Guide: Accounting for Reverse Acquisitions (Share-for-Share Exchanges), Part 1

Introduction

Reverse acquisitions are prevalent in the business world. For example, they arise when a private company seeks a quick public listing by having a smaller, publicly listed company acquire its equity interests. After the acquisition, the private company’s shareholders usually gain control over the merged entity. In recent times they tend to occur through SPAC transactions.

The entity issuing equity (the legal acquirer) becomes the accounting acquiree, while the subsidiary (or the legal acquiree) is deemed the accounting acquirer. The accounting acquirer has a control because “it is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee.”

This text simplifies and explains the basic principles of accounting for reverse mergers and majority of SPAC transactions, specifically focusing on exchanges of basic shares between shareholders where legal target is an accounting acquirer.

It doesn’t address more complex scenarios involving partial cash settlements, warrants, non-controlling interests, complexities about post-acquisition control, or the calculation of earnings per share and the detailed disclosures required in such transactions.

Determining if the Accounting Acquiree Constitutes a Business

The crucial step that determines how reverse acquisition will be accounted for is whether the accounting target constitutes a business, or not.

A business is defined as “An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing goods or services to customers, generating investment income (such as dividends or interest) or generating other income from ordinary activities.”

The emphasis is on inputs and processes. Hence, research-focused startups with necessary inputs and employees engaged in research for future commercial activities are considered businesses, even if they haven’t yet produced clear outputs or generated income.

Many public companies without operational activities do not qualify as businesses. In the context of SPACs, public entities are often shell companies with no significant activities beyond managing financial assets and liabilities, and as such are also not businesses.

Option 1: Accounting When the Accounting Acquiree Constitutes a Business

If a transaction qualifies as a ‘business,’ the process of gaining control over the target is treated as a business combination under IFRS 3, using the acquisition method. Under this method, at the time of acquisition, the acquirer must recognize the identifiable assets and liabilities it has acquired at fair value, as well as any non-controlling interest in the target. Additionally, the accounting acquirer recognizes any goodwill or bargain purchase gain resulting from the acquisition. Compared to standard business combinations accounting, the main difference is in how the consideration exchanged between shareholders is calculated.

Example:

Private company standalone financialsPublic company standalone financialsTransaction adjustmentsConsolidated
Current assets400400800
Non-current assets3,7001,9003005,900
Goodwill100100
Total assets4,1002,3006,800
Current liabilities8004001,200
Non-current liabilities9001,1002,000
Total liabilities1,7001,5003,200
Retained earnings2,2005001,2002,200
Other equity1,2001,200
Share capital (300)300
Share capital (200)200200
Total equity2,4008003,600
Total liabilities and equity4,1002,3006,800

Let’s assume that the pre-combination shares are trading at $6 and $2 for Private and Public Company respectively. Furthermore, the Public Company has customer lists which are not recognised in the books, but their fair value is $300. Imagine that this is a share-for-share transaction, where the Public Company is poised to acquire each of Private Company’s shares by issuing 3 shares for each of Private Company’s share. The Public Company would end up issuing 600 shares to Private Company’s shareholders, and as a result, the Private Company’s shareholders would end up having a control of approx. 67% over the combined company. The Private Company would end up being an accounting acquirer. Consequently, the acquisition accounting should be followed from their perspective, and the first step would be to determine the acquisition price of 67% of the 300 ordinary shares of Public Company. The goal here would be to follow the approach as if the shares were acquired in an orthodox way, i.e., as if Private Company purchased them directly from the Public Company.

Consideration calculation method

Total number of shares of the Public Company: 300

Price per share of the Private Company: $6

Deemed % of shares acquired: 67% ( 600 / (300 + 600) )

Consideration exchanged with Public Company’s shareholders: $1,200 (300 x $6 x 67%)

Goodwill calculation

Consideration exchanged with Public Company’s shareholders: $1,200

Net assets (carrying value): $800

Fair value of customer lists: $300

Resulting goodwill: $100 ($1,200 – $800 – $300)

Option 2: Accounting When the Accounting Acquiree Does Not Constitute a Business

IFRS 3 lacks specific instructions for transactions where the accounting acquiree is not a business, and such cases can’t be treated as acquisitions. In these situations, management should turn to IAS 8 for guidance. Essentially, the operating company (accounting acquirer) has used share-based payment to acquire a stock listing, including the listed company‚Äôs cash and other net assets, if any. This should be accounted for under IFRS 2.

IFRS 2 states that any discrepancy between the transaction price’s fair value and the fair value of acquired net assets represents a service received. Therefore, any excess over the acquired cash balances and other identifiable net assets is a cost for services in obtaining a listing.

Example:

Private company standalone financialsPublic company standalone financials (shell company, no business)Transaction adjustmentsConsolidated
Current assets400300700
Non-current assets3,7003,700
Goodwill
Total assets4,1003004,400
Current liabilities80010810
Non-current liabilities900900
Total liabilities1,700101,710
Retained earnings2,200-10-3101,890
Other equity600600
Share capital (300)300
Share capital (200)200200
Total equity2,4002902,690
Total liabilities and equity4,1003004,400

Let’s assume that the pre-combination shares are trading at $6 and $2 for Private and Public Company respectively. In this case, let’s assume the Public Company does not have any activities and the assets held are mainly cash accounts. Hence we treat this as a share-based transaction whereby the Private Company is issuing some of its own equity to the shareholders of the Public Company, in exchange for the Public Company’s net assets as well as “services received” which in this case would be a listing of the company. In such circumstances, the value of the equity instruments issued is determined with reference to the assets and services received. Given that this can be hardly determined, we approximate referring to the market value of Public Company’s shares just prior to the transaction. Consequently, the Private Company should to book the following accounting entries under IFRS 2:

DebitCredit
Net assets of the Public Company290
Equity600
P&L expense – IFRS 2310

Conclusion

The above text explained the basic principles of accounting for reverse mergers, specifically focusing on share exchanges between shareholders. It did not explore more intricate scenarios involving partial cash settlements, warrants, non-controlling interests, complexities about post-acquisition control, or the calculation of earnings per share and the detailed disclosures required in such transactions. Real cases are more complex and necessitate a detailed assessment of these aspects.

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