Purchase Accounting for a Merger or Acquisition
Mergers and acquisitions (M&A) occur when businesses combine to achieve corporate objectives. In an acquisition, a company purchases another company’s assets, identifiable business segments, or subsidiaries. In a merger, a company purchases another company in its entirety. In either situation, there is a union of businesses. Along with mergers and acquisitions come special accounting principles. This guide will cover purchase accounting for mergers and acquisitions.
The Acquisition Accounting Process
Accounting for an M&A transaction can be broken down into the following steps:
- Identify a business combination
- Identify the acquirer
- Measure the cost of the transaction
- Allocate the cost of a business combination to the identifiable net assets acquired and goodwill
- Account for goodwill
#1 Identify a business combination
The main purpose of a business combination is to achieve some form of synergy. In the combination, the acquirer hopes to assume control of the acquiree. Numerous legal, taxation or other business-related strategies may be used to structure an M&A deal. When analyzing an M&A, a common approach is the acquisition method, wherein the deal is viewed from the perspective of the combining entity that is identified as the acquirer. The acquirer assumes control of the acquiree’s assets, liabilities, and any other business pieces pertinent to the acquiree’s operations.
#2 Identify the acquirer
In every business combination, there is always an acquirer, the party that retains control of the combined entity. Control is defined as “power to govern the financial and operating policies of an entity or business so as to obtain benefits from its activities.” In most combinations, an entity is said to have obtained control when it acquires more than one-half of the other entity’s voting rights, unless such a majority stake does not constitute control. Although it may be difficult to identify an acquirer in an M&A, indicators of the acquirer may include:
- The entity with the greater fair value, if there is a significant difference, is likely to be the acquirer; or
- The entity giving up cash or other assets in the deal is likely to be the acquirer; or
- The entity whose management is the definitive dominator in the deal is likely to be the acquirer
These are only possible factors in assessing control. Numerous factors are involved in determining which entity has the power to govern the financial and operating policies of the post-merger firm.
There also exist reverse acquisitions. In a reverse acquisition, the acquirer is the entity whose equity interests have been acquired and the issuing entity is the acquiree. For example, a private entity arranges to have itself ‘acquired’ by a smaller public entity as a means of obtaining a stock exchange listing. In actuality, this private entity is the acquirer if it has the power to govern the financial and operating policies of the legal parent. Note that the acquirer need not be the larger of the two entities.
#3 Measure the cost of the transaction
The cost of a business combination is the sum of:
- The fair values, at the acquisition date, of assets, liabilities (incurred or assumed), and equity instruments issued by the acquirer; plus
- Any costs directly attributable to the business combination.
The acquisition date is the date on which the acquirer effectively obtains control of the acquiree. Assets given and liabilities incurred or assumed by the acquirer must be measured at their fair values at the date of acquisition. If any of the cost of a combination is deferred, the fair value of that deferred component is calculated by discounting the amounts payable to their present value at the date of acquisition, including any premium or discount likely to be incurred in the settlement.
Fair value guidance
The published price at the date of exchange of an equity instrument provides the best measurement of value and is used except in rare circumstances. Other valuation methods should be considered only if the acquirer can demonstrate that the published price at the date of exchange is an unreliable indicator of fair value and that the other evidence and valuation methods more reliably measure fair value. If the published price at the date of exchange is an unreliable indicator, the fair value of those instruments can, for example, be estimated by referencing their proportional interest in the fair value of the acquirer or the proportional interest in the fair value of the acquiree obtained, whichever is the clearer measurement.
Directly attributable costs of the business combination
Directly attributable to a combination include professional fees paid to:
- Legal advisers
- Valuators and other consultants to affect the combination
Under new M&A accounting rules, the costs are treated as expenses in the period of service. General administrative costs are recognized as an expense when incurred. General administrative costs, including the acquisition’s department maintenance cost, that are not traceable to a particular combination are not included in the cost of the combination; they are instead expensed when incurred. Furthermore, costs incurred while dealing with financial liabilities are not included in the cost of a business combination. They should instead be included in the initial measurement of the liability.
Deferred and contingent acquisition costs
There are circumstances when the acquisitions costs will not only be deferred but may also be contingent on future events, often linked to the future profitability of the acquired business. The contingency will be included in the cost of the acquisition if the payment is probable and can be reliably measured. Deferred consideration is discounted back to present value to determine its fair value. Consider the following example:
Jenas PLC acquires the entire ordinary share capital of Shearer Ltd. Shearer’s been profitable, with an average net income per year of between £2,950,000 and £3,250,000 over the last 8 years.
Jenas agreed as part of the acquisition cost to pay an additional £1,000,000 to the previous owners of Shearer if over the next three years the average profitability of Shearer exceeds £3,000,000 at the net income level.
Given the historical profitability of Shearer, it is probable that the payment will be made in 3 years’ time. Therefore, the deferred contingent consideration will be included in the cost of the acquisition at the acquisition date.
If at any stage there is evidence to suggest that the deferred contingent payment is unlikely to be paid (not probable), the cost of the acquisition should be adjusted with a subsequent amendment made to goodwill.
From the shareholders of the acquiree’s perspective, being acquired with equity issued by the acquirer carries its own risks. For instance, the acquiree faces the risk that the equity instruments issued by the acquirer will lose value. In some acquisitions, the acquirer agrees to issue additional equity instruments to the acquiree if the fair value of the equity instruments given initially as consideration for the purchase falls below a particular level.
#4 Allocate the cost of a business combination
The acquirer should, at the acquisition date, allocate the cost of a business combination by recognizing the acquiree’s identifiable assets, liabilities, and contingent liabilities that satisfy the recognition criteria at their fair values at that date. Differences between the cost of the business combination and the acquirer’s interest in the net fair value of the identifiable assets, liabilities, and contingent liabilities should be accounted as goodwill.
An acquirer should use the following notes to determine fair value:
|Allocation of acquisition cost||Fair value determination|
|Financial instruments traded in active market||Current market values|
|Financial instruments not traded in an active market||Use estimated values of comparable instruments of entities with similar characteristics|
|Receivables, beneficial contracts and other identifiable assets||Present values of the amounts to be received, determined at appropriate current interest rates, fewer allowances for uncollectibility and collection costs|
|Inventories of finished goods and merchandise||Selling prices less the sum of the costs of disposal and a reasonable profit allowance for the selling effort of the acquirer|
|Inventories of work in progress||Selling prices of finished goods less the sum of:|
• Costs to complete
• Costs of disposal
• A reasonable profit allowance for the completing and selling effort based on profit for similar finished goods
|Inventories of raw materials||Current replacement costs|
|Land and buildings||Market values|
|Plant and equipment||Market values |
(An acquirer may need to estimate fair value using an income, cash flow or a depreciated replacement cost approach if no current market values are given)
|Intangible assets||Determine fair value:|
• By reference to an active market
• If no active market exists, on the basis that reflects the amounts the acquirer would have paid for the assets based on the best information available
|Net employee benefit assets or liabilities for defined benefit plans||The present value of the defined benefit obligation less the fair value of plan assets|
|Accounts and notes payable, long-term debt, liabilities, accruals and other claims payable||The present values of amounts to be disbursed in settling the liabilities determined at appropriate current interest rates.|
|However, discounting is not required for short-term liabilities when the difference between the nominal and discounted amounts is not material.|
|Onerous contracts and other identifiable liabilities||The present values of amounts to be disbursed in settling the obligations determined at appropriate current interest rates|
|Contingent liabilities||The amounts that a third party would charge to assume those contingent liabilities. Such an amount should reflect all expectations about possible cash flows.|
Recognizing acquired assets and liabilities
The acquirer should recognize separately the acquiree’s identifiable assets, liabilities, and contingent liabilities at the acquisition date only if they satisfy the following criteria at that date:
- In the case of an asset other than an intangible asset, it is probable that any associated future economic benefits will flow to the acquirer and its fair value can be measured reliably.
- In the case of a liability other than a contingent liability, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation and its fair value can be measured reliably
- In the case of an intangible asset or a contingent liability, its fair value can be measured reliably.
The acquirer’s income statement should incorporate the acquiree’s profits and losses after the acquisition date by including the acquiree’s income and expenses based on the cost of the business combination to the acquirer.
Acquiree’s identifiable assets and liabilities
Subject to the recognition criteria, the acquirer recognizes separately, as part of allocating the cost of the combination, only the identifiable assets, liabilities, and contingent liabilities of the acquiree that existed at the acquisition date. Therefore, the acquirer should:
- Recognize liabilities for terminating or reducing the activities of the acquiree as part of allocating the cost of the combination. This is only recognized when the acquiree has, at the acquisition date, an existing liability for restructuring in its accounts; and
- Not recognize liabilities for future losses or other costs expected to be incurred as a result of the business combination.
Acquiree’s intangible assets
An intangible asset should be recognized at cost of the acquisition at fair value. An acquirer should recognize separately an intangible asset of the acquiree at the acquisition date only if it satisfies the definition of an intangible asset:
- Separately identifiable
- A resource that is controlled by the entity
- A probable source of future economic benefits
- Its fair value can be measured reliably
An asset meets the identifiability criterion in the definition of an intangible asset if it:
- Is separable (traceable); or
- Arises from contractual or other legal rights.
For identifiability, separability, as well as contractual and legal rights, are taken into account. Accounting principles want to reflect that an entity’s equity value is reflected in the value of its intangible assets. Under previous accounting rules, the identifiability of separate net assets relied purely on the ability of the entity to identify an asset or liability separately. Current accounting rules examine the amount an acquirer is willing to pay for an acquisition and allocate it through a more thorough set of intangible asset recognition criteria. Note that not all items that are deemed to add value to the entity in question should be recognized separately. This is usually because the entity does not control the resource in question. For example, the skills of a workforce embodied in a group of people do not meet the intangible asset definition, as the entity often has insufficient control over the actions of the group. In conclusion, the skills of a company’s workforce do not qualify as a separate intangible asset.
In-process research and development
Under IFRS, the expenditure during the research of an in-process research and development (IPRD) project must be expensed. However, subsequent expenditures during the development phase of a project (the commercial development of existing research knowledge) may be capitalized post-acquisition. Under US GAAP, neither past expenditure on research nor on development is treated as a separable asset acquired as part of the acquisition.
Separately recognized intangible assets
- Trade names
- Non-compete agreements
- Customer lists
- Patented technology
#5 Accounting for goodwill
On the date of acquisition, goodwill arising from the business combination should be recognized in the balance sheet of the acquirer as an intangible asset. The asset is measured as the excess of the acquisition cost over the acquirer’s interest in the fair value of the assets acquired and the liabilities assumed.
A detailed summary of the goodwill calculation is illustrated below:
The goodwill sits as an intangible non-current asset on the balance sheet of the acquiring entity. It is not amortized but is tested for impairment periodically.
Discounts on acquisitions (negative goodwill)
Negative goodwill arises when the acquisition cost of a business combination is less than the fair value of the net assets acquired. If the initial calculation of the goodwill is deemed appropriate, the negative goodwill is written off and a gain is recognized in the income statement. Negative excess is recognized immediately in profit or loss for the period.
Minority interest in purchase accounting
A minority interest is a portion of profit or loss and net assets of a subsidiary attributable to equity interests that are not owned, directly or indirectly through subsidiaries, by the parent.
Consider the group structure below. The parent company owns 75% of the equity voting share capital of the subsidiary. The rest of the voting share capital of the subsidiary is owned by parties external to the group shareholders.
The minority interest in the income statement represents the appropriation of profit that is owned by parties outside the group shareholder structure.
A more comprehensive example of minority interest is available in the full investment banking training manual.
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