Accounting Requirements for Business Combination - Essay Example

RESEARCH PAPER ON RECENT MNC ACQUISITION Acquisition Selected In Novartis acquired majority stake in Alcon. Novartis initially owned 25% stake in Alcon and then acquired the remaining 52% form Nestle and the deal was worth USD 28.3 billion. Alcon offers a wide range of unparallel products in the eye care segment starting from nearsighted contact lens for children to cataract implantation of grandparent. The company’s innovative products help people all over the world to cure eye diseases and disorders. The annual sales of Alcon in 2009 was above USD 6.6 million and its operating profit stood over USD 2.2 billion while net income was over USD 1.99 billion. The acquisition of the Alcon will give Novartis the opportunity to expand its portfolio in the eye care segment where there is a latent potential for growth due to aging population and globalisation of emerging markets. The combined portfolio of Alcon and Novartis can now tackle a broad range of untapped demands in this segment. The most important thing to note about the success of this acquisition is the complementary pharmaceutical portfolios of these two companies that filled the gaps between the back and frontal eye. It also has the chance to gain leverage form its strong global brands in eye lens. Financial impact In April 2008, Novartis and Nestle entered into agreement for Nestlé’s sale of 77% stake in Alcon. It was divided in two stages – stage one required Novartis acquiring 77% majority stake in Alcon from Nestle by paying $168 per share taking the deal to $ 38.7 billion. In this stage Novartis acquired 25% stake in Alcon for $ 10.5 billion. In the second stage, Novartis acquired remaining 52% stake from Nestle for $ 28.4 billion. The majority stake cost Novartis $ 38.69 billion that includes adjustments for interest and dividend. The initial 25% stake was financed by $ 17 billion in cash and $ 13.5 billion was financed by bonds. Remaining $ 8.19 billion was financed by US commercial papers. The weighted average external financing cost stood at 2.5% per year as on March 2010. With 77% stake in the majority ownership of Alcon, it will consolidate Alcon’s financial statement into Novartis’ financial reporting. Preliminary assessment shows that initial 25 % stake in Alcon need to be re-valued to its fair value. Such revaluation will result in $ 200 million gain for Alcon. The additional amortization before tax of intangible assets stood at $ 2.2 billion per year. The four month analysis of balance sheet of Alcon in 2010 till April estimates Alcon’s value at $ 200 million including increased inventory. Over the next three years after acquisition, the onetime cost to achieve a synergy of approximately USD 199 million is expected to be around $ 139 million including transaction and other charges. Accounting Requirements for Business Combination Accounting requirements for combination of business requires parent entity to prepare a consolidated financial statement that includes the report of all subsidiaries. However, this does not mean that the subsidiaries are excluded from presenting consolidated reports. All items must be accounted for at fair value including investments. In case of shared power as in case of joint ventures, the consent of all parties will be required. For acquisitions, it is extremely important for the acquirer to determine the timing and the nature of acquisition. The profits and losses as a result of intra-firm transactions between Novartis and Alcon including treatment of fixed assets and inventories must be eliminated. The accounting for contingent asset or liabilities and subsequent adjustment at fair value is also one of the challenging aspects in case of business combinations. Other factors to care of during business combination include pre-acquisition contingencies treatment, interaction of accounting standards between the acquirer and the acquired, treatment of intangible assets (including goodwill), treatment of risk management, proper disclosures under accounting policies, treatment of depreciations and provisions, deferred and corporate taxes (International Accounting Standards Board, 2009, p.331). When one business entity acquires another, the differences in consolidated financial statements of the combined business may face challenges with regard to the following factors: a) Revenue recognition – The control may transfer either on date of acquisition or over a period of time. Determination of exact point of transfer is very important since the financial position of the parent and subsidiary would depend on it. If the control is transferred over a period of time, then acquiring company use the input methods (cost incurred) of output methods (revenue realised) to recognise revenue. b) Determining the asset’s fair value – The assets of Alcon should be measured at fair market value less cost. This fair value should also reflect a liquidating price for third party liabilities in case the company becomes insolvent in future. More specifically, there is nothing mentioned in the IFRS guidelines about which market should Novartis use as base to calculate the fair value of assets. Thus, it completely depends on Novartis to determine the market for valuing assets at fair value since it will be the reporting entity after acquisition. c) Differences in how the economic benefits will be evaluated on the basis of cash flow. Novartis should present expected future cash flow statement that is used in impairment analysis. These estimates must include expected cash inflows from the use of fixed assets over its remaining useful life. It should also include future cash out flow estimates about fixed assets but excluding the cost of improvements. The cash flows associated with disposal of all assets also has to be included in the reporting prepared by Novartis. d) Impairment of long lived assets – While US GAAP requires combining companies to test and measure long term asset impairments in two step impairment test IFRS impairment measure requires companies to recognise impairments of long term assets without the impairment test. Also the IFRS do not specifically provide any guidelines about determination of fair value. e) Determining the useful life of asset – While IFRS requires the estimate for future projection to cover a period of maximum five years, US GAAP requires that the useful life of asset should be based on remaining useful life of the primary asset. f) Accounting treatment for terminated employees at the time of acquisition – Mergers and acquisitions generally lead to reduction in redundancies. As a result of M&A, many mid-level executive roles becomes overlapping which is often eliminated to reduce the operating cost of the new entity. In case of Novartis and Alcon, Novartis may use accounting for termination indemnities as M-T-M (mark to market) accounting or fully defined benefit accounting. Evaluation of Goodwill Goodwill can be treated as an intangible asset during acquisition or business combination. Goodwill that is generated internally cannot be reflected in balance sheet. However, they are identifiable when they are consequence of legal rights such as separation of entity or joint ventures (Deloitte, 2008, p.41). The acquisition of the intangible assets of Alcon by Novartis has to be recognised in the consolidated balance sheet of Novartis and amortised over life. The acquired assets which are identifiable in the business combination are to be valued at their fair values. IFRS requires gain or loss of goodwill to be recognised in Profit & Loss account. On the day of acquisition of Alcon by Novartis, the acquirer has to allocate goodwill to cash generating unit. According to US GAAP, goodwill can be recorded as excess of acquisition cost over the fair value net assets acquired. Goodwill has to be tested for impairment for which Novartis will have to first assign purchased goodwill to its respective reporting unit. This is done by comparing the fair value of reporting unit with net identifiable assets. If there is any loss of impairment then it has to be recognised. When the amount of goodwill exceeds the fair value of the net assets acquired it has to be written down. The goodwill and synergy generated from the acquisition of Alcon by Novartis is expected to add value to both companies by creating opportunities which has the potential to generate USD 200 million pre tax synergy (Ray, 2010, p.311). This value is not unnatural considering the combined portfolio of Alcon and Novartis. Novartis can now tackle a broad range of untapped demands in eye care segment. The most important thing to note about the success of this acquisition is the complementary pharmaceutical portfolios of these two companies that filled the gaps between the back and frontal eye disorders and diseases. It also has the chance to gain leverage form its strong global brands in eye lens. Hence, the business value created from the business combination of Novartis and Alcon is supported. Special Issues Related to Business Consolidations The Special issues related to business consolidation are discussed as follows: Ownership – In acquisitions where the acquiring company owns more than fifty percent of outstanding paid up equity capital in the target or the holding company then the acquiring company has control over the management of the target. The control in this framework refers to the power to direct management and policies. In addition to this, the parent company must issue consolidated financial statements in their annual report. In this case Novartis is the acquiring company and hence it has ownership rights and powers. Liquidation - In case the parent company ceases to exist, then the consolidated group under the parent will also cease to exist. This means that when the parent company (Novartis) becomes insolvent it loses the ownership rights as well as all powers vested upon it at the time of acquisition. Insolvency – It is the duty of the parent company (Novartis) to protect the interest of all creditors, lenders, customers, and interest of minority of shareholders, in case the subsidiary (Alcon Inc.) group becomes insolvent. However, if the Novartis becomes insolvent, its fixed assets may be liquidated to pay off debts of the lenders. Business reorganisation – The business reorganisation program includes consolidation of surplus facilities (overlapping plants or machinery), reduction of workforce by sharing resources (only one management), office consolidation, assets written off (debts paid off by acquiring company), cost of acquisition (like professional fee). All these issues must be addressed by Novartis at the time of acquisition of Alcon Inc. Comparison between Reporting in IFRS and US GAAP IFRS is different from US GAAP regarding treatment of existing liabilities. While US GAAP considers existing liabilities during acquisition, IFRS reporting of acquisition does not mandate it. Hence, the reporting requirements under US GAAP is more detailed than IFRS. The acquisition reporting in IFRS and US GAAP can be distinguished on the basis of following aspects: Indirect effects – Under IFRS acquisition reporting, Novartis will have to include all changes in current and expected future cash flows or profit sharing plan as a result of acquisition. However, under US GAAP, Novartis would only have to state all direct effects due to acquisition like changes in cash flows, financing of acquisition, etc. Certain disclosures norms will be exempted for Novartis under IFRS like nature of asset and liability, assumptions, current period disclosures about cumulative amounts during acquisition. The disclosure requirements are mandatory under US GAAP. Segment reporting - Under IFRS, Novartis will now have to present their new matrix of organisational structure on the basis of geographic segmentation while under US GAAP, the same is required to be presented on the basis of products and services. References Ray, K. G. (2010). Mergers and Acquisitions: Strategy, Valuation and Integration. New Delhi: PHI Learning Pvt. Ltd. Deloitte. (2008). Business Combinations and Changes in Ownership Interests. London: Deloitte Touche Tohmatsu. International Accounting Standards Board. (2009). International Financial Reporting Standards. London: IASC Foundation Publications Department. Read More