Mergers & Acquisitions

Topic 5:
Accounting for Business
Combinations
Reading: Gaughan Chapter 16
Week 6
 Caterpillar grapples with accounting scandal
• World’s largest manufacturer of tractors and excavators
• Discovered accounting misconduct at a Chinese firm
Zhengzhou Siwei Mechanical & Electrical Equipment
Manufacturing Company it bought for USD700m
• Write down more than half its earnings
• Found “deliberate, multi-year, coordinated accounting
misconduct”
• Caterpillar has to take a non-cash goodwill impairment
charge of USD580m
• Misconduct beginning several years prior to Caterpillar’s
acquisition
• Found discrepancies between inventory in Siwei’s books and
its actual inventory
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accounting p. 3
 Learning outcomes
• To get behind the accounting numbers to see the validity
and value of any investment plans in M&A
• To understand the role played by the Financial Accounting
Standards Board of the Financial Accounting Foundation
in M&A
• To walk through the reasons to eliminate formally the
pooling-of-interests method of accounting for M&A
• To have a brief idea how business combination is
accounted under latest FRS3 in Hong Kong

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 Historical Background (US)

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 Accounting Principles Board of AICPA
• On August 2, 1970, the Accounting Principles Board of
AICPA issued
 Opinion 16:
 Deals with guidelines for corporate mergers
 Opinion 17:
 Deals with goodwill arising from mergers

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 Two Prescribed Accounting Methods
• Opinion 16 prescribes two accounting methods for
recording the acquisition:
 The pooling of interests method 权益结合法 of
accounting requires that
 the “historical cost” basis of the assets and liabilities
 earnings of the combined entities are combined for any
reporting periods
 The purchase method 购买法 of accounting requires
that
 a NEW “historical cost” basis be established
 earnings of the acquired company are reported by the
acquirer only from the date of acquisition forward
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 Problems with the Pooling Method
• Problems with the pooling method:
 It ignores the new market values
 Not record what the buyer paid
 Use pooling to avoid recording goodwill 商誉

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 Elimination of Pooling Method by FASB

• FASB voted unanimously to eliminate pooling of

interests as a method of accounting for business
combinations as
 The method provides less relevant information
 Financial statements of companies less comparable

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 FASB ADOPTS STATEMENT NO. 141
ENDING POOLING ACCOUNTING
• FASB on June 29 of 2001 approved new business
combination rules that eliminate the pooling method
• FASB Statement No.141 became effective on June 30 of
2001 and replaced the old APB Opinion No. 16.
• Goodwill does not have to be amortized, but will have to
be tested annually for impairment
• A write-down must be taken whenever impairment
occurs.

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 Purchase Accounting
• One company is identified as the buyer and records the
company being acquired at the price it actually paid
• All identifiable assets acquired and liabilities assumed should
be assigned a portion of the cost of the acquired company
• The excess acquired net of liabilities assumed should be
recorded as goodwill
 For write-off, the new law is 20 years
 Under a 1993 tax law change, goodwill can be amortized over
15 years for tax accounting
 Under some circumstances, the total of goodwill can be written
off in the year of acquisition

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 Tighten the recognition of intangible assets

• Clarify the recognition of intangible assets as a separate

asset category
• Contractual-legal criterion held that some intangible
assets arise from contractual rights
• Separation criterion allowed that intangible asset is
capable of being separated from the target firm and sold,
then it may be recognized

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 Amortization of intangible assets, and charges
for impairment
• Intangible assets may have indefinite useful lives and need
not be amortized under the new rules
• Several points of judgement for M&A practitioner
 Fair market values of tangible and intangible assets
 Useful lives of tangible assets and their annual depreciation
charge to earnings
 Useful lives of intangible assets and their annual
amortization charge to earnings
 Value of goodwill as part of annual impairment test

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 Acquisition of 100% of the target
• Buyer should recognize an acquisition at cost of transaction
as if buyer were purchasing a bundled set of assets and
liabilities on the open market
• Inventory could be substantially restated in value
• Accounts receivable will be recorded by the buyer at the cash
flows it expects to realize
• Fixed assets would be restated to fair market value
• Goodwill may be created
• Liabilities are recorded at their fair market value
• No retroactive restatement of buyer’s past financial results is
permitted under purchase accounting

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 Examples of high-flying goodwill
• AOL-Time Warner: USD54b
• JDS Uniphase: USD48b
• Worldcom: USD17b
• Vivendi Universal: USD16b
• Nortel Networks: USD12b

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 Acquisition of less than 100% of target firm
• Partial acquisitions will use some variation of purchase accounting
• Intent is that parent should consolidate the partially owned target
when parent effectively controls it
Method of accounting Ownership % of Implied degree of
shares control

Consolidation method Larger than 50% Majority voting

control

Equity method 20% to 50% Material voting power

without majority
control

Cost method Less than 20% Less significant voting

power

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 Financial Implications of the Two Methods
• Accounting net income
 Purchase method is usually lower
• Cash flow
 Purchase method will be higher
• Main drawback is focus on short term data: one year’s
future projected results, and perhaps 1 to 3 years ago

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 Other measures of financial performance

• Financial leverage ratios: many firms are debtors

• Profit margins: purchase accounting for M&A affects
many asset categories which affect items on I/S
• Asset efficiency and leverage, and ROE and ROA: choice
among methods of accounting for a partial acquisition can
affect if target appears on- or off-balance sheet of buyer
• Liquidity: larger allocations of fair market value of target
purchase to current assets will enhance appearance of
liquidity of Newco

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 Purchase vs. Pooling of Interests
Purchase Pooling
Transaction treated as a classic acquisition Transaction treated as a classic merger

The purchase price is allocated to the net The buyer’s and seller’s ownership
assets obtained interests are “pooled” into a single entity

The net effect is that the financial The net effect is that the assets and
performance of the buyer and seller are liabilities of the combined companies are
consolidated only for post-closing not stepped up
reporting periods

This method applies to all deals unless the Only applies if specific conditions are met
pooling-of-interest conditions are met

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 Linkage among accounting choices, form or
payment, financing and price
• Reported financial results are affected by accounting
choices
• Form of payment: accounting choices and form of payment
can both affect buyer’s earnings dilution
• Financing: presentation of pro forma and forecasted
financial results can influence creditors and major investors
• Price: higher prices will be associated with more goodwill
• Executive and M&A professional should think critically
about these linkages

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 Earnings management and fraud
• Dark side of accounting choices for M&A transactions
• Executives may be motivated to manipulate financial
accounting for combinations to give it the best
appearance
 Earnings and EPS enhancement games
 Credit enhancement games
 Price maximization games
 Tax management games

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 A spectrum of earnings management practices

• Conservative accounting: may stimulate civil litigation

 E.g. overly aggressive recognition of provisions or reserves
• Neutral earnings: earnings result from a neutral operation
of the financial reporting and auditing process
• Aggressive accounting: may stimulate civil litigation
 E.g. understatement of the provision for bad debts
• Fraud: violates GAAP; subject to civil and criminal
penalties
 E.g. recording fictitious sales

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 Sarbanes-Oxley Act
• “corporate corruption [that]…. has struck at investor
confidence, offending the conscience of our nation”
• Establish PCAOB Public Company Accounting Oversight
Board (similar organization in HKG)
• Prohibit auditors from providing ancillary services
• Require public companies to appoint independent
directors
• Require certification of financial reports by the CEO and
CFO
• Prohibit insider trading during periods of “blackout”

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 International oversight bodies
• UK-FRC
• EU- 8th Directive
• HK- AFRC
 Government plans to expand its authority
 Changed name to Accounting and Financial Reporting Council
 Current CEO Marek Grabowski agrees with the move
 Ms Janey Lai Chui-pik, Head of Inspection as CEO until further notice
 Chief Executive’s appointment of Mr Marek Grabowski as Chief Executive Officer (the
CEO) and Executive Director of the FRC for a term of three years from 12 October 2020
to 11 October 2023, just retired A veteran in the accounting profession, Mr Grabowski was
the Director of Audit Policy of the Financial Reporting Council of the United Kingdom
(UK FRC) whereby he led the development and maintenance of the standards for auditing,
assurance and professional ethics for auditors and reporting accountants. Prior to joining
the UK FRC in 2010, he was a Partner of an international accounting firm for 20 years,
taking up technical, audit and capital markets transaction reporting roles in the UK and
overseas.

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 The Setting
• The acquirer, Firm A, is twice as big as the target, Firm T
• The P/E ratio for A is 15 and for T is 20
• The share price of A is $30 and the share price of T is $20
• A buys T in a share exchange ratio of 1:1

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 An illustration: background

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 Purchase Accounting
• A buys T for 20,000 shares of A with a market price of
$30/share
• some of the premium would be assigned to identifiable
assets and some as goodwill.
 All premium goes to identifiable assets
 All premium goes to goodwill

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 All Premium Goes to Identifiable Assets
• Total market value of A’s new shares = $600,000
 Since shareholders’ equity of T is $120,000
 Premium = $480,000
 Since BV of A’s 20,000 shares is $80,000
 Credit to Paid-in capital = $520,000
• The adjustments shown by (1) represent the elimination of the
net worth accounts of T by debits totaling $120,000
• The total asset value of the merged firm increases
 BV(TA)M = $400,000 + $80,000 + $600,000 = $1,080,000

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 All Premium Goes to Identifiable Assets

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 All Premium Goes to Goodwill

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 Effects on Income Measurement
• Under Pooling method:
 EPS = Total NI / Total shares outstanding = $1.50
 Cash flows per share = (NI + Depr) / # shares = $2.25
• Under Purchase method:
 All premium to identifiable assets:
 Depreciation = P&E / 10 years = $75,000
 Cash flows = NI + Depr = $108,000
 All premium to goodwill:
 Depreciation = $30,000
 Amortization
 If tax-deductible, Goodwill / 15 years = $32,000
 If not tax-deductible, Goodwill / 20 years = $24,000
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 Effects on Income Measurement

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 Effects on Leverage
• In pooling, debt-equity ratios at BVs would remain
unchanged if A and T have the same capital structure

D  DA  DT  D D

          
 E  M  E A  ET   E  A  E T
$(100,000  60,000) $(50,000  30,000) 2
  
$240,000 $120,000 3

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 Effects on Leverage
• In purchase accounting:
 When stock is used, the leverage ratio declines
D  DA  DT  DA  DT
     
 E  M  E A  MV ( E )T  E A  ET
 DM = DA + DT = $160,000 + $80,000 = $240,000
 EM = EA + Acquisition Value = $240,000 + $600,000 =
$840,000
D $240,000 2
   
 E  M $840,000 7
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 Effects on Leverage
• When cash is used, the leverage ratio increases
• Since cash is acquirer’s own asset, nothing will change in
the total asset value of the merged firm except ET is
eliminated
• TAM = TAA + TAT – ET
• EM = EA
D  DA  DT  DA  DT
     
 E M  EA  E A  ET

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 HK FRS 3
Business Combinations:
Reasons for issue the HKFRS
• Improve quality of accounting for business combinations:
 Initial measurement of identifiable assets acquired and
liabilities and contingent liabilities assumed
 Recognition of liabilities for terminating or reducing the
activities of an acquiree
 Treatment of any excess of acquirer’s interest in the fair
values of identifiable net assets acquired in a business
combination over the cost of the combination
 Accounting for goodwill and intangible assets acquired in a
business combination

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 Main features
• All business combinations within its scope to be
accounted for by applying the purchase method
• Acquirer to be identified for every business combination
within its scope – combining entity that obtains control of
the other combining entities or businesses
• Measure the cost of a business combination as the
aggregate of: the fair values, at the date of exchange, of
assets given, liabilities incurred or assumed, and equity
instruments issued by the acquirer, in exchange for
control of the acquiree; plus any costs directly attributable
to the combination

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 Main features
• Recognise separately, at the acquisition date, the
acquiree’s identifiable assets, liabilities and contingent
liabilities
• Goodwill acquired in a business combination to be
recognised by the acquirer as an asset from the
acquisition date, initially measured as the excess of the
cost of the business combination over the acquirer’s
interest in the net asset value of the acquiree’s identifiable
assets, liabilities and contingent liabilities recognised

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 Main features
• Prohibits the amortisation of goodwill acquired in a
business combination and instead requires the goodwill to
be tested for impairment annually, or more frequently if
events or changes in circumstances indicate that the asset
might be impaired, in accordance with HKAS 36
Impairment of Assets
• Disclosure of information that enables users of an entity’s
financial statements to evaluate the nature and financial
effect of business combinations that were effected during
the period and previous periods

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 Identify a business combination
• Bring together of separate entities or businesses into one
reporting entity
• One entity, the acquirer, obtains control of one or more
other businesses, the acquiree
• When an entity acquires a group of assets or net assets
that does not constitute a business, it shall allocate the
cost of the group between the individual identifiable
assets and liabilities in the group based on their relative
fair values at the date of acquisition

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 Purchase method accounting
• Views a business combination from the perspective of the
combining entity that is identified as the acquirer
• Acquirer purchases net assets and recognises the assets
acquired and liabilities and contingent liabilities assumed,
including those not previously recognised by the acquiree
• Measurement of the acquirer’s assets and liablities is not
affected by the transaction

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 Cost of a business combination
• The acquirer shall measure the cost of a business
combination as the aggregate of
 Fair values, at the date of exchange, of assets given,
liabilities incurred or assumed, and equity instruments
issued by the acquirer, in exchange for control of the
acquiree; plus
 Any costs directly attributable to the business combination

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 Goodwill
• The acquirer shall, at the acquisition date:
 Recognize goodwill acquired in a business combination as
an asset; and
 Initially measure that goodwill at its cost, being the excess
of the cost of the business combination over the acquirer’s
interest in the net fair value of the identifiable assets,
liabilities and contingent liabilities recognised
 After initial recognition, the acquirer shall measure
goodwill acquired in a business combination at cost less
any accumulated impairment losses

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 Goodwill
• If the acquirer’s interest in the net fair value of the
identifiable assets, liabilities and contingent liabilities
recognised exceeds the cost of the business combination,
the acquirer shall:
 Reassess the identification and measurement of the
acquiree’s identifiable assets, liabilities and contingent
liabilities and the measurement of the cost of the
combination; and
 Recognise immediately in profit or loss any excess
remaining after that reassessment

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 International Financial Reporting Standards

• Convergence of accounting standards globally

• Target may consider restate historic financial results
under IFRS
• Include a reconciliation of adjustments in information
released to potential buyers
 IFRS require far more intangible assets to be recognized
separately from goodwill
 Goodwill cannot be amortized
 Financial instruments may be accounted quite differently
 More options are available for accounting for cost of
defined benefit pension schemes

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 IFRS3
• https://www.iasplus.com/en/standards/ifrs/ifrs3
• Such business combinations are accounted for using the
'acquisition method', which generally requires assets
acquired and liabilities assumed to be measured at their
fair values at the acquisition date.

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 Related websites
• www.hkicpa.org.hk
• www.afrc.org.hk
• www.dealogic.com

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