RSS feedsThe last 24 months has seen a high level of mergers and acquisitions activity in Europe. With the adoption of international financial reporting standards, the M&A accounting rules have changed significantly during this time.
Citigroup Investment Research has published a report examining M&A in an
IFRS world. The report examines the major changes in business combinations due
to the introduction of IFRS3 Business Combinations as follows:
• Elimination of merger accounting – Merger accounting was
already difficult because of the tight construction of the criteria. So the
elimination of this approach seems sensible. By only having one business
combination accounting approach it should enhance inter-company comparability in
the future. The elimination of merger accounting means the attraction of using
share consideration has diminished.
• Change in the definition of goodwill – IFRS3 marks a distinct
change from the previous approach, where goodwill was merely a residual
difference between the purchase consideration and the fair value of the net
assets. Instead, the onus will now be on the company to split any separately
identifiable intangible assets on future acquisitions. This means the amount
allocated to goodwill on future acquisitions would be lower. However, there is
some evidence that companies are allocating very low levels of the purchase cost
to other intangibles, and goodwill is still dominant despite the expectation
that this would change.
• No more goodwill amortisation – There is no longer any
systematic amortisation of goodwill. However, amortisation of other intangibles
will be required. Goodwill will instead be subject to an annual impairment test.
Most companies have applied this change prospectively so that existing goodwill
has, in essence, been frozen at its current value and then subject to impairment
tests.
• Less opportunity to manipulate post-acquisition results –
Restructuring provisions on acquisitions have been severely restricted which
should mean fewer opportunities for management to manipulate post-acquisition
results.
The elimination of goodwill amortisation will result in an increase in earnings per share. But this should not cause higher valuations because, from an investment theory perspective, goodwill amortisation is not relevant because companies do not have to replace the goodwill.
Financial analysis in M&A
• Fair value – Establishing an initial estimate of fair value
of an asset and any subsequent adjustment can have important implications for
key performance indicators. For example, if an initial fair value estimate for a
property were conservative, then depreciation would be understated with goodwill
overstated. Any changes to these fair values from the initial estimates could be
significant.
• Valuation and amortisation of intangibles – What separable
intangibles have been recognised? Does this reveal extra value in the target?
Are the amounts recognised unexpectedly high or low? Are the separable
intangibles maintained? If these assets do not have to be replaced, is
amortisation a real economic cost or merely double counting?
• Impairment disclosures – Extensive disclosure is required in
impairment disclosures, but may have significant value relevance. However, it is
rarely examined in detail by investors.
Empirical evidence
• Method of payment – The financing structure is one of the
most important discriminating factors between value enhancing and value
destroying acquisitions. The results suggest that acquirers that pay by cash
enjoy a much better performance.
An equity financed deal is associated with share price weakness as it is often perceived as a signal that the acquirer’s shares are overvalued and that the buyer is not confident about synergy gains. In contrast, a cash or debt financed offer tends to send a positive signal to the market about the buyer’s confidence in its ability to reload its cash balance. Those cash offers that involve a debt issuance can provide a significant additional incentive to make the merger work to realise synergy gains quickly.
Tax
Often, the tax aspects of a deal are particularly important motivators offering
opportunities for acquirers to unlock tax value. Any recognition of previously
unrecognised deferred tax assets indicates the creation of value in the deal.
• Use of losses – One attractive aspect of a target may be that
it has losses carried forward that can be used more efficiently. However, this
issue is fraught with complexity because most countries have anti-avoidance
rules that restrict or deny the use of losses by third parties.
• Deferred tax and business combinations – Assets are revalued
to fair value for financial reporting purposes at the point of acquisition. This
causes temporary differences between the tax value (base) of the assets and
their book value. Therefore, there will be a disconnect between book and tax
depreciation.
• Tax deductibility of goodwill – The importance of the tax
dimension of a takeover has been illustrated very clearly with the recent
interest in Spanish companies going on the acquisition trail. In Spain, goodwill
inherent in the purchase of the stock is tax deductible, so a Spanish business
can theoretically pay more for a target and get the same value for stockholders.
• Capital structure – Interest is tax deductible; dividends are
not. This encourages companies to allocate as much debt as possible to
particular subsidiaries. Generally, to maximise the value of the tax shield, the
debt will be allocated to higher tax regimes.
Successful deals
According to Citigroup, historically successful deals share the following
characteristics:
• Received positive market reaction on announcement
• Funded by cash
• Acquirer is materially larger than the target
• Acquirer and target are in the same industry
M&A Manoeuvres - in the Dark? An Investors' Guide to Analysing Business Combinations in an IFRS World, by Kenneth M Lee and Dimitris Karydas of the valuation and accounting team at Citigroup Investment Research.
