2.5.1 Acquisition expenses

The inclusion of directly attributable costs within the cost of a business combination (effectively reflecting them within goodwill) under FRS 102 differs significantly from IFRS 3, which requires that acquisition-related transaction costs are expensed.

2.5.2 Contingent consideration

FRS 102 requires recognition of any contingent consideration to be made at the acquisition date if the adjustment is ‘probable and can be measured reliably’. [FRS 102.19.12]. If the potential adjustment is not recognised at the acquisition date, but subsequently becomes probable and can be measured reliably, the additional consideration is treated as an adjustment to the cost of the combination. [FRS 102.19.13]. Similarly, if the future events that, at the acquisition date, were expected to occur do not occur, or the estimate needs to be revised, the cost of the business combination is adjusted accordingly. [FRS 102.19.13A].

Some clarifications to FRS 102's requirements for contingent consideration were made as part of the Amendments to FRS 102 Triennial review 2017 – Incremental improvements and clarifications (Triennial review 2017). See discussion at 3.6.2 below.

In contrast, under IFRS 3, the acquisition-date fair value of any contingent consideration is recognised as part of the consideration transferred in acquiring the business – regardless of whether payment is probable or can be measured reliably. The obligation for the contingent consideration is classified as equity or a financial liability based on the definition of an equity instrument and a financial liability in IAS 32 – Financial Instruments: Presentation. Contingent consideration that is classified as equity is not remeasured. [IFRS 3.58]. This contrasts with FRS 102, under which, we believe that contingent consideration classified as equity would be adjusted for the number of equity instruments issued, but not changes to their fair value (see 3.6.5 below).

Under IFRS, subsequent changes in the fair value of the contingent consideration classified as a financial liability are not accounted for as adjustments to the consideration transferred, but are reflected in profit or loss – they therefore do not result in changes to goodwill as they would under FRS 102. [IFRS 3.58].

2.5.3 Contingent payments to employees or selling shareholders

FRS 102 provides no guidance on the accounting to be applied where further contingent amounts may be payable to vendors who become, or continue to be, key employees of the acquiree subsequent to the acquisition.

In contrast, IFRS 3 specifically identifies a transaction that remunerates employees or former owners of the acquiree for future services as not part of the cost of the business combination, [IFRS 3.52(b)], and contains specific guidance to assist in the determination of whether arrangements for contingent payments to employees or selling shareholders are contingent consideration in the business combination or are separate transactions. [IFRS 3 Appendix B.54-55]. That guidance specifically states that ‘a contingent consideration arrangement in which the payments are automatically forfeited if employment terminates is remuneration for post-combination services’. [IFRS 3 Appendix B.55(a)].

Under FRS 102, we believe that an acquirer must make this same distinction and therefore identify contingent consideration that is, in substance, compensation for future services, and account for this separately from the cost of the combination. This is because Section 2 – Concepts and Pervasive Principles – includes as one of the qualitative characteristics of information in financial statements ‘substance over form’, requiring that ‘transactions and other events and conditions should be accounted for and presented in accordance with their substance and not merely their legal form’. [FRS 102.2.8]. Therefore, where a vendor is also a continuing employee, it is necessary to determine whether payments are made to them in their capacity as vendor or as employee.

3.1.1 Application of the purchase method

FRS 102 requires all business combinations to be accounted for by applying the purchase method, except for: [FRS 102.19.6]

• group reconstructions which may be accounted for by using the merger accounting method; and
• public benefit entity combinations that are in substance a gift or that are a merger which shall be accounted for in accordance with Section 34.

The accounting for group reconstructions under FRS 102 is discussed at 5 below.

Public benefit entity combinations are discussed in Chapter 31 at 6.4.

3.2.1 Business combination defined

FRS 102 defines a business combination as ‘the bringing together of separate entities or businesses into one reporting entity’. [FRS 102.19.3]. It then goes on to say that ‘the result of nearly all business combinations is that one entity, the acquirer, obtains control of one or more other businesses, the acquiree’. [FRS 102.19.3].

For this purpose, FRS 102 defines a ‘business’ as ‘an integrated set of activities and assets conducted and managed for the purpose of providing:

1. a return to investors; or
2. lower costs or other economic benefits directly and proportionately to policyholders or participants’.

‘A business generally consists of inputs, processes applied to those inputs, and resulting outputs that are, or will be, used to generate revenues. If goodwill is present in a transferred set of activities and assets, the transferred set shall be presumed to be a business.’ [FRS 102 Appendix I].

3.2.2 Inputs, processes and outputs

FRS 102 does not discuss further the meaning or interaction of inputs, processes or outputs. However, the application guidance to IFRS 3 expands upon them as follows: [IFRS 3 Appendix B.7]

• Input: Any economic resource that creates, or has the ability to create, outputs when one or more processes are applied to it. Examples include non-current assets (including intangible assets or rights to use non-current assets), intellectual property, the ability to obtain access to necessary materials or rights and employees.
• Process: Any system, standard, protocol, convention or rule is a process if, when applied to an input or inputs, it either creates or has the ability to create outputs. Examples include strategic management processes, operational processes and resource management processes. These processes typically are documented, but an organised workforce having the necessary skills and experience following rules and conventions may provide the necessary processes that are capable of being applied to inputs to create outputs. Accounting, billing, payroll and other administrative systems typically are not processes used to create outputs so their presence or exclusion generally will not affect whether an acquired set of activities and assets is considered a business.
• Output: The result of inputs and processes applied to those inputs that provide or have the ability to provide a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants.

As noted at 2.3 above, the IASB has issued an amendment to the definition of a business and related application guidance in IFRS 3, which will apply to business combinations for which the acquisition date is, or asset acquisitions occurring, on or after the beginning of the first annual reporting period beginning on or after 1 January 2020 (with earlier application permitted). The changes to the application guidance may lead to different determinations of what constitutes a business under IFRS 3 compared to FRS 102 (which has no application guidance). The amendment also makes some clarifications to the descriptions above of inputs and processes and narrows the definition of outputs by focusing on goods and services provided to customers and by removing the reference to an ability to reduce costs, in order to better distinguish between a business combination and an asset acquisition.

As discussed at 3.1 above, the acquisition of a group of assets – notwithstanding that they may be held within a separate entity or entities – which do not constitute a business is excluded from the scope of Section 19. In some situations, there may be difficulties in determining whether or not an acquisition of a group of assets constitutes a business, and judgement will need to be exercised based on the particular circumstances.

The following are examples from extractive and real estate industries that illustrate the issues.

There is a rebuttable presumption that if goodwill arises on the acquisition, the acquisition is a business. [FRS 102 Appendix I]. If, for example, the total fair value of an acquired set of activities and assets is £15 million and the fair value of the net identifiable assets is only £10 million, the existence of value in excess of the fair value of identifiable assets (i.e. goodwill) creates a presumption that the acquired set is a business. However, care should be exercised to ensure that all of the identifiable net assets have been identified and measured appropriately. While the absence of goodwill may be an indicator that the acquired activities and assets do not represent a business, it is not presumptive.

3.2.3 Differing combination structures

FRS 102 indicates that a business combination may be structured in a variety of ways for legal, taxation or other reasons. It may involve: [FRS 102.19.4]

• the purchase by an entity of the equity of another entity;
• the purchase of all the net assets of another entity;
• the assumption of the liabilities of another entity; or
• the purchase of some of the net assets of another entity that together form one or more businesses.

It may be effected by the issue of equity instruments, the transfer of cash, cash equivalents or other assets, or a mixture of these. The transaction may be between the shareholders of the combining entities or between one entity and the shareholders of another entity. It may involve the establishment of a new entity to control the combining entities or net assets transferred, or the restructuring of one or more of the combining entities. [FRS 102.19.5]. Whatever the legal structure, if it is a ‘business combination’ then the requirements of Section 19 apply (unless it is specifically excluded).

As indicated above, a business combination may involve the purchase of the net assets, including any goodwill, of another entity rather than the purchase of the equity of the other entity. Such a combination does not result in a parent-subsidiary relationship. Nevertheless, the acquirer (even if it is a single entity), will account for such a business combination in its individual or separate financial statements and consequently in any consolidated financial statements.

3.3.1 Company law issues

The purchase method as outlined in Section 19 corresponds with the description of the acquisition method in UK company law: [6 Sch 9]

• the identifiable assets and liabilities of the undertaking acquired must be included in the consolidated balance sheet at their fair values as at the date of acquisition;
• the income and expenditure of the undertaking acquired must be brought into the group accounts only as from the date of the acquisition;
• there must be set off against the acquisition cost of the interest in the shares of the undertaking held by the parent company and its subsidiary undertakings the interest of the parent company and its subsidiary undertakings in the adjusted capital and reserves of the undertaking acquired;
• the resulting amount if positive must be treated as goodwill, and if negative as a negative consolidation difference; and
• negative goodwill may be transferred to the consolidated profit and loss account where such a treatment is in accordance with the principles and rules of Part 2 of Schedule 1 to these Regulations.

The accounting for goodwill (positive or negative) under Section 19 is discussed at 3.9 below.

3.4.1 Reverse acquisitions

While not explicitly mentioned in FRS 102, it is implicitly recognised that in some business combinations, commonly referred to as reverse acquisitions, the acquirer is the entity whose equity interests have been acquired and the issuing entity is the acquiree. This might be the case when, for example, a private entity arranges to have itself ‘acquired’ by a small public entity as a means of obtaining a stock exchange listing and, as part of the agreement, the directors of the public entity resign and are replaced with directors appointed by the private entity and its former owners. Although legally the issuing public entity is regarded as the parent and the private entity is regarded as the subsidiary, the legal subsidiary is the acquirer if it has the power to govern the financial and operating policies of the legal parent so as to obtain benefits from its activities. See 3.10 below for further discussion on reverse acquisitions.

3.4.2 Newly incorporated entities formed to effect a business combination

Occasionally, a new entity is formed to issue equity instruments to effect a business combination between, for example, two other entities. FRS 102 does not explicitly deal with this situation, but it is dealt with in IFRS 3 and was dealt with under previous UK GAAP in FRS 6. IFRS 3 requires that one of the combining entities that existed before the combination be identified as the acquirer. [IFRS 3 Appendix B.18]. Similarly, FRS 6 required that where the combination of the entities other than the new parent would have been an acquisition, one of the combining entities would be identified as having the role of the acquirer. This acquirer and the new parent company would be first combined by using merger accounting, and the other entities would be treated as having been acquired by this combined company. [FRS 6.14].

FRS 102 contains no such explicit guidance that a new entity would not generally be identified as the acquirer. However, we believe that the same approach should be adopted when a new entity effects a business combination. The substance of the transaction is that one of the two other entities has acquired the other, but they have been brought together legally under the new entity rather than one of these entities acquiring the other. The new entity, itself, has little substance other than as a vehicle to hold the shares in the combining entities, and may have been structured in this way for legal, taxation or other reasons. Therefore, in such a transaction, the combination between the new entity and the identified acquirer is effectively the same as if a new entity had been inserted above an existing entity. Such a ‘group reconstruction’ would be accounted for under merger accounting (see 5.3 below). Reverse acquisition accounting (see 3.4.1 above) is unlikely to be appropriate in this situation because the definition of a business combination (see 3.2.1 above) generally involves an acquirer obtaining control of a business, [FRS 102.19.3], and a newly formed entity would not meet the definition of a business.

However, that is not to say that a new entity that is established to effect a business combination cannot ever be identified as the acquirer. For example, there may be situations where a new entity is established and used on behalf of a group of investors or another entity to acquire a controlling interest in a ‘target entity’ in an arm's length transaction and the consideration is cash or other assets.

3.6.1 Costs directly attributable to the combination

The cost of a business combination includes any costs directly attributable to the combination. FRS 102 does not indicate what types of costs these might be, but we consider that they would include costs such as professional fees paid to accountants, legal advisers, valuers and other consultants to effect the combination. General administrative costs, including the costs of maintaining an acquisitions department, and other costs that cannot be directly attributed to the particular combination being accounted for are not included in the cost of the combination: They are recognised as an expense when incurred. Only incremental internal costs should be included.

It may be that an entity engages another party to investigate or assist in identifying a potential target. Whether any fee payable to such party can be included as part of the cost of the business combination will depend on whether the work performed can be regarded as directly attributable to that particular business combination. Where the fee is payable only if the combination takes place then it should be included as part of the cost.

Transaction costs (for financial instruments) are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or liability, or the issue of an entity's own equity instrument. [FRS 102 Appendix I]. These costs are not included as costs of the business combination, but are accounted for as costs of issuing those instruments. [FRS 102.11.13, 22.9]. They therefore do not affect the measurement of goodwill in the business combination.

Where professional advisors provide advice on all aspects of the business combination, including the arranging and issuing of financial liabilities and / or issuing equity instruments, it will be necessary for some allocation of the fees payable to be made, possibly by obtaining a breakdown from the relevant advisor.

It may be that an entity, at its balance sheet date, is in the process of acquiring another business and has incurred costs that are considered to be directly attributable to that expected business combination. At the balance sheet date, the entity has not yet obtained control over the business. In this situation how should the costs be accounted for? One view is that the costs must be expensed since at the balance sheet date there has been no business combination. However, we believe that since directly attributable costs are to be included in the cost of a business combination, then the costs should be carried forward as an asset from the date that is considered probable that the business combination will be completed. Any costs incurred prior to the date that it is considered probable that the business combination will be completed should be expensed, and remain written off regardless of whether the acquisition takes place; they cannot be reinstated and capitalised at a later date. In the subsequent period, when the business combination is completed, the costs carried forward will be reclassified as part of the cost of the business combination (and therefore into goodwill). If in the subsequent period it is no longer considered probable that the business combination will be completed, then the costs initially recognised as an asset will be expensed to the income statement.

3.6.2 Adjustments to the cost of a business combination contingent on future events (‘Contingent consideration’)

FRS 102 recognises that the terms of a business combination agreement may provide for an adjustment to the cost of the combination contingent on future events, and requires that, in such cases, the acquirer includes an estimate of that adjustment (reflecting the time value of money, if material) in the cost of the combination at the acquisition date if the adjustment is probable (i.e. more likely than not) and can be measured reliably. [FRS 102.19.12].

Such future events might relate to a specified level of profit being maintained or achieved in future periods. A provision for an adjustment is more likely to be made in those situations where the contingent consideration is based on the acquiree maintaining a level of profits which it is currently earning (either for a particular period or as an average over a set period) or achieving profits which it is currently budgeting.

If the potential adjustment is not recognised at the acquisition date but subsequently becomes probable and can be measured reliably, the additional consideration shall be treated as an adjustment (reflecting the time value of money, if material) to the cost of the combination. [FRS 102.19.13]. If the future events that, at the acquisition date, were expected to occur do not occur, or the estimate needs to be revised, the cost of the business combination is adjusted accordingly. [FRS 102.19.13A]. Any subsequent adjustments in respect of contingent consideration will consequently be reflected in the carrying amount of goodwill. However, if an impairment loss has already been recognised in respect of the goodwill (see Chapter 24), this may require a further impairment loss to be recognised.

FRS 102 does not address whether these adjustments should be reflected retrospectively or prospectively. In our view, changes in the probability of an event occurring (or not) reflect conditions arising after the acquisition date and so represent a change in estimate. Changes in accounting estimates are accounted for prospectively (see Chapter 9 at 3.5).

If contingent consideration is adjusted for the time value of money, the unwinding of any discounting is recognised as a finance cost in profit or loss, in the period it arises. [FRS 102.19.13B].

The Triennial review 2017 clarified that the time value of money should be taken into account when determining contingent consideration (if material) and that subsequent adjustments to contingent consideration should be recognised in the cost of the combination. It is not expected that these clarifications will lead to significant changes in practice.

FRS 102 does not provide guidance on determining the discount rate to be used in respect of contingent consideration. In our view, an entity can determine an accounting policy, to be applied consistently, either by analogy to financial liabilities at amortised cost or to provisions. This is further explained in Example 17.6 below.

The following example illustrates how changes to discount rates could be considered.

3.6.3 Distinguishing ‘contingent consideration’ from other arrangements

Other than noting that the cost of a business combination is the aggregate of ‘the fair values, at the acquisition date, of assets given, liabilities incurred or assumed, and equity instruments issued by the acquirer, in exchange for control of the acquiree’ [emphasis added], [FRS 102.19.11], FRS 102 provides no further guidance in distinguishing between consideration given in exchange for control of the acquiree and payments pertaining to other arrangements.

It is important to be able to identify those arrangements that represent contingent consideration and those that do not because contingent consideration generally results in some form of adjustment to the accounting for a business combination (including goodwill). Notwithstanding the structuring of a purchase agreement, which may be for legal, tax, or other reasons, transactions and other events and conditions should be accounted for and presented in accordance with their substance and not merely their legal form. [FRS 102.2.8].

In our view, an arrangement that provides for additional payments to be made to the vendors of an acquiree should be accounted for as contingent consideration if the payment:

1. is made as consideration for the acquisition of a controlling interest in the acquiree (based on the substance of the arrangement); and
2. is contingent on future events that relate to the value of the acquiree (for example, an acquirer makes an additional cash payment if the acquiree achieves a profit target).

It is necessary to consider the substance of the arrangement to determine whether additional payments are made as consideration for the acquisition of a controlling interest in the acquiree (criterion (a) above). Where a vendor has a continuing relationship with the acquirer (for example, an on-going customer or supplier relationship) it is necessary to determine in what capacity payments are made to the vendor. As there is no specific guidance, the following factors may be considered in evaluating the substance of the arrangement:

• whether the additional payments are linked to the on-going relationship;
• what are the reasons for the additional payments; and
• the nature of the formula for determining the additional payments.

Criterion (b) above involves a consideration of whether the contingency relates to the value of the acquiree. If it is not clear what the contingency relates to, it will be necessary to consider its nature carefully in order to determine whether it should be accounted for as contingent consideration or separately from the business combination.

3.6.4 Contingent consideration relating to future services

A particular example of a situation where vendors may have a continuing relationship with the acquirer is where they become, or continue to be, key employees of the acquiree subsequent to the acquisition.

While IFRS 3 specifically identifies a transaction that remunerates employees or former owners of the acquiree for future services as not part of the cost of the business combination, [IFRS 3.52(b)], FRS 102 does not distinguish between contingent consideration that, in substance, is additional purchase price and contingent consideration that, in substance, represents compensation for future services. However, consistent with the discussion at 3.6.3 above, we believe that an acquirer must make such a distinction and therefore identify contingent consideration that is, in substance, compensation for future services, and account for this separately from the cost of the combination. This is because Section 2 includes as one of the qualitative characteristics of information in financial statements ‘substance over form’, requiring that ‘transactions and other events and conditions should be accounted for and presented in accordance with their substance and not merely their legal form’. [FRS 102.2.8]. Therefore, where a vendor is also a continuing employee it is necessary to determine whether payments are made to them in their capacity as vendor or as employee.

If, for example, the consideration takes the form of share-based payments, it is necessary to determine how much of the share-based payment relates to the acquisition of control (which forms part of the cost of combination, accounted for under Section 19) and how much relates to the provision of future services (which is a post-combination operating expense accounted for under Section 26 – Share-based Payment). This would be the case if, for example, the vendor of an acquired entity receives a share-based payment for transferring control of the entity and for remaining in continuing employment.

In the absence of specific guidance, entities will need to apply judgement for evaluating the substance of the contingent consideration or determining an appropriate split. In making such a judgement, entities may consider the requirements and guidance in EU-adopted IFRS dealing with similar or related issues. [FRS 102.10.6]. IFRS 3 contains specific guidance for determining whether arrangements for contingent payments to employees or selling shareholders are contingent consideration in the business combination or are separate transactions. This includes consideration of a number of indicators relating to continuing employment, duration of continuing employment, level of remuneration, incremental payments to employees, number of shares owned, linkage to valuation, formula for determining consideration, and other agreements and issues. [IFRS 3 Appendix B.54-55].

In making such an evaluation, all terms of the agreement have a critical role in this assessment, and the reasons for structuring the terms of the transaction in a particular way, and the identity of the initiator, should be understood. Nevertheless, when the agreement includes employment conditions such that the payments are forfeited upon termination of employment, all or a portion of, the additional payments will generally be classified as employment compensation.

3.6.5 Contingent consideration to be settled by equity instruments

In some business combination agreements involving contingent consideration, it may be that additional consideration will not be settled by cash, but by shares.

Section 19 makes no explicit reference to such a situation. Section 11 scopes out from its provisions ‘Financial instruments that meet the definition of an entity's own equity’, [FRS 102.11.7(b)], while Section 12 and Section 22 – Liabilities and Equity – both scope out from their respective requirements ‘Contracts for contingent consideration in a business combination’ (this exemption applies only to the acquirer). [FRS 102.12.3(g), 22.2(c)].

Section 26 applies to ‘share-based payment transactions’. [FRS 102.26.1]. Section 26 does not explicitly scope out transactions in which an entity acquires goods as part of the net assets acquired in a business combination to which Section 19 applies nor equity instruments issued in a business combination in exchange for control of an acquiree. On this matter, IFRS 2 – Share-based Payment – explicitly scopes these out from its requirements. [IFRS 2.5].

In our view, while not explicitly excluded, as the nature of a business combination is fundamentally different from a transaction to acquire goods or services, we do not consider that the provisions of Section 26 should extend to equity instruments issued in a business combination.

In practice, there is a wide variety of share-settled contingent consideration arrangements, but they are generally based on one of two models:

• arrangements whereby shares are issued to a particular value based on certain conditions being met, e.g. if profits are £A then additional consideration of £M will be given, to be satisfied by shares based on the share price at date of issue; or
• arrangements whereby a particular number of shares are issued if certain conditions are met, e.g. if profits are £A then X shares will be issued, but if profits are £B then Y shares will be issued.

The issues that need to be considered in accounting for such arrangements are:

• If the consideration is recognised, should it be classified as a liability or as equity?
• How should the consideration be valued, both on initial recognition and if reassessed at a later date?

In the above example, the arrangement was of the type where the shares issued to settle the consideration were equivalent to a particular value. However, what if the arrangement was of the type where a particular number of shares are to be issued to satisfy the consideration?

3.7.1 Acquiree's identifiable assets and liabilities

3.7.2 Exceptions to the general recognition and measurement rules

Section 19 makes three exceptions from the general requirements of recognising and measuring the acquiree's assets and liabilities at their acquisition-date fair values.

3.7.3 Determining the acquisition-date fair values

There is no specific guidance in Section 19 on the determination of the fair value of particular assets and liabilities. However, in Appendix I to FRS 102, fair value is defined as ‘the amount for which an asset could be exchanged, a liability settled… between knowledgeable, willing parties in an arm's length transaction. In the absence of any specific guidance provided in the relevant section of this FRS, the guidance in the Appendix to Section 2 – Concepts and Pervasive Principles – shall be used in determining fair value’. [FRS 102 Appendix I]. See Chapter 10 at 8.6 for discussion of this guidance.

Other guidance that might be relevant to the determination of the fair values of specific items includes that in other sections of FRS 102 (see 3.7.3.A to 3.7.3.H below) and also guidance included in IFRS 3 and IFRS 13.

3.7.3.B Intangible assets

Section 18 – Intangible Assets other than Goodwill, provides no guidance on the determination of fair value and so the general guidance in the Appendix to Section 2 is used.

Under IFRS, there are three broad approaches to valuing intangible assets that correspond to the valuation approaches referred to in IFRS 13. [IFRS 13.62]. These are the market, income and cost approaches. The diagram below shows these valuation approaches, together with some of the primary methods used to measure the fair value of intangible assets that fall under each approach, shown in the boxes on the right.

Income-based approaches are the most commonly used of the three in respect of intangible assets. These involve identifying the expected cash flows or economic benefits to be derived from the ownership of the particular intangible asset, and calculating the fair value of an intangible asset at the present value of those cash flows.

Two income-based methods that are commonly used to value intangible assets are:

• the Multi Period Excess Earnings Method (‘MEEM’); and
• the Relief from Royalty method.

The MEEM is a residual cash flow methodology that is often used in valuing the primary intangible asset acquired.

The Relief from Royalty method is often used to calculate the value of a trademark or trade name. This approach is based on the concept that if an entity owns a trademark, it does not have to pay for the use of it and therefore is relieved from paying a royalty. The amount of that theoretical payment is used as a surrogate for income attributable to the trademark. The valuation is arrived at by computing the present value of the after-tax royalty savings, calculated by applying an appropriate royalty rate to the projected revenue, using an appropriate discount rate.

3.7.4 Subsequent adjustments to fair values

If the initial accounting for a business combination is incomplete by the end of the reporting period in which the combination occurs, the acquirer recognises provisional amounts for the items for which the accounting is incomplete. Within twelve months of the acquisition date, the acquirer retrospectively adjusts the provisional amounts recognised as assets and liabilities at the acquisition date to reflect new information obtained, i.e. the adjustments are accounted for as if they were made at the acquisition date. [FRS 102.19.19].

Therefore, FRS 102 requires the allocation of the cost of the business combination to be completed within twelve months of the acquisition date. Where, as a result of completing the initial accounting, adjustments to the provisional values are identified, FRS 102 requires them to be recognised from the acquisition date. Although not explicitly stated in FRS 102, this means that:

1. the carrying amount of the identifiable asset, liability or contingent liability that is recognised or adjusted as a result of completing the initial accounting is calculated as if its fair value at the acquisition date had been recognised from that date;
2. goodwill is adjusted from the acquisition date by an amount equal to the adjustment to the fair value at the acquisition date of the identifiable asset, liability or contingent liability being recognised or adjusted; and
3. comparative information presented for the periods before the initial accounting for the combination is complete is presented as if the initial accounting had been completed from the acquisition date. This includes any additional depreciation, amortisation or other profit or loss effect recognised as a result of completing the initial accounting.

These requirements are illustrated in the following example; the deferred tax implications have been ignored.

The above example illustrates a situation where a provisional value of an asset was finalised at a different amount as part of the completion of the initial accounting. By contrast, the following example illustrates the identification of a new asset as a result of finalising the business combination accounting.

It is important that any adjustments to the provisional allocation reflect conditions as they existed at the date of the acquisition, rather than being affected by subsequent events; the objective is to determine the fair values of the items at the date of acquisition. There is a parallel to be drawn here with the accounting treatment of events subsequent to the balance sheet date. Only those events which provide further evidence of conditions as they existed at the acquisition date should be taken into account.

Beyond twelve months after the acquisition date, adjustments to the initial accounting for a business combination are to be recognised only to correct a material error in accordance with Section 10. [FRS 102.19.19]. This would probably be the case only if the original allocation were based on a complete misinterpretation of the facts that were available at the time; it would not apply simply because new information had come to light which changed the acquiring management's view of the value of the item in question.

Adjustments to the initial accounting for a business combination after it is complete are not made for the effect of changes in estimates. In accordance with Section 10, the effect of a change in estimate is recognised in the current and future periods (see Chapter 9 at 3.5). [FRS 102.10.15-17].

Section 10 requires, to the extent practicable, an entity to correct a material error retrospectively, and to restate the comparative information for the prior period(s) in which the error occurred. [FRS 102.10.21]. The accounting is similar to that outlined above for adjustments upon completion of initial accounting. The only difference being that there is no time limit as to when such adjustments may be required. Section 10 also has specific disclosure requirements in respect of material prior period errors (see Chapter 9 at 3.7.3). [FRS 102.10.23].

3.9.1 Initial recognition

Section 19 requires that an acquirer, at the acquisition date, recognises goodwill acquired in a business combination as an asset. However, rather than attributing a fair value to the goodwill directly, the initial measurement of goodwill is required to be its cost, being the excess of the cost of the business combination over the acquirer's interest in the net amount of the identifiable assets, liabilities and contingent liabilities recognised and measured in accordance with FRS 102. [FRS 102.19.14, 22]. Thus, as discussed at 3.8 above, no amount is included for any goodwill relating to the non-controlling interests.

FRS 102 considers goodwill acquired in a business combination to represent a payment made by the acquirer in anticipation of future economic benefits from assets that are not capable of being individually identified and separately recognised.

Since goodwill is measured as the residual cost of the business combination after recognising the acquiree's identifiable assets, liabilities and contingent liabilities, then, to the extent that the acquiree's identifiable assets, liabilities and contingent liabilities do not satisfy the criteria for separate recognition at the acquisition date, there is a resulting effect on the amount recognised as goodwill. Section 19 makes an explicit statement that this will be the case if the fair value of a contingent liability cannot be measured reliably. [FRS 102.19.20(a)].

3.9.2 Subsequent measurement

After initial recognition, an acquirer measures goodwill acquired in a business combination at cost less accumulated amortisation and accumulated impairment losses. [FRS 102.19.23]. Section 19 defers to Section 18 and Section 27 – Impairment of Assets – for the detailed requirements in relation to amortisation and impairment, respectively. Section 19 requires that goodwill is to be amortised on a systematic basis over a finite useful life following the principles of paragraphs 19 to 24 of Section 18, and that Section 27 is to be followed for recognising and measuring any impairment of goodwill. [FRS 102.19.23].

However, Section 19 states that ‘if, in exceptional cases, an entity is unable to make a reliable estimate of the useful life of goodwill, the life shall not exceed 10 years’. [FRS 102.19.23(a)]. This is consistent with UK company law. [1 Sch 22].

If the useful life of goodwill cannot be reliably estimated, disclosure must be made of the reasons supporting the period chosen (which cannot exceed 10 years). [FRS 102.19.25(g)].

See Chapter 16 at 3.4.3.A and Chapter 24 for further discussion of the requirements of Sections 18 and 27 regarding estimating the useful life, and impairment, respectively.

3.9.3 Excess over cost of acquirer's interest in the net fair value of acquiree's identifiable assets, liabilities and contingent liabilities (negative goodwill)

In some business combinations, the acquirer's interest in the net fair value of the acquiree's identifiable assets, liabilities and contingent liabilities exceeds the cost of the combination. That excess is commonly referred to as ‘negative goodwill’.

Where such an excess arises, Section 19 requires the acquirer to reassess the identification and measurement of the acquiree's identifiable assets, liabilities and contingent liabilities and the measurement of the cost of the combination. [FRS 102.19.24(a)].

Having undertaken that reassessment, any excess remaining after that reassessment is then required to be recognised and separately disclosed on the face of the statement of financial position, immediately below goodwill, and followed by a subtotal of the net amount of goodwill and the excess (i.e. negative goodwill). [FRS 102.19.24(b)].

Following initial recognition on the statement of financial position, negative goodwill up to the fair value of the non-monetary assets acquired is recognised in profit or loss in the periods in which the non-monetary assets are recovered. [FRS 102.19.24(c)]. The reference to ‘non-monetary assets’, which includes items such as inventories, may not actually postpone recognition of negative goodwill for very long. FRS 102 does not specify whether, for example, to allocate negative goodwill to non-monetary assets on a pro rata basis or to specific assets. This determination will lead to different profiles of amortisation. For example, since inventories are usually turned over relatively quickly, any negative goodwill up to the fair value of the inventories (or allocated on the basis of the fair value of the inventories) may be released to the profit and loss account over a short period following the acquisition.

The secondary basis on which negative goodwill should be released to profit or loss involves that element, if any, of negative goodwill in excess of the fair values of non-monetary assets acquired. This element should be released in the periods expected to benefit. [FRS 102.19.24(c)]. The exact meaning of this wording is not completely clear, but any reasonable interpretation is likely to be acceptable. It is unusual for negative goodwill to exceed the non-monetary assets acquired.

3.10.1 Measuring the cost of the business combination

In a reverse acquisition, the accounting acquirer usually issues no consideration for the accounting acquiree; equity shares are issued to the owners of the accounting acquirer (i.e. the legal subsidiary) by the accounting acquirer (i.e. the legal parent). In a reverse acquisition, the cost of the business combination is deemed to have been incurred by the legal subsidiary in the form of equity instruments issued to the owners of the legal parent. The cost of the combination is based on the number of equity instruments the legal subsidiary would have had to issue to provide the same percentage ownership interest of the combined entity to the owners of the legal parent as they have in the combined entity as a result of the reverse acquisition. The fair value of the number of equity instruments so calculated is used as the cost of the combination.

If the fair value of the equity instruments of the legal parent is used as the basis for determining the cost of the combination, it is the total fair value of all the issued equity instruments of the legal parent before the business combination that is used. This might be the case, for example, where the fair value of the legal subsidiary's shares is not clearly evident.

3.10.2 Preparation and presentation of consolidated financial statements

Since the legal parent is the acquiree for accounting purposes, the consolidated financial statements prepared following a reverse acquisition reflect the fair values of the assets, liabilities and contingent liabilities of the legal parent, not those of the legal subsidiary. Therefore, the cost of the business combination is allocated by measuring the identifiable assets, liabilities and contingent liabilities of the legal parent that satisfy the recognition criteria at their fair values at the acquisition date. Any excess of the cost of the combination over the acquirer's interest in the net fair value of those items is then accounted for as goodwill.

In Example 17.15 above, goodwill of £300 would be calculated as the difference between the cost of the combination of £1,600 and the fair value of the assets acquired of £1,300.

Although the accounting for a reverse acquisition reflects the legal subsidiary as being the acquirer, the consolidated financial statements prepared following a reverse acquisition are issued under the name of the legal parent (accounting acquiree). Consequently, we believe that they should be described in the notes as a continuation of the financial statements of the legal subsidiary (accounting acquirer), with one adjustment, which is to adjust retrospectively the accounting acquirer's legal capital to reflect the legal capital of the accounting acquiree. Comparative information presented in those consolidated financial statements is therefore that of the legal subsidiary (accounting acquirer) – not that originally presented in the financial statements of the legal parent (accounting acquiree) – but is adjusted to reflect the legal capital of the legal parent (accounting acquiree).

Because the consolidated financial statements represent the continuation of the financial statements of the legal subsidiary except for its capital structure, the consolidated financial statements reflect:

• the assets and liabilities of the legal subsidiary (accounting acquirer) recognised and measured at their pre-combination carrying amounts, i.e. not at their acquisition-date fair values;
• the assets and liabilities of the legal parent (accounting acquiree) recognised and measured in accordance with Section 19, i.e. generally at their acquisition-date fair values;
• the retained earnings and other equity balances of the legal subsidiary (accounting acquirer) before the business combination, i.e. not those of the legal parent (accounting acquiree);
• the amount recognised as issued equity interests in the consolidated financial statements determined by adding the issued equity interest of the legal subsidiary (accounting acquirer) outstanding immediately before the business combination to the fair value of the legal parent (accounting acquiree). However, the equity structure (i.e. the number and type of equity interests issued) reflects the equity structure of the legal parent (accounting acquiree), including the equity interests the legal parent issued to effect the combination. Accordingly, the equity structure of the legal subsidiary (accounting acquirer) is restated using the exchange ratio established in the acquisition agreement to reflect the number of shares of the legal parent (accounting acquiree) issued in the reverse acquisition;
• any non-controlling interest's proportionate share of the legal subsidiary's (accounting acquirer's) pre-combination carrying amounts of retained earnings and other equity interests (as discussed at 3.10.3 below); and
• the income statement for the current period reflects that of the legal subsidiary (accounting acquirer) for the full period together with the post-acquisition results of the legal parent (accounting acquiree) based on the attributed fair values.

The equity as shown above would require further adjustment in a UK company. As stated above, the amount of share capital in the consolidated balance sheet does not equal the nominal value of either Entity B's share capital (£60) or that of Entity A following the acquisition (£250). Although the total share capital and share premium (issued equity) in the consolidated balance sheet of £2,200 is equivalent to the total as it would have been if Entity B had been the legal acquirer, the equity structure (i.e. the number and type of equity instruments issued) should reflect that of the legal parent and in a UK GAAP context, the amounts for share capital and related reserves, such as share premium, in the consolidated financial statements should also reflect the legal position. On this basis, a reserve, often called a ‘reverse acquisition reserve’ would be reflected as illustrated below.

3.10.3 Non-controlling interests

In some reverse acquisitions, it may be that some of the owners of the legal subsidiary (accounting acquirer) might not exchange their equity interests for equity interests of the legal parent (accounting acquiree), but retain their interest in the equity instruments of the legal subsidiary. Those owners are treated as a non-controlling interest in the consolidated financial statements after the reverse acquisition. That is because the owners of the legal subsidiary that do not exchange their equity interests for equity interests of the legal acquirer have an interest in only the results and net assets of the legal subsidiary – not in the results and net assets of the combined entity. Conversely, even though the legal parent is the acquiree for accounting purposes, the owners of the legal parent have an interest in the results and net assets of the combined entity.

The assets and liabilities of the legal subsidiary are measured and recognised in the consolidated financial statements at their pre-combination carrying amounts. Therefore, in a reverse acquisition, the non-controlling interest reflects the non-controlling shareholders' proportionate interest in the pre-combination carrying amounts of the legal subsidiary's net assets. These requirements are illustrated in the following example.

4.3.1 Contingent liabilities

Where contingent liabilities of the acquiree cannot be reliably measured, the acquirer discloses the information about that contingent liability as required by Section 21 (see Chapter 19 at 3.10.3). [FRS 102.19.20(b)].

4.3.2 Step acquisitions

As discussed at 3.11 above, in rare cases where the method for calculating goodwill set out in company law and paragraph 9.19B would be misleading, the goodwill should be calculated as the sum of goodwill arising from each purchase of an interest in the relevant undertaking adjusted as necessary for any subsequent impairment. Where the FRS 102 or statutory requirement is not applied, paragraph 3.5 sets out the necessary disclosures when applying a ‘true and fair override’ (see Chapter 6 at 9.2.2).

4.3.3 Company law disclosures

The CA 2006 contains a number of detailed disclosure requirements that are relevant for business combinations to be shown in the notes to the financial statements. [6 Sch 13]. Some of these duplicate those contained in FRS 102 but there are a few additional matters in the legislation that need to be considered.

The CA 2006 requires disclosure of the names of subsidiaries acquired, and whether they have been accounted for by the acquisition or the merger method of accounting, even if they do not significantly affect the figures shown in the consolidated financial statements. [6 Sch 13(2)].

In relation to an acquisition which significantly affects the figures shown in the consolidated financial statements, the CA 2006 requires disclosures of: [6 Sch 13(3)-(4)]

• the composition and the fair value of the consideration for the acquisition given by the parent company and its subsidiary undertakings;
• where the acquisition method of accounting has been adopted:
  • the book values immediately prior to the acquisition of each class of assets and liabilities of the undertaking or group acquired (to be stated in tabular form);
  • the fair values at the date of acquisition, of each class of assets and liabilities of the undertaking or group acquired (to be stated in tabular form);
  • a statement of the amount of any goodwill or negative consolidation difference arising on the acquisition;
  • an explanation of any significant adjustments made.

There must also be stated the cumulative amount of goodwill resulting from acquisitions in that and earlier years which has been written off otherwise than in the consolidated profit and loss account. That figure must be shown net of any goodwill attributable to subsidiary undertakings or businesses disposed of prior to the balance sheet date. [6 Sch 14]. This disclosure requirement would apply in limited circumstances only, for example when the entity has legacy amounts of goodwill written off directly to reserves, which was a policy permitted under previous UK GAAP prior to the introduction of FRS 10 – Goodwill and intangible assets. Under FRS 102, such amounts are never recycled to profit or loss.

UK company law provides an exemption from disclosing the above information in certain circumstances. It need not be disclosed with respect to an undertaking which:

• is established under the law of a country outside the United Kingdom, or
• carries on business outside the United Kingdom,

if in the opinion of the directors of the parent company the disclosure would be seriously prejudicial to the business of that undertaking or to the business of the parent company or any of its subsidiary undertakings and the Secretary of State agrees that the information should not be disclosed. [6 Sch 16].

5.2.1 Company law considerations

UK company law sets out requirements that have to be met in consolidated financial statements before merger accounting can be applied. The conditions laid down in the Regulations for accounting for an acquisition of a subsidiary undertaking as a merger are that: [6 Sch 10]

1. the undertaking whose shares are acquired is ultimately controlled by the same party both before and after the acquisition (see 5.2.1.A);
2. the control referred to above is not intended to be transitory (see 5.2.1.B); and
3. the adoption of the merger method of accounting accords with generally accepted accounting principles or practice (see 5.2.1.C).

The conditions set out in the Regulations apply only to consolidated financial statements and where an undertaking becomes a subsidiary undertaking of the parent company. [6 Sch 7(1)]. They do not apply to group reconstructions involving a business which is not a subsidiary undertaking.

There are no longer restrictions over the extent of the consideration not in the form of equity shares or over the percentage shareholding in the acquiree obtained, which were conditions of merger accounting under now superseded company law.

5.3.1 Carrying values of assets and liabilities

For group reconstructions involving the transfer of an equity holding in a subsidiary from one group entity to another, no adjustments would be expected to be required to conform accounting policies. This is because in the preparation of the consolidated financial statements of the ultimate parent entity, uniform accounting policies would have been expected to be adopted by all members of the group. However, it may be necessary to make adjustments where the combining entities have used different accounting policies when preparing their own financial statements. This is more likely to be the case for a group reconstruction involving the combination into a group of two or more entities that before the combination had the same equity holders.

The main issue relating to the use of carrying values is whether the amounts for the transferred entity (or entities) should be based on the carrying values reported at the level of:

1. financial statements of the transferred entity; or
2. the consolidated financial statements of the parent.

The carrying amounts with respect to the reporting entity are the same as those in its existing financial statements prior to the transfer of the other entity.

In our view, either basis would be acceptable. Using the carrying values reported in the financial statements of the transferred entity is more straightforward. Rather than the assets and liabilities being reported in two previous sets of financial statements, they are now reported in a single set of financial statements. Indeed, the Regulations state that ‘the assets and liabilities of the undertaking acquired must be brought into the group accounts at the figures at which they stand in the undertaking's accounts, subject to any adjustment authorised or required by this Schedule’. [6 Sch 11(2)]. However, where the transferred entity had been previously acquired by the parent, using the carrying values (including any fair value adjustments and goodwill arising on that acquisition) reported in the consolidated financial statements of the parent may be more appropriate. This results in the assets and liabilities being reported on the same basis as if the transferred entity had been acquired by the reporting entity at the time the transferred entity was acquired by the parent, and could be considered to provide information that may be more relevant to the parent.

5.3.2 Restatement of financial information prior to the date of the combination

The description of the merger accounting method explicitly requires the results (and cash flows) of all combining entities to be included from the beginning of the financial year and for comparatives to be restated. [FRS 102.19.30]. This will be appropriate where the entity applying the merger accounting method in its consolidated financial statements and the entity (or entities) transferred to it under the group reconstruction have been under the control of the ultimate parent or common controlling party for at least that period of time. Indeed, this is consistent with the equivalent requirements in the Regulations which are as follows:

• the income and expenditure of the undertaking acquired must be included in the group accounts for the entire financial year, including the period before the acquisition; and
• the group accounts must show corresponding amounts relating to the financial year as if the undertaking acquired had been included in the consolidation throughout that year. [6 Sch 11(3), (4)].

Effectively, the use of the merger accounting method results in the consolidated financial statements reflecting information as if the new sub-group had existed for the entire duration of the period covered by the financial statements. However, where the entities have come under the common control of the ultimate parent or common controlling party at a date after the beginning of the comparative period, this will not have been the case. In that situation, we believe that the results (and cash flows) of the transferred entity (or entities) should be included only from the date that it, and the entity applying the merger method of accounting, came under the control of the parent or the controlling party. This is the earliest date that the sub-group could have been created, and the results (and cash flows) should reflect that position.

5.3.3 Equity eliminations

As well as combining the assets and liabilities of the companies concerned, it will be necessary to eliminate the share capital of the new subsidiary against the cost of the investment as stated in the balance sheet of the new holding company. This is in principle a straightforward exercise, but when the two amounts do not equate to each other, the question arises of what to do with the difference, positive or negative.

The description of the merger accounting method at 5.3 above appears to presume that the cost of the investment will normally be carried at the nominal value of the shares of the new holding company which have been issued to effect the combination, together with the fair value of any other consideration given. (The ability to record these shares at nominal rather than fair value on issue depends on qualifying for merger relief under section 612 of the CA 2006, which is discussed at 5.5.1 below.) This will not be the case in a group reconstruction falling within the ambit of group reconstruction relief under section 611 of the CA 2006 (see 5.5.2 below) where, as a result of recognising a minimum premium value in share premium, the cost of investment reflects an amount in excess of the nominal value of the shares issued. However, we believe that this cost should be used in determining the difference to be accounted for under FRS 102, consistent with the requirements of the CA 2006 (see 5.5.2 below). [6 Sch 11(5), (7)].

FRS 102 requires the difference to be shown as a movement on other reserves in the consolidated financial statements and also to be shown in the statement of changes in equity. [FRS 102.19.31]. The CA 2006 also requires such difference to be shown as a movement in consolidated reserves. [6 Sch 11(6)]. However, neither FRS 102 nor the legislation specifies any particular reserve.

Where the cost of the investment is less than the nominal value of the share capital of the subsidiary, the elimination of these two amounts will leave a residual credit in shareholders' funds in the consolidated balance sheet; this is generally classified as some form of capital reserve (or merger reserve).

Where the reverse situation applies, the net debit has to be eliminated against consolidated reserves. There are no particular rules on the matter, but common practice is to eliminate against a merger or similar reserve, or retained earnings, although some companies create a separate debit reserve. To the extent that the subsidiary has reserves that may be reclassified to profit or loss in the future under FRS 102, e.g. a cash flow hedge reserve, a fair value available-for-sale reserve (where IAS 39 – Financial Instruments: Recognition and Measurement – is applied) or a reserve arising from debt assets at fair value through other comprehensive income under IFRS 9 – Financial Instruments, it would not be appropriate to eliminate any debit adjustment against such reserves.

Apart from the effects of dealing with any imbalance as discussed above, there is no other elimination of the reserves of the subsidiary, which are combined with those of the holding company, in contrast to the treatment under the purchase method. However, some of the subsidiary's other reserves may need to be reclassified in order to make sense in the context of the group financial statements.

FRS 102 requires that any existing balance on the share premium account or capital redemption reserve of the new subsidiary undertaking should be brought in by being shown as a movement on other reserves. [FRS 102.19.31]. This is because these statutory reserves do not relate to the share capital of the reporting entity. Again, this difference should be shown in the statement of changes in equity. [FRS 102.19.31]. Such a difference should probably be taken to the same reserve as that on the elimination of the share capital of the subsidiary, because in reality the distinction between share capital and share premium can be considered arbitrary in this context.

Although the discussion above deals with the equity eliminations required, the application of the merger method of accounting also requires comparative information in the consolidated financial statements to be restated (see 5.3.2 above). Assuming the new subsidiary is being included from the beginning of the comparative period, this will generally mean that where share capital has been issued by the reporting entity to effect the group reconstruction, in applying the merger method of accounting, it should also be treated as if it had been in issue at the beginning of that period. However, if the subsidiary had issued any share capital between that date and the date of the group reconstruction, the equivalent amount of shares issued by the reporting entity to acquire those shares should be treated as if the shares had been issued on the same date as the subsidiary, not at the beginning of the comparative period. Where the reporting entity has given any other form of consideration to effect the group reconstruction, e.g. cash or incurred an inter-company financial liability, arguably this should also be accounted for as if the liability for such consideration arose at the beginning of the comparative period, but this then raises an issue as to whether the liability should be discounted to its present value at that date, with any unwinding of the discount reflected in the consolidated profit or loss. However, we believe it would be acceptable to account for the liability for such consideration at the date of the reorganisation, with the corresponding debit being reflected in the consolidated statement of equity at that time.

5.3.4 Expenses of the merger

One other question which sometimes arises in this context is how to account for the expenses of the merger. FRS 102 requires that all merger expenses should be charged to the statement of comprehensive income as part of profit or loss of the combined entity at the effective date of the group reconstruction. [FRS 102.19.32].

However, some of these costs may be regarded as share issue expenses and therefore qualify to be written off against any share premium account recognised by the holding company in respect of the shares issued to effect the group reconstruction. FRS 102 does not prohibit the subsequent charging of such costs to the share premium account by means of a transfer between reserves.

5.3.5 Non-coterminous accounting periods

Particular practical problems in applying the merger method of accounting can arise when the accounting periods of the combining companies do not match each other. For many group reconstructions involving existing companies within a group, this should not be an issue as the ultimate controlling parent may have taken steps to ensure that its subsidiaries had coterminous accounting periods (or prepared interim financial statements as at the ultimate controlling parent's reporting date). However, for some forms of group reconstructions that may not be the case and the requirement (in applying merger accounting) to restate the consolidated financial statements retrospectively can cause difficulties.

Company law dictates that directors of a company, as well as preparing individual accounts for a company's financial year (based on its accounting reference period), must also prepare group accounts for the same year. [s399(2)]. The Companies Act group accounts so prepared must give a true and fair view in respect of the accounting period of the parent company, [s404(2)], so this will require the period used by the subsidiary to be made to conform to that of its parent rather than the other way round. Naturally, the parent could change its own accounting reference date, but this can be amended only for the future, not retrospectively. It will therefore be necessary to try to draw up financial statements for the subsidiary at each of the relevant balance sheet dates of its new parent company.

Another treatment which may be appropriate is to use non-coterminous years for the comparative figures, with the result that there will be the need to deal with the effects of either a ‘gap’ or an overlapping period as an adjustment to reserves. However, the use of such non-coterminous financial statements would be appropriate only if the consolidated financial statements present materially the same picture as if coterminous years had been used. As indicated in Chapter 8 at 3.5.2, the Regulations and Section 9 require that, in preparing consolidated financial statements, a subsidiary's reporting date can be used only if it is no more than three months before that of the parent, and that adjustments are made for the effects of significant transactions or events that occur between the subsidiary's reporting date and those of the consolidated financial statements.

A particular problem can arise when a company is incorporated for the purpose of acting as the new parent company in a group reconstruction. The accounting reference period of the group must by law be that of the parent company, so this may result in the inadvertent creation of an accounting period which is not the one the group would have preferred. Moreover, unless the company has been in existence for two years, arguably its statutory accounts should not be able to deal with the results of the group for the current and comparative periods, because strictly they should go back only as far as the date of incorporation of the parent company.

However, in practice, particularly in situations where a new top holding company is set up as part of a group reconstruction, many companies simply produce consolidated financial statements for the more relevant period(s), as if the company had always been in existence. Only the individual financial statements of the new top holding company are prepared for the period from the date of incorporation. The justification for this approach is based on the more specific provisions of the Regulations relating to group accounts:

• the consolidated balance sheet and profit and loss account must incorporate in full the information contained in the individual accounts of the undertakings included in the consolidation; [6 Sch 2(1)] and
• the principles of the merger accounting method require information for the undertaking acquired to be included for an entire year, with comparatives for the previous year. [6 Sch 11(3)-(4)].

Consider the following example:

5.4.1 Hive transactions

A common transaction in the individual financial statements of entities within a group is the transfer of trade and assets from one entity to another. These result in different accounting issues, which are discussed at 5.4.1.A to 5.4.4 below. This guidance focuses on three variations of a transfer of trade and assets from:

• a subsidiary to a parent, (‘hive up’);
• one subsidiary to a fellow subsidiary, (‘hive across’); and
• a parent to a subsidiary, (‘hive down’).

In all of the following discussion and examples in 5.4.1.A to 5.4.4 below, it is assumed that the conditions for the use of merger accounting in FRS 102 are met (see 5.2 above), i.e.:

• the ultimate equity holders remain the same, and the rights of each equity holder, relative to the others, are unchanged; and
• no non-controlling interest in the net assets of the group is altered by the transfer.

The other condition is that the use of the merger accounting method is not prohibited by company law or other relevant legislation. [FRS 102.19.27]. All of the following examples relate to individual accounts. Therefore, the conditions for use of the merger accounting method included in the Regulations and LLP Regulations do not apply; these conditions apply only in group accounts. [6 Sch 10, 6 Sch 10 (LLP)].

In addition, it is assumed that the trade and assets transferred meet the definition of a business in the Glossary to FRS 102, [FRS 102 Appendix I], (see 3.2.1 above).

5.4.2 Hive up transactions

5.4.3 Hive across transactions

Similar issues arise when considering a hive across transaction, as when considering a hive up (see 5.4.2 above): the seller must consider whether it is making a sale at undervalue (see 5.4.1.B above), and the buyer must consider the appropriate basis on which to recognise the net assets acquired in its individual financial statements (see 5.4.1.A above).

5.4.4 Hive down transactions

5.4.5 Financial information prior to the date of the combination

The description of the merger accounting method explicitly requires the results (and cash flows) of all combining entities to be included from the beginning of the financial year and for comparatives to be restated. [FRS 102.19.30]. While these paragraphs are framed in the context of a parent combining with a new subsidiary, and will apply to consolidated financial statements prepared by the parent, the definition of a group reconstruction includes, for example, the hive transactions discussed at 5.4.1 to 5.4.4, above.

Application of the requirement to restate comparative information to such transactions, [FRS 102.19.30], would mean that the entity accounting for the acquired business under the merger method of accounting would include the results of that business from the beginning of the financial year and in the comparative year in its individual financial statements. However, in the context of individual financial statements, consideration needs to be given to paragraph 13(a) of Schedule 1 to the Regulations which requires that only profits realised at the reporting date are included in profit or loss. [FRS 102 Appendix III.25]. This results in two possible approaches, of which the former is most common practice (note that legal mergers can create complexities and are not addressed in this guidance):

• Since the pre-transaction profits of the acquired business are not profits (and consequently cannot be realised profits) of the acquiring entity, they should not be included in the acquiring entity's profit and loss account. For UK companies, the Regulations require that only realised profits (with limited exceptions relating to the fair value accounting rules) are included in the profit and loss account. [1 Sch 13, 40]. The acquiring entity ‘merger accounts’ in its individual financial statements on a prospective basis only from the date of transfer, rather than reflecting it from the beginning of the financial year and for comparative periods.
• If the profits of the acquired business represented realised profits of that business, the acquiring entity could reflect the transfer from the beginning of the financial year and comparatives could be restated. The fact that the cumulative pre-transaction profits of the acquired business are not realised profits of the acquiring entity could be dealt with by disclosure or by transferring those profits to a ‘non-distributable’ reserve.

FRS 102 does not explicitly deal with this issue. However, in our view, the first approach should be applied in statutory accounts of a UK company. This does not preclude presentation of the pre-transaction and comparative profits using the second approach on a pro forma basis. Such information may be particularly relevant where a group reconstruction represents the continuation of an existing business – for example, where a business is transferred to a newly incorporated group entity. In our view, however, such pro forma figures are not required to be given. In this context, it is notable that the Statement of Recommended Practice Accounting by Limited Liability Partnerships (‘LLP SORP’) issued by CCAB effective for LLPs adopting FRS 102 recommends use of the first approach in relation to the application of merger accounting on initial transition of an existing entity to a single-entity LLP for the same reasons as explained above. However, the LLP SORP also considers that the second approach gives relevant information and recommends presentation of pro forma numbers on that basis. [LLP SORP Appendix 4].

Where the company applying the merger method of accounting is a newly-incorporated company, the company law requirements relating to a company's first accounting period will also need to be considered (see 5.4.7 below). This will further restrict the capability of including the pre-transaction results of the acquired business, and is another reason for using a prospective approach.

5.4.6 Equity eliminations

As discussed at 5.3.3 above, the merger method of accounting under FRS 102 involves an equity elimination relating to the difference between the share capital of the new subsidiary (and any share premium or capital redemption reserve) and the cost of the investment as stated in the balance sheet of the new holding company.

However, in the context of applying the merger method in a hive transaction, there is no share capital (or share premium or capital redemption reserve) of the business transferred requiring elimination. Therefore, the difference to be shown as a movement on other reserves relates to the nominal value of any shares issued plus any share premium recognised plus the fair value of any other consideration given by the acquiring entity. This difference will always be a debit to reserves (i.e. debit reserves, credit consideration transferred).

As indicated at 5.3.3 above, there are no particular requirements governing where to eliminate any debit adjustments in reserves arising on the application of the merger method of accounting in consolidated financial statements. The same is true for any debit adjustment for individual financial statements.

For some group reconstructions, the nominal value of the shares issued plus any share premium recognised plus the fair value of any other consideration given will be less than the book amount of the net assets acquired in the group reconstruction. In that situation, there will be a net credit to be taken to equity equivalent to the reserves being recognised in applying the merger accounting method in respect of the trade and assets acquired, less the debit adjustment relating to the nominal value of the shares issued plus the fair value of any other consideration given.

We recommend that the net credit is taken to a separate merger reserve.

Whether any net debit or credit arising from applying the merger accounting method represents a realised loss or profit is discussed at 5.4.1.C above.

5.4.7 Newly incorporated companies

It may be that in certain hive transactions involving the acquisition of the trade and net assets within the same group, the company acquiring the business is a newly incorporated company.

As discussed at 5.3.5 above, when a company is incorporated for the purpose of acting as the new parent company in a group reconstruction (Newco), it might not have been in existence for the entirety of the current and comparative period that would have been presented in respect of the transferred business if no reorganisation had occurred. In contrast to common practice in consolidated financial statements, individual financial statements cannot be prepared for a period prior to incorporation. In addition, as discussed at 5.4.5, hive transactions in individual financial statements of UK companies are accounted for prospectively from the date of the reorganisation. Therefore, Newco must present financial statements for its actual period since incorporation, recognising the hive transaction from the date that it takes place. However, if considered relevant, the pre-reorganisation period(s) could be given as supplementary pro forma information, as explained in Example 17.33 below.

This approach is recommended in the LLP SORP in relation to the application of merger accounting on initial transition of an existing entity to a single-entity LLP for the same reasons as explained at 5.4.5 above. [LLP SORP Appendix 4].

5.5.1 Merger relief

The rules on merger relief and those on merger accounting are frequently confused with each other. However, not only are they based on the satisfaction of different criteria, they in fact have quite distinct purposes. As discussed at 5.3 above, merger accounting is a form of financial reporting which applies to a group reconstruction meeting certain qualifying conditions, but although the merger relief provisions were originally brought in to facilitate merger accounting, merger relief is purely a legal matter to do with the maintenance of capital for the protection of creditors and has very little to do with accounting per se. Moreover, merger relief may be available under transactions which are accounted for as acquisitions, rather than mergers, and the two are not interdependent in that sense.

Section 612 of the CA 2006 broadly relieves companies from the basic requirement of section 610 to set up a share premium account in respect of equity shares issued in exchange for shares in another company in the course of a transaction which results in the issuing company securing at least a 90% holding in the equity shares of the other company. The precise wording of section 612 (and related sections) should be considered carefully in order to ensure that any particular transaction falls within its terms. ‘Equity shares’ mean shares in a company's equity share capital. [s548]. See Chapter 8 at 4.2.1.

Over the years there have been some differences of legal opinion as to whether merger relief is in fact compulsory when the conditions of section 612 are met, or whether it is optional. The CA 2006 says that where the conditions are met, then section 610 ‘does not apply to the premiums on those shares’ issued. Therefore some people argue that the effect of this relief is simply to make section 610 optional rather than mandatory, but the more prevalent view is it makes it illegal to set up a share premium account. Therefore, if a company wishes to set up a share premium account where merger relief is available, we recommend that the directors take legal advice.

Where merger relief is taken, and the purchase method is applied, as the cost of the business combination is based on the fair value, any amount that would have been taken to share premium account needs to be reflected in another reserve, generally a ‘merger reserve’ in the consolidated financial statements. Where merger accounting is applied, such an amount is not reflected in any ‘merger reserve’ as the mechanics of merger accounting uses the nominal value of shares issued. Whether such a reserve arises in the separate financial statements is discussed in Chapter 8 at 4.2.1.

It should be noted, however, that merger relief is not applicable in a case falling within the ambit of ‘group reconstruction relief’ (see 5.5.2 below). [s612(4)].

5.5.2 Group reconstruction relief

Section 611 of the CA 2006 provides a partial relief from the basic requirement to Section 610 as regards transfers to the share premium account where the issuing company is a wholly-owned subsidiary of another company (the holding company) and allots shares to that other company or another wholly-owned subsidiary of the holding company in consideration for the transfer to the issuing company of non-cash assets of a company (the transferor company) that is a member of the group of companies that comprises the holding company and all its wholly-owned subsidiaries. [s611(1)].

Application of the relief in this instance means that just a ‘minimum premium value’ is required to be transferred to the share premium account – that amount being the amount (if any) by which the base value (see Chapter 8 at 4.2.1) of the consideration for the shares allotted exceeds the aggregate nominal value of the shares. [s611(2)-(5)].

Where group reconstruction relief is taken, and the purchase method is applied, as the cost of the business combination is based on the fair value, any amount that would otherwise have been taken to share premium account needs to be reflected in another reserve, generally a ‘merger reserve’ in the consolidated financial statements. Where merger accounting is applied, such an amount is not reflected in any ‘merger reserve’ as the mechanics of merger accounting uses the nominal value of shares issued (or the base value of the consideration).

Chapter 8 at 4.2.1 provides further detail and examples of the application of merger relief and group reconstruction relief in separate financial statements and Example 17.32 above demonstrates an application of group reconstruction relief to a hive down.