In the UK, Part 17 of the Companies Act 2006 dictates the accounting for share capital being issued. Legislation has established a number of statutory reserves, including share premium, capital redemption reserve and share capital. The regulations restrict what statutory reserves can be used for. This article highlights the requirements of accounting for share issues as part of a share for share exchange, often as a result of a group’s reconstruction, and the implications for the statutory reserves. Merger relief amends the “standard” double entry for certain share issues.
The accounting for an issue of shares for cash is:
When shares are issued as part of a share for share exchange, instead of debiting bank, the debit is to investments:
Share for share exchanges often occur as part of a group reconstruction, through changing the parent company to another group entity or adding an intermediate parent into the structure. The basic rule within UK regulation is that shares are issued for the value of consideration received in the exchange. Section 612 of the Act includes a mandatory relief, which must be adopted when the relevant criteria (see below) are met. This prevents the excess of the consideration received above the nominal value of the shares issued being recognised as share premium. This relief is merger relief.
The qualifying criteria for merger relief is at least a 90% equity holding in another company is obtained by the company issuing shares. During most group reconstructions, inserting a new intermediate or ultimate parent company, or transferring ownership of subsidiaries around the group, the 90% threshold is obtained.
The company issuing the shares has a choice of accounting for the shares at their nominal value or at their fair value if they adopt FRS 102. Their fair value is their stake in their newly obtained subsidiary. If the company chooses to recognise the transaction at its fair value, a non-statutory and non-distributable reserve is created, often named a merger reserve or a merger relief reserve.
For example, a new parent company has been incorporated and has issued 100 ordinary shares of £1 each for the entire share capital of its subsidiary. The subsidiary has a fair value of £10,000,000.
The new parent company has a choice of recognising either:
OR
For IFRS reporters, who have adopted the cost model for their investment in subsidiaries, IAS 27 requires that the new parent measures the cost of their investment as their share of the original parent’s equity items, as shown in the original parent’s separate financial statements at the date of the reorganisation. Measuring the cost of investment at the nominal value of the shares issued is not permitted. Using the example above, the net equity included in the subsidiary’s own financial statements when the re-organisation occurred was £2,000,000. The double entry for the investment would be:
The merger reserve/merger relief reserve isn’t a statutory reserve or distributable. Subject to any restrictions within the issuing company’s articles of association, the merger reserve/merger relief reserve can be used to issue shares. A reduction in share capital can be undertaken to create distributable reserves.
A transfer between the merger reserve/merger relief reserve and the profit and loss reserve can also be made when the investment has been impaired or has been disposed of.
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