When companies merge or acquire, the accounting can get complicated.
This article will clearly explain the key differences between merger accounting and acquisition accounting, so you can understand the financial implications.
We'll cover the purchase vs pooling methods, how goodwill and assets are treated, impacts on financial ratios and taxes, and future accounting trends.
Introduction to Merger and Acquisition Accounting
Mergers and acquisitions can significantly impact a company's financial statements. Understanding the key accounting methods used is important for accurate financial reporting.
Defining a Merger
A merger refers to the combination of two or more separate companies into one legal entity. In a merger, the acquired company ceases to exist as a separate legal entity. Its assets, liabilities, and equity are absorbed by the acquiring company.
Defining an Acquisition
An acquisition refers to one company purchasing a controlling ownership stake in another company. The acquired company continues to exist as a separate legal entity. Its assets and liabilities remain on its own financial statements.
Overview of Purchase vs. Pooling of Interests Methods
There are two main accounting methods for handling mergers and acquisitions:
- Purchase Method: The transaction is accounted for as an acquisition of assets. Assets are valued at fair market value, which may increase the value of assets like property and equipment on the books. Goodwill is also recognized. This method is required under current US GAAP.
- Pooling of Interests Method: The transaction is accounted for as a pooling of assets. Asset values remain at their historical cost basis. No goodwill is recognized. This method is no longer allowed under US GAAP.
The key difference lies in how the assets are valued and whether goodwill is recognized. Understanding these methods is critical for accurate accounting and financial reporting of mergers and acquisitions.
What is the difference between merger and acquisition accounting?
Merger accounting and acquisition accounting refer to the different accounting methods used when companies combine their operations. The key differences between the two are:
Merger Accounting
- Used when two companies of roughly equal size agree to combine into one new company
- The assets and liabilities of both companies are combined at their carrying values
- No goodwill is recorded
- The financial history of both companies is combined going forward under the new company name
Acquisition Accounting
- Used when one company purchases or takes control of another company
- The acquired company's assets and liabilities are revalued to fair value, which often results in goodwill
- The financial history of the acquiring company continues forward, while the acquired company's individual history ends
So in summary:
- Merger accounting maintains the carrying value of assets/liabilities and combines financial histories, with no goodwill recorded
- Acquisition accounting revalues assets/liabilities resulting in goodwill, and only continues the acquirer's financial history
The type of accounting impacts the balance sheet and financial statements, but economically the transaction has a similar effect - two previously separate companies now operating jointly under common control. The accounting treatment simply differs based on the legal structure of the combination.
What is the accounting method for merger and acquisition?
The key accounting methods used for mergers and acquisitions are purchase acquisition accounting and pooling of interests accounting.
Purchase Acquisition Accounting
Purchase acquisition accounting strengthens the concept of fair market value at the time of a merger or acquisition. The purchase acquisition accounting approach requires that all assets and liabilities, tangible and intangible, be measured at fair market value.
Some key aspects of purchase acquisition accounting include:
- Assets and liabilities are recorded at their fair market values on the purchase date, which often increases the value of assets like property and equipment on the books.
- Any excess of purchase price over the fair value of identifiable net assets is recorded as goodwill.
- Reported net income will often be lower in periods immediately following the merger under this approach, as increased asset values result in higher depreciation and amortization expenses.
- Purchase accounting can better reflect the actual cost of an acquired company.
Overall, purchase acquisition accounting aims to more accurately represent the market value of the combined companies after a merger or acquisition event occurs.
Pooling of Interests Accounting
Pooling of interests accounting treats the combination of two companies as a pooling of equals. This means:
- Assets and liabilities are recorded at their pre-merger carrying values, rather than adjusting them to fair market value.
- There is no creation of goodwill or recognition of other intangible assets.
- The income statements of the merged companies are combined going back to the beginning of the fiscal year when the merger occurred.
The pooling method aims for continuity in reporting. However, it does not reflect changes in asset values or the effective purchase cost like the purchase acquisition approach does.
In summary, purchase accounting better reflects fair market value while pooling aims for continuity of financial reporting. Understanding these key differences can help guide the choice of method during a merger or acquisition.
How do you account for merger in accounting?
In a merger, two companies combine together to form one legal entity. The accounting treatment depends on whether it is an "acquisition" or a "true merger".
Acquisition Accounting
If one company acquires another company, it is considered an acquisition. The acquiring company records all of the acquired company's assets and liabilities at their fair market value, including any intangible assets that were not previously recorded. This often results in the acquired company's assets being recorded at a higher value, leading to recognition of "goodwill" - an intangible asset representing things like brand awareness and customer loyalty.
The acquiring company consolidates the acquired company into its financial statements after the acquisition date. The acquired company's revenues, expenses, gains, and losses are included going forward. Acquisition accounting enables the combined company's financial statements going forward to reflect the true fair market value of the acquired assets.
True Merger Accounting
In a "true merger" of equals, there is no clear acquirer, so it is accounted for similar to a pooling of interests. The assets and liabilities of both companies are combined at their pre-merger carrying values rather than fair market value. No additional intangible assets are recognized and no goodwill is recorded.
The pre-merger financial statements of both companies are restated on a combined basis for all periods prior to the merger. This enables trends to continue seamlessly, reflecting the merged company's financials as if they had always been combined. The primary advantage of this method is to simplify accounting and avoid revaluations of assets.
In summary, the key difference in merger accounting vs acquisition accounting is in the valuation and recognition of assets. Merger accounting uses existing carrying values while acquisitions revalue assets to fair market value.
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What is the accounting standard for mergers and acquisitions?
As per Indian Accounting Standard 103 (AS 103), all business combinations are accounted for using the purchase method, which considers the acquisition date fair values of all assets, liabilities, and contingent liabilities of the acquired company.
The key points of AS 103 regarding merger and acquisition accounting are:
- The company that acquires another company is called the acquirer. The company being acquired is called the acquiree.
- All identifiable assets, liabilities, and contingent liabilities of the acquiree are recorded at their fair values as of the acquisition date. This includes tangible assets like property and equipment, as well as intangible assets like trademarks and patents.
- Any excess of the purchase price over the fair value of net assets acquired is recorded as goodwill. Any shortfall is immediately recognized as a gain in the acquirer's income statement.
- The financial statements prepared after a merger or acquisition reflect only the acquirer's financial position. The acquiree's individual financial statements are discontinued.
- All acquisition-related costs like legal fees and due diligence costs are expensed by the acquirer. These are not added to the purchase price.
- Contingent liabilities assumed are recognized if their fair values can be measured reliably. If not, they are disclosed in the notes to the financial statements.
In summary, AS 103 stipulates the purchase method of accounting for all business combinations. This requires identifying and measuring the acquiree's assets, liabilities, and contingent liabilities at their acquisition date fair values before recording the merger or acquisition transaction.
Key Differences Between Merger and Acquisition Accounting
Purchase Price Allocation
The key difference in purchase price allocation between a merger and an acquisition relates to the purchase method. With an acquisition that utilizes the purchase method, the total purchase price paid is allocated across identifiable tangible and intangible assets acquired, based on their fair market values. This includes assets like property, equipment, customer lists, trademarks, etc. Any excess purchase price after this allocation is recorded as goodwill.
In contrast, with a merger that utilizes the pooling of interests method, no purchase price allocation occurs. The assets and liabilities of the merging companies are combined at their pre-merger historical cost carrying values instead of a new fair value assessment.
Goodwill Treatment
With the purchase method used for acquisitions, any excess amount of purchase price over the fair value of net assets acquired gets recorded as goodwill. This reflects the premium paid by the buyer for benefits like an assembled workforce, brand reputation, etc. that aren't individually identified intangible assets.
Under the pooling method for mergers, goodwill is not recorded. Assets retain their historical book value rather than a new fair value assessment that could result in goodwill. The difference between the amount paid and net assets acquired does not exist.
Asset Valuation
The purchase method, used for acquisitions, requires assets acquired to be marked to their fair market value at the time of transfer, which likely differs from historical carrying amounts. This includes both tangible assets like property and equipment and intangible assets like trademarks or patents.
In contrast, the pooling method used for mergers keeps assets at their pre-combination historical cost carrying values. No revaluation to fair market value occurs, which is an important distinction between merger and acquisition accounting.
Financial Statement Presentation
Under the purchase method, the financial statements reflect the acquirer's accounting basis. The parent company consolidates the newly acquired subsidiary's financial results with its own from the date of acquisition onward.
With the pooling method for mergers, combining companies' financial statement elements are aggregated together as a mathematical summation. This reflects the concept that the merged companies have effectively pooled their interests to form a new reporting entity.
Impacts and Implications
Effects on Financial Ratios
The choice between merger accounting and acquisition accounting can have a significant impact on a company's financial ratios in the year the merger or acquisition takes place.
With pooling of interests method (merger accounting), the assets and liabilities of the combining companies are consolidated at their carrying values. This means there is no step-up in asset basis and no recognition of goodwill. As a result, key ratios like earnings per share (EPS) and return on assets (ROA) are not impacted. The financial statements simply combine the historical amounts of the merging companies.
On the other hand, the purchase method (acquisition accounting) requires the acquirer to record assets and liabilities of the target company at fair value. This normally results in a step-up in asset basis, recognition of goodwill, and possibly some one-time merger-related charges. Consequently, financial ratios like EPS and debt-to-equity ratio are impacted in the period the acquisition takes place.
So while merger accounting portrays business combination as a pooling of equals and shows continuity, acquisition accounting treats it as an exchange of assets and impacts key financial metrics.
Tax Implications
The choice of accounting also has tax implications. With the purchase method, the step-up of asset basis presents opportunities for additional depreciation and amortization tax deductions. The pooling method does not provide these tax benefits as assets are recorded at historical cost.
However, the pooling method allows net operating losses (NOLs) of the combining companies to be used by the merged entity. The purchase method causes a change in ownership, limiting the use of NOL carryforwards.
So companies should evaluate the tax impacts to determine which accounting method better aligns with their tax planning objectives.
Continuity of Operations
Conceptually, merger accounting portrays the combination as a pooling of equals - implying continuity of operations. Acquisition accounting on the other hand sees it as an exchange of assets, with the acquirer clearly gaining control.
Operationally, the pooling method also better promotes continuity as both companies’ management often continue to have active roles. With purchase accounting, the target becomes just another division within the acquirer’s structure.
So companies that want to achieve more of a “merger of equals” rather than acquisition may prefer using merger accounting.
Investor Perceptions
Some critics argue that merger accounting is deceptive as it hides the real economics of the business combination from investors. The pooling method does not highlight the premium paid to acquire control or the fair value of assets obtained.
Acquisition accounting provides more transparency around the price paid and what assets were obtained at what value. This helps investors better analyze if the acquisition price was justified.
So while merger accounting provides more continuity, acquisition accounting gives investors a clearer picture of the economics exchanged in the deal. Companies should weigh these investor perception issues in choosing between the methods.
Current State of Merger and Acquisition Accounting
GAAP Stance
The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141 in 2001, which made the purchase method the only allowable method for business combinations initiated after June 30, 2001. This effectively eliminated the use of the pooling of interests method under GAAP. As a result, nearly all mergers and acquisitions since then have followed purchase accounting guidelines.
Current Trends
Today, the vast majority of M&A transactions are accounted for using the purchase method. According to research, over 90% of all deals in 2020 used purchase accounting principles to record the transaction. This dominance is largely driven by the GAAP requirements instituted in 2001. Most analysts expect this trend to continue going forward.
Future Outlook
Given the long-standing GAAP guidance in favor of purchase accounting, most experts believe it will remain the standard approach for the foreseeable future. Barring any major shifts in accounting standards, the pooling method is expected to remain essentially obsolete. However, some have suggested that pooling could make a comeback if standards change to allow more flexibility in merger accounting methods again. Still, any such changes would likely take many years to be approved and implemented.
Conclusion and Key Takeaways
In conclusion, while mergers and acquisitions both result in combined entities, there are important accounting differences regarding purchase price allocation, asset valuation, goodwill, and financial statement presentation. The purchase method is dominant today for sound economic reasons, though the pooling method is occasionally still referenced.
Purchase vs. Pooling Methods
The key difference lies in purchase price allocation and asset valuation, with implications for goodwill, ratios, taxes, operations, and investor perceptions. Specifically:
- The purchase method requires the buyer to allocate the purchase price to acquired assets and liabilities based on fair value. This can increase asset values and create goodwill.
- The pooling method combines assets and liabilities at existing book value. No purchase price allocation is made and no goodwill is recorded.
The purchase method provides a more accurate economic picture of the transaction, which is why accounting standards now mandate its use in nearly all cases.
Prevalence of Purchase Accounting
Nearly all deals today use the purchase method due to GAAP standards and improved reflection of transaction economics. Specifically:
- The purchase method is required under the FASB's ASC 805 accounting standards for business combinations. This standardized treatment enables comparability across firms.
- Recording assets and liabilities at fair value better reflects the actual market economics of the acquisition.
- Goodwill recognition under purchase accounting provides investors transparency into the implied market value of the target.
The consistency and transparency of the purchase method explains its dominance.
Understanding Impacts
Properly accounting for mergers and acquisitions requires analyzing impacts across the combined entity, including:
- Financial statements - Purchase accounting can directly impact asset values, expenses, profits, and key ratios. Forecasting these impacts is critical.
- Operations - Integrating systems, processes, and personnel poses major operational challenges that can undermine mergers if not managed properly.
- Taxes - Structuring deals to maximize tax efficiency is often a key consideration.
- Investors - Clear communications regarding purchase price allocation, goodwill, and expected synergies help align investor expectations.
Overall, understanding the accounting and operational implications sets up mergers and acquisitions for success.
