Figuring out acquisitions

For some, growing via acquisitions is a way of life. It is almost all they do, or so it seems from the outside. Take Intertek (ITRK), a FTSE 100 company that provides the inspection, testing and certification services on which so much commerce depends. It has bolted on acquisitions at the rate of three a year for the past seven years. Yet that’s nothing compared with the Footsie’s supreme acquisition machine, distribution services provider Bunzl (BNZL). Over the same period, Bunzl has made 68 acquisitions, including 16 in 2015 alone.

Given the prevalence of acquisitions, it follows that anyone interested in the fortunes of deal-making companies – especially investors – should be able to assess the deals they do. That’s where IFRS 3 Business Combinations comes in. It is the accounting standard that establishes the principles by which a company recognises and measures the assets and liabilities that come with an acquisition – especially the amount of goodwill in the deal – and tells acquiring companies how they should disclose such information.

That sounds obvious enough. Why should company bosses do any different if they want to help those who rely on their accounts and quite likely own a chunk of their company’s shares? Because the plain truth is that bosses have a lot of incentive to dress up their deals, to highlight the good bits they’ve bought and to hide away the smelly parts. Go back to the 1980s and 1990s and some did just that with such creativity that they made it an art form.

So much so that Sir David Tweedie, who was to become the first chairman of the International Accounting Standards Board, which aims to develop globally-accepted accounting rules, at that time labelled acquisition accounting “the black hole of British accounting”. Or, as Chris Higson, now a professor of accounting at the London Business School, said in a research paper from that period, accounting rules “may allow acquisitive companies to achieve their performance goals by accounting means alone”.

Most important in this context, after making an acquisition, a company had the choice whether to use ‘merger accounting’ or ‘acquisition accounting’ to report what had happened. Conceptually, merger accounting often strained credibility. It assumed that, in a deal, there was no acquirer but two companies that came together as equal partners and presented accounts as if they had always been one. True, that could happen, but it rarely did.

In contrast, acquisition accounting stuck closer to reality. There was an acquirer and the company it acquired was subsumed into the enlarged group only from the day that control passed. So, if company A bought company B exactly eight months into its accounting year, A would consolidate B for just the four remaining months. Under merger accounting, holding company AB would be created and would present its accounts as if only AB had ever existed (or, at least, as far back as AB’s finance team made the historic adjustments).

The great attraction of merger accounting was that it did not create goodwill, the amount by which the purchase price of a deal exceeds the fair value of the assets acquired. Technically, it could not since there was no acquisition, just two businesses coming together as equal partners. Happily, no goodwill meant no intangible assets to amortise on a regular basis, nibbling bits out of profits. Better still, it meant no swingeing charges that would wreck profits when the future made it clear that, actually, the goodwill from an old deal was illusory.

If the absence of these benefits deterred companies from using acquisition accounting, then lax accounting standards encouraged its use. In particular, companies used the so-called ‘merger relief’ provisions of company law that permitted an acquirer to deduct the goodwill it had paid against its shareholders’ funds (technically, against its share premium account). Merger relief was wonderful. It removed the charge of amortising goodwill against profits – thus helping earnings per share. It also boosted measures for return on capital – and especially for return on equity – because the book value of equity employed was reduced by the amount of goodwill written off.

Small wonder that almost every company using acquisition accounting in deals adopted the merger-relief provision. Better still, acquisition-driven companies cherry-picked between the merger and acquisition accounting formats, depending on which one would flatter their performance most. Equally smaller wonder, eventually City fund managers and analysts rumbled this practice and got fed up with it as they struggled to see how well – or badly – companies were performing.

Thus a succession of accounting standards addressed the issue and tightened it up. The alphabet soup of relevant standards started with SSAP 23, which gave way to FRS 6, which was superseded by IAS 22, which made way for IFRS 3. This standard – our chief focus – was first used in 2004, then thoroughly revised to take effect from 2009.

IFRS 3 lays down some core requirements:

●  It specifies that only acquisition accounting must be used to account for a business combination (and the merger relief provisions are a thing of the past). In turn, that demands:

●  For every transaction an acquiring company must be identified – that’s the business that gains control of the other.

●  The deal must be dated. That’s when control passes to the acquirer, which is usually the date at which its offer becomes unconditional because it has received enough acceptances.

●  The acquirer must ‘recognise’ the assets and liabilities it has taken on. In its accounts, that means broadly defining them and quantifying them at ‘fair value’, which is an estimate of the amount for which they would change hands in an arm’s-length transaction.

●  Any goodwill in the deal must also be recognised at fair value; goodwill defined as the amount of the consideration in excess of the fair value of the net assets acquired. On the rare occasions when the acquisition is a so-called ‘bargain purchase’ (ie, the consideration is less than the fair value of the net assets) then the acquiring company must account for the difference as a gain in its income statement.

●  Last, there is the little matter of measuring the consideration and specifying how it has been paid (usually some combination of cash and securities issued by the acquiring company).

Fulfilling the requirements of IFRS 3 can run to several pages in the accounts of an acquisitive company. In the case of hyper-active Bunzl, explaining acquisitions took up three pages to the notes in its 2018 accounts, although the company has got such reporting down to a fine art and, as the report acknowledges, 2018 was a comparatively quiet year by its standards.

The deal from 2018 on which to focus is surely the acquisition of the venerable engineering group, GKN, by the comparative upstart Melrose Industries (MRO). This was a monster of a deal and not just because it was the London market’s biggest of that year. There was also the size disparity between the small predator and its huge victim. When Melrose made its cash-and-shares offer, its annual sales ran at £3.9bn compared with approaching £10bn at GKN; and the value of the offer – at £8.3bn – was more than two times the £3.9bn market value of Melrose’s own equity.

To add spice, the bid came with shades of the fun and games of the acquisition-crazy 1980s. Not only was it a hostile bid – a rarity nowadays – but one of the trio of businessmen who founded Melrose – and still run it – is Christopher Miller. He had got first-hand experience of growing via acquisitions at Hanson, the Yorkshire-based conglomerate that – along with BTR – epitomised the hostile deal in that period.

In the end, Melrose landed GKN for £8.4bn and control passed on 19 April 2018 as 85 per cent of GKN’s shareholders accepted the offer of 1.69 new Melrose shares (valued at 235p each) plus 81p cash for each GKN share. Thus Table 1, showing that Melrose paid £7.1bn for net assets of £4.6bn, does not tell the whole story. There was still the matter of those GKN shareholders who had not yet accepted the deal. Hence the £857m minority interest in the table, which nowadays is termed ‘non-controlling interest’. That outside interest was mopped up by the end of June. So, by the time Melrose produced its 2018 accounts, £1.26bn had been handed over to the minority GKN shareholders, GKN was 100 per cent owned and the minority interest was eliminated from the balance sheet via a bookkeeping adjustment to the statement of Melrose’s equity.

Table 2 shows in more detail how Melrose used IFRS 3 to adjust the book value of what it bought with GKN. Chiefly, it massively raised the value of GKN’s intangible assets, from £488m to over £5.7bn. Other than saying the valuation was done by outside experts, Melrose does not explain how the value of GKN’s intangibles – the likes of its brands, customer relationships and intellectual property – was marked up so much. Pity.

Set against this, Melrose cut the book value of what it bought by adding on over £1bn-worth of provisions. Most of that figure – £629m – was related to lossmaking contracts. Implicitly, that was an indictment of GKN’s former bosses since Melrose’s accounts point out that about 10 per cent of GKN’s revenues needed some provision. In addition, warranties required £295m of the provision and legal claims £123m. Obviously, it will help Melrose’s future profits should some of those provisions turn out to be unnecessary.

Net out all these items and Melrose ended up adding £2.5bn of goodwill in its accounts relating to GKN. This tallies with the £7.1bn it paid for its 85 per cent interest in GKN at the point of acquisition less £4.6bn of net assets acquired (see Table 1). What that also means is that there was no further adjustment to goodwill following the acquisition of the minority interest in GKN.

Naturally, so big an acquisition had a profound effect on Melrose’s accounts. As Table 3 shows, the group’s balance sheet swelled hugely. Gross assets of £3.1bn in December 2017 became £19.7bn a year later as the book value of all classes of assets was increased, although none more than the £8.9bn uplift in goodwill and intangibles (the breakdown of which is shown in Table 4). In keeping with a group whose turnover was about to quadruple, its property and plant, inventories and receivables all increased substantially. Obligations on the other side of the balance sheet rose at an even faster rate. The near-10-fold increase in ‘other liabilities’ from £538m to £5.2bn contains a potpourri of obligations, most obviously including a £2.2bn increase in trade payables.

IFRS 3 has toughened up rules on the acquisition costs that an acquiring company can capitalise (ie, can dump onto its balance sheet with only limited effects on profits and earnings). In particular, fees payable to the likes of bankers, lawyers and accountants for helping fix a deal have to expensed as incurred. Hence the £153m of acquisition and disposal costs that are charged against Melrose’s operating profits in 2018 (see Table 5), almost all of which relate to the GKN deal.

Similarly, it is more difficult for acquiring companies to capitalise the costs they are likely to incur to restructure their new business. Instead, most of such costs must be expensed in the normal way. The usual exception would be where the acquired company had already made restructuring provisions before its predator came along. In its 2018 accounts, Melrose identified £156m specific to GKN out of £240m total restructuring charges against profits. But it was also able to capitalise £24m of restructuring provisions in its balance sheet, all of which is likely to have incurred cash costs by now.

One anomaly of IFRS 3 related to this is that the direct costs of raising debt or equity are not expensed immediately. Debt-raising costs are written off over the life of the debt. Equity-raising costs are deducted from equity. Thus there is a tiny detail in Melrose’s 2018 accounts to say that £1m of costs have been charged against the £5.6bn premium over the par value of shares issued to fund GKN’s purchase.

In a sense, however, all the data in the five tables might be torn up and restated. Granted, that’s an exaggeration, but it’s another way of saying that IFRS 3 allows an acquirer up to 12 months to finalise its accounting for a deal, so Melrose can make adjustments in its 2019 accounts. After that, the curtain comes down.