NORTHEASTERN ILLINOIS UNIVERSITY

Consolidation Accounting for Mergers & Acquisitions

Alexander Adamov
Current Topics in Financial Accounting
ACTG 421-1
Recent M&A Trends
The pace of mergers and acquisitions (M&As) picked up in the early 2000s after collapsing in the wake of
the subprime crisis. M&A volume was quite strong over the period 2003–2007. This strength was
apparent globally, not just in the United States. However, the United States entered the Great Recession
in 2008 and the recovery from this strong economic downturn would prove difficult. A number of deals
that were planned in 2007 were canceled.

The rebound in U.S. M&A started in 2010 and became quite strong in 2011, only to weaken temporarily
in 2012 before resuming in 2013. The U.S. M&A market was very strong in 2014, and in 2015 it hit an all-
time record, although, on an inflation-adjusted basis, 2000 was the strongest M&A year. In 2016, the
M&A market was still strong in the United States, although somewhat weaker than 2015.
A merger differs from a consolidation, which is a business combination whereby two or more companies
join to form an entirely new company. In a consolidation, the original companies cease to exist and their
stockholders become stockholders in the new company. One way to look at the differences between a
merger and a consolidation is that with a merger, A + B = A, where company B is merged into company
A. In a consolidation, A + B = C, where C is an entirely new company. Despite the differences between
them, the terms merger and consolidation, as is true of many of the terms in the M&A field, are
sometimes used interchangeably. In general, when the combining firms are approximately the same
size, the term consolidation applies; when the two firms differ significantly in size, merger is the more
appropriate term. In practice, however, this distinction is often blurred, with the term merger being
broadly applied to combinations that involve firms of both different and similar sizes.

Types of Mergers
Mergers are often categorized as horizontal, vertical, or conglomerate. A horizontal merger occurs when
two competitors combine. For example, in 1998, two petroleum companies, Exxon and Mobil, combined
in a $78.9 billion megamerger. Another example was the 2009 megamerger that occurred when Pfizer
acquired Wyeth for $68 billion. If a horizontal merger causes the combined firm to experience an
increase in market power that will have anticompetitive effects, the merger may be opposed on
antitrust grounds.

In this paper I will talk about the three different approaches to the financial reporting of such
investments that GAAP recognizes:
• The fair-value method
• The consolidation of financial statements
• The equity method

I will also review the tax implications and strategies that firms use when structuring their mergers
and/or consolidations.
Fair Value Method
In many instances, an investor possesses only a small percentage of a target company’s outstanding
stock – up to 20 percent of the total shares outstanding. Because of the limited level of ownership, the
investor cannot expect to significantly affect the investee’s operations or decision making. These shares
are bought in anticipation of cash dividends or in appreciation of stock market value. Such investments
are recorded at cost and periodically adjusted to fair value according to the Financial Accounting
Standards Board (FASB) Accounting Standards Codification (ASC) Topic 320, Investments – Debt and
Equity Securities. Several other important items need to be noted.
• Initial investments in equity securities are recorded at cost and subsequently adjusted to fair
value if fair value is readily determinable (typically by reference to market value); otherwise, the
investment remains at cost.
• Equity securities held for sale in the short term are classified as trading securities and reported
at fair value, with unrealized gains and losses included in earnings.
• Equity securities not classified as trading securities are classified as available-for-sale securities
and reported at fair value with unrealized gains and losses excluded from earnings and reported
in a separate component of the shareholder’s equity as part of other comprehensive income.
• Dividends received are recognized as income for both trading and available-for-sale securities.
This is an important difference between the FV and the Equity method.

Example
1. Pete’s buy 4,000 of Tom’s shares for 4% stake of the total 100,000 shares outstanding at $50 per
share. The entry will be as follows:
Investment in Tom’s $200,000 (4,000*$50)
Cash $200,000

2. The next day the price per share is $63 and Pete’s records:
Fair Value Adjustment $52,000 (4,000*(63-50))
Unrealized Gain $52,000
3. Tom’s pays out a dividend of $25,000
Cash $1,000 ($25,000*0.04)
Dividend Revenue $1,000, which will increase your Net Income by $1,000

4. At the end of the week the price per share is $57 and Pete’s sells all 4,000 shares.
Cash $228,000 (4,000*57)
Unrealized gain $52,000
FV Adjustment $52,000
Investment in Tom’s $200,000
Realized Gain $25,000

Consolidated Balance Sheet with a Non-Controlling Interest (NCI)

Many corporate investors acquire enough shares to gain actual control over the target’s operations.
Such control is recognized when a stockholder accumulates more than 50 percent of an organization’s
outstanding voting stock. Control generally requires the consolidation of the accounting information
produced by the individual companies. Thus a single set of financial statements is created for external
reporting purposes with all assets, liabilities, revenues, and expenses brought together.
The adjusting and eliminating entries are:
a. Eliminate the parent’s investment in the target
b. Eliminate the target’s equity accounts
c. Step up target’s assets to fair value
d. Recognize any Goodwill
e. Recognize the NCI

Example
Purchaser pays $3,060,000 to acquire 90% of Target.
• FV of Target’s net fixed assets is $2,625,000
• FV of Target’s net identifiable assets is $3,000,000

Pre-acquisition Balance Sheet Implied (Grossed-Up) 90 = $ 3,060,000

Value of Target 100 X
Target Purchaser
Current Assets $ 500,000 $ 3,750,000 X = $ 3,400,000
Fixed Assets (net) $ 1,625,000 $ 5,000,000
Liabilities $ 125,000 $ 250,000 Net Identifiable Assets: $500,000 – Cash
Common Stock $ 1,500,000 $ 7,000,000 add: $2,625,000 – FV of FA (net)
Paid-in-Capital $ - $ 500,000 less: $125,000 – Liabilities
Retain Earnings $ 500,000 $ 1,000,000 $3,000,000

Goodwill is $400,000 ($3.4 mil. of Implied Value less Net Identifiable Assets of $3 mil.) and the step-up in
assets is $1,000,000 ($2,625,000 FV less 1,625,000 BV).

Journal Entries for Purchaser

1. Investment in Target $3,060,000

Cash $3,060,000

2. Common Stock (Target) $1,500,000

Retained Earnings (Target) $500,000
Investment in Target $2,000,000

3. Fixed Assets (net) $1,000,000

Goodwill $400,000
Investment in Target $1,060,000
NCI $340,000 ($3,400,000*0.10)

Which leads us to the Consolidated Balance Sheet below.

 Consolidated Balance Sheet
Adj. Entries
Target Purchaser Debit Credit Consolidated B/S
Current Assets $ 500,000 $ 690,000 $ 1,190,000
Fixed Assets (net) $ 1,625,000 $ 5,000,000 $ 1,000,000 $ 7,625,000
Invesment in Target $ 3,060,000 $ 3,060,000 $ -
Goodwill $ 400,000 $ 400,000
Total Assets $ 9,215,000

Liabilities $ 125,000 $ 250,000 $ 375,000

Common Stock $ 1,500,000 $ 7,000,000 $ 1,500,000 $ 7,000,000
Paid-in-Capital $ - $ 500,000 $ 500,000
Retain Earnings $ 500,000 $ 1,000,000 $ 500,000 $ 1,000,000
NCI $ 340,000 $ 340,000
Total Liabilities $ 9,215,000

Equity Method
The equity method is a type of accounting used for intercorporate investments. This method is used
when the investor holds significant influence over the investee, but does not exercise full control over it,
as in the relationship between a parent company and its subsidiary. In this case, the terminology of
“parent” and “subsidiary” are not used, unlike in the consolidation method where the investor exerts
full control over its investee. Instead, in instances where it’s appropriate to use the equity method of
accounting, the investee is often referred to as an “associate” or “affiliate”.

Although the following is only a general guideline, an investor is deemed to have significant influence
over an investee if it owns between 20% to 50% of the investee’s shares or voting rights. If, however,
the investor has less than 20% of the investee’s shares but still has significant influence in its operations,
then the investor must still use the equity method and not the cost method.

Unlike with the consolidation method, in using the equity method there is no consolidation and
elimination process. Instead, the investor will report its proportionate share of the investee’s equity as
an investment (at cost). Profit and loss from the investee increase the investment account by an amount
proportionate to the investor’s shares in the investee. Dividends paid out by the investee are deducted
from this account.

Example
Pete’s purchases 100 shares from Tom’s 250 total outstanding shares for $175,000, or 40% stake.

1. Investment in Tom’s $175,000

Cash $175,000

2. Tom’s reports Net Income of $32,000.

Investment in Tom’s $12,800 ($32,000*0.40)
Investment Income $12,800
 3. Tom’s pays out dividend in the amount of $10,000. Investment in Tom's
Cash $4,000 ($10,000*0.40) Dt Ct
Investment in Tom’s $4,000 $ 175,000
$ 12,800
$ 4,000
$ 183,800

Tax Considerations in M&A

Depending on the method used to finance the transaction, certain mergers, acquisitions, and
restructuring may be tax-free. Some firms may use their tax benefits as assets in establishing the correct
price that they might command in the marketplace. For this reason, tax considerations are important as
both the motivation for a transaction and the valuation of a company. Part of the tax benefits from a
transaction may derive from tax synergy, whereby one of the firms involved in a merger may not be able
to fully utilize its tax shields. When combined with the merger partner, however, the tax shields may
offset income. Some of these gains may come from unused net operating losses, which may be used by
a more profitable merger partner. Tax reform, however, has limited the ability of firms to sell these net
operating losses through mergers.

Taxable transactions

A transaction generally will be considered taxable to the target firm's shareholders if it involves the
purchase of the target's stock or assets for substantially all cash, notes, or some other non-equity
consideration. Using the term cash or boot to represent all forms of payment other than equity, taxable
transactions may take the form of a cash purchase of target assets, a cash purchase of target stock, or a
statutory cash merger or consolidation, which commonly includes direct cash mergers and triangular
forward and reverse cash mergers.

TAXABLE MERGERS
In a direct cash merger, the acquirer and target boards reach a negotiated settlement, and both firms
receive approval from their respective shareholders. The target is then merged into the acquirer or the
acquirer into the target, with only one surviving. In a consolidation, the acquirer and the target are
merged into a third legal entity, with that entity surviving. Assets and liabilities on and off the balance
sheet automatically transfer to the surviving firm in a direct statutory merger or consolidation.

In an effort to protect themselves from target liabilities, acquirers often employ so-called triangular
mergers. In a triangular cash merger, the target firm may be merged into an acquirer's operating or shell
acquisition subsidiary, with the subsidiary surviving (called a forward triangular cash merger), or the
acquirer's subsidiary is merged into the target firm, with the target surviving (called a reverse triangular
cash merger). Direct cash mergers and forward triangular mergers (Figure 1) are treated as a taxable
purchase of assets with cash and reverse triangular mergers (Figure 2) as a taxable purchase of stock
with cash.
Figure 1. Forward triangular cash merger.

Figure 2. Reverse triangular cash merger.

TAXABLE PURCHASE OF TARGET ASSETS WITH CASH

If a transaction involves a cash purchase of target assets, which may involve none, some, or all of the
target's liabilities, the target company's tax cost or basis in the acquired assets is increased or “stepped
up” to its fair market value (FMV), which is equal to the purchase price (including any assumed liabilities)
paid by the acquirer. The additional depreciation in future years reduces the present value of the tax
liability of the combined companies. The target firm realizes an immediate gain or loss on assets sold
equal to the difference between the FMV of the asset and the asset's adjusted tax basis (i.e., book value
less accumulated depreciation).

The IRS views transactions resulting in the liquidation of the target firm as actual sales rather than
reorganizations in which the target shareholders have an ongoing interest in the combined firms.
Consequently, the target's tax attributes, such as net operating loss carryforwards and carrybacks,
capital loss carryovers, and excess credit carryovers, may not be used by the acquirer following closing
because they cease to exist along with the target. However, they may be used to offset any gain realized
by the target resulting from the sale of its assets.

The target's shareholders could be taxed twice—once when the firm pays taxes on any gains and again
when the proceeds from the sale are paid to the shareholders either as a dividend or distribution
following liquidation of the corporation. A liquidation of the target firm may occur if a buyer acquires
enough of the assets of the target to cause it to cease operations. To compensate the target company
shareholders for any tax liability they may incur, the buyer usually will have to increase the purchase
price.

TAXABLE PURCHASE OF TARGET STOCK WITH CASH

Taxable transactions often involve the purchase of the target's voting stock, with the acquirer initiating a
tender offer for the target's outstanding shares, because the purchase of assets automatically triggers a
tax on any gain on the sale and another tax on any payment of the after-tax proceeds to shareholders. In
contrast, taxable stock purchases avoid double taxation because the transaction takes place between
the acquirer and the target firm's shareholders. Target shareholders may realize a gain or loss on the
sale of their stock.

The target firm does not revalue its assets and liabilities for tax purposes to reflect the amount that the
acquirer paid for the shares of common stock. Rather, the values of the target's assets and liabilities
before the acquisition (i.e., tax basis) are consolidated with the acquirer's financial statements following
the acquisition; that is, the historical tax basis of the assets continues, and no step-up or increase in the
basis of the assets occurs. The buyer loses the additional tax savings that would result from acquiring
assets and writing them up to fair market value. Consequently, the buyer may want to reduce what it is
willing to pay to the seller.

SECTION 338 ELECTION

Section 338 elections are made in connection with a taxable stock sale and apply to C corporations. The
acquirer and target firms can jointly elect Section 338 of the Internal Revenue Code and thereby record
assets and liabilities at their fair market value for tax purposes. This allows a purchaser of 80% or more
of the voting stock and market value of the target to treat the acquisition of stock as if it were an
acquisition of assets for tax purposes. The target's tax basis in the net acquired assets are increased to
their fair market value and carryover to the buyer when the transaction is completed (i.e., the tax basis
to the buyer is the same as for the target). Benefits to the acquirer include the avoidance of having to
transfer assets and obtain consents to assignment of all contracts (as would be required in a direct
purchase of assets), while still benefiting from the write-up of assets. Asset transfer, sales, and use taxes
may also be avoided. Since the tax basis in the target's net acquired assets is increased to reflect the
purchase price paid, the acquiring firm must pay the taxes on any gain on the sale. For legal purposes
though, the sale of the target stock under a 338 election as an asset sale still is treated as a purchase of
stock by the buyer. Consequently, the buyer remains responsible for the target's known and unknown
liabilities.

Tax-free (deferred) transactions

As a general rule, a transaction is tax-free if the form of payment is primarily the acquirer's stock.
Transactions may be partially taxable if the target shareholders receive some non-equity consideration,
such as cash or debt, in addition to the acquirer's stock. This non-equity consideration, or boot,
generally is taxable as ordinary income.
If the transaction is tax-free, the acquiring company is able to transfer or carry over the target's tax basis
to its own financial statements. There is no increase or step-up in assets to fair market value. A tax-free
reorganization envisions the acquisition of all or substantially all of a target company's assets or shares,
making tax-free structures unsuitable for the acquisition of a division within a corporation.

According to the Internal Revenue Code Section 368, for a transaction to qualify as tax-free, it must
provide for continuity of ownership interest, continuity of business enterprise, a valid business purpose,
and satisfy the step-transaction doctrine. Tax-free transactions require substantial continuing
involvement of the target company's shareholders. To demonstrate continuity of ownership interests,
target shareholders must continue to own a substantial part of the value of the combined target and
acquiring firms. To demonstrate continuity of business enterprise, the acquiring corporation must either
continue the acquired firm's “historic business enterprise” or use a significant portion of the target's
“historic business assets” in a business.

A type A statutory merger or consolidation does not limit the type of consideration involved in the
transaction: Target company shareholders may receive cash, voting or nonvoting common or preferred
stock, notes, or real property. Nor must target shareholders all be treated equally: Some may receive all
stock, others all cash, and others a combination of the two. The acquirer may choose not to purchase all
of the target's assets; the deal could be structured so as to permit the target to exclude certain assets
from the transaction. Unlike a direct statutory merger in which all known and unknown target assets
and liabilities transfer to the buyer by law, a subsidiary merger often results in the buyer acquiring only a
majority interest in the target and then carrying the target as a subsidiary of the parent. The target may
later be merged into the parent in a back-end merger. To ensure that the target does not resemble an
actual sale (thereby making the transaction taxable), at least 50% of the purchase price must be
acquiring company stock to satisfy the IRS continuity of ownership interests requirement, although in
some instances the figure may be as low as 40%. Type A reorganizations are used widely because of
their great flexibility. Because there is no requirement to utilize voting stock, acquiring firms enjoy more
options. By issuing nonvoting stock, the acquiring corporation may acquire control of the target without
diluting control of the combined or newly created company.

In a type B stock-for-stock reorganization, the acquirer must use its voting common stock to purchase at
least 80% of all of the target's outstanding voting and nonvoting stock-outs. Any cash or debt will
disqualify the transaction as a type B reorganization. However, cash may be used to purchase fractional
shares. Type B reorganizations are used as an alternative to a merger or consolidation. The target's stock
does not have to be purchased all at once and allows for a “creeping merger” because the target's stock
may be purchased over 12 months or less as part of a formal acquisition plan. Type B reorganizations
may be appropriate if the acquiring company wishes to conserve cash or its borrowing capacity. Since
shares are being acquired directly from shareholders, there is no need for a target shareholder vote.
Finally, contracts, licenses, and so forth, transfer with the stock, thereby obviating the need to receive
consent to assignment, unless specified in the contract.

The type C stock-for-assets reorganization is used when it is essential for the acquirer not to assume any
undisclosed liabilities. It requires that at least 70% and 90% of the FMV of the target's gross and net
assets, respectively, be acquired solely in exchange for acquirer voting stock. Consideration paid in cash
or nonequity securities cannot exceed 20% of the fair market value of the target's assets. Any liabilities
assumed by the acquirer must be deducted from the 20%, thereby reducing the amount of boot that can
be used. Since assumed liabilities frequently exceed 20% of the FMV of the acquired assets, the form of
payment, as a practical matter, generally is 100% stock. As part of the reorganization plan, the target
subsequent to closing dissolves and distributes the acquirer's stock to the target's shareholders for the
now-canceled target stock.

SECTION 351 MERGERS

IRC Section 351 provides a means to effect a tax-free business combination when the tax-free structures
recognized under Section 368 are impractical. The most notable advantage of Section 351 over Section
368 is that the former does not require continuity of ownership interest, which restricts the amount of
non-taxable consideration (acquirer stock) that the target's shareholders may receive. Thus, a Section
351 merger may include an unrestricted amount of tax-free consideration, benefiting selling
shareholders who value tax deferment over current income.

Founding shareholders in a newly formed corporation generally transfer property (e.g. cash and other
assets) to the new entity (NewCo) in return for ownership interests (e.g. common or preferred stock).
Under IRC Section 351, this transfer is tax-free, provided that the transferors (in aggregate) assume tax
control of NewCo immediately after the transaction, defined as at least 80% ownership of the vote and
value of each class of outstanding stock. The conditions required by Section 368 for tax-free treatment
do not apply.

Transferors may receive boot (e.g. cash and other property) in addition to NewCo stock in exchange for
the property transferred. While the receipt by transferors of NewCo stock is not taxable, transferors
who receive boot recognize a taxable gain equal to the lesser of the boot received and the gain realized
on the transfer of property. Transferors who receive NewCo stock assume a basis in such stock equal to
the basis in the property transferred. However, if the transferors also receive boot in the exchange, their
basis in their NewCo stock is reduced by FV of the boot and any loss they recognize on the exchange.
Conversely, the transferors' basis is increased by the amount of any gain recognized on the exchange.
NewCo assumes a carryover basis in the property received, increased by the amount of any gain
recognized by transferors (when taxes are paid, a step-up is allowed by the IRS).
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