IFRS3: Business Combinations

Elimination of merger accounting: Merger accounting was already difficult because of the tight construction of the criteria. So the elimination of this methodology seems sensible. Having only one business combination accounting approach should enhance inter-company comparability in the future. The elimination of merger accounting also 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 will be lower.

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.

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.

Financial analysis in M&A

Fair value: Establishing an initial estimate of the 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 any 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.

By 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

Use of losses: One attractive aspect of a merger or acquisition 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 tax losses by third parties.

Deferred tax and business combinations: Assets are revalued to fair value for financial reporting purposes at the point of their 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 corporate 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. As a result, a Spanish business can theoretically pay more for a target and get the same value for shareholders.

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.

This is an edited version of an article that first appeared in Financial Director