• Although AAX’s proposed private placement, which precedes acquisitions of AAAGL and AAB, poses an earnings dilution risk, the unusual sequence is understandable as the company risks falling back into PN17 otherwise.
• AAX’s negative total equity position post-acquisition is not a concern since PN17 focuses only on shareholders’ equity, and the company is not obligated to contribute additional capital to subsidiaries in deficit.
• A difference in valuation methods between AAAGL and AAB, along with an equity transfer from AAB to AAAGL, may enable AAX to alleviate the unfair impact on goodwill recognition caused by reverse acquisition accounting.

While many investors seemingly loathe goodwill recognition, this prejudice likely stems from ignorance. The limited explanation of goodwill in the Malaysian Financial Reporting Standards (MFRSs), unfortunately, does not help: Appendix A of MFRS 3 vaguely and rigidly defines goodwill as “an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised.”

However, goodwill is an intuitive concept and can be easily understood when categorised into asset synergy and merger synergy. Asset synergy refers to the additional value from organising various tangible and intangible assets into a business capable of generating economic profit – this is why most companies are worth more when alive than dead. Merger synergy, on the other hand, is simply the additional value from combining two businesses, which may arise from increased market power or cost savings. With the FBMKLCI Index trading at a market capitalisation that is 55.9% above the total net assets, excluding reported goodwill, of its constituents, investors are effectively endorsing the existence of goodwill through their own actions.

Empirical evidence further supports the decision-usefulness of recognising goodwill as an asset. Value relevance studies by Chalmers et al. (2008), Horton & Serafeim (2010), and Oliveira et al. (2010) show that stock prices correlate positively with goodwill. The predictive power of goodwill has also been validated by Lee (2011) and Yehuda et al. (2017), who found positive correlations between goodwill and future cash flows/EBITDA. Undeniably, investors should welcome goodwill recognition as it enhances the relevance of financial reporting.

AAX-AAAGL: an unfortunate case

Despite the relevance of goodwill, the intangible asset can only be recognised during acquisitions [1]. Worse, not all acquisitions result in fair recognition of goodwill. One such case is AirAsia X Berhad’s (AAX) proposed acquisition of AirAsia Aviation Group Limited (AAAGL) for RM3 billion in AAX’s shares.

As existing shareholders of AAAGL would hold the largest voting rights in a combined entity of AAX and AAAGL, AAAGL would be treated as the accounting acquirer, based on guidelines provided in paragraph B15 of MFRS 3. This reverse acquisition would result in the recognition of a lesser amount of goodwill – RM474.4 million (see p.307 of AAX’s circular issued on 24th September 2024) – compared to an estimated RM5.8 billion if AAX were treated as the acquirer.

Worse, the reverse acquisition accounting would erode AAX’s equity, unlike in “usual” acquisitions where the acquirer’s equity would never fall (ignoring transaction costs) owing to goodwill recognition. While the shortfall in recognised goodwill could explain the equity erosion, an easier way to understand this is that existing shareholders of AAX would essentially be swapping their balance sheet for AAAGL’s balance sheet (see paragraphs B21 and B22 of MFRS 3), before accounting for the impact of the acquisition. Considering the “reset” in the initial equity balance from RM1.1 billion to negative RM2.8 billion, AAX's post-acquisition equity deficit of RM1.3 billion would represent a substantial improvement, thanks in part to goodwill recognition.

The expected equity erosion is likely the reason AAX is proposing a private placement to raise RM1 billion before acquiring AAAGL and AirAsia Berhad (AAB). Considering the non-cash nature of the proposed acquisitions, the timing of the private placement is unusual, as shareholders risk earnings dilution if those acquisitions do not materialise (see the list of conditions precedent on p.208-210 and p.216-218 of AAX’s circular). Nonetheless, risking earnings dilution is a much better trade-off than risking a return to PN17 status, as AAX’s shareholders’ equity would be negative post-acquisition without the private placement, triggering the criterion in paragraph 2.1(a) of Bursa Malaysia Securities Berhad’s Practice Note 17.

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A memory from the Jurassic Period

Despite the private placement, some veteran investors might worry about the potential need for additional equity funding by AAX post-acquisition, due to the combined entity’s total equity deficit of RM1.3 billion, which arises from a large negative equity balance of non-controlling interests (as seen on p.300 of AAX’s circular). Rummaging through MFRSs, this concern likely stems from an archaic accounting treatment for non-controlling interests, where losses attributable to non-controlling interests are allocated to majority owners when the equity of non-controlling interests is in deficit. This treatment suggests that majority owners are obligated to maintain subsidiaries in deficit as going concerns by contributing more capital when non-controlling interests abandon their investments.

Basis for Conclusions on MFRS 10

Paragraph BCZ160: “IAS 27 (as revised in 2003) stated that when losses attributed to the minority (non-controlling) interests exceed the minority’s interests in the subsidiary’s equity, the excess, and any further losses applicable to the minority, is allocated against the majority interest except to the extent that the minority has a binding obligation and is able to make an additional investment to cover the losses.”

Paragraph BCZ164(a): “The non-controlling interests are not compelled to cover the deficit (unless they have specifically agreed to do so) and it is reasonable to assume that, if the subsidiary requires additional capital in order to continue operations, the non-controlling interests would abandon their investments. In contrast, respondents asserted that in practice the controlling interest often has an implicit obligation to maintain the subsidiary as a going concern…”

However, the concern of those old-timers is overblown, as majority owners like AAX can also choose to abandon their investments in subsidiaries with negative equity. Affirming this fact, the International Accounting Standards Board, in 2005, conceded that the attribution of losses was inconsistent with the classification of non-controlling interests as equity and amended the guidelines such that non-controlling interests could show a deficit balance. In short, AAX’s negative equity balance after the proposed private placement and acquisitions should not worry investors who keep themselves abreast of the latest accounting standards.

Goodwill hunting

Amid the adversity, Capital A Berhad (Capital A) – the vendor of AAAGL and AAB – has seemingly found a creative way to boost the goodwill to be recognised by AAX, thereby alleviating the negative impact of the proposed acquisitions on AAX’s equity. This could be achieved by leveraging the asymmetric impact of a capital transfer on the goodwill to be recognised for acquiring AAAGL and AAB.

Unlike AAAGL, AAB would be treated as an acquiree, meaning AAB’s negative equity balance would not reduce AAX’s equity post-acquisition. Capital A might be making full use of this accounting treatment by proposing a pre-deal reorganisation that effectively transfers RM3.47 billion of equity from AAB to AAAGL before AAX acquires both companies [2]. This would improve AAAGL’s equity balance, thereby raising the combined equity of AAX and AAAGL, while the negative impact on the combined equity of AAX + AAAGL + AAB from a decline in AAB’s equity balance would theoretically be offset by a smaller amount of consideration to be paid out of AAX’s equity, assuming AAB is perfectly valued. Given that AAX’s shareholders’ equity would likely remain negative post-placement and post-acquisition without such action, the pre-deal reorganisation – despite its challenges [3] – is a logical move.

While the amount of goodwill to be recognised from acquiring AAB should theoretically be the same with or without the pre-deal reorganisation – since the consideration to be paid by AAX should decrease by the same amount as the equity transferred out of AAB – this is not always the case due to the discretion involved in valuing AAAGL and AAB.

Owing to the different valuation methods applied to AAAGL and AAB, the equity transfer likely impacted their valuations asymmetrically. The independent valuer valued AAAGL using the adjusted book value approach, while AAB is valued using the discounted free cash flow to firm approach, with the reason given being that AAB’s net assets “may not be reflective of their its future earnings capabilities” (p.256 of AAX’s circular). As shown on pages 263-264 of AAX’s circular and page 9 of Capital A’s circular, the capital injection from Capital A directly improved AAAGL’s valuation [4], while the impact of a “corresponding” dividend payment of RM3.47 billion by AAB on its own valuation is not clear. Intriguingly, RM1.44 billion in net cash has been added to AAB’s valuation as non-operating assets, even though the company was in a net debt position of RM2.01 billion (disregarding lease liabilities) as at the valuation base date of 31st December 2023. A potential explanation is that the valuer assumed that AAB would monetise RM3.45 billion worth of non-operating assets, say, inter-company debts currently owed by PT Indonesia AirAsia (IAA) and AirAsia Inc. (AAI)/Philippines AirAsia Inc. (PAA).

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Should Capital A manage to maintain AAB’s valuation notwithstanding the latter’s dividend declaration, AAX will be able to recognise a higher amount of goodwill, thereby alleviating the negative impact of reverse acquisition accounting. This would serve as a testament to the intangible expertise of Capital A, which has made AirAsia one of the most efficient airlines in the world. Inquisitive shareholders might want to enquire about the RM3.45 billion gap in valuing AAB during tomorrow’s EGM [5], though this is a minor concern. After all, equity valuation “cannot be regarded as an exact science” (p.257 of AAX’s circular).

[1] MFRS prohibits the recognition of internally generated goodwill, as it cannot be measured reliably, unlike purchased goodwill, which can be implied from acquisition prices.

[2] See p.2 and p.13 of Capital A’s circular issued on 20th September 2024, and p.221 of AAX’s circular. I omit the sale of AAX shares by AAB to Capital A from my discussion, as the purpose of the sale is to prevent AAX from ending up with its own shares.

[3] The declaration of a dividend amounting to RM3.47 billion by AAB to Capital A requires consent from creditors, which could be challenging to secure, given that AAB recorded an equity deficit of RM1.5 billion and accumulated losses of RM4.0 billion as at 31st December 2023 (p.436 of AAX’s circular). Given section 131(1) of Companies Act 2016, AAB’s accumulated losses and 1H24 loss of RM208.8 million (p.28 of AAX’s circular) also mean that the company would need to declare the dividend from its 2023 profit (p.311 of AAX’s circular) of RM3.6 billion, which was boosted by the disposal of the AirAsia brand. This likely establishes a hard deadline of 31st December 2024 for the dividend declaration. Considering these challenges and that AAX will eventually own both AAAGL and AAB, there ought to be strong rationales for the proposed pre-deal reorganisation.

[4] Although I failed to comprehend why the reassignment of intercompany debt amounting to RM1.15 billion owed by AAI/PAA was not included in the amount of capital injected.

[5] A potential question of interest is whether the independent valuer was informed of the proposed dividend payment by AAB and included it within “Capital A’s plan for reorganisation and capitalisation of debts” (p.258 of AAX’s circular), since the dividend payment could technically be segregated from the reorganisation plan.

References

Chalmers, Keryn; Clinch, Greg; and Godfrey, Jayne M. (2008). “Adoption of International Financial Reporting Standards: Impact on the Value Relevance of Intangible Assets,” Australian Accounting Review, Vol. 18(3), pp. 237–247.

Horton, Joanne; and Serafeim, George (2010). “Market Reaction to and Valuation of IFRS Reconciliation Adjustments: First Evidence from the UK,” Review of Accounting Studies, Vol. 15(4), pp. 725–751.

Oliveira, Lídia; Rodrigues, Lúcia Lima; and Craig, Russell (2010). “Intangible assets and value relevance: Evidence from the Portuguese stock exchange,” British Accounting Review, Vol. 42(4), pp. 241–252.

Lee, Cheol (2011). “The Effect of SFAS 142 on the Ability of Goodwill to Predict Future Cash Flows,” Journal of Accounting and Public Policy, Vol. 30(3), pp. 236–255.

Yehuda, Nir; Vincent, Linda; and Lys, Thomas (2017). “The nature and implications of acquisition goodwill,” Asia-Pacific Journal of Accounting & Economics, Vol. 26(6), pp. 709–730.