The influence of acquisition’s parameters on financial
reporting business combination.
Piotr Luty,
MA (Faculty of Finance –
The
number of business combinations in
Key
words: Acquisition, acquirer, purchase method
I Introduction
Nowadays
acquisitions become challenging for both companies and managing boards. At the
beginning of the process of business combination, managing boards and owners
will and decisions about acquisition are needed. Moreover to finalise
acquisition, people responsible for acquiring business units have to remember
about bookkeeping and reporting aspects of that process.
In
After
analysis of the Act of Accounting and the Company Law appears the conclusion
that acquisition takes part when two or more business units bring together and
become one entity. Those two Laws emphasis also on
transferring net assets in acquisition process. Finally, IFRS 3(business
combination) mentions the crux of the acquisition. IFRS 3 states directly that “A
business combination is the bringing together of separate entities or
businesses into one reporting entity”. The appendix A to IFRS 3 provides the
definition of reporting entity. According to this definition a reporting entity
may be one business unit or a group of business units, which consist of parent
entity and subsidiaries. The reporting entity, does not matter if it is one or
more entities, prepares financial reports for broad range of users. The IFRS 3
definition of business combination refers to much more situations than only
acquisition. Therefore acquisition “sensu stricto” is only a small part of all recognised in IFRS 3
business combination.
In
this article I would like to present a thesis that in economic practice there
exists such a business combinations, which in the same time are, but do not
have to be recognised as acquisition by different Laws (the Act of Accounting, the
Company Law and IFRS). Moreover, the choice of some parameters of acquisition
process, for example which entity is an acquirer, may influence on the
financial statements of the reporting entity.
II Identifying
the acquisition in the Company Law, the Act of Accounting and IFRS 3.
In
general, the Company Law regulates legal aspects of setting up and liquidation
of companies. However, one part of the Company Law is focused directly on
acquisition of companies. The Company Law states that as a result of
acquisition at least one entity lose its legal status.
Therefore, there are two possibilities of acquisition. First, in which the
entity that lose its legal status transfers assets and liabilities to the
acquirer. Second, all companies involved in acquisition cease to exist and all
of them transfer their net assets (assets minus liabilities) into newly established
entity. The company which transfers net assets is called acquired entity (acquiree) and the company which takes over net assets is
called acquiring entity (acquirer). The acquisition process has to adhere to
the plan of acquisition, which is approved by owners of combining entities. The
acquiring entity pays the price of acquisition to the owners of acquired entity
as an equivalent of net assets received from them. The Company Law recognises
acquisitions only if the price of acquisition is settled through transfer of
capital instruments of acquiring entity (issued and distributed shares or
stocks of acquiring entity). If the acquisition is done by transferring to the
owners of acquired entity cash, cash equivalents or other assets, or any combination of
all above, such a business combination is not recognised as acquisition in
accordance with the Company Law.
The
Act of Accounting in the line with the Company Law does not define the term of
acquisition. In the Act of Accounting
there is also no explanation what the difference is between acquisition and other
business combinations. Although the lack of direct definition
of acquisition, the Act of Accounting states how the acquisition has to be
entered into the books. The aim of the Act of Accounting, in acquisition
field, is focused on joining accounting books of acquired and acquiring
entities and estimating fair value of acquired assets and assumed liabilities. In Art. 44a of the Act of Accounting is written, that
“business combination of commercial companies shall be accounted for and
recognised as at the business combination date, …, in the books of accounts of
a company to which the assets of the combining companies (the acquirer) or a
new company established as a result of the combination (a newly-formed company)
are transferred, under the acquisition method, and in the cases specified in
Art. 44c – under the pooling of interests method.” There are two methods of
bookkeeping acquisition: purchase method and the pooling of interests method.
The second method mentioned above is widely criticised by accounting
authorities. A. Hendriksen claims that it is hard to
create reasonable criteria for using the pooling of interests method and this
method gives opportunities to forge financial statements.
Therefore the purchase method is the centre of attention and is preferable. The
purchase method does not specify common features of acquirer (e.g. the total
amount of assets or revenue etc.). However, logically is that significantly
bigger entity (bigger in the meaning of for example fair value of net assets)
purchases net assets of another entity and pays price of acquisition. Acquired
assets and assumed liabilities are evaluated to fair value, so new evaluation
gives them bookkeeping “fresh start”. According to the Act of Accounting, the
acquiring entity is that entity, which purchases and adds to accounting books
net assets of acquiring entity. The Act of Accounting states that “accounting
for business combination under a purchase method involves adding particular
items of assets and liabilities of the acquirer, at their book value, and the
relevant items of assets and liabilities of the acquiree,
at their fair value determined as at the business combination date.”
The
most important criteria for recognising purchase method in the Act of
Accounting, mentioned above, is focused on transferring net assts between
combining entities. Therefore the situation in which one entity purchases only equity
of another entity is not recognised as acquisition. One entity becomes dominant
entity and others are subsidiaries. Of course, in future such a situation may
lead to transferring net assets from one entity into another. Purchasing only
equity for example from the stock is excluded from the definition of the
acquisition in the Act of Accounting. The dominant entity prepares consolidated
financial statements of the capital group which include data of parent company
and its subsidiaries, complied in such a manner as if the capital group were
one entity. Although the consolidation of companies consists in adding together
individual items of the relevant financial statements of a parent company and
its subsidiaries, making some eliminations, the
consolidation process does not take place in books of accounting of any combining
entity.
Another
difference in identifying acquisition from all business combinations in the Act
of Accounting and the Company Law relates various forms of price of
acquisition. In accordance with the Act of Accounting the cost of acquisition
may be measured for example as fair value of issued and distributed shares,
acquired own shares for the purpose of a acquisition, cash, other assts or a
combination of various objects covered by the payment. On the contrary, the
Company Law identifies the acquisition only if acquirer issues and distributes
shares. Therefore covering the payment by others forms results in excluding
this business combination from acquisition (in accordance with the Company
Law).
As
it was mentioned in the introduction, IFRS 3 define acquisition as bringing
together of separate entities into one reporting entity. The reporting entity
does not have to be one business unit, but may consists
of different entities (for example capital group). The only one approved method
of acquisition, according to IFRS 3, is purchase method. Both IFRS 3 and the
Act of Accounting consider all aspects of acquisition by purchase method from
acquirer point of view. However IFRS 3 and the Act of Accounting define the acquirer
differently. As it is stated in the Act of Accounting, the acquirer is the
entity, which receives net assets and reflects the acquisition transaction in
books of account. The IFRS 3 states that the acquirer in all business
combinations, including acquisition, is the entity which obtains control of the
other combining entities. Therefore the fact of gaining control by one entity
is much more important than the direction of transferring net assets between
combining entities (which entity recognise assts and liabilities of other
entities).
IFRS
3 presents that purchase of one entity by another may be structured in various
ways. It may involve the purchase by one entity of the equity of another
entity, the purchase of all the net assets of another entity, the purchase of
some of the net assets of anther entity, that together form one or more
businesses.
On
the one hand purchasing equity of other entity leads to establish the relation
between combining entities such as parent company – subsidiaries. On the other hand if acquisition
involves purchase of net assets, the capital relation (parent company –
subsidiaries) between combining entities will not exist.
IFRS
3 points out that in nearly all business combinations identifying acquirer and acquiree is obvious. In most acquisitions the entity, which
delivers its shares or stock, is acquirer. Almost all entities delivering
shares also are entities which obtains control over other entities. However
such a rule has some exclusions. One example of the
exclusion is “reverse merger” in which the company, which delivers shares is
acquired entity and the company, which transfer its net assets is acquirer (in
the meaning of gaining control over other combining entities).
III Business
combinations.
As
it was mentioned above, acquisition may be recognised by the Act of Accounting,
the Company Law and IFRS 3 differently. Recognising acquisition, acquirer and acquiree in Polish law is determined by approved parameters
of acquisition, which are included in combination plan. Changing some
parameters, the managing board may influence on effects of acquisition, presented
in financial statements.
Let
us assume a combination of two companies: A and B. Key data of company A and B
are listed in a table below:
Table 1 Data of company A
|
|
Book value |
Fair value |
|
Book value |
Fair value |
|
ASSETS |
|
|
|
|
|
|
Fixed assets |
2000 |
4000 |
Share capital (1000 shares) |
1000 |
1000 |
|
Current assets |
1000 |
1000 |
Liabilities |
2000 |
2000 |
|
Total |
3000 |
|
Total |
3000 |
|
Source: Piotr Luty
Table 2 Data of company B
|
|
Book value |
Fair value |
|
Book value |
Fair value |
|
ASSETS |
|
|
|
|
|
|
Fixed assets |
10000 |
15000 |
Share capital (1000 shares) |
10000 |
20000 |
|
Current assets |
5000 |
5000 |
Liabilities |
5000 |
5000 |
|
Total |
15000 |
|
Total |
15000 |
|
Source: Piotr Luty
Nominal
value of 1 share company A is 1 and
nominal value of 1 share company B is 10.
Both company A and B have the same amount of listed shares, which is 1000
shares.
As
it is seen in tables, company A has lower book and fair value of net assets
(net assets = assets minus liabilities) than company B. Book value of net
assets of company A is 1000 and fair
value of net assets is 3000. Book value of net assets of company B is 10.000 and fair value of net assets is 15.000. Fair
value of net assets is not equal to fair value of capital in both companies A
and B.
Additionally,
if we assume that fair value of 1 share company A is 1 and fair value of 1
share company B is 20, the huge difference implies that company B will gain
control after acquisition.
Exchange
parity (exchange parity informs about the number of shares that the acquirer is
bond to transfer to the acquiree) is established in
accordance with fair value of share capitals of combining companies.
Consequently, exchange parity states that 20 shares company A equals 1 share
company B and on the other way round 1
share company A equals 0,05 share of company B.
In
all further examples the exchange parity will be fixed and price of acquisition
will consist of new issue decided for the purpose of acquisition.
Example
1
In
case of acquisition company A and company B, the most obvious situation is when
company B (the bigger one) purchases company A. In such a template situation,
company B is identified as acquirer by the Act of Accounting, the Company Law
and IFRS 3. Company A is identified as acquiree. The
acquisition presented from company B (acquirer) point of view shows the table
below.
Table 3 Acquisition of company A and B – acquirer is company B
|
Assets |
|
Liabilities |
|
|
Fixed assets |
14000 |
Share capital holding by owners of
company B – 1000 shares |
10000 |
|
Current assets |
6000 |
Share capital holding by owners of
company A – 50 shares |
500 |
|
|
|
Supplementary capital (difference between nominal value and fair
value of 50 shares 5 issued and distributed to owners of company A ) |
500 |
|
|
|
Net profit (goodwill) |
2000 |
|
|
|
Liabilities |
7000 |
|
Total |
20000 |
Total |
20000 |
Source: Piotr Luty
As
a result of acquisition owners of company A exchange possessing shares – 1000
shares of company A and receive, in accordance with combination plan, 50 shares
of company B (parity exchange states that 20 shares company A equal 1 share
company B; 1000 shares company A / 20 = 50 shares company B). Price of
acquisition, issued 50 shares of company B, is 1000.
Issued shares, as cost of combination, have to be measured in fair value (50 shares
* 20 = 1000). Nominal value of acquired share capital is 500 (50 shares * 10
(nominal value of 1 share company A) = 500 ). The
difference between nominal value and fair value of delivered shares to owners
of company B is recognised as supplementary capital. Acquirer pays 1000 (50
shares) as cost of combination in exchange for net assets company A, which are
worth 3000. The difference between cost of combination and transferred net
assets is recognised as goodwill.
Example
2
Combining
companies can decide that acquirer is company A. In such a situation company B
is losing legal status and transferring net assets to company A. Identifying company A as acquirer is consistent with both the Act of
Accounting and the Company Law. Company A will never be recognised as acquirer
in accordance IFRS 3, but not all Polish companies are obliged to use IFRS
regulations. In example 2 IFRS 3 regulations is going to be omitted. The
balance sheet prepared in the date of acquisition will show as follow:
Table 4 Acquisition of company A and B – acquirer is company A
|
Assets |
|
Liabilities |
|
|
Fixed assets |
17000 |
Share capital – owners company A –
1000 shares |
1000 |
|
Current assets |
6000 |
Share capital – owners company B –
20.000 shares |
20000 |
|
Goodwill |
5000 |
Liabilities |
7000 |
|
Total |
28000 |
Total |
28000 |
Source: Piotr Luty
According
to the exchange parity the owners of company B exchange their 1000 shares into
20.000 shares of company A (1000 shares B * 20 = 20.000 shares A). As a result
of acquisition 5000 goodwill in assets is recognised. Company A issues and distributes shares with total fair value
In
both example 1 and example 2 the percentage of the owners company B in share
capital of entity existing after acquisition is the same and equals over 95%.
Table 5 Percentage in share capital
|
Example 1 |
No. of shares |
Percentage in share capital |
|
Share capital owned by owners of company
A |
50 |
4,76% |
|
Share capital owned by owners of company
B |
1000 |
95,24% |
|
|
1050 |
|
|
|
|
|
|
Example 2 |
No. of shares |
Percentage in share capital |
|
Share capital owned by owners of company
A |
1000 |
4,76% |
|
Share capital owned by owners of company
B |
20000 |
95,24% |
|
|
21000 |
|
( 1000
/ 1050 = 95,24% ; 20000 / 21000 = 95,24% )
Source: Piotr Luty
If
the exchange parity is constant, as it happens in example 1 and example 2, the
decision, which entity is acquirer and acquiree, does
not influence on the percentage in share capital ether owners of company A or
company B. However, this decision influences on the amount of goodwill and
other assets and liabilities in entity existing after acquisition.
Presentation
in two different ways effects of combination of two entities is able only in accordance
with the Act of Accounting and the Company Law. IFRS 3 obliges us to identify
acquirer as the entity which obtains control of other entities. In both
presented examples, 1 and 2, company B is able to control the entity after
acquisition. Therefore company B is always acquirer even if this company
transfers net assets to company A. If companies decide that existing after
combination entity is company A, the combination have
to be done as “reverse merger”. Example 3, shown below, explains this
situation.
Example
3
Company
A is issuing 20.000 shares and distributing them to owners of company B. Company
A is going to continue legal status after acquisition. Company B transfers net
assets to company A in exchange for 20.000 shares. Total number of shares in
company A, as a result of acquisition, is 21.000, whereas company A owes 1000
shares and company B owes 20.000. Therefore company B is able to control the
whole entity after combination in spite of losing legal status.
Table
6 Percentage in share capital
|
Example 2 |
No. of shares |
Percentage in share capital |
|
Share capital owned by owners of
company A |
1000 |
4,76% |
|
Share capital owned by owners of company
B |
20000 |
95,24% |
|
|
21000 |
|
( 1000
/ 1050 = 95,24% ; 20000 / 21000 = 95,24% )
Source: Piotr Luty
Reverse
acquisition indicates that in this situation net assets
of company A are evaluated to the fair values and added to relevant items of
assets and liabilities of company B.
Table 7 Acquisition of company A and B – reverse acquisition
|
Assets |
|
Liabilities |
|
|
Fixed assets |
14000 |
Share capital owned by owners of company
A – 1000 shares |
1000 |
|
Current assets |
6000 |
Share capital owned by owners of company
B – 20.000 shares |
20000 |
|
|
|
Supplementary capital (correction) |
-10000 |
|
|
|
Net profit (goodwill) |
2000 |
|
|
|
Liabilities |
7000 |
|
Total |
20000 |
Total |
20000 |
Source: Piotr Luty
Total amounts of equity, assets and liabilities is
equal to total amounts of equity, assets and liabilities in example 1. The
difference is in number of shares, because company A issued and distributed
shares.
IV Conclusion.
Current Polish legal regulations allows
companies to choose which entity of combining companies is acquirer. The choice
results in various view of a company existing after acquisition. From
economical point of view acquisitions presented in examples above are
identically, because two companies joint together to achieve some goals.
However troubles come out during technical bookkeeping acquisition and
preparing financial reports.
Nowadays
in
In
line with the Company Law combining entities approve combination plan, in which
they inform which company is acquirer and acquiree.
The choice is not linked with the fact which company obtains
control, but reflects which entity takes over net assets of other entities.
The
situation in which company A is acquirer presents example 2. The company A is
acquirer in spite of having slight percentage in share capital after
acquisition. As a result of acquisition 5000 goodwill in assets is recognised
and total amount of assets is 28.000. Acquisition of companies A and B, where
company B is acquirer shows example 1. This time recognised goodwill is 2000
and is presented in liabilities (net profit) and total amount of assets is
20.000.
The
author considers that IFRS regulations, in which in all business combinations
acquirer is recognised as company which obtains control of the other combining
entities, is better then current Polish regulations (the Act of Accounting and
the Company Law). In line with IFRS, the choice which company loses legal
status, does not influence on results of acquisition.
Literature:
1. E.A. Hendriksen, Teoria
rachunkowości, PWN, Warszawa 2002
2.
The Act of Accounting, Dz. U.z 2002 nr 76, poz 694 ze zmian
3. The Company Law, Dz. U. z
2000 nr 94, poz 1037 ze zmian
4. IFRS 3 (MSSF 3)
„Połączenia jednostek gospodarczych”, ISAB 2004, wydanie polskie.