Company takeovers and mergers are important strategic developments that can increase the influence of companies. However, since a corporate merger is not focused on the core business of most companies, those involved often have to venture into unknown territory. To ensure that the potential also arises from the merger, the possible pitfalls must be taken into account. A relevant danger lies in the effect of the merger on the key figures and covenance criteria of the acquiring company. In this regard, the danger does not result from inaccurate or vague budget accounts (the expected result does not come soon enough), but rather from the hard criteria for accounting for the corporate merger itself. In this regard, accounting for financial instruments represents a key point that can give rise to significant effects on goodwill.
A classic challenge results when a higher goodwill value must be established at the time of the acquisition, and a write-down is threatened in an impairment test in the subsequent valuation. In this connection, the amount of goodwill established is often strongly influenced by the valuation of original finance liabilities at fair value. This article indicates different issues that should be investigated from an accounting perspective both before and during the merger.
Three relevant aspects arise in the run up to the acquisition date: obligations under preliminary contracts (e.g. a right of tender offer) and transactions before the merger. The first aspect encompasses the binding offer or preliminary contract that generally precedes the merger. Such a preliminary contract can trigger an accounting obligation on the balance sheet date, for example where the merger is still optional for one of the parties. In this situation a derivative generally arises that is to be recorded in the income statement.
A further aspect relates to transactions between the acquiring entity and the acquired company in the run up to the merger. These transactions serve the utilisation and/or preservation of losses carried forward of individual companies or a desired (re)financing before the merger. If these transactions give rise to withdrawals from or contributions to the net assets of the company being acquired, these are generally to be taken into account in determining the goodwill. The corresponding provisions of IFRS 3 prevent goodwill from being arbitrarily eliminated.
The third aspect arises in connection with the payment of the purchase price. To protect the purchase price in a foreign currency, currency derivatives are entered into at the time the acquisition of another company is sufficiently concretised. In this regard, note that the application of hedge accounting for this form of currency hedging is only possible where there is a firm commitment. In each case it should therefore be ascertained and documented when the acquisition becomes binding or at least highly likely. With regard to cancelling the OCI established during the hedging horizon, it should be decided whether the transaction is to be treated as an acquisition of a financial item (shares) or non-financial items. In the latter case, the changes in value of the hedging instrument marked down in the OCI are cancelled when accrued and therefore affect the amount of the goodwill.
The goodwill is calculated at the time of acquisition. To calculate goodwill, the purchase price is compared with the net asset value of the company being acquired. To determine the net asset value, the book values of the assets and liabilities of the company being acquired are reconciled at fair value and then offset against each other. In doing so, the original financial liabilities are also valued at fair value. This valuation generally triggers the largest reconciliation effect when calculating goodwill since some special features are to be taken into account alongside the nominal values, which are often high. When valuing the original financial liabilities, where possible quoted prices on active markets should be used, but these are frequently unavailable. Normally, the original financial liability must therefore be valued using a net present value process. In the net present value process, the expected payment flows of the financial liability are discounted at a credit risk-adjusted discount rate. When IFRS 13 was published, the IASB specified that the creditor’s point of view is to be taken for this valuation process. If the market is aware of the merger at the time of valuation, the creditors will take into account the foreseeable changed credit risk at the time of the merger. A financial liability on which interest has been charged “fairly” to date - where the interest primarily compensates for the credit risk in addition to the opportunity cost of the money - must be assessed as a low or high interest rate liability. The fair value of high interest rate liabilities lies above its nominal value and, in most cases, significantly above the current book value of the company to be acquired.
Various aspects must be taken into account for the subsequent valuations after the acquisition date. Acquired liabilities are to be investigated for embedded derivatives that must be separated. Furthermore, there is an impact on the accounting treatment of hedging contracts of the acquired company. Because “other comprehensive income” does not represent any part of the acquired net assets in a corporate merger, the existing derivative contracts cannot be continued; instead, the acquired derivatives are either to be designated to a new hedge accounting or to be accounted for at fair value in the income statement as a standalone derivative. With derivatives with several settlement dates in particular (interest rate swaps and cross-currency interest rate swaps), the designation of a derivative with a start value into hedge accounting is not trivial (on the subject of interest rate swaps with a start value in hedge accounting, I would like to take this opportunity to point out the freely available KPMG webinar: “Complex application in interest rate hedge accounting: interest rate swap with start market value”.)
In addition, the accounting and valuation options and their representation in the statements contained in the consolidated group financial statements are to be checked for the group. In relevant situations, a uniform approach and representation for the group must be identified. This applies in particular where both of the companies have a relevant size.
For the reasons specified, it is sensible to support a corporate acquisition or merger from the outset with regard to accounting queries. Critical accounting questions mainly arise in relation to issues involving financial instruments. The timing of the merger should be planned in conjunction with the accounting department. Accounting experts should be involved no later than at the contract drafting stage, otherwise it may only be possible to represent the factual position in the accounts.
Let us speak about the issues that arise in accounting for and valuing financial instruments in the context of corporate mergers. For each of these issues there is a safe path through the accounting requirements whilst preserving the organisational possibilities of such a process.
Author: Felix Wacker-Kijewski, Manager, email@example.com
Source: KPMG Corporate Treasury News, Edition 41, March 2015
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