We previously covered how leveraged Starhub is based on return to equity and debt to equity metrics. After our post, Starhub’s investor relations team contacted us to tell us that because of certain merger accounting implications, we should instead be looking at the company level equity rather than the group level equity. This is seems a tad peculiar and is what we will be discussing today – how merger accounting can distort group level analysis.
Merger Accounting – How consolidation works
We start with how basic consolidation works. Consolidation occurs when a company has at least 1 subsidiary. In order for shareholders to get a holistic picture of all the assets and earnings accrued to him, the accounts of the subsidiary are consolidated with the company to form a group level figure.
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Acquisition and Goodwill
We also need to understand how goodwill comes about. When a company acquires a subsidiary, it usually pays a premium over the net asset value of the subsidiary. This premium will be booked as goodwill at the Group level.
Let’s say the Company A purchases Company B for 10, an excess of 5 over the Company B’s equity and in the process, making Company B a subsidiary.
As an intangible asset, goodwill is tested for impairment annually. If impaired, the impairment loss reduces earnings, total assets and consequently, equity. Assuming an impairment loss of 5, the accounts will look something like this.
If the impairment losses are legitimate (implying that the acquisition was overpriced), then the Group should be penalised and it makes sense to look at the Group level equity which one usually does. However, are there circumstances where booked impairment losses are a mere accounting quirk and are unwarranted?
It boils down to the organization structure of the Group. If the subsidiary was purchased under Group A and injected into Starhub, future earnings of the subsidiary will be booked under Starhub. Consequently, Group A will book an impairment loss because it theoretically paid for an asset that does not give it any return. However, it does not necessarily imply that Group A overpaid for the subsidiary. Unfortunately, the impairment loss of Group A will still be carried over to Group B’s balance sheet. Then, taking the Group B level equity will not be an accurate representation of the Group’s equity.
In Starhub’s case, one can never really confirm this based on the information furnished in the annual report and neither did Starhub’s investor relations furnish us with additional details, so take this to be purely conjecture. But more importantly, the concept is useful as it can apply to other companies as well.
What should we do then?
There are 2 ways an investor can adjust for this accounting quirk. The first, as suggested by Starhub’s investor relations, is to look at the company (Starhub) level equity as Group B’s equity will include the unwarranted impairment losses. Indeed, at the Group level, Starhub has SGD276.3m of goodwill written off. However, an investor who does this might also overlook legitimate losses or profits incurred by subsidiaries. This brings us to our second and preferred form of adjustments – reversing the goodwill that has been written off at the Group level to obtain the adjusted equity figure. Based on this method, Starhub will have a revised Group (Group B) equity of SGD386.9m versus the original SGD110.6m. This corresponds to a revised return on equity and debt to equity of 95.8% and 1.78x.
The post Starhub: A Lesson on Merger Accounting appeared first on ValueEdge.