Makeover for M&A accounting

Merger and acquisition, or M&A, is a broad term used for various transactions such as acquisition of shares, amalgamation of companies, demergers or spinoffs, slump sale, capital reduction or simply balance-sheet restructuring.

A common driver for M&A transactions is growth through acquisition of new business or streamlining operations to increase economies of scale and reduce cost. Some transactions may involve separating the various businesses of a company to unlock their value. A large non-listed entity may merge with a small listed entity to seek immediate listing. Sometimes, an amalgamation may be driven purely by convenience. For example, a parent company may have just one subsidiary, which it could merge with itself. This would result in administrative convenience, such as doing away with the need for consolidated financial statements.

Tax could be a significant motivation as well. In M&A transactions, under certain conditions, a transferee company can carry forward unabsorbed depreciation or tax losses of the transferor company. Furthermore, there is no capital gain tax levied on the transferor company or its shareholders. To reduce minimum alternate tax (MAT) liability, the transferee company can apply the purchase method of accounting under AS-14 Accounting for Amalgamations, and recognise brands of the acquired entity at fair value. Amortisation of brands will reduce book profits, and consequently MAT liability.

The possibility of restructuring financial statements could be a significant driver of M&A transactions. In the past, deferred tax liabilities, impairment of assets, doubtful debts, or other expenses were written off against the securities premium account and other reserves. For listed entities, SEBI specifies that M&A transactions requiring court approval should be accompanied by an auditors’ certificate showing that the proposed accounting complies with standards. However, this does not apply to a non-listed subsidiary of a listed parent. For non-listed entities, the Registrar of Companies should ensure M&A transactions comply with accounting standards. However, in practice, it is seen that compliance is strictly enforced only for listed entities.

AS-14 — which was issued in 1994 and deals with accounting of amalgamations — is outdated. Furthermore, it covers amalgamations only and not demerger, spinoffs, capital reduction, distribution and organisation restructuring. Consequently, other accounting standards are applied by analogy rather than directly. Ultimately, the accounting of M&A transactions could provide counter-intuitive results.

AS-14 has two methods of accounting for amalgamation.

Pooling method , where the transferee records the assets and liabilities taken over at their carrying values.

Purchase method , where the transferee can record the assets and liabilities at either the carrying value or fair value.

A company should mandatorily apply the pooling method when all the five prescribed conditions are fulfilled.

One of the conditions is that no adjustment is made to the book values of the assets and liabilities taken over. A transferee may deliberately breach this, and thereby become eligible to apply the purchase method, where it can choose either the book value or fair value method. The transferee can use this accounting arbitrage to suit its accounting or tax requirement by, for example, recording brands at fair value; a stronger balance sheet can be presented and higher amortisation could result in lower MAT liability.

Under Indian accounting standards, it is possible to account for an acquisition without recording the resultant goodwill. For example, a company may acquire controlling shares in another entity that becomes its subsidiary. Typically, goodwill would arise in the consolidated financial statements if the consideration paid is higher than the book value of the subsidiary. However, the parent may later merge the subsidiary with itself, and no goodwill would be recorded, as pooling is applied as if the two companies were always together.

AS-14 recognises court-determined fair value for recording securities that are issued as consideration. It may so happen that the court determines the face value of securities issued as the fair value. When the gap between fair value and face value is significant, the valuation of consideration and goodwill would be unreliable.

Although the requirement from SEBI and the Registrar of Companies is meant to prevent abuse of accounting standards, it is still possible to restructure balance sheet without applying the standards. For example, with court approval, capital or other specific reserves may be converted to free reserves, which is available for distribution.

Dolphy D'Souza is Partner and National Leader, IFRS Services, in a member firm of Ernst & Young Global

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