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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

Share premium account
Retained earnings

765,000
100,000
347,525
1,212,525
=======

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Fixed assets
Freehold premises

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573,750

Plant and machinery at cost

316,965
Less provision for depreciation (127,500)
189,465
Quoted investments at cost
Net current assets

140,250
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

(91,290)
Trading profit
477,020
Profit on sale of investments
Profit before tax
Tax
Profit after tax

(40,035)
397,035
138,465

477,020 535,500
(119,255) (149,940)
357,765 385,560

Retained earnings:
brought forward
651,015 347,525
carried forward
1,008,780 733,085
Balance Sheets as at 30 June 1999
Fruit plc Vegetables plc

Fixed assets
Freehold premises
1,657,500 573,750
Plant and machinery at cost 653,055 316,965
Aggregate depreciation
(276,165) (167,535)
Net current assets
Equity shares of 1 each
Share premium account
Retained earnings

249,390 874,905
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

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)

ref
1,005,380 1
(131,325) 2

Diff. on sale of investments (40,035)

Amortisation of g'will
(15,594)
Profit before tax
783,461

138,465 3

4
1,012,520

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

(269,195)
514,266
651,015
1,165,281

(269,195) 5
743,325
998,540 6
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
1,124,295
4,352,781

526,320 8
1,124,295 9
3,881,865

Share capital
Share premium account
Capital reserve

1,507,500
150,000
1,530,000

1,507,500 10
150,000 11

12

Merger reserve
Retained earnings

1,165,281
4,352,781

482,500 13
1,741,865
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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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
Freehold premises
Plant and machinery

318,750
828,750
300,000

Net current assets

309,060
(1,756,560)
155,940

So goodwill equals

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
Vegetables 149,430
Total
526,320

376,890
225,000*
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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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:

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

Investment in B
Other net assets

Consolidated

500
1,200 800 2,000
1,700 800 2,000

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.

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