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Does It Matter Which Company Is the "Acquirer"?

Yes, for accounting purposes. But as illustrated in the CenturyTel – Embarq deal, the designation may be management's choice.
Robert Willens, | US
November 18, 2008

For myriad business reasons, companies that plan to merge usually make it abundantly clear which company is the acquirer and which is the target. But the designations take on additional importance when examined from an accounting perspective. Consider that for an acquiring company, the consolidated, post-combination financial statements represent the "continuation" of the company's results, and reflect the assets and liabilities at their pre-combination amounts. Meanwhile, the assets and liabilities of a target company are recognized and measured under guidance provided in FAS 141(R), Business Combinations, at their acquisition date fair market values.

In the case of a business combination completed wholly, or at least primarily, through an exchange of equity interests — like the one recently announced by CenturyTel Inc. and Embarq Corp. — the identity of the acquirer is not always readily apparent. That's a problem because the effect of the business combination on post-combination earnings will, to a large degree, be influenced by the proper identification of the acquirer and the acquiree. Indeed, it is only the latter's assets and liabilities that are recorded using a new basis of accounting.

On October 27, CenturyTel and Embarq, two regional local phone companies, announced that their respective boards approved a definitive agreement under which CenturyTel, by means of a reverse triangular merger, would acquire Embarq in a tax-free stock-for-stock transaction.

By structuring the union as a reverse triangular merger, a newly-created subsidiary of CenturyTel will be merged with and into Embarq. Further, the transaction's claim to tax-free treatment is ironclad, as the merger will constitute a reorganization under the tax code. (Specifically under Section 368(a)(1)(A) by reason of Section 368(a)(2)(E)).

Embarq is by far the larger of the merger partner. Accordingly, the merger agreement notes that for each common share of Embarq, its stockholders will receive 1.37 shares of CenturyTel common stock. When the transactions closes, Embarq shareholders are expected to own approximately 66 percent of the combined company, while CenturyTel shareholders will own about 34 percent, according to the companies.

Nevertheless, CenturyTel chairman and CEO Glen Post will retain his position with respect to the combined company, and following the closing of the transaction, the board of directors of the merged company will comprise eight current CenturyTel board members and only seven members from the current Embarq board.

Ordinarily, in a business combination that is based wholly or primarily on an exchange of equity interests, the acquirer is the company that issues equity in the transaction. Following this general rule, CenturyTel would be viewed as the acquirer.

Under FAS 141, however, so-called reverse acquisitions are viewed under a different light. In a reverse acquisition, an issuing entity (CenturyTel in this case) is properly classified as the acquiree. In making this determination, FAS 141 requires the parties to consider (in addition to the identity of the issuing entity) several other factors — although the rule does not specify the relative weight to be accorded to each of the factors. Thus, financial statement preparers are left to apply their own judgment regarding the importance they give to one factor over another.

Factor Analysis
The factors enunciated in FAS 141 are as follows:
• The relative voting rights in the combined company after the business combination. The acquirer usually is the company whose owners, as a group, retain or receive the largest percentage of the voting rights. Clearly, this factor points to Embarq as the acquiring entity.
• The existence of a large minority voting interest in the combined company if no other owner or "organized group" has a significant voting interest. The acquirer usually is the company that has a single owner or organized group that holds the largest minority voting interest. The factor in this case appears to be neutral.
• The composition of the governing body of the combined entity. The acquirer usually is the company whose owners have the ability to elect or appoint a majority of the members of the governing body. In this case, at least initially, a majority of the governing body of the combined entity will be comprised of former CenturyTel board members.
• The composition of the senior management of the combined entity. The acquirer usually is the company with former management that dominates the management of the combined company. It would seem that this factor clearly points to CenturyTel as being the acquirer.
• The terms of the exchange. Ordinarily, the acquirer is the company that pays a premium over the pre-combination fair value of the equity interests of the merger partner. This factor too seems unmistakably to point to CenturyTel as the acquirer.
• The acquirer usually is the combining company with a relative size (measured, for example, in terms of assets, revenues, or earnings) that is "significantly larger" than that of its merger partner. This factor falls squarely on the side of Embarq's claim to status as the acquirer.

Taken together, some factors point to CenturyTel as being the acquirer. For example, CenturyTel is the issuing entity, it is paying a premium to Embarq shareholders, and its loyalists will comprise a majority of the governing body and senior management of the combining company.

Yet concurrently, there are persuasive factors supports a claim by Embarq as being the acquirer, including the fact that its shareholders emerge with the largest percentage of the voting rights, and that Embarq is by far the dominant constituent with regard to its relative size. All the same, it is our view that in the final analysis CenturyTel will emerge as the acquirer in this business combination.

Oddly, this resolution of the issue seems to give rise to a greater "basis step-up" — and therefore a larger post-combination non-cash charge and correspondingly lower earnings — than would be the case if Embarq was identified as the acquirer. Witness the situation if Embarq was identified as the acquiring company in a reverse acquisition. In that case, the acquisition date fair value of the consideration transferred by the acquirer is based on the number of equity interests the "legal subsidiary" (Embarq) would have had to issue to give the owners of the "legal parent" (CenturyTel) the same percentage equity interest in the combined entity.

It appears, then that Embarq would be viewed as issuing some 77 million shares. And depending on where the stock price sits at the effective date of the business combination, the value of these hypothetically issued shares might even fall below the net fair value of the legal parent's assets. Accordingly, if this business combination was accounted for as a reverse acquisition, "negative goodwill" might arise. In addition, the negative goodwill would be included in earnings for the period in which the business combination takes place.

If however, as we expect, CenturyTel is identified as the acquirer, an increase in the carrying amount of Embarq's assets is likely to ensue. That would result in the earnings of the post-combination company being penalized by the need to depreciate and amortize those higher values — as opposed to the pre-combination amounts reflected on Embarq's financial statements.

In any event, given the subjective nature of the determination, a case can be easily made for labeling either constituent as the acquirer. Therefore, the post-acquisition earnings impact of the transaction might, in some sense, be regarded as unduly within the discretion of management and their advisers.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for

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