Business Combinations
Abstract.
In the corporate finance world, business combinations are not a rarity. In a business world that is increasingly being viewed as increasingly unpredictable, business combinations including mergers and acquisitions put simply as M&A are being seen as a way to secure shareholders interests. It is important to note that the main agenda informing business combinations such as the purchase of a company by another is the creation of shareholder value which is more than the summation of the companies operating separately. As far as business combinations are concerned, it has been argued that in the turbulent business times informing what is the business environment today, two firms combined are better than each operating separately. This is the dominant alchemy of business combinations.
Hence when times are rough, companies seek to combine so as to be more cost efficient as well as enhance their competitiveness. If the combination goes on well, the companies which come together can go ahead to win a greater market share as well as enhanced efficiency.However, it is not only turbulent times that inform business combinations. The need to create economies of scale can sometimes be the main motivator behind business combinations. Every passing day, transactions involving M&A and aimed at forming larger companies from separate ones are arranged in Wall Street as well as elsewhere in the world by teams of investment bankers. In most instances, such transactions which can at times be worth billions of dollars feature prominently in news items. While the issue of business combinations has informed most of the discussions in the corporate circles in the past, what remains to be of most interest today is US GAAP and IFRS conversion issues with regard to business combinations as the world adopts IFRS.
In this regard, those involved in one way or the other with business combinations today as far as structure is concerned are particularly interested in consolidation rules as well as liability/equity. As far as business combinations are concerned, it is encouraging to see that a number of issues have been settled on including but not limited to the issuance of the so called FAS 141 and FAS 160. However, accountants working on mergers and acquisitions still have challenges when it comes to the recognition of a number of items including but not limited to goodwill. As the globe now shifts towards the accounting standards convergence, a number of changes will continue to be evidenced in business combinations accounting. There is hence a great need to know effect of business combinations on financial statements and the dollar value changes that will result as well as the companies that are most likely to be impacted on by the change. There is also an existing need to chart the current issues informing mergers and acquisitions.
Introduction
It is important to note that the purchase method is most recommended when it comes to the accounting of business combinations. Here, the net assets of the acquiring corporation are recorded at the fair market value with regard to the consideration given. In this text, I discuss the effect of business combinations on financial statements and the dollar value changes that will result as well as the companies that are most likely to be impacted on by the change. I also look into the aspect of business combinations an the current issues informing mergers and acquisitions I will also look at the appropriate method of dealing as far as business combinations are concerned.
Mergers & Acquisitions: A definition
Although the terms mergers and acquisitions are often thought to be synonymous and hence are more often than not used in the sme breath, there exists some unique differences between them. An acquisition takes place when a given company, say company A, takes over another company, say company B, whereas company A establishes itself as the new owner of company B. Looking at this from a legal perspective, when company A takes over company B, company B ceases to exist. It can hence be seen that company A has “swallowed” company B.
However, when it comes to the strict application of the term merger, Cartwright et al. (2010) notes that as opposed to an acquisition, a merger occurs when two firms which may happen to be similar in terms of size come together and agree to do business as a single entity as opposed to carrying out their operations separately. Here, a new company is formed and consequently, new stocks may be issued in its place. A good historical example of a merger is when both Chrysler and Daimler-Benz merged and each company ceased to exist on its own hence forming a new entity labeled DaimlerChrysler. Cartwright et al. (2010) however notes that in a practical sense, it is uncommon to have a merger between equals. He notes that in most cases, a company buys another and as part of the purchase deal, the acquiring company allows the company acquired to brand the procedure a merger even though it is an acquisition, technically speaking. This is basically because in the corporate world, being bought out is viewed in a negative light and hence a merger is more palatable.
It is important to note that a purchase deal shall be referred to as a merger when the leadership of both companies agree to bring their companies together in the best interests of the companies while on the other hand, a purchase deal shall be referred to as an acquisition when a target company is taken over by another company be it a hostile takeover or otherwise. A term variously used in issues to do with mergers and acquisitions is a takeover. Basically, we have a hostile takeover as well as a friendly takeover. A friendly takeover in the corporate world is usually a merger euphemism while a hostile takeover comes about when a given company makes unwelcome advances to another company. All in all, whether a take over is hostile or friendly refers to the managements reaction to another firm’s overtures.
Current issues in mergers and acquisitions
Currently, it is important to note that when it comes to the current issues informing business combinations, Deloitte (August 2008) notes that with regard to the classification of liabilities and equity, redeemable shares that are considered contingent and which might be put under equity treatment (though temporary) under the GAAP (US) may be classified under IFRS as liabilities. When we consider the IFRS definition, a number of instruments may be classified as derivatives as far as IFRS are concerned.It is important to note that currently, there are two main differences as far as consolidation is concerned. To begin with, consolidation may be informed by control which can be taken to be ‘de-facto’ and next, in the ‘rewards and risk’ approach to assist in the identification of the controlling entity. With that in mind, businesses carrying our the acquisition must be aware of the fact that a business to be acquired may not be be able to consolidate similar entities set under the IFRS that would be of use as far as the US GAAPS are concerned.
In the recent past, analysts have been optimistic of a comeback of sustained M&A negotiations as well as deals going forward. For instance, according to Cartwright et al. (2010), since July, deals related to M&A have totaled close to $86.4 billion. The current M&A are largely anchored on the ability of Europe to handle its debt crisis, a failure of which would inhibit the global economic recovery. Given the pace of recovery from the global economic meltdown, companies are more confident as borrowing costs decrease. Though analysts note that company boards are still a little bit courteous when it comes to M&A deals, the economic environment is picking up and this is going a long way to reassure boards. According to Keats (2010) potential areas for M&A deals going forward include the software industry, the banking industry as well as the telecom industry.
It is important to note that while some issues have been settled upon as far as business combinations are concerned, some remain to be grey areas. According to PricewaterhouseCoopers (September 2009) much of the ground has been covered especially with the issuance of the so called FAS 141 and FAS 160. When it comes to business combinations, these rules are meant to simplify accounting for mergers and acquisitions. Amongst the issues that have been settled upon include the recognition by an acquiring firm of both assets and liabilities and adopt the fair value of the acquisition date as the primary tool of measurement. The negative goodwill accounting is also a concept that has been agreed upon and when it comes to business combinations, it is a requirement now that investors be informed of substantial information as far as the evaluation of the effects of the combination are concerned PricewaterhouseCoopers (September 2009).
When it comes to the pending issues in the US GAAP and IFRS, a report by PricewaterhouseCoopers (September 2009) notes that accountants involved in business combinations face a number of problems when it comes to the valuation of goodwill. Businesses that have an established goodwill have values that are over and above a summation of all their assets. Good will accounting hence arises when the ownership of a business in changing i.e. incase of a sale, a merger or acquisition deal etc. In the recent past, organizations have been using different methods when it comes to the recognition as well as accounting for goodwill especially for purposes of business combinations. Now as the globe moves towards the accounting standards convergence and the adoption of IFRS, goodwill treatment remains to be a concern or pending issue in the US GAAP and IFRS especially because in the past, the pooling of interest method for business combinations permitted firms to amortize goodwill over forty years in equal installments(Keats 2010). From late June 2001 however, the pooling method has been eliminated as efforts intensify towards the harmonization of US GAAP and IFRS. Now, as far as the convergence of US GAAP and IFRS is concerned, it has become a requirement to review goodwill for impairment at either the lower organizational level or the operating level.
An analysis of why companies go for merger deals
Companies engage in merger and acquisition deals for a number of reasons. These reasons could be either operational or financial. For instance, when it comes to growth; a company cannot expect to enhance rapid growth by engaging in internal expansion only. It hence becomes more sensible to embrace business combinations so as to guarantee the balanced growth of a firm. Further, companies pursuing business combination see the same as less risky as well as more cost effective. The reasoning here is that a going concern eliminates a number of risks coupled with costs when it comes to expansion. All in all, the acquisition of or merging with another firm essentially means that companies can attain their planed growth rate at least cost and risk.
There is also the issue of tax shield utilization. This is mostly in the case of a company that is consistently making losses where it becomes in its own interest to merge with another profit making entity so as to make use of its tax shields. This is informed by the fact that a company that makes losses cannot setoff losses against its profits in future as it is not making any profits.It therefore follows that the merger of such a unit with another profit making entity shall mean that the losses which have been accumulated over time for the loss making entity shall be set off against the profits made in future by the profit making entity. It is the tax benefits that accrue in this case that make companies to favor business combinations. Further, it is important to note that once firms merge, their value increases, that is, the value of the combined unit becomes essentially more than a summation of the entities before the merger deal takes place. This is yet another reason for merger deals.
Impact of Mergers and acquisitions on financial statements and the US GAAP and IFRS conversion issues
According to Deloitte (August 2008) when it comes to M&A, there are two areas of specific interest to financial accountants. These two areas of specific interest include business combinations and instruments (financial).As per the IFRS procedures, business combinations must be accounted for using the purchase method. It is important to note that when it comes to M&A deals, we have two methods which can be used to account for the same. One is the one already listed, i.e. the purchase method and the next is the DCF model. These two methods are permitted under GAAP previsions. As per the IFRS standards, there is need to look beyond a transaction’s legal form and with that in mind, IFRS provide well laid out guidelines when it comes to accounting for M&A.Under the IFRS provisions, there is need to record at fair value all the net assets taken over.
The recording of net assets should also include contingent liabilities. Under the GAAP rules, contingent liabilities are put down as liabilities. When it comes to good will amortization which can be taken to have arisen out of a M&A, IFRS provisions prohibits the same. In instances where we have negative goodwill, IFRS standards dictate that acquires liabilities as well as contingent liabilities, assets which are identifiable and combination cost be measured as well as assessed by the acquirer. The excess identified on this assessment and measurement must be recognized inm the income statement. When it comes to GAAP, when the goodwill amount is identified to be negative, it must be recorded in under the capital reserve account in equity.
It is good to note here that the capital reserve is not availed to shareholders as distribution and it is not also subjected to amortization.IFRS also dictate that all acquisition costs including consulting or professional fees, accounting fees, legal fees, advisory fees, finder’s fees etc. be expensed to the acquiree. The figure to be expensed must also include reimbursements. Deloitte (August 2008) notes that all those involved ion M&A deals must and indeed need be aware of the consequences of such differences as far as the business and its future transactions are concerned. Another worth area to look at as far as M&A are concerned is reverse acquisition. GAAP currently do not deal with reverse acquisitions extensively. A reverse acquisition may manifest itself for instance when a smaller public entity ‘acquires’ a given private entity in a prearranged scenario so that the private entity can benefit from a stock exchange listing. As per the IFRS provisions, the accounting of reverse acquisitions must assume that that the accounting acquirer is the legal acquirer.
Another important issue to address as far as M&A are concerned is consolidation. Under GAAP, when a company acquires more than a half of the voting rights of another company or has gained control of the body of directors composition, then such an entity can be said to have obtained control of that other company. As per the provisions of IFRS, the power of a given company to govern the policies (operating and financial) of another company so as to derive benefits from a set of its activities can be said to be control. However, both GAAP as well as IFRS distinguish control from dual control. Under GAAP provisions, when a company is controlled by two companies where the control for either company is by virtue of agreement or ownership of the voting power’s majority, the controlled company shall be taken to be both controlling companies’ subsidiaries and with that in mind, shall be consolidated by all the controlling companies. When it comes to the IFRS, only a single company can exercise control over another company.
This however should be distinguished from joint control. It therefore follows that in situations where a number of companies hold voting rights which can be taken to be significant, a number of issues must be reassessed so as to identify the controlling company (Deloitte, August 2008).As stated earlier, when it comes to M&A deals; financial instruments form part of the most important items to consider with regard to structure analysis and consideration. Indeed according to PricewaterhouseCoopers (September 2009), analysts, investment bankers and the leadership of companies interested in M&A take the financial instruments as seriously as they take business combinations when it comes to the consideration and analysis of structure. IFRS guidelines are clear on recognition, measurement as well as classification and identification of financial instruments. The GAAP provisions do not however offer a comprehensive guideline as far as financial instruments are concerned. When it comes to valuations related to M&A, IFRS standards dictate that all assets of a financial nature be classified or categorized according to held to maturity (HTM), available for sale (AFS), loans and receivables and fair value-profit and loss (FVTPL).
When it comes to valuation for purposes of M&A deals or otherwise, IFRS dictate that AFS assets be recognized at fair value. A loss or gain on ASF assets must be indicated in equity which is taken to the income statement. When it comes to FVTPL assets, IFRS note that they be measured at fair value. Here, a loss or gain from a shift in fair value or otherwise must be indicated in the financial statements. Next are the HTM and loans and receivables which must be recognized using the effective interest rate. These are however measured are amortized cost (PricewaterhouseCoopers, September 2009). However, Difazio et al. (2009) notes that beginning January 2013, those assets of a financial nature which as at the moment are under IAS 39 – financial instruments: recognition and measurements will be recognized in either of two ways. One, they can be measured at amortized cost and secondly at fair value. This is as per he provisions of IFRS 9- financial instruments.
PricewaterhouseCoopers (September 2009) notes that there are two classifications of debt instruments that must be measured at amortized cost. This includes those that held for purposes of cash flow collection and two, those that have cash flows regarded as contractual and which happen to be principal and interest payments outstanding. Even in cases when an instrument satisfies the test I list above for amortization, IFRS 9 gives an option which allows one to designate an asset (financial) as recognized in FVTPL but only in cases where such an action would lower an inconsistency with regard to recognition or measurement that would otherwise manifest itself from the asset or liability measurement or gain as well as loss recognition on separate or distinct bases. It is however important to note that all other debt instruments should be recognized at fair value.
When it comes to equity investments, IFRS 9 dictates that they be measured in the balance sheet or statement of financial position (SOFP) at fair value. Value changes in this regard must be noted in profit and loss. However, value changes shall not be recognized in the profit and loss when an equity investment chooses to identify such changes in other income (comprehensive). It is good to note that this is possible in a few instances only, i.e. where an investment (equity) does not involve trading. For unquoted equities, we do not have ‘cost exception’. GAAP recognizes investments as current or long term investments. For long-term investments, we have provisions for dimunitions in value deducted from costs while for current investments; we have market value or lower of cost as the carrying amount (Difazio et al. 2009).In conclusion, it may be important to note that a solid understanding of IFRS provisions is critical for al M&A professionals as well as investment bankers, financial analysts, professional investors and management accountants.
Mergers and Acquisitions: IFRS, US GAAP and Tax implications
Delloite (July 2009)indicates that as various companies mostly in US plan to shift fully to the International Financial Reporting Standards (IFRS) from the GAAP (US), much needs to be done to clearly outline the effects of changing policies (accounting), for purposes of book on their structures as far as tax planning is concerned as well as other M&A issues and activities. The internal revenue code (IRC) tax laws in the United States which are in one way or the other associated with M&A deals are not in any way dependent on financial reporting policies. Harwood (2010) argues that the shift to IFRS will have minimal impact, from a tax perspective (US), on M&A deals based on the fact that M&A deals tax laws are not dependent on book accounting policies. It is however important to note that decisions relating to M&A deals shall be affected once IFRS accounting standards are adopted by companies. With that in mind, tax experts should be well aware that a number of components relating to their tax planning strategies as well as analysis will be affected as strategies and financial reporting policies shift as a result of the change to the international financial reporting standards (IFRS).
Cartwright et al. (2010) notes that because a number of financial instruments shall be taken to be liabilities on shifting to IFRS; for book purposes, there may be a change in the rationale of utilizing given instruments for purposes of M&A deals financing. For purposes of meeting a given corporations objectives, there may be need to for the finance and accounting department of an organization to come up with other financial instruments for purposes pf completing a corporate transaction. It is important to note that these differences can have far reaching consequences as far as an organization’s capitalization profile is concerned (Deloitte, July 2009). However, it may help to note that tax experts in the US should go on using the facts and circumstances approach because the tax laws are nor changing when considering the debt versus equity classification.
It is important to note that there shall be no change or shift when it comes to US tax rules concerning distributions and redemptions (corporate) when companies shift to the IFRS. However, it may be prudent for top leadership of companies to understand the impact of book policy changes on the tax planning strategies of a company n shifting to IFRS. For instance, on adoption of the IFRS accounting policies, there will be an impact on cash repatriation strategies as well as financial instrument classifications in terms of either debt or equity.
Friedel (2010) notes that when it comes to corporate mergers, acquisitions as well as mergers and dispositions, there are a wide range of IRS rulings, case law, regulations and US federal tax provisions to be taken into consideration as an addition to corporate operations.In wide terms, a corporate acquisition can either be looked into in the light of either a non taxable or taxable event. This is from both the target company’s as well as acquirer’s point of view. The nature of the acquisition largely depends on or is determined by the beginning tax basis of the acquirer as far as the stock of the target is concerned. For instance, when we consider a stock acquisition, IRC provisions (Sec 1012) dictates that the acquiring company takes the target companies stock in a fair market value basis irregardless of the acquiring values of the target company’s stock.
Friedel (2010) notes that in instances where the acquired company decides to join the consolidated tax return of its acquirer, then it must open a new tax yeas=r immediately after closing its tax year. For purposes of computing carry-forward periods of tax, each and every stub period is considered to be a separate or distinct tax year. What this essentially means is that there is an existing incentive for an acquiring company to acquire a target company on its tax years last day. It should be noted that in instances where a subsidiary is disposed of by its parent company, the tax rules t be applied are those from the sellers perspective. In conclusion, it is important to note that from a tax perspective; corporate acquisitions, mergers as well as dispositions should continue utilizing the US tax laws as well as statutes irregardless of the shift to the international financial reporting standards (IFRS).
Mergers and acquisitions: The dollar value implications of change
When the valuation of a business is anchored on its assets, the price may be set using the balance sheet noteworthy. Marshall et al. (2010) however notes that this should not be taken to mean that the value of appreciated assets shall be governed by book value. In reality, the price may end up being a book value’s multiple of course after deducting liabilities. In the absence of financials as to the current situation, a price may be derived from the net worth of a company. AccordingFriedel (2010), if a buyer acquires a seller for its stock while taking the consideration to be the buyer’s shares, it is taken that the buyer assumes the risk of the share price dropping in which case the M&A deal may end up being worth much lower that what was expected from the shareholders of the acquiring company’s point of view. Consequently, a raise in value of the stock essentially mean s that the buyer will have offered more than it was to and hence the only way to go around this is to avail a given dollar value to the seller. This can go hand in hand with a provision that the buyer will bring fourth an amount of shares that equate to the closing stated value.
Effecting a business combination: Valuation and Companies to be affected most
When it comes to valuing a firm for purposes of a merger or acquisition Deloitte (July 2009) notes that the most appropriate method is the discounted cash flow method. This method involves the establishment of the present value of the equity of an entity that is targeted. Once the present value of the firms equity is established, the merger’s expected synergy present value should be evaluated in the form of savings (cost) or earnings (after tax). The present value of the target firm is given by the summation of the present value of the entity’s equity as well as the merger’s expected synergy present value. The main benefit or advantage of using his method as far as valuation of a M&A deal is concerned is its ability to give the acquiring firms management a value similar to the other firms intrinsic value. Indeed, Friedel (2010) notes that the discounted cash flow method is the closest one can get to any firm’s intrinsic value. Unlike other valuation methods, the discounted cash flow method concerns itself with free cash flows. Here, there is a true picture presented, as far as the reporting of earnings is concerned. It is important to note that coming up with the stock prices is a very difficult and erroneous undertaking. However, with the discounted cash flow method, when it comes to M&A, it is possible to work backwards through the method by incorporating a given firm’s share price into the method so as to determine the time it would take for the company to achieve the stock price by growing its cash flow.
Conclusion
It is laudable that a majority of issues have been settled upon as far as business combinations are concerned. Nevertheless, there are grey areas that must an indeed need to be ironed out in a timely manner so as to ensure a smooth transition. I feel that accounting for mergers and acquisitions shall become easier as far as the issuance of the so called FAS 141 and FAS 160 is concerned. I am however convinced that accounting for goodwill remains to be a challenge. As noted in the earlier sections of this paper, Businesses that have an established goodwill have values that are over and above a summation of all their assets. Good will accounting hence arises when the ownership of a business in changing i.e. incase of a sale, a merger or acquisition deal etc. As per the GAAP provisions, goodwill is not amortized but there is a requirement that it be exposed to a periodical impairment test.
In my own opinion, the IFRS provisions that business combinations use the purchase method as far as accounting is concerned is the first step in enhancing uniformity in accounting for business combinations. The purchase method or what is also known as the acquisition method recommends the identification of the acquirer and the subsequent analysis of the business combination cost. I however feel that contingent liabilities should not be assumed in this process. I feel that they should be recognized if they meet the criteria of recognition as per the GAAP provisions. Other grey areas that I feel should be addressed include issues to do with reverse acquisitions, acquirer’s contractual arrangements reassessment as well as the procedure of identifying assets considered to be tangible.
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