When mergers and acquisitions occur, the combined entity's financial statements have to reflect the effects of the combination. In many countries, accounting regulations require that the accounts of companies which are members of a group be prepared in the form of group accounts. In the year of combination, the consolidation of new subsidiary with the parent is carried out using different sets of accounting rules depending on the nature of the combination: that is, whether it is treated as a merger or as an acquisition. The two sets of rules are known as merger accounting and acquisition accounting.
Sudarsanam (1995) argues that the method of accounting can have a dramatic effect on the combined entity's post-combination financial performance and condition as reflected in its consolidated accounts. A company foreseeing such an impact may structure its acquisition deals in such a way so as to qualify for their preferred method of accounting. This emphasizes a significant issue which is that accounting rules not only influence the presentation of post-combination performance, but also the financial structure of the deal resulting in the combination.
8.1 Accounting Rules
A business combination can be classified as either: (1) an acquisition or (2) a merger. In the case of the former, the acquiring company purchases the acquired company's shareholders in their company. The acquired company ceases to
shareholders continue to maintain their interest in their own companies, but also have an interest in other company: that is, they pool their interests. Hence, the American term 'purchase and pooling' for acquisition and merger, respectively.
The presumption behind merger accounting is that the shareholders of the merging companies pool their interests and continue to retain their interests in their companies, albeit now jointly. Merger accounting seeks to preserve this continuity. The principal of continuity is also to mean that the profits and accumulated reserves of the two firms can be pooled without regard to the date of the merger. Sudarsanam (1995) further clarify these two accounting methods:
Merger accounting presumes that the merger is not an arm's length transaction, such that the assets of the companies and the payment for the deal need not be stated at fair values. He argues that a consequence of this is that the difference between these fair values also needs to be recognized. That is, where the consideration includes shares, the difference between the fair (market) value and the nominal value of the shares must be recognized as a share premium. The excess of fair value of consideration over the fair value of the asset separately is called goodwill. Ross et al. (1996) define goodwill as the fair value of the acquired firm to the acquirer over and above the value of the individual assets of the firm, and it is an intangible asset. Sudarsanam (1995) believes that goodwill is essentially derived from certain competitive advantage that the firm has over its rivals -it consists of the firm's reputation, excellence of research and development, or after-sales service, quality management, demographic advantage, market power, etc. In short, goodwill arises as a result of company's core competencies. In order words, its enabling culture.
According to Ross et al. (1996), merger accounting is used when the acquiring firm issues voting shares in exchange for at least 90% of the outstanding voting shares of the acquired firm. Acquisition accounting is believed to be generally used under other financing arrangements. The literature indicates that, while there are many possible arrangements, the most common is that the acquiring
firm distributes cash and bonds to obtain the assets or share of the acquired firm.
In acquisition accounting, goodwill is amortized over a period of years on the shareholders' books. Therefore, just like depreciation, the amortisation expense reduces the income on the shareholders' books. In addition, the assets of the acquired firm are written on the shareholders' books in acquisition accounting.
This evidently creates a higher depreciation expense for the combined firm than would be the case for a merger. Consequently, both goodwill and asset write- ups, result in lower reported incomes on the shareholders books for the acquisition accounting than for merger accounting.
The above exposition essentially concerns the effects on the shareholders' books, not the tax books. Ross et al. (1996) argue that, because the amount of tax-deductible expenses is not affected by the method of acquisition accounting, cash flows are not affected. Hence the NPV of the method of acquisition should be the same whether merger or acquisition accounting is used. Brealey and Meyers (1984) argue that, in efficient capital markets, the choice between these two methods should not make a difference whatsoever, but managers and accountants agonize the choice anyway.
Despite this caustic view, Sudarsanam (1995) reveals that, in the United Kingdom (UK) at least, companies have found that the differences between the two methods resulted in acquisition accounting being less attractive choice than merger accounting for acquirers. Therefore, in order to prevent the abuse of merger accounting in the UK, the Statement of Standard Practice 23 states a rather strict set of the following conditions for the merger accounting (Sudarsanam, 1995, 166):
• The offer leading to the business combination must be made to holders of all equity shares and for all voting shares not already held by the offeror.
• The offeror must ensure at least 90 per cent of equity and voting rights.
• Before the offer, the offeror's holding in the target company should not
• Equity should not be less than 90 per cent of the consideration. Thus the cash part of the consideration can not exceed 10 per cent.
Sudarsanam (1995, 166) concludes that "the spirit behind these conditions is that only when pooling and continuity of interests are genuinely maintained should merger accounting be used. However, in practice, companies with their advisors have devised ways of observing the latter but not the spirit of merger accounting rules".