A COMMENT ON ESTABLISHING THE FAIR VALUE OF CONSIDERATION GIVEN IN AN ACQUISITION
Trowell, John
The distinction between offer date and acquisition date is important when determining the fair value of shares offered as consideration in an acquisition or takeover. Standards on business combinations have required this to be determined at acquisition date, certainly since 2001, even though earlier opinions such as APB Opinion 16 had allowed the use of offer date. Despite this, Lonergan (2004) continued to favour the use of offer date, using the Wesfarmers takeover of Howard Smith in 2001 as support, and claiming that acquisitions are essentially locked-in from the offer date. But this is generally not the case. This paper shows that acquisition date is correct when conditions change during a takeover.
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This paper is a comment on Lonergan (2004) “Establishing the Fair Value of Consideration Given in an Acquisition”. In his paper, Lonergan addressed the question of determining fair value for share offers in takeovers and argued in favour of using the offer date rather than the acquisition date for establishing fair value because of the effects of timing and adjustment issues. A preference for using the offer date was contrary to the Australian standard AASB 1015 in force at that time and also to FAS 141 in the US and the international standard IAS 22. Indeed, AASB 3 and IFRS 3, which replaced AASB 1015 and IAS 22 respectively, continue to mandate the determination of fair value at acquisition date and even the US now requires the singular use of the purchase method for business combinations. Given this contradiction, then under what conditions does the offer date have some validity and to what extent does this reflect conditions generally when shares are used to acquire assets?
The purpose of this paper is to demonstrate that the use of the offer date would be valid only when conditions are certain and do not change, whereas the use of the acquisition date is generally correct in terms of assessing the cost of the acquisition at fair value. This coincides with the position taken by the standard-setters. It allows for any change in contractual conditions relating to the terms of the offer and its acceptance-by shareholders of the acquired company and it determines ownership and control for accounting and tax purposes.
In addition, this paper cites evidence in the Wesfarmers takeover of Howard Smith not considered by Lonergan (2004), a case used to illustrate his argument. This evidence would have limited the range of $720 million (Lonergan 2004, p. 85) in which Wesfarmers accounted for the acquisition in accordance with AASB 1015. The problem was not the standard but the application and proper use of the evidence for assessing fair value.
Lonergan (p. 89) summarised his argument as: “In a scrip offer it does not seem realistic to argue that the ‘cost’ of the offer (which is set on the offer date) somehow changes at the acquisition date, when the legal, practical and substantive reality is that the bidder is locked into that offer. Further, there seems little merit in having the accounting result at acquisition date being driven by the impact on the bidder’s share price or the vagaries of the stockmarket between the offer date and the date control passes.”
HISTORICAL DEVELOPMENT
Certainly in the US there was some bias in APB Opinion No. 16 Business Combinations towards assessing fair value around the offer date. But this presumed there was no change in the terms of the offer as illustrated in EITF Issue No. 99-12 Determination of the Measurement Date for the Market Price of Acquirer securities Issued in a Purchase Business Combination. By way of background, Paragraph B98 of FAS 141 states that “this Statement carries forward from Opinion 16 contradictory guidance about the date that should be used to value equity interests issued to effect a business combination. Paragraph 74 of Opinion 16, carried forward in paragraph 22, states that the market price for a reasonable period before and after the date the terms of the acquisition are agreed to and announced should be considered in determining the fair value of the securities issued. However, Paragraph 94 of Opinion 16, carried forward in Paragraph 49, states that the cost of an acquired entity should be determined as of the date of acquisition. Paragraph 48 defines that date as the date that assets are received and other assets are given, liabilities are assumed or incurred, or equity interest are issued. The Board decided to defer resolution of that apparent contradiction to its project on issues related to the application of the purchase method. Therefore, this Statement does not change the status of the guidance in EITF Issue No. 99-12.”
EITF Issue No. 99-12 provides guidance on the valuation of equity securities issued in a business combination. The general premise was that equity securities to be issued, unless subject to change, should be valued based on the market price shortly before and after the terms are agreed to and announced. However, if the purchase price (either the number of shares or the total consideration) is subsequently changed, a new measurement date is established for valuing the securities.
In Australia, the Australian securities Commission (ASC) issued Practice Note 54 Accounting for the Acquisition of Net Assets in Financial Statements or a Prospectus in response to a failure by some companies to comply with AASB 1015 in determining the fair value of shares issued in an acquisition. While it allowed for a consideration of factors such as a placement discount, control premium and market liquidity the determination was clearly defined at the date of acquisition. The date of acquisition carries forward into AASB 3. The adjustment and timing issues make the valuation more complex, knowing that to avoid circularity, the fair value of shares issued and the fair value of assets acquired must be determined separately.
ASSESSING FAIR VALUE
When an offer involves shares and when that offer involves variations between the offer date and the acquisition date, then the variation is affected by how the shares trade, knowing the terms of the initial offer and what price the shares trade at, which may cause a change in the offer terms. If the valuation of the consideration given and the assets received do not coincide, then the subsequent accounting measures, such as goodwill, will contain error.
This adjustment process can be illustrated by Table 1 and Figure 1 based on the example where the premium exceeds the discount. This shows how the exchange ratio is affected by the discount and premium in the offer period. Premiums and discounts form a legitimate part of pricing an offer and its acceptance, and are therefore relevant to the determination of fair value. The cost of an acquisition is not always locked-in at the time of the initial offer as demonstrated by the guidance in EITF Issue No. 99-12. Only when there is no change in the terms and the premium/discount parameter is the offer date in effect equivalent to the acquisition date.
To demonstrate this, if Company A issues shares in consideration for Company B’s shares, then the exchange ratio X^sub i^ at time t^sub i^ is given by the expression X^sub i^ = B^sub i^/A^sub i^ This can be generalised as (1 – d^sub i^)A^sub 0^X^sub i^ = (1 + p^sub i^)B^sub 0^ to show that the exchange ratio emerges as a function of the premium p^sub i^ and discount df and the initial conditions at t^sub 0^, when d^sub 0^ and p^sub 0^ are zero and ….
At time … where …
is the premium/discount factor following from the generalised form of the exchange ratio.
For example, if the offer terms are based on Company A shares being valued at $20 and Company B shares being valued at $12, then the exchange ratio would be 0.6 or three A shares for every five B shares. Note the exchange ratio used to define the initial offer necessarily includes an adjustment for the control premium and effective placement discount.
Assume now that trading in the shares after the takeover announcement indicated that Company B shares were undervalued by 50% and that Company A shares were overvalued by 25% relative to the initial offer of three-for-five shares. For the offer to succeed, the offer would need to be revised from 0.6 to 1.2. This means six Company A shares need to be issued for every five Company B shares. This is shown in Figure 1 as the shift in the exchange ratio line from X^sub 0^ to X^sub i^ which is driven by the premium/discount factor c^sub i^. In this case c^sub i^ = 2 since p^sub i^ and d^sub i^ are 0.5 and 0.25 respectively. The line X^sub i^ has a slope of 1.2, twice the slope of the initial exchange ratio line X^sub 0^. The line BA has a slope of -1.2 and intersects X^sub 0^ at (20, 12) and X^sub i^ at (15, 18) which represent the set of Company A and B share prices in the form (A, B) at t^sub 0^ and t^sub i^. Note c^sub i^ has a lower bound of 1 when p^sub i^ and d{ are both O.
While this example is designed to exaggerate the effect, the generalised form shows that by defining the ultimate discount or premium at the initial point of offer it would be inconsistent with the emerging market in A and B shares. It would also give a false exchange ratio in value terms and cause measurement error in the subsequent accounting. The conclusion from the generalised case, which allows for either p^sub i^ ≤ d^sub i^ or p^sub i^ ≥ d^sub i^ or, is that the direction taken by the AASB, FASB and the IASB is theoretically consistent in terms of synchronising the fair value of issued shares and assets acquired at the date of acquisition allowing for variations in the offer terms and the market’s pricing of the offer.
The market may or may not price the offer differently from the initial terms but this is the exception, not the general rule. To price the shares at the offer date assumes that in effect a notional placement has occurred and the offer is equivalent to a cash offer. But this is not the case. This would be equivalent to separate transactions and not constitute a merger unless one assumes that the placement and cash offer involve the same set of shareholders in B. It also assumes no offer variation, otherwise any increase in the cash offer would necessitate an additional placement equal to the difference between the initial and subsequent offer. This is why the offer date would lead to error in determining fair value when the offer changes.
FACTS AND ADDITIONAL EVIDENCE ON THE WESFARMERS CASE
Lonergan (2004) used the Wesfarmers takeover of Howard Smith as an illustrative case, to highlight some of the more important issues involved in the determination of the fair value of issued shares. Three related aspects in the measurement process that add to the complexity are the time delay from announcement of the offer to the completion of the acquisition, the offer variation during this period, and the efficiency with which the market price reflected the fair value of consideration given.
AASB 1015.12.1 defines acquisition date as “the date on which the acquirer obtains control of an asset, group of assets, or net assets”. Determining when control is obtained is not necessarily simple, especially when the purchase consideration involves the issue of equity instruments in exchange for shares in the acquired entity, and when the offer is revised as happened in this case. Lonergan (p. 86, Table 1) calculated the range in the purchase consideration to be approximately $720 million. This is the difference between the market price of issued shares at acquisition date of approximately $2,100 million and what Wesfarmers booked the transaction at: 79,032,975 shares at $18.30 per share.
The following facts are significant in the Wesfarmers case and are relevant to the timing and adjustment issues:
i Wesfarmers’ initial offer was $12.00 cash and two Wesfarmers’ shares for every five Howard Smith shares. This was on 13 June 2001 when Wesfarmers share price closed at $21.32 and continued to trade above this price.
ii Based on Wesfarmers’ closing share price on 12 June 2001, the initial offer valued each Howard Smith share at $11.14 which represented:
a a premium of 26% to the $8.85 pre-buyback announcement price;
b a premium of 22% over the mid-point of the buyback tender price range of $9.10; and
c. a premium of 14% over the closing price of Howard Smith shares on 12 June 2001.
iii On 11 July 2001, Wesfarmers announced that it would increase its takeover offer for all the issued shares in Howard Smith to $13.25 plus two Wesfarmers’ shares for every five Howard Smith shares and extended the offer closing date to 7 August 2001.
iv In an announcement to the ASX dated 12 July 2001 Wesfarmers said the revised offer valued each Howard Smith share at $13.39, based on a Wesfarmers’ closing share price at 11 July 2001 of $26.85. Yet in its 2002 annual report the acquisition of Howard Smith, involving the issue of 79 million shares, was recorded at $18.30 per share which was the same as the underwritten price set for a share placement announced to the ASX on 13 February 2001.
v The equity-restructure, involving the buyback of some 134 million shares valued at $18.06 per share, occurred 4 July 2001 but was deemed to have occurred 24 April 2001. Shareholders approved the buyback on 6 April 2001.
vi The shares of Howard Smith traded in a price range of $13-14.82 in the offer period prior to delisting 16 November 2001, which effectively was 7 August 2001 when Wesfarmers gained control.
vii The share price ofWesfarmers traded well above $18 from April 2001 in a range of $25-$30 for the takeover period and beyond into 2002. The offer was unconditional on 21 August 2001 and closed on 22 August 2001 with a share price of $26.73.
viii The ATO issued a class ruling (CR 2001/51), dated 17 October 2001, that the relevant date for determining the market value of Wesfarmers’ shares for capital gains tax rollover purposes was “the time the shareholder disposed of the Howard Smith Limited shares” which was “the date when the contract for the disposal was entered into”. The market value based on the closing price on the date of acceptance would have been in the range of $23.87-$26.47.
ix UIG Abstract 41.6(b) states “when a market price does exist as at the acquisition date, but that price has not been used as the fair value of the equity instruments; the entity must disclose the method and significant assumptions applied in determining their fair value. Where a market price exists but has not been used as the fair value, the entity must disclose the aggregate difference between the market price and the fair value of the equity instruments, and the reasons why the market price is not the fair value of the equity instruments.” Yet Wesfarmers provided no explanation in its 2002 financial statements or any reconciliation for using a different value.
x Wesfarmers in Note 22 to the 2002 financial statements referenced the following share issues during the year, where apart from their assessment of the Howard Smith acquisition, all transactions reflected trading at the upper end of the range of $25-$30 from April 2001 to well into 2002:
Employee share plan:
5,107,737 ordinary shares fully paid at $30.35 per share
Dividend investment plan:
3,483,716 ordinary shares fully paid at $29.53 per share
2,060,316 ordinary shares fully paid at $30.65 per share
Acquisition of Howard Smith Limited:
79,032,975 ordinary shares at $18.30 per share
Share placement:
860,000 ordinary shares at $29.58 per share
CONCLUSION
As the shares in Wesfarmers and Howard Smith continued to increase over the offer period and because Wesfarmers amended the offer, the use of the offer date would underestimate the fair value of the issued shares. This case demonstrated that the terms of the offer were fully priced for a premium and placement discount when the exchange ratio was set at two Wesfarmers shares for every five Howard Smith shares, as noted in facts i-iv above. Even Wesfarmers highlighted the pricing of the revised offer using a Wesfarmers’ price of $26.85 at 11 July 2001 (see iv above). The share price carried forward at this level to the acquisition date. This effectively occurred at the close of the offer on 22 August 2001 after Wesfarmers had notified the ASX on 21 August 2001 that the 90% acceptance condition had been met and the offer was therefore unconditional. All acceptances then were legally binding and control had passed to Wesfarmers.
In fact it would seem there were no grounds for a notional placement discount based on the above evidence, yet Wesfarmers’ final booking of the Howard Smith transaction suggests a strong influence from the earlier placement and buyback. The impact on goodwill, profit and dividends is significant as Lonergan mentioned. In this case, with something in the order of $600 million and with an amortisation policy of 20 years at the time, this would have translated into a profit effect in the order of $30 million.
This exposed a timing differential in the valuation contrary to the evidence from an active and well-informed market for both Wesfarmers and Howard Smith shares. Indeed, the evidence contained in the ATO class ruling CR 2001/51, not considered by Lonergan, put a lower bound on the range at $23.87 (the closing price at 11 July 2001) and an upper bound at $26.87 (the closing price at 7 August 2001). Wesfarmers shares effectively traded in a range of $24-$27 for the duration of the revised offer and continued to trade above this for a sustained period consistent with disclosures in the 2002 accounts.
Given this evidence and following AASB 1015, the range could not have exceeded $240 million (($27-$24) ? 79,032,975). The standard and guidance notes in this case were not the issue. These provided far less degrees of freedom for estimating fair value than shown by the accounts.
The measurement issue is not resolved by the use of the offer date. Acquisition date captures any variation in the offer terms in respect of the exchange ratio and relative prices. It captures the correct timing for acceptances to be legally binding after conditions are met or waived. It defines the timing in respect of control and tax effects for shareholders. Otherwise the transaction is recorded in a contradictory manner where the price for the issue of shares by the company is not the same as the price shareholders can trade at but who remain with the company as shareholders having accepted the offer.
REFERENCES
Australian Accounting Standards Board, 1999, AASB 1015 Acquisition of Assets.
Australian Securities and Investments Commission, 1994, Practice Note 54 Accounting for the Acquisition of Net Assets in Financial Statements or a Prospectus, September.
Australian Stock Exchange, 2001, Document No. 198707, “Wesfarmers Limited, ‘Letter to SMI Shareholders/Supplementary Bidders Statement/ Notice of Variation'”, 12 July.
Australian Taxation Office, 2001, Class Ruling (CR 2001/51), “Acquisition of Howard Smith Limited by Wesfarmers Retail Pty Ltd”, as at 17 October.
Emerging Issues Task Force, 1999, Issue No. 99-12 Determination of the Measurement Date for the Market Price of Acquirer securities Issued in a Purchase Business Combination, FASB, 1999.
FASB, 2001, Statement 141 Business Combinations, June.
International Accounting Standards Board, 2001, International Accounting Standard IAS 22 Business Combinations.
International Accounting Standards Board, 2004, International Financial Reporting Standard IFRS 3 Business Combinations.
Lonergan, W., 2004, “Establishing the Fair Value of Consideration Given in an Acquisition”, Australian Accounting Review 14,2: 85-90.
Urgent Issues Group, 2001, Abstract 41 Fair Value of Equity Instruments Issued as Purchase Consideration, AASB, September.
Wesfarmers Limited, 2002, Annual Report, June.
John Trowell is a PhD student in the Commerce Research Centre, School of Accounting and Finance, University of Wollongong.
Copyright Australian Society of Certified Practising Accountants Nov 2007
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