Accounting For Takeovers

In terms of its ability to wreak accounting havoc, no corporate event can compare with the takeover of one company by another. Since takeovers are so prevalent and since the values involved are often very large, we need to understand the accounting treatment of takeovers if we are going to interpret financial reports.

But the case of takeover accounting also demonstrates very clearly the difficulties in designing coherent and workable accounting rules.

The sources of difficulty should already be familiar to readers of earlier articles on accounting in Mastering Management. Within one jurisdiction companies may account for takeovers in radically different ways; indeed acquisitive companies making several takeovers during the year have been known to use different methods of accounting within the same financial report. But in addition there are significant differences in takeover accounting rules internationally.

 

Merger or acquisition? Thus far we have talked generally about "takeovers" and have avoided using the words "merger" and "acquisition". While in everyday usage we tend to use these words loosely and interchangeably, in accounting they have specific applications and very different implications.

The question is what the new balance sheet and profit and loss account will look like after the takeover and in subsequent years. Accounting rules assume, unless there is evidence to the contrary, that the takeover is an acquisition. Though the transaction may have been friendly and agreed, rather than hostile and disputed, Company A clearly acquired Company B. Several things follow.

First, accounting rules see an acquisition as equivalent to the purchase of a bundle of assets. A has to bring B's assets into its balance sheet, not at the values at which they were carried in B's balance sheet, but at so-called "fair values", or the prices A would have had to pay for them on the open market at the takeover date.

Second, A has to record the market value of any shares it issues as part of the consideration for B. If the consideration is greater than the fair value of the identifiable assets acquired, as is often the case, then it records the difference as the asset "goodwill".

However, sometimes it is unreasonable to talk in terms of a dominant party and of one company acquiring the other. So long as the takeover passes certain tests (these tests differ in their rigour from one country to another) then it can be accounted for as a merger.

In this case the assets of the two companies are added together at their existing book values - there is no "acquired" company so it is not the case that one company's assets have to be revalued. Any shares that were issued are shown at their nominal, "par value", and no goodwill is recognised.

There is another important difference between acquisition and merger accounting. After an acquisition the profit and loss account will only show the profit from the acquired company since it was acquired, whereas in a merger the full year's profit of both companies will be included. Suppose A has a profit of POUND STERLING 10m in the year to 31 December 1995 and B has a profit of POUND STERLING 6m and the two companies combine on July 1 to form AB. If A acquires B the reported profit for the year will be POUND STERLING 13m; if it was a merger the reported profit would be POUND STERLING 16m.

SmithKline Beecham, formed from the merger of the two drug companies, SmithKline of the US, and the UK's Beecham, provides a striking example of the effects of merger and acquisition accounting.

The new group based its headquarters in Brentford in the UK and produced its first accounts in December 1989 under UK accounting rules. The transaction was accounted as a merger.

This truly was a merger - the companies were of similar size, the group retained listings in both the UK and the US and management went to enormous lengths to ensure equality of treatment of the two workforces, with parity extending right up to the composition of the main board.

Because of the US listing, the SmithKline Beecham annual report must report under US accounting rules. Under the much more demanding US tests for merger the transaction was an acquisition of SmithKline by Beecham and so was "purchase accounted" rather than "pooled" in US parlance.

To see the effect of the accounting we will attempt to calculate return on equity using 1989 year-end figures. Return on equity is a much-used measure of profitability from the ordinary shareholders' perspective, which we will measure as the profit attributable to ordinary shareholders divided by the "year-end book" or balance sheet measure of the shareholders' equity investment in the company. The relevant data from the two versions of SmithKline Beecham's accounts are:

UK (MERGER)...............US (ACQUISITION)

Profit attributable to ordinary shareholders

POUND STERLING 130m...............................POUND STERLING 87m

Shareholders equity

-POUND STERLING 297m..............................POUND STERLING 3,545m

Whereas under acquisition accounting the return is a modest 2.5 per cent, under merger accounting it appears to be infinite, or rather it cannot sensibly be calculated since the equity investment in the business seems to be negative.

Clearly there are other sources of difference between the US and UK results, but in the SmithKline Beecham case the differences are predominantly caused by a shift from merger accounting to acquisition accounting. Book equity is almost POUND STERLING 4bn higher in the US because the US balance sheet records nearly POUND STERLING 4bn of goodwill and intangibles.

Though there are other compensating items, the US profit figure is correspondingly reduced by POUND STERLING 88m for having to amortise the goodwill and intangibles and by a further POUND STERLING 144m, which was earned by SmithKline Beecham before the date of the merger and must therefore be excluded in acquisition accounting. The reader should perhaps be reminded that this is the identical transaction recorded under two different systems.

The UK has recently moved closer to US practice in a new accounting standard, FRS6, which severely limits the use of merger accounting. However, there remain significant differences in practice internationally.

Goodwill

A second area of difficulty, which generates great controversy, is the treatment of goodwill in acquisition accounting. Goodwill is the difference between the price you pay for a company and the identifiable assets you receive.

As the SmithKline Beecham case shows, goodwill can be a very large number indeed. In most countries goodwill is carried in the balance sheet as a fixed asset and amortised against income over some period. However, this period varies widely across countries so that the same takeover will have a very different effect on earnings in different countries. For example in the US goodwill can be amortised over a maximum of 40 years, but in Belgium only 5 years. The International Accounting Standard recommends 5 years but will accept 20.

But UK companies have had an alternative; they can immediately net-off the goodwill against equity in the balance sheet and so avoid diluting reported earnings with goodwill amortisation. Furthermore by taking "merger relief", which became available under the 1981 Companies Act, acquirers were able to net goodwill against the share premium arising on the acquisition, giving a result which, save for the restatement of acquired assets at fair values, is substantially the same as merger accounting. UK companies clearly enjoy the "netting" option since they have almost invariably chosen it in recent years.

However, the goodwill element in takeovers exploded in the mid-1980s. Figure I plots the average goodwill in UK takeovers as a percentage of the acquirers' book equity. Whereas goodwill was negligible in the 1970s and early-1980s, and was negative in many takeovers, by 1987 it averaged over 60 per cent of the equity of the acquirer.

The rapid growth of the goodwill element in takeovers and the widespread netting of goodwill started to cause problems. Acquisitive UK companies were significantly depleting their book equity and some were seeking to restore it by capitalising intangible assets, most controversially, brands. The growth in goodwill was not unique to the UK and at much the same time acquisitive US companies, which have to carry and amortise their goodwill, were complaining about earnings dilution and arguing that accounting rules gave UK acquirers an unfair advantage.

The simple and overwhelming reason for the growth in goodwill was the rise in stock market prices around the world relative to the book value of company assets.

In 1978 the average large UK company had a stock market value that was around POUND STERLING 74 for each POUND STERLING 100 of book equity. The acquirer who paid a (typical) 30 per cent premium to acquire control of a company was thus buying its assets at around book value. By 1988 the same company was trading at POUND STERLING 168, so the acquirer would pay perhaps POUND STERLING 210 for a company with book equity of POUND STERLING 100. The shift in the market-to-book ratio was even more marked for small companies. Accounting has proved to be ill-equipped to deal with the large amounts of goodwill this generated.

In many countries, including the UK, goodwill amortisation is not tax deductible. In this case, it is hard to see why it should really matter whether goodwill is carried and amortised or netted off against equity. The accounting is fairly easy for analysts to unravel. But goodwill raises strong passions. Companies dislike diluting earnings with goodwill amortisation because they believe markets value them on the basis of earnings in a rather uncritical way, but they also dislike the cumulative effects of netting goodwill off against equity.

In response the UK Accounting Standards Board (ASB) has brought forward a proposal that seems to offer the best of both worlds, whereby purchased goodwill is carried in the balance sheet unamortised so long as it passes an annual impairment test. It will be interesting to see how competitor nations react to this accounting innovation.

Summary

The words merger and acquisition have different implications in accounting. Unless there is contrary evidence the assumption is that a takeover is an acquisition - assets are then brought into the acquirer's balance sheet at "fair values". With a merger, assets of the two companies are added together at their existing book values. Other differences affect the profit and loss account.

In most countries goodwill is carried as a fixed asset in the balance sheet and amortised against income. UK companies, however, have been able to net it off against equity, so avoiding a dilution in reported earnings.

Signpost

Accounting

The Module reaches its concluding section, covering takeover accounting. Previous sections appeared in Parts 2,4,5,10,11 and 12 and included sections on a general introduction to the subject, an explanation of the role of accounting in control systems, budgeting, costing, the concept of costing quality, return on capital employed, current value accounting, the financial analysis of banks, the case for an international accounting system, harmonisation, accounting standards and asset reporting.

Chris Higson

Dr Chris Higson is chairman of the accounting group at London Business School. He is a chartered accountant and author of Business finance, Butterworths, London 1995, and publishes widely in the areas of mergers and acquisitions, taxation, and shareholder value.