GAAP Purchase Method, IFRS Purchase Method, and GAAP

Acquisition Method Accounting

Posted on March 19, 2012
by Jaes
in Accounting, !FA "#a, !FA "#a $e%e& 2
'he tab&e be&o( suari)es soe di*erences bet(een GAAP
Purchase Method, IFRS Purchase Method, and GAAP Acquisition
Method accounting+
Ite P,R!-AS"
M"'-./0 GAAP
P,R!-AS"
M"'-./0 IFRS
A!1,ISI'I.2
M"'-./0 GAAP
Purchase
Price
!ash Paid 3 4air
%a&ue o4 other
considerations 3
direct costs
Sae as GAAP
Purchase Method+
!ash Paid 3 4air
%a&ue o4 other
considerations+
Fair
5a&ue o4
Subsidia
ry
6hen 7arent
acquires &ess
than 1008, the
aount o4 4air
%a&ue o%er boo9
%a&ue is
recogni)ed in
7ro7ortion to
the 7arent:s
o(nershi7+
!onso&idated
ba&ance sheet
recogni)es the 4u&&
aount o4 the 4air
%a&ue in e#cess o4
the acquired
co7any:s boo9
%a&ue ;note this
di*erence 4ro
GAAP<+
Sae as IFRS
Purchase
Method+
Subsidia
ry
!ontinge
nt
$iabi&itie
s
Recogni)ed on
the sa&e date at
4air %a&ue+
Sae as GAAP
Purchase Method+
Sae as GAAP
Purchase
Method+
Subsidia
ry In=
Process
R>/
Recogni)ed on
the sa&e date at
4air %a&ue, as
7art o4 the
subsidiary:s net
assets, then
e#7ensed+
Recogni)ed on the
sa&e date at 4air
%a&ue as 7art o4
the subsidiary:s
net assets?
re7orted on the
conso&idated
ba&ance sheet as
Sae as IFRS
Purchase
Method+
an intangib&e
asset+
Minority
Interest
@ased on
subsidiary:s
boo9 %a&ue o4
net assets
o(ned by
inority
shareho&ders+
A77ears
bet(een debt
and equity on
the conso&idated
ba&ance sheet+
"ither0
1< Subsidiary:s 4air
%a&ue o4 net assets
o(ned by inority
shareho&ders,
(hich creates
7artia& good(i&&+
2< Subsidiary:s 4u&&
4air %a&ue, a77&ied
to 7ercent
o(nershi7 by
inority
shareho&ders,
(hich creates 4u&&
good(i&&+A77ears
under equity
section on the
conso&idated
ba&ance sheet+
Subsidiary:s 4u&&
4air %a&ue,
a77&ied to
7ercent
o(nershi7 by
inority
shareho&ders,
(hich creates
4u&& good(i&&+
A77ears under
equity section on
the conso&idated
ba&ance sheet+
Acquisition=Re&ated !osts
Acquisition=re&ated costs are costs the acquirer incurs to e*ect a
business cobination+ 'hose costs inc&ude Ander:s 4ees? ad%isory,
&ega&, accounting, %a&uation, and other 7ro4essiona& or consu&ting
4ees? genera& adinistrati%e costs? and costs o4 registering and
issuing debt and equity securities+ 2o acquisition=re&ated costs are
inc&uded in the 7urchase 7rice a4ter January 1, 2009, in accordance
(ith FAS 1B1r+ 6ith the e#ce7tion o4 costs to issue debt or equity,
FAS 1B1 and FAS 1B1r di*er substantia&&y0
FAS 141 C Inc&ude in 7urchase 7rice
FAS 141r C /o not inc&ude in 7urchase 7rice? e#7ense as
incurred
,nder both FAS 1B1r and FAS 1B1, debt and equity issuance 4ees are
treated di*erent&y 4ro other acquisition=re&ated costs as 4o&&o(s0
Debt C Financing 4ees ca7ita&i)ed and aorti)ed o%er cost o4
the ter o4 the debt
Equity C Fees netted against 7roceeds 4ro the o*ering
A4ter /eceber 1D, 200E, acquisition=re&ated costs are no &onger
inc&uded in the 7urchase 7rice+ Instead, the acquirer e#7enses these
charges as incurred and the ser%ices recei%ed, (hi&e debt and
equity Anancing 4ees continue to recei%e the sae accounting
treatent described abo%e+
Restructuring costs are not considered 7art o4 the 7urchase 7rice
under both FAS 1B1 and 1B1r+
Genera&&y Acce7ted Accounting Princi7&es regarding ergers and
acquisitions continue to e%o&%e+ 'he Financia& Accounting Standards
@oard, or FAS@, issued Stateent 1B1 in 2001 to re7&ace the 7oo&ing
ethod (ith the 7urchase ethod+ 'he 7oo&ing ethod re&ied on
boo9 %a&ues, (hereas the 7urchase ethod a&&ocated costs to
acquired assets and &iabi&ities+ In 200F, FAS@ issued an u7date,
Stateent 1B1R, (hich e%o&%es the 7urchase ethod into the
acquisition ethod+
@argain Purchases
An acquirer ay 7ay ore or &ess than 4air %a&ue 4or its acquisition+
,nder both ethods, e#cess 7ayent creates the intangib&e asset
Ggood(i&&+
H I4 instead the acquirer scores a bargain 7urchase, the 7urchase
ethod treats the bargain sa%ings as negati%e good(i&& that creates
7rorated reductions in asset and &iabi&ity %a&ues+ 'his treatent
does not a*ect the acquirer:s incoe stateent+ ,nder the
acquisition ethod, the acquirer si7&y recogni)es the bargain
sa%ings as a gain on its incoe stateent+
Pee&ing the .nion on the 2e( @usiness !obination Standards0 FAS
1B1R and FAS 1I0
This post examines the onion skin, if you will, of the new business
combination standards. I'm going to explain the diferences between the so-
called 'purchase' method of accounting and the new 'acquisition' method. s
is my habit, let's begin with a simple example.
ssume that !arent"o acquires #$% of the outstanding shares of &ub"o for
'(,$$$. dditional facts are as follows)
!arent"o estimates that the fair *alue of ($$% of &ub"o is '(,+$,)
-ou should note that the fair *alue of &ub"o may not
ordinarily be calculated by extrapolating the purchase price
paid to the remaining shares outstanding .i.e., '(,$$$/#$%
0 '(,+12 is not ordinarily the fair *alue3. The reason is that
a portion of the purchase price contains a payment for the
ability to exercise control.
In this case, the control premium would be ',,, calculated
as follows)
.'($$$ - .#.'(+$,33/.(-.#3 0 ',,
It may be di4cult to estimate the control premium, because it
may ha*e to be deri*ed from an estimate of the full fair *alue
of the acquired company, as abo*e.
The book *alue of &ub"o's assets and liabilities approximate their fair
*alue, except for one asset with a remaining useful life of ($ years.
5or that asset, the fair *alue exceeds the book *alue by '($$.
The table below displays the following) .(3 respecti*e balance sheets of
!arent"o and &ubco at the date of acquisition, .13 consolidated results under
the purchase and acquisition methods, and .63 the goodwill calculations
under each method.
The purchase method had a lot of warts, but it took the 5&7 decades to
replace it. In essence, it was nothing more than a sla*ish application of the
historic cost principle to mute the future efect of an acquisition on operating
expenses. The idea was that if you purchased #$ percent of the outstanding
shares of another company, then re*aluation of assets would take place only
to the extent of the shares purchased. mong other things, this meant that
the basis of the assets of a subsidiary acquired in business combination
transaction would be the sum of the fair *alue of the portion acquired and
the historic cost of the portion not acquired. This is illustrated abo*e by the
calculation of consolidated assets) '1,$$$ 8 '9$$ 8 .#.'2$$ - 9$$3 0
'1,9#$. The mix of fair *alue and historic cost to measure one asset reminds
me of something my father would say when someone .mainly me3 was less
than fully committed to a principle) :you can't be half pregnant.:
The acquisition method represents a full commitment to fair *alue, yet
ironically, the 5&7 still doesn't require fair *alue for all assets and liabilities
assumed .more on that in another post3. In other words, if the transaction
results in the acquisition of control of an entity, assets acquired and liabilities
assumed will be initially measured at ($$% of their fair *alue--e*en if less
than ($$% of the outstanding shares are purchased. That's why consolidated
assets are '6$ higher in the illustration under the acquisition method.
The example also illustrates two other important diferences between the
methods)
The consolidated amount attributed in consolidation to the non-selling
shareholders was; termed 'minority interests' under the purchase
method. It was reported on the balance sheet between liabilities and
shareholders' equity'< and following the same reasoning allowing
half-pregnant measures of consolidated assets and liabilities, was
measured based on the historic costs of the subsidiary.
'=oncontrolling interests' .="I3, has replaced minority interests, and
are now measured on the same basis as the 'controlling interests',
and >rmly categori?ed as part of shareholders equity.
@ell, maybe not so >rm. &ee my post on the 5&7's recently
issued !reliminary Aiews document entitled Financial
Instruments with Characteristics of Equity, which proposes
to mo*e ="I to liabilities. In fact, one intrepid 5&7 member
obBected to the issuance of 5& (+(C until the 5&7 could
actually enunciate clear principles for distinguishing
between liabilities and equity. Dntil then, it's Bust another
rule that's subBect to change.
:Eoodwill: is higher under the acquisition method, because as can be
seen by comparing the calculations, it now includes amounts
attributable to ="I.
@hat hasn't changed, though, is that goodwill is still a
euphonious sobriquet for a random number masquerading
on the balance sheet as an asset measurement. .I'll write
more about this in a post soon to come.3 Under the
purchase method, it's the diference between the
purchase price and amounts for the other assets and
iabiities recorded! Under the acquisition method,
it's fair "aue of Sub#o $equi"aenty, purchase price
pus amount reco%ni&ed for noncontroin% interests'
minus the amounts for the other assets and
iabiities recorded! SFAS 141( may describe %oodwi
in more di%ni)ed terms, but the way I Bust did is more
accurate. t least I'm not as blunt as @alter &chuet?e,
former &F" "hief ccountant, who is fond of calling goodwill
:the lump left o*er.: I smile to myself e*ery time I think of
that.
&ince only balance sheet diferences are illustrated abo*e, I ha*e only told
part of the story so far. The table below extends the illustration to the end of
the >rst year subsequent to the acquisition of &ub"o.
The foregoing illustrates that there is an additional step on the income
statement. It may be hard for some people to get used to, but net income is
no longer the bottom line. In fact, the bottom line doesn't change in this
case, because '6 of additional depreciation expense is recorded, but it is
taken out of the earnings attributed to ="I. If you are familiar with the &F"'s
required presentation of 'net income applicable to common stock .&7 Topic
G.7.(3, you will know that the idea is not new.
@ell, that's all for now. If you want to look at my spreadsheet, you can get it
by clickinghere. I'll ha*e a lot more to say about goodwill and accounting for
business combinations in the near future, and it won't be pretty.
Note: The original version of this post contained an error in the calculation of
the control premium. Thanks to allace Enman of !oody"s for pointing out
the error# and for helping me to get it right. Thanks also to $ar% Foerster of
estern &nion for 'nding another technical error that I have now corrected.
'he @att&e .%er Merger Accounting
Pro7osed 7oo&ing ban un&i9e&y to ha&t acti%ity+
@y MI!-A"$ /A5IS, P-/
1$$$ Aolume 6 Issue 6
Hespite proposed pooling rule >rms urged to pursue mergers that make
economic sense.
Iaybe youJ*e ne*er taken an accounting class, or maybe you took one years
ago and donJt remember much. Kowe*er, if your >rm is in the acquisition
mode, one issue in accounting should be of interest to you. This issue is
whether or not pooling of interests accounting should be allowed, and it is
creating a >restorm in the merger and acquisition arena arena.
In essence, when two >rms combine, there are two methods that can be
used to account for the combined *alue of the >rm. They are the purchase
method and the pooling of interests method. In most cases, they yield
radically diferent outcomes L with pooling resulting in a much better looking
income statement for years to come. -et, the 5inancial ccounting &tandards
7oard .5&73, the primary accounting rule-making body in the D.&., has
preliminarily decided to eliminate this method by the end of the year.
&hould you be concernedM Iore importantly, if you are thinking of acquiring
another company or are in the market to be acquired, should you be trying to
wrap it up by the end of this yearM If you take literally some of the comments
reported recently in the business press, it would surely seem that you should
be. 5or example, in a report entitled (aluing the New Economy: )ow New
*ccounting +tandards will Inhi%it Economically +ound !ergers and )inder
the E,ciency and Innovation of &.+. $usiness, Ierrill Nynch states that Othe
.purchase3 accounting method itself would pro*e an obstacle to a merger
that both parties want to consummate. s a result, the wa*e of
consolidations that has enhanced producti*ity, encouraged inno*ation, and
stimulated dynamism in the D.&. economy may notably decline.P
In a report titled entitled The Furor -ver .urchase/.ooling, Haniel Honoghue
and others with the in*estment banking >rm D.&. 7ancorp !iper Qafray make
the following alarming statement right after summari?ing the proposed new
rules) OThese changes could potentially ha*e a chilling impact on the
mergers and acquisitions market.P -et listen to the *ery next, *irtually
contradictory, statement) OThe new rules ha*e no real economic
consequences since corporate cash Rows are not impacted.P In other words,
the proposed new rules donJt change cash Rows one iota.
&o, how can such toothless rules that do not afect real *alue possibly ha*e a
OchillingP impact on the IS marketplaceM The authors pro*ide a partial
answer to this question when they write, G'he 7ro7osed accounting on&y
a*ects re7orted earningsH .emphasis added3. Therein lies the real issue)
Is the market fooled by cosmetic accounting diferencesM
To help you separate the wheat from the chaf and pro*ide e*idence to
answer this question for yourself .and for your company if youJre feeling the
Ourge to mergeP3, this article will >rst pro*ide a simple example to illustrate
the >nancial statement diferences between the two methods so you can see
what the big deal is all about. Then, a brief summary of research >ndings on
this issue will be presented, some of which are fairly startling. 5inally, there is
a prediction about the >nal outcome of this battle that may help you decide
whether or not you need to be concerned.
'he '(o Methods o4 Merger Accounting
In the simplest of terms, the issue can be illustrated by the following
scenario. If two companies merge, each one ha*ing only one asset, say a
truck, the combined balance sheet would consist of two trucks and the
combined income statement would consist of the total combined re*enues.
The contro*ersial issue is) @hat *alue should be used for the two trucksM
&hould they be combined using their existing recorded *aluesM Tr should
both be restated to their current market *alueM Tr should the truck of the
company being OacquiredP be restated to the price actually paid by the
acquiring companyM "urrent rules say that if the merger is a pooling, the
assets are combined at their book *alues. If one company is OpurchasingP
the other company, the purchased asset is recorded at its purchase price.
There are actually twel*e rules, all of which must be met, that determine if
the new company can use the pooling method of accounting. The main rule
is that stock must be used for the payment instead of cash. The implication
is that there is a continuity of ownership and that nothing has really changed
for the two companies. In other words, if the company being OacquiredP is
gi*en stock in the acquiring company, the two ownership groups ha*e simply
combined to own a larger basket of assets. There is no sale and there are no
tax implications. If cash is used, howe*er, the owners of the acquired
company are *iewed as ha*ing sold the assets so that they ha*e a taxable
gain .or loss3, and the buyer records the assets at the price paid for them.
more helpful example would be as follows) "ompany pays 'G,$ in stock
to acquire "ompany 7. The book *alue of "ompany 7 is ',$, composed of
'(,$ in assets minus '($$ in liabilities. The 'G$$ excess o*er book *alue is
allocable '($$ to under*alued plant, property and equipment and ',$$ to
goodwill due largely to intellectual property.
*f the combination is treated as a pooin%, the combined baance
sheet and income statement oo+ as foows,
@a&ance Sheet
7 87
O!oolingP
"urrent ssets 1$$ ($$ 6$$
!!SF ,$$ ,$ ,,$
Intangibles
'ota& F00 1D0 ED0
"urrent Niabilities ($$ ,$ (,$
Nong Term Niabilities 1$$ ,$ 1,$
&tockholderJs Fquity +$$ ,$ +,$
'ota& F00 1D0 ED0
Incoe Stateent
7 87
!ooling
Ce*enues ($$$ G$$ (G$$
Fxpenses -+$$ -1$$ -G$$
2et Incoe I00 B00 1000
*f, howe"er, the combination is treated as a purchase, the combined
)nancia statements wi oo+ as foows $pooin% totas shaded for
comparison',
@a&ance Sheet
7 87
!ooling
!urchase
dBustments
87
!urchase
"urrent ssets 1$$ ($$ 6$ 6$$
!!SF ,$$ ,$ ,, 8($$ G,$
Intangibles 8,$$ ,$$
'ota& F00 1D0 ED 1BD0
"urrent Niabilities ($$ ,$ (, (,$
Nong term
Niabilities
1$$ ,$ 1, 1,$
&tockholderJs +$$ ,$ +, 8G$$ ($,$
Fquity
'ota& F00 1D0 ED 1BD0
Incoe Stateent
7 87
!ooling
!urchase
dBustments
87
O!urchase
P
Ce*enues ($$$G$$ (G$$ (G$$
Fxpenses -+$$ -1$$-G$$ -G$$
2et Incoe I00 B00 1000 1000
Fxtra Hepreciation .($ year life3 -($
morti?ation of goodwill .1$ year life3 -1,
2et Incoe a4ter e#tra de7reciation and aorti)ation o4
good(i&&
9ID
=ote that the balance sheet looks stronger under the purchase method due
to a higher asset base. The income statement looks worse, howe*er, due to
the extra depreciation and amorti?ation of goodwill. In many of todayJs mega
mergers, the income statement diferences are far greater because goodwill
can comprise 9$-2$% of the purchase price resulting in huge amorti?ation
charges that can e*en cause the combined entity to report operating losses
for years to come.
To put the diference between the two methods into the simplest terms, the
pre*iously cited Ierrill Nynch report states it this way) OThe premium paid for
the intangible goods L the goodwill L is ne*er recorded .in a pooling3.P -et, if
you think about it, this is an ama?ing statement that actually highlights the
fatal Raw of the pooling method L 'he 7reiu 7aid is ne%er recorded.
lthough >nancial accounting may be de>cient in myriad ways, there is no
other instance in which it is proper and legal to a*oid recogni?ing a payment
for something L especially something that can run into the billions of dollars.
Research Findings
question that has been directed to the 5&7 is whether an acquisition paid
for with stock is fundamentally diferent from an acquisition paid for with
cash. The 5&7 has been asked to consider this. Kar*ey Eolub, chairman and
"FT of merican Fxpress, put it this way in a recent article in theall +treet
0ournal) OUa merger with stock isnJt the same as a purchase for cash.
Hiferent business combinations require diferent accounting treatment. Tne
company buying another for cash is decidedly diferent than an exchange of
stock, which consolidates the ownership of the two entities.P
The problem with this argument is two-fold. 5irst, in negotiating the
exchange ratio of the stocks, the current market *alue of both companiesJ
stock, and not book *alue, is the primary determinant of the ratio. In a *ery
real sense, the acquiring >rm estimates what the target >rm is worth in total,
di*ides that by the acquiring >rmJs current share price to determine the
number of shares to be ofered, and then breaks that down into a share-for-
share ratio. In other words, a companyJs stock is a negotiable type of
currency L Bust one step away from cash.
&econd, the continuity of interests only lasts for a moment in time. In fact,
there may be a large number of shares trading hands all the way up to the
date of the formal exchange. Ioreo*er, most shareholders in the target >rm
recei*ing shares of the acquiring >rm are free to sell them immediately after
recei*ing the shares.
more con*incing argument, howe*er, is what has occurred in the
marketplace. In an article published in the 0ournal of Finance, Tim Noughran
and rnand AiBh examine bene>ts accruing to target shareholders in the >*e-
year period after the combination. Those that recei*ed cash and immediately
in*ested that cash into the acquirerJs stock reali?ed substantial returns by
holding that stock for >*e years. In contrast, target shareholders who
recei*ed stock in the acquiring company and held that for >*e years reali?ed
essentially no gain as any premium recei*ed at the time of the acquisition
tended to dissipate.
These results are consistent with the popular theory that a >rm issues stock
when insiders belie*e the stock is o*er*alued. dding fuel to the pooling >re,
consider the results from two other streams of research. 5irst, there ha*e
been about ten academic studies using diferent methodologies and time
periods that ha*e consistently demonstrated that, in spite of the higher
reported earnings, the stock performance is not better for pooling method
>rms after the combination. In fact, two studies, including one by this author,
found that the stock of >rms that used the purchase method performed
signi>cantly better than that of >rms using the pooling method. In other
words, the market is not fooled by the higher cosmetic earnings reported by
pooling method >rms, and it appears to reward >rms using the more
conser*ati*e purchase method.
-et, in spite of these consistent research results, some >rms are willing to
pay extra to be able to pool. Tne example is the well-documented (22(
TST-="C pooling method merger. conser*ati*e estimate is that TST paid
',$ million to be able to pool but, depending on how stock price changes
during the negotiation period are interpreted, the additional cost may ha*e
been as high as ',$$ million for a merger that was ultimately disastrous. Two
additional academic studies examined large samples of pooling method
mergers and found that, in general, not only does the likelihood of using the
pooling method increase with the si?e of the potential goodwill to be
recorded, but the premiums paid for similar si?ed target >rms are higher if
the pooling method is used.
6here /o 6e Go Fro -ereJ
The 5inancial ccounting &tandards 7oard held public hearings on the
proposed new rules in 5ebruary, 1$$$. =ot only did they hear the same Osky
is fallingP arguments described earlier, but not a single person who testi>ed
was able to present a workable alternati*e to the 5&7Js proposed new rules.
F*en if con*incing e*idence had been presented indicating that the new
rules would ha*e a signi>cant negati*e impact, the 5&7Js mandate is to
ad*ocate rules that present the economic reality of a transaction and not to
be swayed by the potential Oeconomic consequencesP of those rules.
dding to the 5&7Js resol*e on this issue is the fact that most maBor
industriali?ed countries do not allow poolings or allow them only in *ery rare
circumstances. Tnly "anada has rules similar to ours, and they are also
proposing to eliminate poolings. ll of this has not stopped those who want
to maintain the a*ailability of pooling from urging members of "ongress to
pressure the 5&7 into not changing the rules. Kowe*er, it appears likely that
the 5&7 will stick to its guns and eliminate poolings by the end of this year.
@hat the business press has not reported is that the elimination of pooling
does not eliminate the possibility of using stock to acquire another >rm.
&tock exchanges will still be possible L they e*en can still be tax-free L but
companies wonJt be able to use the pooling method of combining both >rms
at book *alue. In other words, mergers that make economic sense will
continue to make economic sense. Hue to the growing si?e of goodwill, more
and more >rms are highlighting either earnings before goodwill amorti?ation
.as the 5&7Js proposed rules require3 or cash earnings since goodwill
amorti?ation is not tax deductible in most cases.
&o, >rms need not stiRe the urge to merge. Instead, they must redouble
eforts to identify >rms that >t strategically with their growth plans, and use
cash or stock L whiche*er makes the most sense in a particular situation.
lthough Ir. Eolub made se*eral questionable statements in his +0 article,
he clearly get one thing right at the end when he writes, O&e*eral recent
studies Ushow that the market does not gi*e higher *aluations to companies
that combine *ia pooling rather than purchase accounting. The market
doesnJt seem to care which accounting method merging companies use.P