrics if replacement expenditure is likely to be expensed rather than capitalised, which is almost certainly the case for ‘reacquired rights’. We explain further in our article ‘Should you ignore intangible amortisation?’.
One interesting further complication relating to reacquired rights is that under IFRS accounting they are not actually measured at fair value. Generally identifiable assets acquired, and liabilities assumed, are recognised at their acquisition date fair values. IFRS 3 provides a few exceptions to both the recognition and measurement principles, including for reacquired rights. IFRS 3 states that:
“The acquirer shall measure the value of a reacquired right recognised as an intangible asset on the basis of the remaining contractual term of the related contract regardless of whether market participants would consider potential contractual renewals when measuring its fair value.”
This is yet another example of the inconsistencies in measuring goodwill that we highlight in our article ‘Goodwill accounting – Investors need something different’.
Insights for investors
- A change in control may result in remeasurement gains and losses. These should be ignored to assess performance over a particular accounting period. However, they may inform you about the company’s ability to create value with its investments in associates, joint ventures and subsidiaries.
- An increase in an equity investment can result in a remeasurement gains or loss due to the need to measure at fair value the total consideration in a business combination. No such gain or loss arises where the stake in a subsidiary is increased.
- Do not rely on the cash flow statement to identify cash paid in business combinations. The cash flow effect of a purchase of a business when full consolidation is first applied includes the cash of the subsidiary that is newly consolidated.
- In a business combination, the previously unrecognised intangible assets of the new subsidiary, potentially including ‘reacquired rights’, are recognised in the consolidated financial statements at their fair value. Reacquired rights can be regarded as effectively part of acquired goodwill.
- Be careful with amortisation charges relating to acquired intangibles. Double counting arises if future expenditure on maintaining the value of the purchased intangibles is expensed rather than capitalised.