Jane Doe is the recently appointed Group Accountant at Acquisitivea company listed on the Antarctican Stock Exchange.1 She is preparing to deliver her first press release and investor conference callto announce Acquisitives preliminary consolidated results for the year ended 31 December 20x5, and she anticipates receiving a number of questions from existing and potential shareholders and the financial press about some significant issues that are mentioned in the forthcoming release.

Jane is aware that Acquisitive has operated successfully in the Antarctican manufacturing sector for more than fifty years and for many years has prepared its financial statements in accordance with International Financial Reporting Standards (IFRS). In accordance with the listing requirements of the Antarctican Stock Exchange, Acquisitive also prepares half-yearly interim financial statements in accordance with IAS 34 Interim Financial Reporting.

Issue: Controlling shareholder buys out the non-controlling interests

On 1 July 20x5 Acquisitive increased its equity interest in its subsidiary Booming from 75 per cent to 100 per cent in exchange for CU10 billion cash. While Jane is aware that this transaction is between equity holders (and consequently, in accordance with IFRS, has no effect on reported earnings) she recalls last night reading a related issue in Warren Buffetts letter to Berkshire Hathaway Inc. shareholders (see extract reproduced below) and consequently she expects that some might ask her about the effects of Acquisitives purchase of Boomings non-controlling interests on Acquisitives soon-to-be released preliminary consolidated financial information.

Extract from Warren Buffetts letter to Berkshire Hathaway Inc. shareholders 2013(see http://www.berkshirehathaway.com/letters/2013ltr.pdf)

Last year we invested $3.5 billion in the surest sort of bolt-on: the purchase of additional shares in two wonderful businesses that we already controlled. In one caseMarmonour purchases brought us to the 100% ownership we had signed up for in 2008. In the other instanceIscarthe Wertheimer family elected to exercise a put option it held, selling us the 20% of the business it retained when we bought control in 2006. These purchases added about $300 million pre-tax to our current earning power and also delivered us $800 million of cash. Meanwhile, the same nonsensical accounting rule that I described in last years letter required that we enter these purchases on our books at $1.8 billion less than we paid, a process that reduced Berkshires book value. (The charge was made to capital in excess of par value; figure that one out.) This weird accounting, you should understand, instantly increased Berkshires excess of intrinsic value over book value by the same $1.8 billion.

Jane is aware that, unlike Acquisitive (which reports its financial information in accordance with IFRS), Berkshire Hathaway uses US GAAP3. However, she recalls that IFRS3 Business Combinations is the product of a joint FASB4 and IASB5 project, so she expects that the same (or similar) issues would exist for Acquisitive. This is confirmed when she reads a UBS Research Footnotes Compendium issued by Dennis Jullens, former UBS Accounting and Valuation Analyst (8 December 2010)an extract from which is set out below.

In 2009, Swiss company Roche increased its stake in US group Genentech from 56% to 100% by buying out the minority interest. As Roche already fully consolidated Genentech, the transaction from the accounting perspective was viewed as a transaction between shareholders that does not give rise to goodwill.

In the case of the Roche/Genentech transaction, the difference between purchase price and net asset value of minority interest of CHF 43.8bn was charged to Roches shareholders equity. This accounting adjustment caused return on equity to increase from 17% in 2008 to 119% in 2009... (p68) However, the principal reason for Roches return on equity is accounting rather than underlying economics. (p71)

The rationale here is that the wealth-generating ability of business assets is unaffected by the acquisition of the minority interest. That is to say, the parent is not investing in more or new assets. It is simply acquiring more rights to income from the assets it already controls, but to which non-controlling interests previously had rights... (p68)

Janes preparations for the forthcoming release also led her to an article by Dr Alan Teixeira (2014): The International Accounting Standards Board and Evidence-Informed Standard- Setting, Accounting in Europe, DOI: 10.1080/17449480.2014.900269. In particular, her attention is drawn to the following extract:

When the IASB developed IFRS 3 Business Combinations we faced significant opposition from lobby groups. One of the issues was the proposed treatment when non-controlling (minority) interests were acquired by the controlling interest. Opponents claimed that most of the equity of listed European companies would be wiped out. As part of the effects analysis for this Standard, I examined reported equity for the largest 600 European and the largest 600 US-listed entities (IASB, 2008). The analysis found that less than 1% of these entities had economically significant non-controlling interests. An analysis of the individual cases provided the IASB with evidence that non-controlling interests were less economically significant

than had been asserted by our detractors. And the reasons for the high proportion of non-controlling interests in the few cases we did observe made economic sense.[6] We also ran a series of calculations to estimate the likely effect on financial reports of various buy-out scenarios. The analysis suggested that the assertions and claims against us were without foundation.

Jane is aware that Acquisitives soon-to-be-released preliminary consolidated financial information makes much of Acquisitives purchase of the 25 per cent non-controlling interests in Booming for CU10 billion, which results in non-controlling interests declining by CU4 billion and equity attributable to Acquisitives shareholders declining by CU6 billion. She re-examines the due diligence reports prepared before making the decision to purchase the non-controlling interests and is satisfied that the valuations set out therein support her understanding that the transaction was priced at the market. She is also aware that Boomings financial performance in the six months since this transaction has greatly exceeded expectations and has thus contributed greatly to the impressive performance of Acquisitive for the six months ending 31 December 20x5, thereby providing good value to Acquisitives shareholders for the CU10 billion cash spent to buy out the non-controlling interests in Booming.

Questions: Assuming that the purchase of the non-controlling interests in Booming is priced at the market why does this transaction, when accounted for in accordance with IFRS, result in the net assets (and equity) of the Acquisitive group declining by CU6 billion?

Reflecting on Warren Buffetts commentary, how would you advise Jane Doe to explain this transaction to Acquisitives shareholders at the forthcoming earnings release?

What changes, if any, do you think could be made to IFRS to provide information in a way that addresses the question raised by Warren Buffett?

Would your answer to the question above be affected by the option chosen by Acquisitive when, many years ago, measuring non-controlling interests in its accounting for the acquisition of Boomingthat is to say: (i) fair value (sometimes called full goodwill method) or (ii) the present ownership instruments proportionate share in the recognized amounts of the Boomings identifiable net assets (sometimes called partial goodwill method)