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11 Mergers and acquisitions Introduction Accounting for acquisitions and mergers has long been a controversial area of accounting. In particular, there have been disputes about whether the technique of merger accounting should be permitted, and about the nature and accounting treatment of goodwill. Changes in US accounting rules in this area shortly before the IASB was formed led to changes in IFRS; IFRS 3 ‘Business combinations’ was published in March 2004 and is the extant standard on this topic (with a revised version shortly to supersede it – see below). In a nutshell, merger accounting is no longer permitted in IFRS, although the scope of IFRS 3 does not extend to group reconstructions where the use of merger accounting has been, and continues to be, prevalent in the UK. Goodwill is no longer amortised; IFRS 3 requires goodwill to be carried at cost less any accumulated impairment losses. IFRS 3 was the output of Phase I of the IASB project on business combinations. Phase II, which was a joint project with the FASB (the US standard setter), sought to improve and align further the accounting for business combinations. Phase II was recently completed and a revised version of IFRS 3 was published in January 2008. It is effective for business combinations for which the acquisition date is on or after the start of the accounting period beginning on or after 1 July 2009. For a company with a calendar reporting period, it is effective for business combinations made on or after 1 January 2010. Some of the changes to IFRS 3 are controversial and reflect a desire for the standard to move away from the parent entity perspective to the economic entity concept. Much of the standard nevertheless remains the same and in this chapter we highlight separately the key changes introduced in Phase II. UK law sets out some details about acquisition and merger accounting, although, with the exception of the provisions about share premium, merger relief and group reconstruction relief, these do not apply to entities applying IFRS. Current UK GAAP rules are found in FRS 6 ‘Accounting for acquisitions and mergers’, FRS 7 ‘Fair values in acquisition accounting’ and FRS 10 ‘Accounting for goodwill and intangibles’. Under these, merger accounting is still permissible in limited circumstances as well as in group reconstructions and, when acquisition (rather than merger) accounting is applied, goodwill is 100 Mergers and acquisitions carried at cost and amortised unless it is regarded as having an indefinite useful economic life, in which case it is not amortised, but is reviewed annually for impairment. Overview of acquisition and merger accounting Introduction The generic term applied where one company, or group of companies, acquires or merges with another company or group of companies is a ‘business combination’. Once a business combination has taken place, say, Fast Growing Group Plc acquires Newcomer Plc, this must be reflected in the financial statements. Assuming that Fast Growing Group Plc bought all the issued shares of Newcomer Plc, the business combination will be accounted for in the group financial statements of Fast Growing Group Plc using either acquisition or merger accounting, except that in IFRS merger accounting is no longer allowed. In the international arena, the terms ‘purchase method’ and ‘acquisition accounting’ are both used, with the original version of IFRS 3 using the former, while the 2008 revised version of IFRS 3 uses the latter. Since ‘acquisition accounting’ is the term used in the revised version, we will use this term throughout this chapter. Summary of acquisition accounting Key features of acquisition accounting (under IFRS and UK GAAP) are as follows: r One of the companies is treated as the acquirer for accounting purposes. r The assets and liabilities of the acquired company are restated to reflect fair values at the date of acquisition. r The numbers of one or both of the combining companies (but typically those of the acquired company) are restated, where necessary, to harmonise accounting policies for the enlarged group. r The income statement/statement of comprehensive income for the year of acquisition comprises the results for the whole of the current year for the acquiring group together with the results for the post-acquisition period only of the acquired company. The comparative figures are those of the acquiring group only. The same principle is used for the cash flow statement. r The balance sheet at the start of the year of acquisition is that of the acquiring group only. The balance sheet for any date after the acquisition includes also the net assets of the acquired company. r Goodwill arises and is recognised in the group balance sheet; it is generally positive, but can be negative. 101 Accounting Principles for Non-Executive Directors r The fair value of the net assets acquired is brought into the consolidated balance sheet in place of the capital and reserves of the acquired company at the date of the acquisition. It follows from this that the group reserves at any year end after acquisition comprise the reserves of the acquiring group and its share of the post-acquisition retained reserves of the acquired company. The pre-acquisition reserves of the acquired company remain in that entity, but do not form part of the consolidated reserves of the enlarged group. It will be noted that the acquisition accounting presentation shows growth as a result of the combination. Thus an acquisitive group can, in its headline figures, give the appearance of growth even though the underlying businesses may be stagnant. However, various required disclosures (under IFRS and UK GAAP) show whether growth is organic or bought-in. In an acquisition, the acquirer (Fast Growing Group Plc) pays to buy the shares of the acquired company, the acquiree (Newcomer Plc). Having bought all of the shares in another company, the acquirer now controls the business(es) of that other company and needs to account for it/them. It accounts for them in its consolidated financial statements as it does all the other businesses that it controls, that is, it brings in each asset and liability of the business on a line-by-line basis. As its name suggests, the thinking underlying acquisition accounting is that the acquirer has purchased these businesses (and thus the underlying assets and liabilities) and must account for this as it would the acquisition of any asset. Since, in its group financial statements, it brings in each asset and liability of the acquired entity (rather than simply bringing in the shares that it has bought), it needs to work out how much of the total payment was for each asset and liability. The fair values of the assets and liabilities of the acquiree on the date of acquisition are calculated and it is assumed that these are what the acquirer would have paid for them individually and so it is at these amounts that they are brought into the consolidated financial statements on acquisition. In addition, the acquirer is required to calculate what it paid for the shares. Where cash was paid, it is a case of simply adding up how much cash was paid out. If the acquirer paid partly in cash and partly in something else, or wholly by some other means, it is necessary to work out how much that was worth so that the accounting entries can be made. For example, if shares were given, their value has to be determined. Where the cash is paid out at a later date, rather than immediately, the cash to be paid out is discounted back to its value at the date of acquisition. In this way, the fair value of what was paid is calculated. Where all of the acquiree’s shares were purchased, the difference between the total paid out (the fair value of what was given to the vendor) and the sum of the fair value of the individual assets and liabilities acquired is goodwill, positive or negative. 102 Mergers and acquisitions So, for example, assume that: r FGG acquires 100 per cent of N; r N’s net assets at book value are 70, but when stated at fair value are 90; r FGG pays shares worth 115 plus 10 in cash; total consideration 125. The (positive) goodwill is 125 – (90 × 100%) = 35. As we saw in chapter 8, it is not necessary to own 100 per cent to acquire a subsidiary. Now, for example, assume that: r FGG acquires 80 per cent of N; r N’s net assets at book value are 70, but when stated at fair value are 90; r FGG pays 93 in shares plus 10 in cash; total consideration 103. Under the current version of IFRS 3 (and UK GAAP), the (positive) goodwill is 103 – (90 × 80%) = 31. On acquisition, FGG would still record the fair value of N’s assets and liabilities in full, namely, 100 per cent of each asset and liability. A minority (or non-controlling) interest is then presented, which in IFRS financial statements must be presented in equity, equal to 20 per cent of N’s net assets just recognised in FGG’s group financial statements, i.e. the minority interest recognised on the date of acquisition is 18. In UK GAAP financial statements, the minority interest is presented either in equity or as a deduction from net assets. A choice is allowed in the revised version of IFRS 3: either the goodwill and minority interest are calculated as above; or the goodwill can be ‘grossed-up’ to include the minority’s share. For example, assume that, as before: r FGG acquires 80 per cent of N; r N’s net assets at book value are 70, but when stated at fair value are 90; r FGG pays 93 in shares plus 10 in cash; total consideration 103. In addition, assume that: r the remaining shares representing 20 per cent of N are valued at 22 (less per share than the 80 per cent stake acquired as the 80 per cent stake included a premium for obtaining control). Under the alternative option, the (positive) goodwill is (103 + 22) – (90 × 100%) = 35. The minority (or non-controlling) interest is then presented, in equity, on the date of acquisition as 22 (not the 18 under the earlier option). This alternative, ‘grossing up’, option is derived from US GAAP and we believe that it is unlikely to be widely adopted among UK companies that follow IFRS. From a practical point of view, the step up in asset values to fair value, which is a fundamental part of acquisition accounting, leads to increased charges for depreciation and greater risk of impairments. Additionally, goodwill arises; in service and technology company acquisitions this can be a very large component of the overall value. Any impairment (or, in UK GAAP, amortisation) 103 Accounting Principles for Non-Executive Directors of goodwill hits reported profits. Furthermore, goodwill on the balance sheet increases the reported capital employed, which worsens the return on capital employed ratio; on the other hand, it improves gearing. Summary of merger accounting The key features of merger accounting (UK GAAP only) are as follows: r Neither company is treated as the acquirer for accounting purposes. r There is no restatement of the carrying values of the assets of either merging company to reflect fair values. r No goodwill arises (although any goodwill already in the balance sheet of either party to the merger as a result of previous acquisitions remains there). r The income statement is presented on an aggregated basis, as if the two companies had always been merged. The same principle is used for the cash flow statement. r The balance sheets, both pre and post the combination, are aggregated in a similar way, as if the two companies had always been combined. r The numbers of one or both of the combining companies are restated, where necessary, to harmonise accounting policies for the enlarged group. r The reserves of the two companies are combined to form the group reserves; there is no elimination of pre-acquisition reserves. r Despite the notions of equality, as a practical matter one company – either one of the two merging companies, or a new holding company superimposed – becomes the top company in the group’s legal structure, and is the one that issues shares to the former shareholders of the other company(ies). It will be noted that, in the financial statements of the year of a merger, the merger accounting presentation shows no growth as a result of the combination. This is because comparative figures are restated as if the two companies had always been merged. Any growth in the numbers would reflect growth in the underlying businesses. For third-party transactions, merger accounting is not commonly used in UK GAAP as the criteria are restrictive and is not used at all in IFRS. However, it is used in accounting for group reorganisations, such as when a ‘newco’ is inserted or a group of subsidiaries is moved from one part of a group to another. Application of IFRS 3 The current international standard on business combinations is IFRS 3. For business combinations for which the acquisition date is on or after the first day of the first accounting period starting on or after 1 July 2009, a revised version of IFRS 3 (referred to here as IFRS 3 (2008)) will apply. Key changes 104 Mergers and acquisitions to be introduced by IFRS 3 (2008) are highlighted. For companies with a 31 December year end, IFRS 3 (2008) will apply to acquisitions made on or after 1 January 2010. Merger accounting banned Unlike the predecessor standard (IAS 22), IFRS 3 bans the use of merger accounting: all business combinations (excluding group reconstructions, which are outside the scope of IFRS 3) should be accounted for as acquisitions. That is, an acquirer should be identified for accounting purposes even if the two parties are of similar size and describe the combination as a merger. Merger accounting has, except in the context of group reconstructions, been quite rare in recent years, and it has gradually become discredited. This is largely because it is almost impossible to develop criteria that effectively distinguish genuine mergers. The view, particularly of the standard-setters, is that, even when restrictive criteria are used, some combinations that meet the criteria are in fact acquisitions in substance and an acquirer is identifiable. Perhaps there are genuine mergers, but they are so rare in the business environment, and so difficult to identify, that it is not worth having a different method of accounting just to get the accounting right for those few, if the result is getting the accounting wrong for some of the combinations that should properly be presented as acquisitions. Thus, IFRS 3 bans merger accounting. However, IFRS 3 does not include group reconstructions in its scope and thus merger accounting principles continue to be used in intra-group transactions, in the short term at least. Acquisition accounting under IFRS 3 In an acquisition, one party gains control over the other. Control is a question of fact – does one party have the power to govern the financial and operating policies of the other? There is a presumption that acquisition of more than one-half of the voting rights of another entity confers control. The key features of acquisition accounting generally are set out above under ‘Summary of acquisition accounting’ and apply equally to IFRS 3 (both the current version and IFRS 3 (2008)) and UK GAAP. There are, however, two key differences between IFRS 3 and UK GAAP and these are in the areas of goodwill and intangibles. The first difference is that IFRS 3 requires that more separate intangibles be identified than previous standards, and than UK GAAP, and this has the effect of reducing the residual amount attributed to goodwill. Recognising intangibles is discussed later – see goodwill and other intangibles. Second, there is a different approach to amortisation of goodwill. Goodwill is not amortised at all under IFRS 3. It is tested for impairment annually. This means that if the goodwill is shown to have at least retained its value, there is no charge in arriving at profit/loss. However, if there is shown to 105 Accounting Principles for Non-Executive Directors have been an impairment, there is an immediate charge to write down the goodwill to its recoverable amount. Under UK GAAP, although goodwill is in some circumstances subject to an annual impairment review in place of annual amortisation, in practice this route is less common than annual amortisation over a twenty-year life. IFRS 3 (2008) introduces an alternative way of calculating goodwill from that in the current version of IFRS 3 and UK GAAP – see above under ‘Summary of acquisition accounting’. Fair value of the consideration given The cost of acquisition of the shares in the new subsidiary has to be measured at fair value for group accounts purposes. Most commonly, the consideration given for the acquisition of a new subsidiary will include cash paid or securities issued by the acquiring company, such as its equity or loan stock. When securities are issued, their fair value needs to be established. If they are quoted securities, this is given by their market value. If they are not quoted, a range of valuation techniques is available. The question arises as to what date should be used. Where control is achieved in a single transaction, rather than a holding being gradually built up over a period, the price used is that on the date of acquisition. Using one date or another can make a big difference. This was the subject of a Review Panel press release in 2006, albeit under UK GAAP, in which it was announced that the directors of the particular company had agreed to change the accounting and value the shares on a different date (when the value was 7.25 pence per share) to the one they had originally used (when the value was 12.475 pence per share). The exception to using acquisition date price is where the share price on that date has been affected by the thinness of the market. Where the payment involves a contingent element, the treatment differs between IFRS 3 and IFRS 3 (2008). Contingent consideration often forms part of consideration paid – for example, additional cash consideration will be paid if profits post-acquisition exceed a specified amount. Where such payment is probable and can be measured reliably, the fair value of such amount (e.g. discounted to reflect the time value of money) is included as part of the cost of consideration under IFRS 3, whereas under IFRS 3 (2008) the fair value of the amount is included irrespective of whether its payment is probable. In the post-acquisition period, adjustments are made to the estimate of contingent consideration payable and, under IFRS 3, these are adjusted against goodwill. IFRS 3 (2008), on the other hand, requires such adjustments (that are beyond one year from the acquisition date) to be charged or credited in arriving at profit/loss. Under the current version of IFRS 3, acquisition expenses, such as legal fees and necessary due diligence, are added to the fair value of the consideration paid to give the total cost of acquisition. IFRS 3 (2008), however, precludes 106 Mergers and acquisitions the acquisition expenses from being treated as part of the cost of acquisition; instead they have to be expensed in the group financial statements in arriving at profit/loss. Fair value of the net assets acquired In preparing the consolidated financial statements, the cost of investment, which is itself given by the fair value of the consideration given, is disaggregated into the fair value of the separable net assets acquired, with the residue forming part, or all, of goodwill. This is often referred to as the ‘fair value exercise’ or ‘purchase price allocation’. Detailed rules relating to the fair value of the net assets acquired are set out in IFRS 3. Fair value is defined by IFRS 3 (and IFRS 3 (2008)) as ‘The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction’. It follows that market values, such as quoted prices, should be used if available. Although fair value is the general principle, IFRS 3 and IFRS 3 (2008) set out some specific rules that must be applied to particular assets and liabilities. Two important practical questions are which assets and liabilities should be recognised, and from what perspective should they be fair valued. It is only the assets and liabilities, including contingent liabilities, of the acquired entity that existed at the date of acquisition that are to be recognised in the fair value exercise. They are to be reflected based on their condition at the date of acquisition; thus, how the acquiror is to alter them in the future does not affect the amount at which they are to be recognised. In fact, the definition of ‘fair value used’ means that the value is not affected by how profitably or unprofitably the acquired entity was using the asset nor how profitably or unprofitably the acquiror will use the asset; it is the amount that a third party would pay for the asset that is included in the accounts. If an asset has been badly damaged in the past and not repaired, this will be reflected in its fair value. The major example of how this impacts the accounts is that often an acquirer will wish to reorganise the target after acquisition, frequently involving redundancies and integration of the target into the acquirer’s group. Under earlier accounting practice, it used to be possible to provide for the costs of such reorganisations as part of the fair value exercise. This had a beneficial effect on the post-acquisition results, as the reorganisation cost, when incurred, could be charged against the provision that had been established, and hence did not appear as a charge in arriving at profit/loss for the period. However, this is no longer possible. Planned expenditure on reorganisation cannot be provided for, as it is not a liability of the target. It has to be charged in arriving at profit/loss of the enlarged group when incurred. However, where the target company was itself committed to a restructuring before the acquirer intervened, the acquired entity has a liability at the date of acquisition for that restructuring and so this would be included in the fair value exercise. 107 Accounting Principles for Non-Executive Directors The exception to ignoring the acquiror’s intentions and to including the net assets at fair value is if the acquirer intends to dispose of unwanted portions of the acquired business; IFRS 3 requires non-current assets and disposal groups (including subsidiaries) that are classified as held for sale in accordance with IFRS 5 to be carried at fair value less costs to sell. Any contingent liabilities of the acquired entity are included in the fair value exercise, and thus in the post-acquisition consolidated balance sheet of the group. As with the other net assets, they are included at fair value. Intuitively, this can seem an odd approach; contingent liabilities are generally only included in balance sheets if it is probable that there will be an outflow of resources (see chapter 14). However, as explained above, the objective of the fair value exercise is to record what the acquirer has purchased and record it at the price paid. Hence, if an acquired entity had a contingent liability under which it was possible, but not probable, that it would need to pay out cash, this must be included in the fair value exercise and hence the group financial statements, even though it does not appear in the balance sheet of the financial statements of the acquired entity. If an entity were to take on a potential liability from another entity, it would do so only if it received a sufficient amount of compensation in return; this is the amount at which the contingent liability would be recorded in the fair value exercise. Future developments in IFRS The IASB is now embarking upon a project to consider the accounting for business combinations under common control, mainly group reconstructions, which are currently outside the scope of IFRS 3 and IFRS 3 (2008). In addition, the project will consider the accounting for demergers, such as the spin-off of a subsidiary or business. Goodwill and other intangibles Goodwill and other intangibles are quite similar to each other in many respects. At the margin, it is hard to distinguish one from the other. Nevertheless, in one sense, they are treated very differently, namely that in acquisition accounting, separate intangibles, to which a fair value is ascribed, are accounted for much like any other separable asset such as inventory or plant. In contrast, goodwill is the residue that remains. Additionally, under IFRS 3, the income statement treatment can be very different. A difficult question in many fair value exercises is to what extent to identify amounts as relating to separate intangibles, and to what extent they should be subsumed within goodwill. Under IFRS 3 and IFRS 3 (2008), generally speaking, more intangible assets will be separately accounted for than under FRSs 7 and 10 in UK GAAP. IFRS 3 requires intangible assets of the acquired entity that meet the definition of intangible asset in IAS 38 to be recognised in 108 Mergers and acquisitions the fair value exercise, providing their fair value can be measured reliably. The effect of applying IFRS 3 (2008) is similar. The definition of intangible asset in IAS 38 is ‘an identifiable non-monetary asset without physical substance’. Key to this definition is the meaning of ‘identifiable’; under IAS 38 an asset is identifiable if it is either separable or arises from legal rights (whereas under UK GAAP an intangible asset has to be separable from the business in order for it to be recognised). Examples of intangible assets that may be recognised in a business combination under IFRS include: marketing-related intangibles (including trademarks, newspaper mastheads and non-competition agreements); customerrelated intangibles (including customer lists and non-contractual customer relationships); artistic-related intangible assets (including plays, operas and ballets and musical works such as compositions); contract-based intangibles (including franchise agreements and servicing contracts); and technologybased intangibles (such as databases and trade secrets). A list of identifiable intangibles may be found in the illustrative examples at the back of IFRS 3. The IASB’s principle is sound, namely that the more a company can identify exactly what it has bought, the more informative the financial statements will be. However, practical implementation issues arise, as the valuation of such intangibles is problematical. Part of the recognition criteria under the current version of IFRS 3 is that the fair value of the intangible asset can be measured reliably, and although IFRS 3 (2008) does not explicitly refer to ‘measured reliably’, this is brought in via the Framework’s guidance on recognition. The reference to reliable measurement does not mean that there needs to be a market value. Indeed, there are not many examples of intangibles with a market value. However, there are techniques by which, for example, licences can be valued. In practice, a degree of professional judgement is applied in deciding whether in a particular instance an intangible should be recognised separately from goodwill or subsumed within goodwill. There has been considerable controversy among accountants over the decades as to what goodwill is and how it should be accounted for. For many years, in the UK and elsewhere, it was common practice to write off goodwill to reserves immediately upon acquisition of the business. As a result, it did not feature on the balance sheet, neither did the calculation of profit/loss reflect any charges in respect of its amortisation or impairment. However, since the introduction of FRS 10 in the UK in 1998, it has been necessary to treat goodwill as an asset and, with exceptions, to amortise it against earnings. Under IFRS 3, goodwill is carried on the balance sheet as an asset, but it is not amortised; instead, it is tested annually for impairment. An impairment review is an onerous exercise, and it carries the risk that it will identify that a significant impairment write-down is necessary. Any necessary impairment charges are expensed in arriving at profit/loss. As explained above, under summary of acquisition accounting, in the current version of IFRS 3 and in UK GAAP, goodwill is the difference between 109