Accounting for Mergers & Acquisitions
This article explains the basic principles relating to accounting for mergers and acquisitions. The article provides an overview of mergers and acquisitions, with explanations of the most common types of mergers, merger procedures and the means by which companies finance a merger or acquisition. The two most common types of accounting methods for mergers and acquisitions are also described, including the pooling method, which was traditionally used but was phased out in 2001, and the purchase method. In addition, this article also describes the valuation procedures for accounting for mergers and acquisitions, including valuation methodologies using the purchase method, calculating the purchase price and the required disclosures using the purchase method. Finally, various applications of accounting in business combination activities are described, such as tax considerations in a merger or acquisition, pension liabilities and the accretion or dilution of earnings following a merger or acquisition.
Keywords Acquisition; Adjusted Grossed-up Basis; Asset; Business Combination; Carryback; Carryforward; Contra Accounts; Earnings Per Share (EPS); EBITDA; Financial Accounting Standards Board (FASB); Generally Accepted Accounting Principles (GAAP); Goodwill; Income Statement; Liability; Merger; Net Identifiable Assets; Net Operating Loss; Old Target; Pooling; Purchase Method; Realize; Recognize; Salvage Value; Target; Valuation
Accounting: Accounting for Mergers
Mergers and acquisitions are types of business combinations in which separate entities or operations of entities are merged into one reporting entity. Mergers occur when two or more corporations become one. In a typical merger, the assets and liabilities of one company are transferred to another and the two companies no longer operate independently. Shareholders of the merging company become shareholders of the resulting company or are entitled to compensation for their shares. Mergers occur for many reasons such as improved market share or ownership of supply or distribution channels. Mergers can be either friendly or unfriendly. Friendly mergers develop with the management of the merging firms approving and supporting the combination. Hostile mergers are known as takeovers, because they are met with resistance and opposition from the merging firm.
An acquisition occurs when one company acquires, or takes control, of another company. This can occur when the acquiring company assumes total control of the target, or the company that has been identified for acquisition, or when the acquiring company purchases the majority of another company's stock or all of its assets. Although acquisitions can be unfriendly, as in a hostile takeover, in a purchase of assets the acquiring company must still negotiate the asset acquisition with the management of the target. The following sections provide a more in-depth explanation of mergers and acquisitions, and the accounting techniques used in these business combinations.
Mergers and acquisitions are methods by which corporations legally unify ownership of assets formerly subject to separate controls. Mergers and acquisitions are regulated by federal and state laws that are aimed at monitoring the effects of the elimination of competition in an industry, which increases the potential for the dominant company to raise prices or reduce output. However, mergers and acquisitions often result in a number of social benefits. Mergers can bring better management and technical skills to smaller companies and can streamline production processes resulting in reduced costs, quality improvement and product diversification. The following sections explain the types of mergers and acquisitions and the procedures and methods companies use to complete and finance the business combination.
Types of Mergers
There are three common forms of mergers that are the result of the relationship between the merging parties.
- In a horizontal merger, a company acquires a competitor firm that produces and sells an identical or similar product in the same geographic area.
- In a vertical merger, a company acquires a customer or supplier.
- Conglomerate mergers include a number of other types of business combinations, regardless of common geographic location or industry affiliation. Conglomerate mergers may arise when a company wants to expand for reasons not directly related to competition in the marketplace, such as when a furniture manufacturer buys an appliance manufacturer or when a sales agency in Ohio buys a sales agency in Florida.
Like mergers, acquisitions can take several forms. In a tender offer, the acquiring company makes a public offer to purchase a majority of shares from the target company's shareholders, thus bypassing the target company's management. In order to induce the shareholders to sell, or "tender," their shares, the acquiring company typically offers a purchase price higher than the market value of the shares, although the acquiring company may require that enough shares must be tendered in order for the acquiring company to gain control of the target company. If the tender offer is successful, the acquiring company may change the management and certain procedures of the target company or the acquiring company may use its newfound control to effect a merger of the two companies. For instance, in a cash-out merger, the target company is merged into the acquiring company, and the shareholders of the target company are given the right to receive cash for their shares.
Procedures for Mergers
There is no single corporate law in the United States that governs business combinations. Instead, each individual state has its own domestic corporation law. However, companies involved in a merger or acquisition must generally obtain the approval of the board of directors for certain significant corporate changes. In addition, the shareholders of a target company are typically required to give their approval for a merger or acquisition.
The approval of the boards of directors of the companies has to include such information as the terms of the merger and the entities that will survive or be acquired in the transaction. Once the required approvals are obtained, a notice is filed by the surviving entity with the Secretary of State within the state where the entity has been formed. Statutes often provide that corporations formed in different states must follow the rules of the respective states for a merger to be effective.
In addition, companies involved in a merger or acquisition may need to comply with federal securities laws, unless the transaction is exempt from registration under the Securities Act of 1933. For transactions that are not exempt, a registration with the Securities and Exchange Commission is required if the transaction includes corporate modifications, reorganizations or transfers of control in a company.
There are several different methods by which companies finance mergers and acquisitions.
- First, payment may be by cash from the acquiring company's reserves or from cash that has been borrowed from a bank or raised by an issue of bonds.
- Companies may also participate in a leveraged buyout, in which most of the debt is financed by selling off some of the target company's divisions or assets while the acquiring company pays only a small percentage of the total purchase price.
- Also, an acquisition can involve a combination of cash and debt, or a combination of cash and stock of the purchasing entity.
- Finally, there are Employee Stock Ownership Plans ("ESOP"), which call for a firm to tender its own stock, paying for it by borrowing at a bank and then repaying the loan from the employee stock fund.
Ideally, mergers are implemented to facilitate synergism, whereby the value of the merged firm is greater than the sum of the two separate entities. However, mergers are not always this neat. The combined company after a merger can become too large, which can create management problems. Also, company founders or top performers who have aggressively pursued profits at an individual company may become disenchanted by heavy-handed managerial oversight from an acquiring company. Or, the combined operations of the merged companies may not operate as efficiently and effectively as a smaller, streamlined business.
Methods of Accounting for Mergers
Mergers and acquisitions are reported and analyzed using unique accounting methods. Historically, there were two accepted methods of accounting for business combinations: the pooling method and the purchase method, sometimes referred to as the purchase acquisition method. However, the pooling method is no longer permitted for new business combinations initiated after June 30, 2001. Although the pooling method has been phased out, it is still an important accounting method to understand, as many business combinations used this accounting method until it was eliminated. The following sections will provide greater details about these two accounting methods.
Under the pooling method, all assets and liabilities were recorded at existing book values while goodwill was not recorded. As a result, the values for the assets and liabilities listed in the accounting records and financial statements of each company involved in a merger or acquisition were carried forward to the surviving company that remained or was created after the business combination. Under the pooling method, no new assets or liabilities were created by the business combination. Further, the income statement of the surviving company included all of the revenues and expenses of the fiscal year for each company. Ultimately, the operating results for both companies were combined for all periods prior to the closing date, and previously issued financial statements were restated as though the companies had always been combined.
The pooling method was not designed to be used whenever it would produce favorable accounting records. Instead, it was intended to be used only for mergers of two entities of approximately equal value. This method came under increasing scrutiny and disfavor because over time it created disparate financial outcomes in transactions that were otherwise relatively similar, and thus became a tool that could be misused for financial gain. For instance, if an acquiring company paid cash for an acquisition, the accounting records created using the pooling method could appear to reflect that the acquiring company had lower earnings and financial returns compared to companies that paid using debt or a cash and stock combination because an acquiring company paying cash could amortize the additional goodwill on its income statement. In addition, the pooling method was unique to the United States, and this raised concern among the global accounting community that the use of different accounting methods may produce unequal or biased financial statements. As a result, the pooling method was eliminated as an approved accounting method in July of 2001.
The purchase method is now the preferred accounting method used for business combinations. Under the purchase method, the purchase price and costs of the acquisition are allocated to the identified assets that are acquired, whether tangible or intangible, and to any liabilities that are assumed based on the current fair market value of the assets and liabilities. If the purchase price exceeds the fair value of the purchased company's net assets, the excess is recorded as goodwill. Goodwill, or the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed, is almost always present because the purchase price of a target or its assets is almost always higher than the sum of the fair values of all of the assets being purchased. This is because a company is more than just the sum of its assets. It also has intangible qualities such as its reputation in the business community that add to its value beyond the market value of its assets. However, the purchase method does not allow the allocated purchase price for any asset to exceed its fair value. Thus, the excess is recorded as goodwill as a type of catchall category.
In addition, under the purchase method, earnings or losses of the purchased company are included in the acquiring company's financial statements beginning on the closing date of the acquisition. The total liabilities of the combined firms equal the sum of the two firms' individual liabilities. The equity of the acquiring firm is increased by the amount of the purchase price. Short-term or current liabilities have a current fair value equal to their book value. Long-term liabilities may have fair values different from current book value should the face amount of the interest rate not fluctuate with current market conditions.
Attitudes toward the purchase method are not altogether positive. The method was blamed by Gerard Cassidy, a director of equity research, for M&A activity in the banking industry slowing down considerably following the thrift and banking crises of the late 1980s and early 1990s (Anason, 2012).
Accounting Procedures for Mergers
Under the purchase method of accounting for mergers and acquisitions, all assets acquired and liabilities assumed are recorded at their current fair market value. This process follows certain valuation procedures.
- First, the process of allocating valuation among the various assets purchased starts with the determination of tangible assets purchased, such as inventory, equipment or furniture.
- Next, any identifiable intangible assets are classified and valued, such as trademarks, patents or covenants not to compete.
- Finally, if appropriate, goodwill is recorded and expensed down to its fair value.
In addition to the valuation of a target's assets and liabilities, an appropriate purchase price for the target must also be calculated. This calculation involves determining the minimum and maximum price that an acquiring company should pay for the target. Once this range has been established, the negotiations between the acquiring company and the target get underway. Finally, when the transaction has been completed, certain information must be disclosed in the financial statements of the companies. The following sections will provide further explanation of these valuation procedures.
Valuation Using the Purchase Method
Under the purchase method of accounting, there are specific methodologies for valuing each major balance sheet category, and each of these categories must be assessed and valued in order to properly calculate the assets of the target company. For cash and accounts receivable, these items are reduced for bad debt and returns and are then valued at their values on the books of the target company prior to the acquisition. Marketable securities are valued at their realizable value after any transaction costs. Inventories are broken into finished goods and raw materials. Finished goods are valued at their liquidation value; raw materials inventories at...
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