AC330 Financial Accounting, Analysis and Valuation

Lecture 5
Accounting for business combinations II
Merger accounting

Lecturer: Dr Vasiliki Athanasakou

Office number: Old 2.20 (Old Building)

AC330 Lecture 5 –
Accounting for Business Combinations II

Methods to account for groups:

Full consolidation:
– Purchase (or ‘Acquisition’) accounting
• Lectures 3 & 4
– Merger accounting
• Lecture 5
– ‘Fresh‐start’ accounting
• Will be discussed

AC330 Lecture 5 –
Accounting for Business Combinations II
Topics and detailed reading list

Topic Accounting for Business Combinations II

Merger Accounting
Conditions under which merger accounting was
thought appropriate; preparing the CBS and CIS under
merger accounting;
Reading Lewis and Pendrill (2004) Chapters 13 and 14.
Elliott and Elliott (2012) Chapter 22.
Relevant IAS 27 Consolidated and Separate Financial Statements
accounting IFRS 3 Business Combinations
standards
Lecture Slides Lecture 5

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 AC330 Lecture 5 –
Accounting for Business Combinations II
Group structures – Example 3

New Holding Company

H&S

Subsidiary Company Subsidiary Company

H S

AC330 Lecture 5 –
Accounting for Business Combinations II
Example 3 ‐ Real case
In January 2000, Glaxo Wellcome and SmithKline Beecham announced their
$76bn proposed merger and shareholders approved by 99% majority of
shareholders.

GlaxoSmithKline

Glaxo Wellcome SmithKline Beecham

Share Deal:
For each Glaxo Wellcome share – 1 GlaxoSmithKline share
For each SmithKline Beecham share – 0.4552 GlaxoSmithKline shares.

AC330 Lecture 5 –
Accounting for Business Combinations II

Why merger accounting?

A combination on equal footing (pooling of interests)

Astra Zeneca

Now banned by IFRS3 (and in US by SFAS141)!

But… conceptually relevant

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 AC330 Lecture 5 –
Accounting for Business Combinations II

Merger Accounting – Lecture outline

– FRS6 definition and criteria for merger accounting

– Acquisition vs. merger accounting
– Merger relief
– Method
– Controversy!

AC330 Lecture 5 –
Accounting for Business Combinations II
Definition of Merger
• Combination on equal footing – no resources leave the group (FRS
6 definition*):
– a business combination that results in a new reporting entity
– the shareholders of the combining entities come together in a
partnership for the mutual sharing of risks and benefits
– no party in substance obtains control over the other or is
otherwise seen to be dominant
• If met criteria, HAD TO use merger accounting,
otherwise HAD TO use acquisition accounting
*NB: no longer relevant to listed companies

AC330 Lecture 5 –
Accounting for Business Combinations II
Aim of merger accounting
Companies have simply pooled interests so present the group
accounts as if always operating as one
– Book values of assets used even if fair values different
– Reserves are aggregated – no distinction between pre‐ and
post‐acquisition
– Only adjustments required relate to adoption of uniform
accounting policies, and elimination of inter‐company
transactions (and unrealised profits) and balances

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 AC330 Lecture 5 –
Accounting for Business Combinations II
Merger Accounting – The good news
• Merger accounting is a lot more straightforward
– No share premium
– No goodwill to calculate and amortise
– No fair values
– No pre‐acquisition profits
• But – still need to deal with accounting policy adjustments, inter‐
company transactions, balances and unrealised profits, and

AC330 Lecture 5 –
Accounting for Business Combinations II
Merger Accounting – The bad news
• UK listed companies may no longer use merger
accounting but have to use purchase accounting under
IFRS3

• Levels the playing field with US companies under

SFAS141 (no more goodwill amortization – just
impairment reviews)

AC330 Lecture 5 –
Accounting for Business Combinations II
Purchase (‘Acquisition’) vs. Merger Accounting
• Shares issued accounted for at • Shares issued accounted
fair value for at nominal value
• Assets acquired consolidated • Assets acquired consolidated
at fair value at book value
• Goodwill may arise/capitalize • ‘Difference on consolidation’
& test for impairment treated as capital reserve
• Pre‐acq. reserves excluded • Pre‐acq. reserves included
• Consolidated only from date • Consolidated as if always part
of acquisition of group

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 AC330 Lecture 5 –
Accounting for Business Combinations II
Basic premise: Merger Relief
• This legally affected H’s own accounts

• H was allowed to value the investment in its own BS at

nominal value of shares issued  no share premium

• Criteria for merger relief:

– at least 90% ownership of S
– using shares exchange

AC330 Lecture 5 –
Accounting for Business Combinations II
If no Goodwill then: Difference on consolidation
Difference between nominal value (NV) of shares issued (+ other
consideration) and NV of shares acquired including any share
premium (SP) attached to those shares

Merger reserve = NV of shares issued−(NV+SP) of shares acquired.

If negative  add as Capital (Merger) reserve under (non‐distributable)

If positive  deduct from other reserves: retained earnings.

AC330 Lecture 5 –
Accounting for Business Combinations II
Merger accounting – example
Left Right
Fair value of
plc Ltd
Right Ltd’s fixed
£ £ assets = £36,000
Non‐Current Assets 15,000 30,000 (so FV of net
Net Current Assets 18,000 9,000 assets = £39k).
10% Debentures (4,000) (6,000) Left plc’s shares
have MV £3 per
29,000 33,000 share. Left plc
issues new
£1 Ordinary Shares 10,000 8,000 shares in
Share Premium 4,000 5,000 exchange for
Retained Profits 15,000 20,000 100% of Right
Ltd.
29,000 33,000
Assume Left acquired all of Right issuing 4 shares of its own for every 2 in Right
i.e. Purchase consideration = 8,000/2 x 4 x £3= £48,000 [£16,000SC+£32,000SP)
Account for the acquisition and prepare CBS using ‘Purchase’ accounting

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 AC330 Lecture 5 –
Accounting for Business Combinations II

Under Purchase Accounting:

Purchase consideration £48,000
Minus FV of Net Assets acquired (£39,000)
Goodwill 9,000

AC330 Lecture 5 –
Accounting for Business Combinations II
Purchase accounting – CBS
Left Right CBS
plc Ltd
£ £ £
Non‐Current Assets 15,000 30,000
Goodwill (£48k‐£39k)
Net Current Assets 18,000 9,000
10% Debentures (4,000) (6,000)
29,000 33,000

£1 Ordinary Shares 10,000 8,000

Share Premium 4,000 5,000
Retained Profits 15,000 20,000
29,000 33,000

AC330 Lecture 5 –
Accounting for Business Combinations II
Merger accounting – main steps
1. Adjust Left’s own accounts to reflect investment in Right at NV of
shares issued (merger relief)
2. Adjust both company’s accounts to bring accounting policies into
line
3. Add Left and Right together line‐by‐line
4. Eliminate the cost of investment (post‐relief) against the ordinary
shares and share premium acquired; difference = ‘difference on
consolidation’  goes to reserves
5. Eliminate inter‐company balances, transactions and unrealised
profits

Dr V.Athanasakou_AC330MT2010

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 AC330 Lecture 5 – Accounting for Business Combinations II

Left plc’s own accounts –

without merger relief
£
Non‐Current Assets 15,000
Investment in Right Ltd 48,000
Share deal
Net Current Assets 18,000
a) 4 shares in Left for 2 in Right
10% Debentures (4,000)
8,000x4/2 = 16,000 shares issued
77,000
 £16000SC + £32000SP =
£48,000 = Investment in Right
£1 Ordinary Shares 26,000
Share Premium 36,000
Retained Profits 15,000
77,000

Dr V.Athanasakou_AC330MT2010

AC330 Lecture 5 – Accounting for Business

Combinations II
Left plc’s own accounts –
with merger relief £
Non‐Current Assets 15,000
NV of shares
Investment in Right 16,000
Ltd issued
Net Current Assets 18,000
10% Debentures (4,000)
45,000

£1 Ordinary Shares 26,000 10,000+16,000

Share Premium 4,000 4,000 + 0
Retained Profits 15,000
45,000
Type of share deal:
a) 4 shares in Left for 2 in Right [£16000SC + £0SP]

Dr V.Athanasakou_AC330MT2010

AC330 Lecture 5 – Accounting for Business

Combinations II
Consolidated Accounts
Merger accounting with merger relief
Left Plc Right Addition Elimination CBS
Ltd MA
Non‐Current Assets 15,000 3,000 45,000 45,000
Investment in Right 16,000 ‐ 16,000 (16,000) ‐
Goowill
Net Current Assets 18,000 9,000 27,000 27,000
10% Debentures (4,000) (6,000) (10,000) (10,000)
45,000 33,000 78,000 62,000

£1 Ordinary Shares 26,000 8,000 34,000 (8,000) 26,000 Only

Share Premium 4,000 5,000 9,000 (5,000) 4,000 Left (Holding)
Retained Profits 15,000 20,000 35,000 (3,000) 32,000
45,000 33,000 78,000 62,000

(d) – difference on consolidation = £16,000 ‐ £8,000 ‐ £5,000 = +£3,000

 deduct from existing reserves: Retained profits.

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 AC330 Lecture 5 –
Accounting for Business Combinations II
Recall
Left Right CBS ‘Purchase Accounting
plc Ltd
£ £ £
Non‐Current Assets 15,000 30,000 51,000
Goodwill (£48k‐£39k) 9,000
Net Current Assets 18,000 9,000 27,000
10% Debentures (4,000) (6,000) (10,000)
29,000 33,000 77,000

£1 Ordinary Shares 10,000 8,000 26,000

Share Premium 4,000 5,000 36,000
Retained Profits 15,000 20,000 15,000
29,000 33,000 77,000
Which CBS do you prefer?

AC330 Lecture 5 – Accounting for Business

Combinations II
Note: Acquisition accounting for (d)
Merger CBS Diff. Acquisition CBS
FA 45 to FV +6 51
Goodwill ‐ +9 9
NCA 27 27 Assets ↑
Debentures (10) (10)
62 +15 77
Share Capital 26 26
Share Premium 4 +32 36
Profit ↓
Capital Reserve 0
Retained profit 32 ‐20+3 15
62 +15 77

AC330 Lecture 5 – Accounting for Business

Combinations II

Try out another share deal!

Type of share deal:
b) 3 shares in Left for 4 in Right

Dr V.Athanasakou_AC330MT2010

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 AC330 Lecture 5 – Accounting for Business
Combinations II

Left plc’s own accounts –

(b)
without merger relief
£
Non‐Current Assets 15,000
Investment in Right Ltd 18,000 3 shares in Left for 4 in Right 
Net Current Assets 18,000 8,000x3/4=6,000 shares issued
10% Debentures (4,000)  £6000SC + £12000SP =
47,000 £18,000 = Investment in Right

£1 Ordinary Shares 16,000

Share Premium 16,000
Retained Profits 15,000
47,000

Dr V.Athanasakou_AC330MT2010

AC330 Lecture 5 – Accounting for Business

Combinations II
Left plc’s own accounts –
with merger relief (b)
£
Non‐Current Assets 15,000
NV of shares
Investment in Right 6,000 issued
Ltd
Net Current Assets 18,000
10% Debentures (4,000)
35,000
10,000+6,000
£1 Ordinary Shares 16,000 4,000 + 0
Share Premium 4,000
Retained Profits 15,000
Type of share deal: 35,000
(b) 3 shares in Left for 4 in Right [£6000SC + £0SP]

Dr V.Athanasakou_AC330MT2010

AC330 Lecture 5 – Accounting for Business

Combinations II Consolidated Accounts
Merger accounting with merger relief (b)
(b) Left plc Right Addition Eliminatio CBS
Ltd n
£’000 £’000 £’000 £’000 £’000

Non‐Current Assets 15,000 30,000 45,000 45,000

Investment in Right 6,000 ‐ 6,000 (6,000) ‐
Net Current Assets 18,000 9,000 27,000 27,000
10% Debentures (4,000) (6,000) (10,000) (10,000)
35,000 33,000 68,000 62,000
£1 Ordinary Shares 16,000 8,000 24,000 (8,000) 16,000
Share Premium 4,000 5,000 9,000 (5,000) 4,000
Capital Reserve ‐ ‐ ‐ 7,000 7,000
Retained Profits 15,000 20,000 35,000 35,000
35,000 33,000 68,000 62,000
(b) difference on consolida on = £6,000 − £8,000 − £5,000 = −£7,000
 create Capital reserve = £7,000

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 AC330 Lecture 5 –
Accounting for Business Combinations II
Merger accounting – Consolidated Income Statement
‘As if had always been one’
• For whole year of acquisition
• Comparatives for both together for whole of previous year

AC330 Lecture 5 –
Accounting for Business Combinations II
Managers and merger accounting
Managers favour merger accounting as:
– It enables profits to be realised when assets are Profit ↑
subsequently sold at (higher) fair value, and keeps
depreciation charges low
– Pre‐acquisition profits of acquired company in merger
year boost profits of combination Profit ↑
– No goodwill
– Improves rate of return on investment Assets ↓
(ROCE, ROSF)

AC330 Lecture 5 –
Accounting for Business Combinations II
Purchase (‘Acquisition’) vs. Merger Accounting
• Shares issued accounted for at • Shares issued accounted for at
fair value nominal value
• Assets acquired consolidated • Assets acquired consolidated
at book value Assets ↓
at fair value
• Goodwill may arise/capitalize • ‘Difference on consolidation’
& test for impairment treated as capital reserve
• Pre‐acq. reserves included
• Pre‐acq. reserves excluded Equity ↑
• Consolidated as if always part
• Consolidated only from date of group
of acquisition

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 AC330 Lecture 5 –
Accounting for Business Combinations II
So what drove to merger accounting?
• The need to distinguish combinations where no material
resources leave the group
But SSAP 23, that allowed merger accounting as an option,
was criticised for too much flexibility and for transaction
structuring possibilities

AC330 Lecture 5 –
Accounting for Business Combinations II
How was merger accounting restrained?
The ASB issued FRS 6 (1994) to counter these criticisms.
– Restricted use of merger accounting to ‘very rare’ cases
– Combinations meeting criteria MUST use merger
accounting, other combinations MUST NOT
– Use of merger accounting subsequently declined BUT
although rare, it began to increase again
– It was argued that some combinations would not have
gone ahead if merger accounting was not available
(e.g. Astra and Zeneca (1999), BP and Amoco (1999), Halifax and
Bank of Scotland (2002))

AC330 Lecture 5 –
Accounting for Business Combinations II
What were the remaining issues?
• Size/publicity attracted attention:
– Commentators reported perceived abuses
– Poor comparability between combinations using
different methods
– Merger accounting provided less information as no
FV adjustments

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 AC330 Lecture 5 –
Accounting for Business Combinations II
The demise of merger accounting
• US FASB banned merger accounting in SFAS141
But allowed companies to impair goodwill when applying
purchase accounting
• IASB banned merger accounting (IFRS 3)
Saying ‘true’ mergers are so rare they do not warrant
different treatment
• ASB resisted ban
But listed UK companies now have to apply IFRS from
January 2005

AC330 Lecture 5 –
Accounting for Business Combinations II
Is there an alternative?
• A possible alternative to merger accounting exists –
‘Fresh Start’ Accounting
• Unlikely to be abused as involves FV restatements of
both combining entities
– In contrast acquisition accounting only restates
acquired company’s assets/liabilities
– Traditional merger accounting restates neither
• Not currently in use.

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