Business Combinations Under Common Control

The Evolution of Predecessor Accounting

Staff of the Standard Setting Department,

Hong Kong Institute of CPAs

Agenda Paper 8

2

Why are we looking at this

• BCUCC are scoped out of IFRS 3

• Currently, BCUCC are commonly accounted for

by some form of predecessor method

• If we were to continue applying predecessor

accounting, its history and concepts should be

understood

3

• Understand the rationale behind the predecessor

accounting and how it was applied in the past

Expected outcome • Incorporate lessons learnt from past experience and

develop a way forward for BCUCC

Objective of the presentation

4

Formal use of Predecessor Accounting

US

Pooling of

interests

UK

Merger

accounting

IAS / IFRS

Uniting of

interests

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

5

Overview of US M&A landscape

• Evidence of a purchase method and the pooling method

in use as early as the 1920s

• Pooling method was originally intended for combinations

of affiliated companies—in practice applied to

combinations of unrelated companies

• A legal case led to the formation of an Accounting

Bulletin

- 1946 Celanese/Tubize merger

- Celanese was five times larger than Tubize

- Celanese and Tubize are unrelated

6

Pooling of interests – USA Accounting Research Bulletin No.40 Business Combinations

1950 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Pooling concept • All or substantially all of the equity interests in predecessor

companies continue in a surviving company/or a newly created

one

Accounting

• Book values of predecessor companies carried forward

• No other specific accounting requirements

Criteria • Relative size of predecessor companies

• Continuity of ownership interest

• Continuity of management or power to control management

• Business activities are similar or complementary

• No plan to retire capital stock issued to owners or substantial

changes in ownership before or after combination

Related

developments/

issues

• Misuse of pooling of interests

• Companies structured transactions to apply 'pooling' method

and disliked goodwill under purchase method

1955

7

Pooling of interests – USA Accounting Principles Board No.16 Business Combinations (1/3)

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Pooling concept • Uniting of ownership interests of companies by exchange of

equity interests

• No disbursement of resources

• BCUCC scoped out

Accounting

• Book values of predecessor corporations carried forward

• Prior year restatement required

• No other specific accounting requirements

Criteria • 12 criteria must be fulfilled, details in slide 9

Related

developments/

issues

• 39 interpretations issued to address application difficulties

• 1970s: FASB started reconsidering accounting for business

combinations

• Rapid increase in global M&As heightened the need for

international comparability in accounting for business

combinations and triggered international discussion

8

Pooling of interests – USA Accounting Principles Board No.16 Business Combinations (2/3)

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Related

developments/

Issues

(continued)

• 1998: FASB and other standard setters jointly concluded that

only purchase method should be used for business

combinations

• Disadvantages of more than one accounting method:

- Produces different financial statement results for economically

similar transactions

- Difficult to draw a clear line for when they would apply

• Reasons for adopting the purchase method:

- Adheres to traditional principles of accounting for acquisition of

assets

- Better reflects the initial costs of investments made and the

subsequent performance of those investments

9

Pooling of interests – USA Accounting Principles Board No.16 Business Combinations (3/3)

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

12 criteria – for reference only

•Combining companies are autonomous (not a subsidiary or division of another company within

2 years before the plan of combination)

•Combining companies are independent of the other, e.g. <10% shares held in each other

•The combination is effected in a single transaction within 1 year

•Offers by issuance of only common stock within rights identical to majority of the outstanding

voting common stock

•Exchange >90% of the voting common stock

•Voting stock interest in combined entities is exactly in proportion to relative voting interest

before the plan of combination

•Voting rights are exercisable

•No change in equity interest of voting stock within 2 years before the plan of combination

•No contingent consideration

•The combined company does not retire/reacquire the stock issued to effect the combination

•The combined company does not enter into other financial arrangements for the benefit of the

former stockholders of the combining companies

•The combined company does not intend to dispose of a significant part of the assets of the

combining companies within 2 years

10

Pooling of interests – USA FASB Statements SFAS No.141 Business Combinations

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Concept • All business combinations are acquisitions

• BCUCC scoped out

Accounting

• Acquisition method

• Pooling method for BCUCC provided as guidance:

- Book values of predecessor companies carried forward

- Prior year restatement required

- No other specific accounting requirements

Criteria • N/A

Related

developments/

issues

• 2002: IASB-FASB joint project on application of the purchase

method and accounting for BCUCC

• 2007: SFAS No. 141 (Revised) issued to address issues on the

application of purchase method

• 2014: SFAS No. 141 (Revised) codified to Topic 805

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• Mergers and acquisitions occurred in the UK as early

as 1800s

• 1971: first ED on business combinations outlined

acquisition method and merger method (continuation

of ownership concept similar to the US concept)

• Limited documentation found on ED feedback

• However, merger method was inconsistent with UK

law, which required shares issued as consideration to

be fair valued

• Changes to law in 1981 led to SSAP 23

Overview of UK M&A landscape

12

Merger accounting – UK SSAP 23 Accounting for Acquisitions and Mergers (1/2)

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Merger

concept

• No material resources leave the group

Accounting

• Optional if criteria satisfied:

- Book values of predecessor companies carried forward

- Prior year restatement required

- No other specific accounting requirements

Criteria • All equity holders are involved

• Buyer did not hold more than 20% of the equity interests prior to

the offer

• At least 90% of the fair value of consideration in the form of

equity shares

• At least 90% of the equity interest in the target company is

transferred after the transaction

13

Merger accounting – UK SSAP 23 Accounting for Acquisitions and Mergers (2/2)

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Related

developments/

issues

• Criteria too readily circumvented

• Companies preferred merger method to enhance current and

historical performance of the buyer

14

Merger accounting – UK FRS 6 Acquisitions and Mergers (1/2)

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Merger

concept

• Formation of a new reporting entity as a substantially equal

partnership where no party is dominant

Accounting

• Mandatory if criteria satisfied:

- Book values of predecessor companies carried forward

- Prior year restatement required

- Difference between consideration and book values exchanged

recognised in other reserves

• Optional for certain group reconstructions—it was considered

inappropriate to recognise goodwill when the transaction does

not alter the relative rights of the ultimate shareholders

15

Merger accounting – UK FRS 6 Acquisition and Mergers (2/2)

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Criteria • For mergers:

- No acquirer identified

- Similar size

- All parties to the combination participate in the management

- Consideration primarily comprised of equity shares

- No equity shareholders retain material interest in future

performance of only part of the combined company

• For group reconstructions:

- Ultimate shareholders remain the same, and the rights of each

such shareholder are unchanged

- No minority interest in the net assets of the group is altered

Related

developments/

issues

• 2015: FRS 102 for private companies superseded FRS 6 and

merger accounting is:

- Optional for group reconstructions

- Mandatory for true mergers among Public Benefit Entities

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• 1973: the International Accounting Standards

Committee was established, the predecessor of IASB

• 1983: IAS 22 Business Combinations issued, scoped

out BCUCC with little documentation explaining why

• 2001: IAS 22 reviewed for international convergence,

which led to IFRS 3 Business Combinations

Overview of International Standards

17

Uniting of interests – IASC IAS 22 Accounting for Business Combinations

1950 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Uniting

concept

• No acquirer can be identified

• All shareholders mutually share risks and benefits of the

combined company

• Scoped out BCUCC

Accounting

• Book values of predecessor companies carried forward

• Prior year restatement required

• Difference between consideration and book values exchanged

recognised in other reserves

Criteria • No acquirer identified

• Pooling of majority of voting shares

• Continuance of substantially the same voting rights and

shareholder interests

• Relative equality in fair values of the combining companies

1955

18

Acquisition method − IASB IFRS 3 Business Combinations

1950 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Concept • Virtually all combinations are acquisition (acquisition method)

• Scoped out BCUCC

• Eliminated uniting of interests and rejected pooling method

Why eliminated

uniting concept

• Acquisitions and mergers are economically similar

• Very rare cases that no acquirer can be identified

Why rejected

pooling method

• Pooling method ignored the fair value exchanged

• Residual interest changed in the net assets of the combined

entity after merger

• Does not hold management accountable for the investments

made and subsequent performance

Related

developments/

issues

• 2002: IASB-FASB joint project on application of the purchase

method and accounting for BCUCC

• 2007: IASB issued IFRS 3 (Revised) which only addressed

issues on the application of purchase method

1955

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• Predecessor accounting initially applied to mergers of

affiliated companies but eventually also applied to

unrelated companies

• BCUCC not excluded until 1970; limited literature on why

• Economic expansion in US and UK, predecessor

accounting preferred to avoid goodwill recognition

• Criteria for applying predecessor accounting proliferated

and became complex, but little change to the accounting

• Can be difficult to distinguish between mergers and

acquisitions; they are economically similar because all

business combinations bring together some synergies in

the newly combined entity

• Predecessor method is currently disallowed for mergers of

unrelated companies

Evolution summary: staff observations

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Food for thought: staff observations

• In an ideal world, acquisition method should work for

all types of business combinations (including

BCUCC) as synergies will arise in the newly

combined entity

• In reality, not always possible to identify an acquirer;

goodwill is still a mystery; and acquisition method

may not be relevant or cost beneficial in all

situations

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Ways forward: staff analysis

Status Quo Specific method

for different BC

Acquisition

method apply to

all BC

Pros • Commonly

accepted

practices

already

developed

• Faithful

representation

• Improve

relevance and

comparability

between similar

BCs

• Improve

comparability of

all BCs

• Reduce abuse

Cons • Existing

diversity and

application

concerns

remain

unaddressed

• Difficult to

develop criteria

• Potential abuse

• Difficult to apply

in particular

cases

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Discussion Point

What should be our next step as standard setters?

1. It's too difficult − status quo

2. Develop specific accounting for BCUCC with focus

on:

- criteria / characteristics for BCUCC

- accounting method

3. IFRS 3 apply to all business combinations

4. Other e.g. more study on M&A, goodwill