Chapter 6

Accounting for Mergers and Acquisitions

Accounting for business restructuring is an important step in assessing the financial viability of the proposed changes. In the United States, financial statements relating to any mergers or acquisitions must receive the approval of Securities and Exchange Commission before permit is issued to investors. In this chapter, we will discuss the purchase accounting method, currently the only method in use, for merger and acquisition (M&A) accounting.

Accounting Methods for M&A

Two accounting methods for M&As existed until January 2001. These methods are the pooling-of-interest method and the purchase method. The pooling-of-interest method requires the original “historical cost” of the assets and liabilities of the target company to be carried forward, while the purchase method requires a new historical cost for the assets and liabilities of the target to be specified. Additionally, a difference between the two methods regarding reporting the earnings exists. The pooling-of-interest method requires that the combined earnings of the combined businesses for any reporting periods, both before or after merger, be reported. According to the purchase method, the earnings of the acquired company are reported by the acquiring company only after the date of acquisition.1

After many years of debate among the concerned parties including investment bankers, corporate leaders, banks, and regulatory agencies about the virtues and weaknesses of the respective methods of accounting for M&As, the Financial Accounting Standards Board (FASB) formed a task force to examine the issue. In January 2001, FASB ruled that the purchase method of accounting for M&As be used. The ruling by FASB to move to the purchase method for merger accounting was based on three considerations. First, FASB argued that the pooling method provides investors with less information. Second, the ruling was based on the notion that the pooling method ignores values exchanged in combination transactions. Finally, the members of FASB’s task force believed that the pooling method provides artificial accounting differences, while the purchase method supplied real economic differences.

Beginning in 2001 all companies, which maintain financial statements under International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP), were required to use the purchase method for business combinations.

Since the pooling method of accounting for mergers is no longer used, we do not discuss the method in this book.

Purchase Method

According to the purchase accounting method, the acquiring company must record the acquired firm at the price it was purchased. All assets and liabilities of the acquired firm must be assigned a percentage of the purchase price of the target firm. This implies that both the assets and liabilities of the acquired firms are imputed according to their current market value. Moreover, the purchase method considers the goodwill that may arise in the transaction as an asset, which can be written off2 over a 40-year period.

The relationship between the price paid for a target company and the acquired firm’s net asset value determines the nature of purchase accounting. Three situations could arise:

1.Price paid = net asset value

The consolidated balance sheet of the new firm is based on merging the assets and liabilities of acquiring and target companies.

2.Price paid > target company’s net asset value

The asset value must be increased to reflect the paid price.

3.Price paid < target company’s net asset value

The assets must be written down3 when preparing the consolidated balance sheet.

Example 6.1

Firm A buys another company by exchanging 1 million dollars of stocks for 1 million dollars’ worth of assets. The book value of the asset shows a value of $250,000. The acquiring company books show assets valued at $250,000; however, the actual value is $1,000,000. After the merger, the acquiring firm would sell the assets for $1,000,000 realizing an earned income of $750,000.

Example 6.2

To illustrate the purchase method of merger accounting, assume that company A purchases company B. The balance sheets of both companies appear as follows.

NAV = A – L,

where NAV denotes net asset value, A refers to assets, and L means liabilities.

In purchasing the assets of another company, three situations arise: payment of a price that is exactly equal to, more than, or less than the net asset value. Each situation requires a different accounting procedure. We  illustrate these cases next.

1.Price = net asset value of the acquired firm

Consolidate the balance sheets by merging the balance sheets of both companies.

Assumptions for calculations of figures in Table 6.4

•Both current and fixed asset values are underestimated by five dollars each. The finding is based on the fair market value of the assets.

•Allocate the balance of $10 as a goodwill value.

Income Statement Effects

If after completion of the merger the asset value has increased, which is often the case, the increased asset value must be reflected in depreciation charges.

We illustrate the income statement effects of the write-up4 of current and fixed assets, under the assumptions of the aforementioned case c.

Summary

This chapter briefly discussed the history of accounting for M&A methods in the United States. It further used a set of simple examples of income statements and balance sheets of an acquiring and a target company to illustrate the purchase method of accounting for mergers.