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FRS 6, Acquisitions and mergers | | | ACCA Page 1 of 16 FRS 6, ACQUISITIONS

FRS 6, ACQUISITIONS AND MERGERS

by Paul Robins 01 Oct 1999

In this article we will consider the contrasting methods of accounting for business combinations which do not involve a dissolution or liquidation of any of the combining entities. It is in such situations, of course, that consolidated accounts are typically required. If two or more entities, let us call them entities A and B, wish to combine to form one economic entity, but leave the entities separate legally, then a parent/subsidiary relationship must be established. In other words, a group must be created which will have to prepare consolidated accounts dealing with the state of affairs of two or more separate legal entities as though they were one economic entity. In the circumstances we are outlining, the group could be created by any one of the following three methods:

1 Entity A could become the parent of entity B;

2 Entity B could become the parent of entity A;

3 A new entity (H) could be formed to become the parent of both entity A and entity B.

In practice a parent/subsidiary relationship is established when the parent establishes control over the subsidiary. Control can in fact be established in a number of different ways. However, in practice the most common method of establishing control is for the parent to obtain a majority holding in the equity shares (or equivalent) of the subsidiary. In the majority of group structures, both the parent and the subsidiary(ies) will be companies and so we will confine our attention to companies from now on.

However the new group is established, the process will usually involve the new parent company entering into an arrangement with the former shareholders of the subsidiary company(ies). The former shareholders of the subsidiary(ies) will clearly require payment in exchange for their shares. The parent could effect this payment by:

paying the former shareholders an agreed amount of cash; or issuing the former shareholders with an agreed amount of loan stock in the parent; or issuing the former shareholders with an agreed amount of non-equity shares in the parent;or issuing the former shareholders with an agreed amount of equity shares in the parent. An important issue in accounting for business combinations is exactly

how the group companies should be consolidated. You are probably aware already that the two methods of consolidation that might be used are the Acquisition Method and the Merger Method. There are essentially two aspects to the problem:

how to prepare consolidated financial statements under the two methods; when each of the two methods is likely to be appropriate. The subject matter included in this article is theoretically examinable both at paper 10 and at paper 13. However, questions involving accounting for business combinations as an

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acquisition or a merger will only appear at an introductory level in paper 10. The more complex aspects of this article apply at paper 13 only.

Acquisition method vs merger method — an outline

In the previous section, we explained that in a business combination the former equity shareholders of the new subsidiary company will receive consideration from the new parent in exchange for their equity shares and that consideration could take the form of:

cash; loan stock; non-equity shares; equity shares. In all but the final case, the income entitlement of the former equity shareholders of the subsidiary is not dependent on the level of profits of any company in the new group (since their income entitlement is either fixed or non-existent). Therefore in each of these first three cases the former (equity) shareholders have relinquished their risk capital in exchange for non-risk capital (or cash). Therefore there is a sense in which those equity shareholders have received a repayment of their risk capital as a result of the business combination. In such circumstances the Acquisition Method (the `normal' method of consolidation which applies in the vast majority of situations) is always appropriate. Thus it is only relevant to compare the Acquisition Method of consolidation with the Merger method of consolidation in the context of an exchange of equity shares since in all other circumstances the Acquisition Method would definitely be used.

Features of acquisition accounting in the consolidated accounts

(a) Only the post-acquisition profits of a newly acquired subsidiary are included in

consolidated reserves.

(b) The net assets of a newly acquired subsidiary should be brought into the consolidated

balance sheet at fair value to the acquiring group at the date of acquisition (the

implications of this will be more fully discussed in a future article).

(c) The difference between the fair value of the consideration given and the fair value of the

net assets acquired represents goodwill.

(d) Where the consideration given is wholly or partly shares the difference between the fair

value of the shares issued and their nominal value must be shown in the consolidated balance sheet (although not necessarily in the individual balance sheet of the parent company) as a capital reserve. If the ownership of the equity shares of the acquired subsidiary following the issue of shares by the parent company is less than 90% then this capital reserve must be called a share premium account. A share premium account must appear in the individual balance sheet of the parent company as well as in the consolidated balance sheet (the legal reasons for this will be fully explained later).

Features of merger accounting in the consolidated accounts

(a) All the profits of the newly merged subsidiary will be included in consolidated reserves

(subject to any minority interest — relatively

uncommon where the Merger Method is appropriate).

(b) No restatement is made of the net assets of the newly merged subsidiary to fair value at

the date of the merger.

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(c) The consideration given by the parent company to facilitate the merger is recorded as

the nominal value of the equity shares issued (plus any non-equity included in the consideration). Consequently no goodwill arises.

(d) The difference between the nominal value of the equity shares issued by the parent

company plus the fair value of any other consideration given and the group share of the equity share capital (plus share premium if any) of the newly merged subsidiary is adjusted

against consolidated reserves.

Legality of merger accounting

For many years the legality of merger accounting was doubted due to the requirement of Section 56 of the old 1948 Companies Act for a company to create a share premium account whenever it issued shares (whether for cash or otherwise). Relief was provided in the 1985 Act (s.131) which provided that where a company (A) obtained the ownership of at least 90% of the equity shares of another company (B) by an issue of its own equity shares there was no requirement for it to create a share premium account. Where the company (B) had more than one class of equity share capital in issue then the requirement had to be satisfied for each class.

It is important to realise that the Companies Act 1985 rule discussed above does not refer to merger accounting at all, merely to the need (or otherwise) for a company to create a share premium account. Therefore the fact that no share premium account is required due to the relief available by virtue of s.131 of the 1985 Companies Act is no

guarantee that merger accounting can be used. We will see later in the article that a number of stringent tests need to be passed before a business combination can be consolidated as a merger.

Preparation of consolidated financial statements under the two methods

One type of examination question could call on you to contrast the mechanics of the two methods. We will use the data from the following past examination question (old syllabus — new dates included) to illustrate the differences between them. We will prepare the consolidated financial statements for the Fruit group using both the acquisition and the merger methods of consolidation. The relevant data appears below:

On 1 July 1998 Fruit plc acquired all of the issued equity share capital of Vegetables plc in exchange for shares in Fruit plc. Shares in both companies have a nominal value of £1 each and a market value at 1 July 1998 of £5 for a Fruit plc share and £2.25 for a Vegetables plc share. The agreed terms were 1 equity share in Fruit plc for every 2 equity shares in Vegetables plc.

At 30 June 1999 the register of members of Fruit plc was correct but no entries had been made in the books of account of the company to record the equity shares issued to obtain ownership of the equity shares of Vegetables.

At 1 July 1998 the Balance Sheet of Vegetables plc was as follows:

 

£

£

Equity shares of £1 each

765,000

Share premium account

100,000

Retained earnings

347,525

1,212,525

=======

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Fixed assets Freehold premises

573,750

Plant and machinery at cost

316,965

Less provision for depreciation (127,500)

 

189,465

Quoted investments at cost

140,250

Net current assets

309,060

1,212,525

=======

At 1 July 1998 the quoted investments had a market value of £318,750; the freehold premises a market value of £828,750; The plant and machinery (which had an expected unexpired useful life of four years) a market value of £300,000. Vegetables plc advised that it was their policy to invest surplus cash on a short term basis in quoted investments. Draft accounts prepared for the two companies at the end of their financial year on 30 June 1999 showed the following:

Profit and Loss Accounts for the year ending 30 June 1999

Profit before depreciation

Fruit plc

Vegetables plc

£

£

568,310 437,070

Depreciation for the year Trading profit Profit on sale of investments

(91,290)

(40,035)

477,020

397,035

138,465

Profit before tax Tax Profit after tax

477,020

535,500

(119,255) (149,940)

357,765

385,560

Retained earnings:

— brought forward

651,015

347,525

— carried forward

Balance Sheets as at 30 June 1999

1,008,780 733,085

Fruit plc

Vegetables plc

£

£

Fixed assets

Freehold premises

Plant and machinery at cost 653,055

Aggregate depreciation

Net current assets

1,657,500 573,750

316,965

(276,165) (167,535)

249,390

2,283,780 1,598,085

1,125,000 765,000

150,000 100,000 1,008,780 733,085 2,283,780 1,598,085

874,905

Equity shares of £1 each

Share premium account Retained earnings

You are required to prepare draft consolidated accounts for the year ending 30 June 1999 on the basis that:

(a)

Merger accounting is applied.

(b)

Acquisition accounting is applied — assume a policy of amortisation of any goodwill on

consolidation over 10 years and ignore any deferred taxation implications.

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The financial statements of the Fruit plc group under both acquisition accounting and merger accounting will be as follows:

Profit and Loss Accounts

Acquisition Merger

Working

£ Profit before depreciation. 1,005,380

Depreciation (166,290) (131,325) 2

£

ref

1,005,380 1

Diff. on sale of investments (40,035)

138,465

3

Amortisation of g'will Profit before tax

(15,594)

4

783,461

1,012,520

Tax Profit after tax Retained profit b/fwd Retained profit c/fwd

(269,195)

(269,195) 5

514,266

743,325

651,015

998,540

6

1,165,281

1,741,865

Balance Sheets Unamortised goodwill Freehold premises

140,346

2,486,250

2,231,250 7

Plant and machinery Net current assets

601,890

526,320

8

1,124,295

1,124,295 9

 

4,352,781

3,881,865

Share capital Share premium account Capital reserve

1,507,500

1,507,500 10

150,000

150,000

11

1,530,000

12

Merger reserve

482,500

13

Retained earnings

1,165,281

1,741,865

4,352,781

3,881,865

Workings/notes

1 Profit before depreciation

This is simply the sum of the relevant figures for Fruit and Vegetables from their individual financial statements.

2 Depreciation

In the case of merger accounting, this is once again the sum of the figures from the individual financial statements. However under acquisition accounting the net assets of Vegetables are first consolidated based on their fair value on 1 July 1998 (the date of acquisition). The fair value of the plant at that date was £300,000 and its remaining useful life four years. Therefore the depreciation based on this carrying value will be £75,000 (£300,000/4) and the consolidated figure £166,290 (£91,290 {Fruit} + £75,000 {Vegetables}).

3 Difference on sale of investments

Again the figure is straightforward in the case of merger accounting. In the case of acquisition accounting, the difference is computed by comparing the proceeds of sale (£138,465 + £140,250 = £278,715) with the carrying value (which based on the fair value of the investments at the date of acquisition is £318,750) giving the loss of £40,035.

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4 Goodwill

The goodwill on consolidation is calculated as follows:

 

£

£

Fair value of consideration given:

[765,000 x 1/2 x £5.00] Fair value of net assets of Vegetables at the date of acquisition:

1,912,500

Quoted investments

318,750

Freehold premises

828,750

Plant and machinery

300,000

Net current assets

309,060

 

(1,756,560)

So goodwill equals

155,940

5 Taxation

Because the question tells us to ignore deferred taxation the taxation charge is straightforward in both cases. If it were necessary to consider deferred taxation the taxation charge under acquisition accounting would have been harder because we would have had to consider the deferred taxation implications of the fair value adjustments.

6 Retained profit brought forward

In acquisition accounting none of the retained profit brought forward of Vegetables is included because it is all pre-acquisition. Under merger accounting pre-merger profits are consolidated in full.

7 Freehold premises

Under merger accounting, the figure can be derived by totalling the figures from the individual financial statements. Under acquisition accounting, the premises of Vegetables will be consolidated based on its fair value on 1 July 1998 (the date of acquisition) so we will have

£1,657,600 + £828,750 = £2,486,250.

8 Plant and machinery

Similar principles apply to plant. Under merger accounting, the net book values are taken from the Balance Sheets of the individual companies whereas under acquisition accounting the plant of Vegetables is consolidated based on its fair value at 1 July 1998. Therefore we have:

Acquisition Merger

 

£

£

Fruit

376,890

376,890

Vegetables 149,430

225,000*

Total

526,320

601,890

* £300,000 - £75,000.

9 Net current assets

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This is straightforward under both methods because there is no information that the fair value of any of the net current assets of Vegetables is any different from their carrying value in the individual financial statements.

10 Share capital

The figure of £1,125,000 in the draft Balance Sheet of Fruit does not include the 382,500 (765,000/2) shares that were issued in exchange for the shares in Vegetables.

11 Share premium

As with share capital the amount shown in the consolidated balance sheet relates to the parent only. There is no effective difference in treatment between share capital and share premium since both relate to shares issued by group companies.

12 Capital reserve

This reserve only arises under acquisition accounting. When we acquisition account we need to record the issue of shares by Fruit at its fair value. This means accounting for a `premium' of £1,530,000 (382,500 x £4.00). Because the new shares were issued as part of a transaction which took Fruit's ownership of shares in Vegetables to over 90% (100% in fact) there is no requirement to call this reserve a share premium account. The reserve is sometimes called a Merger Relief Reserve because the Companies Act provisions which allow dispensation from the requirement to show a share premium account are known as the Merger Relief Provisions. This is a very confusing name for the reserve, however, because the reserve does not arise when merger accounting is used! Only under Acquisition Accounting does the difference between the fair value and the nominal value of any shares issued by the parent to effect the business combination need to be recorded.

13 Merger reserve

This represents the consolidation difference that arises under Merger Accounting. It is computed by comparing the investment in subsidiary (let us call this figure `I') which appears in the books of the parent with the nominal value of the shares of the subsidiary which the parent has purchased plus any share premium attaching to those shares (let us call this figure `S').

`I' will be a debit balance from the books of the parent and will be made up of the nominal value of the equity shares issued by the parent plus any non-equity element included in the consideration. There are severe restrictions on the level of this non-equity element which we will discuss later in this article. In the example we are looking at here, `I' will be a debit of £382,500.

`S' will be a credit balance from the books of the parent and (as explained in the previous paragraph) will be the nominal value of the shares acquired in the new subsidiary (£765,000 in this case) plus any premium at which those shares were originally issued (£100,000 in this case). Therefore `S' will be a credit of £865,000.

Where the consolidation difference is a debit (not the case here) then the difference should be deducted from other reserves. Where the difference is a credit (here the difference is a credit of £482,500) then the difference is shown as a merger reserve.

Advantages of using merger accounting

Following the issue of FRS 7 (to be considered in more detail in a future article in this series) the creation of provisions for future reorganisation as part of the fair value exercise

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to artificially improve the profile of earnings following a business combination was effectively outlawed. Therefore the use of merger accounting as a means of recording a business combination became relatively more attractive. The reasons for the relative attractiveness of merger accounting are as follows:

(a) Since net assets are not revalued to fair value, merger accounting will report higher post

merger profits (because of lower charges for items such as depreciation {see the example

Fruit and Vegetables which we worked earlier in the article}).

(b) Following on from the above, merger accounting will report higher returns on capital. It

must however be acknowledged that, because of the restatement of pre-merger figures which takes place under merger accounting, the past returns on capital with which the current returns are being compared will also be higher under merger accounting.

Because of the possibly understandable wish of parent companies to use merger

accounting to account for business combinations in their consolidated financial statements

it has been necessary to put various restrictions on the ability of companies to use merger

accounting to account for business combinations. The restrictions currently in place are

found in the Companies Act 1985 and FRS 6. We will consider each in turn.

The 1985 Companies Act

Following the adoption by the United Kingdom of the EC. 7th Directive on Group Accounts

it was necessary for legislation to be passed detailing when Merger Accounting was

available for use. The necessary legislation was included in the 1989 Companies Act (by amendment to The 1985 Act). The 1989 Act laid down that all of the following conditions had to be satisfied before Merger Accounting was available for use. (NB: in what follows, the offeror company is the prospective parent company of the new group, and the offeree company the prospective subsidiary).

(a) The offeror obtains the ownership of at least 90% of the equity shares of the offeree as

a result of the combination (necessary in order for the offeror company to be exempt from

the requirement to create a share premium account on the new shares issued in exchange for the shares in the offeree company). You should remember that under merger accounting the shares issued by the offeror must be recorded at their nominal value.

(b) The holding of shares in the offeree company by the offeror company was obtained

pursuant to an arrangement providing for the issue of equity shares by the offeror.

(c) The fair value of any consideration given other than the issue of equity shares does not

exceed 10% of the nominal value of the equity shares issued.

(d) The adoption of merger accounting accords with generally accepted accounting

principles i.e., in the UK with the requirements of FRS 6 — see later.

Following the issue of FRS 6 in 1994 conditions (b) _ (c) above have only limited practical relevance. This is because the detailed conditions laid down in FRS 6 are considerably more stringent and they are effectively encapsulated in condition (d). However, condition (a) is still of some importance. With the possible exception of a group reconstruction (see later in the article for more details) a business combination which leaves a minority interest of more than 10% in the offeree company cannot be dealt with as a merger.

Before we leave the Companies Act conditions, it is worth emphasising that they are presented in such a way that Merger Accounting is

permitted, but

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not required, where the conditions are satisfied. We will see later in the article that, in the relatively rare circumstances where a business combination does satisfy the FRS 6 conditions, Merger Accounting is (under FRS 6) mandatory.

FRS 6, Acquisitions and Mergers

Overall objectives

The objective of FRS 6 is to ensure that merger accounting is used only for those business combinations that are, in substance, the formation of a new economic entity as a substantially equal partnership where no party is dominant. Accordingly the FRS identifies in general terms the type of business combination which would fall to be treated as a merger. According to FRS 6, a merger is:

"A business combination that results in the creation of a new reporting entity formed from the combining parties in which the shareholders of the combining entities come together in a partnership for the mutual sharing of the risks and benefits of the combined entity, and in which no party to the combination in substance obtains control over any other, or is otherwise seen to be dominant, whether by virtue of the proportion of its shareholders'rights in the combined entity, the influence of its directors or otherwise. "

Those students who keep abreast of current activity in the field of business combinations by reading the financial press will appreciate that the majority of business combinations are not of the type described above, being framed in terms of a `predator' and a `victim'. Therefore, as has already been stated, the vast majority of business combinations will fall to be treated as acquisitions.

The specification by the ASB of a merger in terms of commercial substance is consistent with both the general Statement of Principles that it is seeking to develop and with the content of FRS 5, Reporting the Substance of Transactions. However the determination of the commercial substance of a business combination is an extremely subjective matter. Therefore the ASB identified five specific criteria in FRS 6 which had to be satisfied, in addition to the Companies Act conditions which we have already discussed and evaluated, before a business combination was to be accounted for as a merger. We will discuss each of the criteria in turn and comment in each case on the reasons for its inclusion in the list of requirements.

FRS6 — The Specific Criteria

Criterion 1

Criterion 1 states that no party to the combination is portrayed as either acquirer or acquired, either by its own board or by that of any other party to the combination.

It is clear that if this criterion is not satisfied, then we have an acquisition rather than a merger. In seeking to determine whether or not this criterion is satisfied, it would be necessary to consider matters such as the proposed corporate image of the new entity and its plans for the future. If the corporate image seemed to focus on one of the previous combining parties at the expense of the other, then this could well indicate an acquisition. Similarly, if there were plans to dispose of a material part of the operations of one of the combining entities rather than the other, this would also indicate the presence of an acquisition, rather than a merger.

Criterion 2

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Criterion 2 states that all parties to the combination, as represented by the boards of directors or their appointees, should participate in establishing the management structure for the combined entity and in selecting the management personnel, and such decisions should be made on the basis of a consensus between the parties to the combination rather than purely by exercise of voting rights.

An essential feature of a merger is that no one combining party is able to dominate the management of the combined entity. If management decisions can only be reached by the exercise of the voting rights of one party to the combination, possibly against the wishes of one of the other parties, then clearly in substance we have an acquisition. Therefore it is necessary for the management structure at all levels, but particularly at senior management level, to be such as to include representatives of each of the combining parties.

Criterion 3

Criterion 3 states that the relative sizes of the combining entities should not be so disparate that one party dominates the other by virtue of its relative size.

It is clear that where two parties of materially different sizes enter into a business combination there is the potential for the larger party to dominate the smaller party. It is also clear that the substance of a combination that involves the dominance of one party by another is an acquisition, rather than a merger. FRS 6 states that one party would be presumed to dominate another if it is more than 50% larger than each of the other parties to the combination, judged by reference to the ownership interests in the new entity. The presumption can be rebutted if it can be proved that no such dominance in fact exists (perhaps by the existence of special voting powers for the smaller party(ies)) but such circumstances would need to be clearly explained.

Example of the `50% test'

Sooty has an issued equity share capital of 5 million £1 shares. Sooty enters into a business combination with Sweep. The terms are that Sooty issues new equity shares to the current equity shareholders of Sweep in exchange for the equity shares that they currently hold (in Sweep). We will assume that Sooty issues:

(a)

4 million new shares;

(b)

3 million new shares.

All equity shares in Sooty (both existing and new) have equal voting rights.

Solution

(a) Where Sooty issues 4 million new equity shares the new share capital of Sooty is £9 million in £1 equity shares. These shares are allocated as follows:

— 5 million to existing Sooty shareholders.

— 4 million to existing Sweep shareholders.

The disparity in ownership (and therefore voting) between the old Sooty shareholders and the old Sweep shareholders is 25% ({5 _ 4}/4 x 100)%. Therefore there would be no presumption of dominance by Sooty in this case.

(b) Conversely, where Sooty issues 3 million new shares then the new share capital of

Sooty is 8 million, with a 5:3 split between the old Sooty shareholders and the old Sweep

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shareholders. The disparity in ownership is now therefore 66.7% ({5 _ 3}/3 x 100)%. Therefore there would be presumption of dominance by Sooty here.

Criterion 4

Criterion 4 states that under the terms of the combination the consideration received by the equity shareholders of each party to the combination should comprise primarily equity shares in the combined entity, and that any non-equity consideration, or equity shares which carry substantially reduced voting rights, should represent an immaterial proportion of the fair value of the consideration received by the equity shareholders of that party. Where one of the combining entities has, within the two year period immediately before the combination, acquired equity shares in another of the combining entities, the consideration for this acquisition should be taken into account in determining whether criterion 4 has been met.

There is a clear link here with one of the conditions (c) identified in the Companies Act. However criterion 4 is in fact a tighter restriction. The reason is that criterion 4 effectively states that all but an immaterial part of the consideration should be in the form of shares which are in substance equity. The Companies Act condition leaves open the possibility of its being satisfied by the use of shares which fall within the statutory definition of equity, but which in fact have characteristics that are closer to non-equity. Although the term `materiality' is not specifically defined in FRS 6, it is probable that a figure of 10% for the non-equity consideration would represent an upper limit.

The FRS specifically refers to arrangements made in connection with the combination whereby parties initially receive equity shares but subsequently exchange or redeem those shares for cash (or other non-equity consideration). Such arrangements, known as vendor placings, were used by some companies prior to the issue of FRS 6 to allow them to account for business combinations as mergers where one of the combining parties required cash. Clearly such an arrangement is in substance an acquisition. FRS 6 says that, in determining whether or not criterion 4 is satisfied, the parties who actually acquire equity shares with the rights to exchange or redeem them for cash or other non-equity consideration will be deemed to have received non-equity consideration.

It should be emphasised that the arrangements referred to above are pre-arranged rights of exchange or redemption that are actually established as part of the combination agreement. Clearly it is always possible for any shareholders to individually arrange a sale of their shares at any time, either in the market or privately. Clearly the incidence of one or more such sales prior to a business combination would not of itself invalidate its treatment as a merger.

Criterion 5

Criterion 5 states that no equity shareholders of any of the combining entities should retain any material interest in the future performance of only part of the combined entity.

If this criterion were not satisfied, the business combination would be incompatible with part of the general concept underlying a merger, which is that the participants enter into a mutual sharing of the risks and rewards of the combined entity. Therefore any business combination which allocated equity shares to any material extent to one or more of the parties on the basis of the future performance of the entity in which they previously held shares would not fall to be treated as a merger. Similarly, if any material (not defined) minority interest remains in any of the combined entity this indicates the existence of shareholders who have not accepted the terms of the combination, and are therefore solely

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interested in the performance of one of the entities. Once again, such a combination would not fall to be treated as a merger.

Before we leave the detailed conditions, it is worth noting three matters:

(a) Incidences of business combinations satisfying all of the criteria are likely to be few and

far between. Indeed, some commentators have expressed the opinion that, aside from inter-group reconstructions (discussed later) the practical effect of FRS 6 is to completely prevent new business combinations from being accounted for as mergers.

(b) The criteria that we have been discussing are all subjective to a greater or lesser

extent. Therefore their practical application is bound to be problematical.

(c) Any business combinations that do satisfy the detailed criteria must be accounted for

as mergers (the Companies Act conditions

allow, but do

not require, the use of merger accounting where the relevant conditions are satisfied).

FRS 6 — a Summary of the Mechanics of Merger Accounting and Acquisition Accounting

Merger Accounting:

The carrying values of assets and liabilities are not adjusted to fair value on consolidation. However appropriate adjustments should be made to achieve uniformity of accounting policies in the combining entities. The results and cash-flows of all the combining entities should be brought into the financial statements of the combined entity from the beginning of the financial years in which the combination occurred. Corresponding prior-period figures should be restated. The difference, if any, between the nominal value of the shares issued plus the fair value of any other consideration given, and the nominal value of the shares received on exchange should be shown as a movement on other reserves in the consolidated Balance Sheet. Any existing balance on the share premium account or capital redemption reserve should be brought in as part of this movement on other reserves. These movements should be shown as part of the reconciliation of movements on shareholders' funds. Merger expenses should be charged to the profit and loss account of the combined entity at the effective date of merger. If the expenses relate to the issue costs of equity shares then the parent will deduct these from its share premium account in accordance with the provision of FRS 4. Therefore in the consolidated accounts the group may transfer such issue costs to the share premium account by means of a reserve movement. Acquisition accounting

All business combinations not accounted for as mergers should be accounted for as acquisitions. The assets and liabilities should be included in the acquirer's consolidated Balance Sheet at fair value at the date of acquisition.

The results and cash flows of the acquired companies should be brought into the group accounts only from the date of acquisition. No adjustment of prior period results is required. FRS 6 disclosure requirements

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All business combinations should disclose the names of the combining entities, the date of the combination and the method of consolidation used(acquisition or merger). Where business combinations are accounted for as acquisitions information regarding the fair value of the consideration given and the fair value of net assets acquired should be given. Information is also required regarding the pre-acquisition performance of the acquired business. Where an acquisition is substantial then the pre-acquisition information needs to be given in respect of the last complete year as well. When FRS 6 was issued `substantial' was defined in terms of classifications under the Stock Exchange Listing Rules. In August 1995 the classifications were changed. However under the provisions of UITF 15, Disclosure of Substantial Acquisitions, it was decided to retain the old classification for the purposes of determining whether an acquisition was `substantial' for FRS6 disclosure purposes. The latest version of UITF 15 — revised in February 1999 — states that the effect is to require the additional disclosure where certain ratios (e.g., the ratio of the assets of the target undertaking to those of the offeror undertaking) exceed 15%. If business combinations are accounted for as mergers then it is necessary to give details of the pre and post merger results of each business and of the book values of the merged assets and liabilities. Disclosure of the nature and treatment of the consolidation difference is also required.

Group reconstructions

The Underlying Background

Everything we have said so far in this chapter refers to a business combination that creates a new group of companies where none existed before. A group reconstruction is an arrangement whereby an existing group is rearranged in some way. According to FRS 6, any of the following arrangements constitutes a group reconstruction:

(a) The transfer of a shareholding in a subsidiary undertaking from one group

company to another.

Suppose H is the parent of a wholly owned subsidiary S and a 75% subsidiary, T. H paid £350,000 for its equity shares in T. As part of a group reorganisation H's equity shares in T were transferred to S. The consideration was satisfied by the issue by S of 100,000 new equity shares to H, which had a market value of £5 per share.

The effect of this group reconstruction is to alter the group from being one with a parent and two directly owned subsidiaries to a group with one directly owned subsidiary and a sub-subsidiary (although the effective interest of H in T is unchanged at 75%.

(b) The addition of a new parent company to the group

Suppose the group structure in the example given in (a) above was altered so that all the equity shares in H were transferred to a new company, let us say G, and the old shareholders of H were issued equity shares in G in exchange for their equity shares in H. In these circumstances, we have a group reconstruction. It should be straightforward to see that effectively the group is unchanged.

(c) The transfer of shares in one or more subsidiary undertakings of a group to a

new company that is not a group company, but whose shareholders are the same as those of the group's parent.

Using the same set of circumstances once again, let us assume that another company, say company I does a deal with company H to acquire its shareholdings in S and T. In return

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company I issues its own new equity shares. However the recipients are the shareholders

of company H rather than the company — the company H being the legal owner of the

shares in S and T prior to their transfer. In these circumstances we effectively have a group

reconstruction. Once again the practical effect of the group reconstruction is limited as the ultimate controls remain with the shareholders of H (since they are also shareholders of I).

(d) The combination into a group of two or more companies that before the

combination had the same shareholders.

Using the circumstances outlined in (c). above let us assume a slightly different scenario. Let us assume that a company J has exactly the same shareholders as company H. Let us further assume that company J becomes part of the HST group by company H doing a deal with the shareholders of company J (and therefore their own shareholders also!) to acquire their shares in company J. This is another example of a group reconstruction.

A common feature of all the group reconstructions we have described here is that they do

not really create a new group, but effectively rearrange an existing one. In these circumstances, the use of merger accounting to record the setting up of the new group seems eminently sensible. This is because Merger Accounting effectively amalgamates the results of the companies in the new group as if the group was constituted before the date of

the combination, which of course is effectively the situation!

Merger accounting for group reconstructions — the requirements of FRS 6

FRS 6 provides that group reconstructions (as already defined) may be accounted for as a merger whether or not the detailed criteria discussed earlier in this chapter are satisfied provided they satisfy the following:

(a)

The use of merger accounting is not prohibited by companies legislation.

(b)

The ultimate shareholders remain the same, and the rights of each such shareholder

relative to the others are unchanged.

(c) No minority's interest in the net assets of the group is altered by the transfer.

Conditions (b) and (c) can effectively be summarised by saying that Merger Accounting is permitted for group reconstructions that have no effect in substance on the composition of the group or of its ultimate shareholders.

Group reconstructions — Companies Act legislation

You will recall from earlier in the article that, when MergerAccounting is used, shares issued as part of the business combination are recorded at their nominal value. Therefore it

is necessary for legislation to be in place exempting companies from the normal

requirement to create a share premium account when it issues shares. We saw that, for business combinations which result in new groups, the necessary legislation is found in

s.131 of the 1985 Companies Act. This legislation exempts companies from creating a share premium account in circumstances where they issue shares so as to acquire 90% or more of the equity shares of another company.

This legislation is not sufficient for group reconstructions. In the example we looked at when considering group reconstructions the s.131 legislation would not have exempted S from the requirement to record the new shares it issued at a premium, because they were issued pursuant to an arrangement which allowed S to obtain 75% (less than 90%) of the shares in T. The facts of the example are restated below for ease of reference:

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Suppose H is the parent of a wholly owned subsidiary S and a 75% subsidiary, T. H paid £350,000 for its equity shares in T. As part of a group reorganisation H's equity shares in T were transferred to S. The consideration was satisfied by the issue by S of 100,000 new equity shares to H, which had a market value of £5 per share.

Section 132 of the 1985 Act contained provisions to deal specifically with group reconstructions. The main thrust of the legislation is that if a wholly owned subsidiary allots shares to its holding company or to another wholly owned subsidiary in the group then the transfer to the share premium account is restricted.

We will illustrate the practical effect of the legislation by reference to the HST example. You should notice that, because of the fact that S is a 100% subsidiary (the percentage ownership of T is not relevant) the group structure is not affected by the reorganisation. In such circumstances, s.132 of the 1985 Act does not require the normal transfer by S to a share premium account. If this normal transfer were made, S would be required to account for a premium of £4.00 on each share issued — a total of £400,000 in this case. This in turn would mean that S would have to debit its account `Investment in T' with the fair value

of the shares issued — £500,000. The investment only cost the group £350,000, so the

transfer would create a problematic consolidation difference if the normal share premium account were required.

In such circumstances s.132 allows the normal share premium requirements to be

dispensed with. Instead, the credit to the share premium account is restricted to the

Minimum Premium Value (MPV). The MPV is the difference between the base value of the consideration given for the shares and their nominal value. The base value of the consideration given is the lower of:

(a)

The original cost to the group of the investment in T.

(b) The amount at which the investment in T is stated in the books of H immediately before the transfer.

In this case therefore the base value is £350,000 and the MPV £250,000. Therefore the

entry S will make will be:

CR: Share capital — £100,000

CR: Share premium — £250,000

DR: Inv. in T — £350,000

The `group reconstruction' provisions of s.132 take priority over the `90% ownership' provisions of s.131 where the two are in conflict.

Accounting for de-mergers

1 Introduction

A de-merger refers to splitting up an existing group of companies into two or more separate

groups in order to separate their different trades, possibly as a prelude to floating off one of the businesses. A number of routes are possible to achieve this objective but the most common is probably the one indicated in the following diagram:

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FRS 6, Acquisitions and mergers | | | ACCA Page 16 of 16 What has happened

What has happened is that Company A has transferred its shareholdings in a subsidiary B to its shareholders. This effectively represents a distribution to its shareholders and is referred to as a

dividend in specie.

An alternative way of achieving the same results for the shareholders in A is to transfer the shares in B to a new company (C) and to issue shares in C to the shareholders of A. This is illustrated by the diagram which is shown below:

A. This is illustrated by the diagram which is shown below: The ultimate effect on the

The ultimate effect on the shareholders of A is the same.

The accounting treatment

The principle will be illustrated with the aid of the following example. B is a subsidiary of A and is to be de-merged from the group. The form of the transaction is that the shareholders of A are to receive the shares held by A in B as a dividend in specie. The Balance Sheets before the de-merger are as follows:

A

B

Consolidated

£

£

£

Investment in B Other net assets

1,200 800 2,000 1,700 800 2,000

500

Share capital

1,000 500 1,000

Profit and loss account 700

300 1,000

1,700 800 2,000

In the consolidated financial statements of the A group the effect of the de-merger is to reduce the net assets of the group by £800. This amount will be reflected either in the consolidated profit and loss account as a dividend in specie or as a movement in retained earnings.