The Two Types: Merger and Purchase
Chapter Two
Syllabus topic 2, "Types of amalgamation – merger and purchase"
Pages 4 to 7 of 168
In one line
A merger is a genuine pooling in which the businesses and the owners both continue on the same book values; a purchase is everything else.
The distinction in substance
Ask two questions of the facts.
Do the owners of both firms continue as owners of the combined business, in substantially the same interest? If the partners of the old firms simply become partners of the new one, carrying their stake across, that is a pooling.
Are the book values carried across unchanged? If the assets and liabilities go into the new books at what they stood at in the old ones, nothing has been bought; the two sets of books have been added together.
If both answers are yes, it is a merger. If either is no, it is a purchase.
The five conditions, as the standard states them
AS 14 defines an amalgamation in the nature of merger as one satisfying ALL of the following, and its own words are:
(i) All the assets and liabilities of the transferor company become, after amalgamation, the assets and liabilities of the transferee company.
(ii) Shareholders holding not less than 90% of the face value of the equity shares of the transferor company (other than the equity shares already held therein, immediately before the amalgamation, by the transferee company or its subsidiaries or their nominees) become equity shareholders of the transferee company by virtue of the amalgamation.
(iii) The consideration for the amalgamation receivable by those equity shareholders of the transferor company who agree to become equity shareholders of the transferee company is discharged by the transferee company wholly by the issue of equity shares in the transferee company, except that cash may be paid in respect of any fractional shares.
(iv) The business of the transferor company is intended to be carried on, after the amalgamation, by the transferee company.
(v) No adjustment is intended to be made to the book values of the assets and liabilities of the transferor company when they are incorporated in the financial statements of the transferee company except to ensure uniformity of accounting policies.
And an amalgamation in the nature of purchase is defined negatively: one which does not satisfy any one or more of those conditions.
What the five conditions are actually testing
Read them again with the purpose beside each, because that is what makes them memorable and what lets you apply them to a firm.
| Condition | What it tests |
|---|---|
| (i) All assets and liabilities pass | Completeness. Nothing is left behind, so the whole business really has combined |
| (ii) 90 per cent of owners continue as owners | Continuity of ownership. The same people still own it |
| (iii) Consideration discharged wholly in equity | No cashing out. Owners take a stake, not a payment |
| (iv) The business is intended to be carried on | Continuity of business. It is not being bought to be closed |
| (v) No adjustment to book values | Continuity of measurement. The numbers are not restated |
The Two Types: Merger and Purchase
Three of the five are about continuity - of ownership, of business, and of measurement - and that is the idea to carry. A merger is a combination in which nothing is really disturbed but the name over the door.
Applying the test where the parties are firms
Conditions (ii) and (iii) speak of equity shares and shareholders, and a firm has neither. The next chapter deals with that squarely. For working a question, translate them:
| The standard's condition | Its equivalent for firms |
|---|---|
| 90 per cent of equity shareholders continue | All or substantially all partners of the old firms become partners of the new firm |
| Consideration discharged wholly by equity shares | The consideration is credited to the partners as capital in the new firm, not paid out in cash |
Say in an answer that you are translating. A sentence such as "the conditions are framed for companies; applied to firms they require that the partners continue as partners and are settled in capital rather than in cash" shows you know what you are doing, and it costs one line.
Why the type matters
Because it decides the method, and the method decides every figure in the new firm's balance sheet.
| Merger | Purchase | |
|---|---|---|
| Method | Pooling of interest | Purchase method |
| Assets and liabilities recorded at | Existing book values | Agreed or fair values |
| Reserves of the old firms | Carried into the new books | Not carried; they merge into the consideration |
| Difference on consideration | Adjusted in reserves | Goodwill if consideration exceeds net assets; capital reserve if it falls short |
| Effect on the new balance sheet | The two old balance sheets, added | A fresh statement at agreed values |
That table is the answer to the distinguish-between MU is most likely to set, and the chapter after next works both methods on one set of figures so that the differences can be seen rather than recited.
Worked test: which type is it?
State, with reasons, whether each is a merger or a purchase.
| The facts | Type | Why |
|---|---|---|
| Both firms transfer everything; all partners join the new firm; each is credited with capital equal to his old capital; book values unchanged | Merger | All five tests satisfied |
| Both firms transfer everything; all partners join; assets revalued upward before transfer | Purchase | Condition (v) fails: book values were adjusted |
| One firm's partner takes cash for his share and does not join the new firm | Purchase | Continuity of ownership and the wholly-in-capital condition both fail |
| One firm retains its motor van, which the new firm does not want | Purchase | Condition (i) fails: not all assets pass |
| The new firm intends to close down one of the businesses it has taken | Purchase | Condition (iv) fails |
The Two Types: Merger and Purchase
Row two is the one students get wrong. Revaluation alone makes it a purchase, even where everything and everybody has come across. Continuity of measurement is a condition, not a detail.
What it does NOT mean
A merger is not a friendly amalgamation and a purchase is not a hostile one. The test is the five conditions, not the mood of the negotiation.
A purchase does not require cash. It requires only that one of the five conditions fails.
"Purchase" here does not mean the purchase consideration. Every amalgamation has a purchase consideration; only some are amalgamations in the nature of purchase.
Quick revision
- Merger satisfies all five conditions; purchase is one that fails any.
- The five: all assets and liabilities pass; 90 per cent of owners continue; consideration wholly in equity; the business is to be carried on; no adjustment to book values.
- Three of the five are about continuity - of ownership, of business, of measurement.
- For firms, translate: all partners continue as partners, and are settled in capital, not cash. Say that you are translating.
- Merger takes pooling of interest, at book values, carrying reserves across; purchase takes the purchase method, at agreed values, throwing up goodwill or capital reserve.
- Revaluation alone makes it a purchase.
Test yourself
1. State the five conditions for a merger. That all the assets and liabilities of the transferor pass to the transferee; that holders of not less than ninety per cent of the face value of the equity shares of the transferor become equity shareholders of the transferee; that their consideration is discharged wholly by the issue of equity shares, apart from cash for fractions; that the business is intended to be carried on; and that no adjustment is made to book values except for uniformity of accounting policies.
2. How is an amalgamation in the nature of purchase defined? Negatively, as one which does not satisfy any one or more of the merger conditions.
3. Two firms combine, everything passes and all partners join, but the buildings are revalued before transfer. Which type is it? A purchase, because the condition against adjusting book values has failed, and the conditions are cumulative.
4. How do you apply conditions (ii) and (iii) to firms? By translating them: the partners of the old firms must all, or substantially all, become partners of the new firm, and their consideration must be credited as capital in the new firm rather than paid out; and the answer should say that the translation is being made.
The Two Types: Merger and Purchase
5. Why does the type matter? Because it decides the method: a merger is accounted for by pooling of interest at book values with the reserves carried across, and a purchase by the purchase method at agreed values with the difference on the consideration going to goodwill or capital reserve.
Answer in one sentence
Distinguish the two types of amalgamation. An amalgamation in the nature of merger is one satisfying all five conditions - that all assets and liabilities pass, that holders of at least ninety per cent of the equity continue as owners, that their consideration is discharged wholly in equity, that the business is to be carried on, and that book values are not adjusted except for uniformity of policies - so that ownership, business and measurement all continue; an amalgamation in the nature of purchase is one that fails any of those, so that in substance one business has been bought; and the distinction decides everything that follows, since a merger is recorded by the pooling of interest method at existing book values with the reserves carried across, while a purchase is recorded by the purchase method at agreed values with any excess of consideration over net assets becoming goodwill and any shortfall a capital reserve.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.