Ron Paterson: merger accounting

There is international pressure to kill off merger accounting completely. The ASB should resist it.
Ron Paterson

Sometimes an accounting standard stimulates the very practice it seeks to control, perhaps on the basis that forbidden fruit tastes sweetest. SSAP 23, Accounting for Acquisitions and Mergers, was one example. Merger accounting was rarely used in the UK until this standard tried to restrict it, but its rather feeble rules only encouraged creative accountants to find loopholes, which was not hard to do. But it soon became apparent that acquisition accounting was much more fun. Since at that time there were no rules on how to attribute fair values to the assets and liabilities acquired, and as goodwill was sent off to reserves, it was far easier to massage post-acquisition earnings by using acquisition accounting, and enthusiasm for merger accounting waned once more.

However, the Accounting Standards Board realised that its plans to reform acquisition accounting might revive interest in merger accounting, and was careful to close this door in advance. It replaced SSAP 23 with

FRS 6, Acquisitions and Mergers, which allows merger accounting to be used only in very rare circumstances, essentially when it is not possible to say which of the combining parties should be regarded as the acquirer. This has proved much more successful, and very few business combinations are now accounted for as mergers. Exasperated

The US experience has been rather more fraught. At present, their very mechanistic standard enables a large number of takeovers to be treated as mergers, or 'poolings' in their parlance. The US Financial Accounting Standards Board has noted the extraordinary lengths that companies go to in reshaping their transactions so as to qualify for this treatment, and is now so exasperated with the issue that it is no longer content with trying to restrict pooling to 'true' mergers; it wants to ban it altogether. And it would like standard-setters around the world to support this move by taking the same step.

But is merger accounting really so inferior to acquisition accounting? There is no denying that the two methods give rise to different reported earnings. This is mainly because acquisition accounting requires the target company's goodwill to be recognised, and its other net assets adjusted to fair values, whereas merger accounting does not. But this is only a big problem if analysts cannot see beyond the headline numbers. Obviously the combined group's cash flow is the same, regardless of how the deal is accounted for, and a more important question might be which of the two methods is likely to facilitate better insights into the group's future cash flows.

It doesn't seem to me that there is such a clear answer to this that merger accounting deserves to be banned. The recent correspondence in this magazine about the merits of ebitda (see March, p 24, April, p 28, May, p 28) tends to suggest that the presence or absence of a charge for goodwill amortisation is not of great interest to the City. Having to adjust the target's net assets to fair values is more significant, but this is more of an argument for using current costs rather than historical costs, and since the acquirer's figures are left on a historical basis, the use of acquisition accounting doesn't take this process very far. In any case, notwithstanding the ASB's attempt to regulate it, the practice of fair value accounting still seems very variable; many groups continue to treat it as an exercise in writing net assets down rather than up, resulting in higher subsequent earnings than the historical cost figures would show.

Less confusing?

Acquisition and merger accounting would be better regarded as offering alternative perceptions of a business combination, rather than 'right' and 'wrong' answers. Whereas acquisition accounting portrays the deal as one business swallowing up another, with only the acquirer's continuity being preserved, merger accounting retains the history of both enterprises. Each method has some merit in appropriate circumstances, and there is no compelling reason to ban either of them completely as being irredeemably wicked.

Of course, in the general interests of standardisation, it would be less confusing if there were only one method. One reason that opponents of merger accounting are sceptical about

FRS 6 is that they doubt there is ever a case in which it is impossible to identify one party as the dominant force and therefore characterise it as the acquirer. If they are right, and it is possible to apply acquisition accounting in every case, we do not need an alternative. Exceptions

The problem is that I don't think they are right. While I agree that in nearly all cases it is obvious that one party has taken over the other, there are exceptions. Although these are likely to be rare in two-party deals, it should not be forgotten that the rules must also cater for amalgamations of more than two businesses. Where three or more companies of a similar size decide to combine forces, it may be very clear that no one of them has acquired the others.

Bringing it closer to home, any future mergers of accounting firms that use the limited liability part-nership structure will be governed by these rules, because normal rules of GAAP will apply. Obviously, some mergers involve more equality than others, but where all the partners in two combining firms continue on an equal basis in the enlarged business then it would not seem at all appropriate to try to force that into the mould of acquisition accounting.

I therefore hope that the ASB will resist any international pressure to ban merger accounting outright.

FRS 6 ain't broke, and it doesn't need to be fixed.

Ron Paterson is a former partner in Ernst & Young, and is one of the authors of UK GAAP.

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