Accounting for goodwill in China: a case study of two-step acquisitions

ABSTRACT

We use a case study to illustrate how different acquisition methods can result in different amounts of goodwill recognised on financial statements in China. China Merchants Bank adopted a two-step acquisition method: first, it acquired 53% of the shares of Hong Kong’s Wing Lung Bank to gain corporate control in 2008; second, it acquired the remaining 47% of shares in 2009. Using this method, China Merchants Bank recognised the acquisition premium as goodwill only in the first step and recognised the acquisition premium in the second step as a decrease in additional paid-in capital. This two-step acquisition method significantly reduces the amount of goodwill shown on financial statements and lowers the likelihood and amount of subsequent goodwill impairment. Different acquisition methods can lead to different amounts of goodwill initially recognised when accounting standards permit the partial goodwill method and regard the transactions between the parent and non-controlling shareholders as equity transactions.

KEYWORDS:

• Accounting standard
• goodwill
• two-step acquisition
• China

1. Introduction

Goodwill of public firms has grown rapidly in China due to the rise of high-premium merger and acquisition (M&A) transactions. By the end of 2020, the total book value of goodwill of all A-share firms had reached 1,179.7 billion yuan (the Chinese currency), which was 8.55 times that in 2011.¹ If goodwill is impaired, the large amount of goodwill would have a significant negative impact on accounting performance. Therefore, managers have strong incentives to manipulate goodwill impairment. Some avoid reporting goodwill impairment losses until the next M&A, management turnover, or serious deterioration of the macroeconomic situation; others recognise staggering losses of up to billions of yuan all at once.

Prior studies focus mainly on managers’ manipulation in subsequent goodwill impairment tests. In such manipulation, managers can fail to recognise adequate goodwill impairment losses or take a big bath (Filip et al., 2015; Ramanna & Watts, 2012). However, goodwill is derived from M&A transactions. There is still a lack of evidence on whether managers will choose an M&A method that is conducive to reducing the amount of goodwill initially recognised on financial statements to reduce the risk of goodwill impairment in the future. Of course, the M&A method an acquirer adopts is also affected by various economic factors, such as the price negotiation between the acquirer and the acquiree, the complexity of the acquisition, the popularity of the acquiree, the payment method and financing cost of the acquirer, and the legal or regulatory restrictions on M&A. We only argue that the amount of goodwill recognised on financial statements can be one factor that the acquirer considers when choosing different acquisition methods.

For business combinations not under common control, different M&A methods adopted by the acquirer can result in different amounts of goodwill initially recognised. In general, there are three M&A methods. First, the acquirer can complete M&A all at once (we term this ‘Method 1’). Under Method 1, the acquirer should recognise the goodwill corresponding to all the equity purchased. Second, the acquirer can purchase part of the equity without gaining corporate control in the first step, then purchase the equity necessary to gain corporate control in the second step (‘Method 2’). Under Method 2, the acquirer should recognise the goodwill corresponding to all the equity purchased when the acquirer gains corporate control in the second step. In the meantime, the acquirer should remeasure the value of the equity acquired in the first step and recognise any value changes of the equity as current profits or losses. Third, the acquirer can purchase part of the equity to gain corporate control in the first step and then purchase the non-controlling interests (NCIs) in the second step (‘Method 3’). Under Method 3, the acquirer should recognise goodwill only when it gains corporate control in the first step. The purchase of the NCIs shall be accounted for as an equity transaction, and the premium shall be recognised against the additional paid-in capital of the parent.

All three M&A methods can entail trade-offs between current and future accounting performance. Under Method 2, revaluation of equity acquired in the first step often improves current performance (given the general upward trend in the acquiree’s stock price). Under Method 3, the lower amount of goodwill initially recognised can reduce the risk of future goodwill impairment. Consequently, when an acquirer faces greater earnings pressure in the period of gaining control, it may choose Method 2, through which the acquirer can remeasure the equity interest acquired from the first step and recognise any possible gains in the second step. In contrast, when the acquirer faces higher future operating risks, it may choose Method 3 to lower the amount of goodwill initially recognised so as to avoid goodwill impairment in the future. Nevertheless, even if a firm aims to reduce the amount of recognised goodwill through the adoption of Method 3, its ability to implement this approach may be limited by various economic factors, including competition from other bidders, as well as regulatory approval and oversight from government agencies. Moreover, a firm’s choice of Method 3 to acquire a target does not mean that its only purpose in doing so is to lower the amount of goodwill recognised. Despite these caveats, it is important to understand the implications of different M&A methods for accounting for goodwill.

We explore the theoretical bases behind the accounting standards in different jurisdictions. Accounting standard setters’ selection of the partial or full goodwill method and their view of the nature of transactions between the parent and the NCIs have important implications for the amount of goodwill recognised. When the accounting standards, such as International Financial Reporting Standards (IFRS), permit the partial goodwill method and regard changes in a parent’s ownership interest while the parent retains its controlling interest in its subsidiary as equity transactions, purchasing part of the equity to gain control in the first step and then purchasing the noncontrolling shareholders’ equity in the second step can reduce the amount of goodwill recognised and reduce the risk of goodwill impairment in the future.²

In our case study of China Merchants Bank’s (CMB) acquisition of Hong Kong’s Wing Lung Bank (WLB), we analyse the accounting implications of CMB’s M&A methods. We argue that partly due to lower short-term earnings pressure but higher future operational uncertainty, CMB adopted Method 3, i.e. acquiring 53% of WLB’s shares to gain control in the first step, and then acquiring the remaining 47% of shares in the second step. In the first step, CMB accounted for the goodwill of 53% of shares at about 10,200 million yuan. In the second step, it accounted for the acquisition premium at about 9,200 million yuan as a decrease in additional paid-in capital. It significantly reduced the amount of goodwill initially recognised, thereby lowering its risk of future goodwill impairment.

This paper offers two main contributions to the literature. First, it explores the economic consequences of accounting standards for business combinations. Bartov et al. (2021) find a significant increase in overbidding when accounting standards changed from a periodic amortisation plus impairment to a pure impairment regime under U.S. Statement of Financial Accounting Standards (SFAS) 142. While they investigate the role that the subsequent measurement of goodwill plays in the bidding decision, we discuss how accounting standards requiring different initial recognition of goodwill can potentially affect the M&A methods adopted by firms, which leads to different goodwill impairment risks in the future. Second, while several studies examine the discretion of managers to delay goodwill impairment in post-acquisition periods (Beatty & Weber, 2006; Ramanna & Watts, 2012, Filip et al., 2015; Li & Sloan, 2017), little attention has been paid to tracing goodwill impairment back to original acquisitions, except in the case of overpayment (Gu & Lev, 2011; Hayn & Hughes, 2006; Li et al., 2011). This paper discusses the influence of different M&A methods on goodwill recognition and thus subsequent impairment.

2. Related literature

2.1. Earnings management

Prior studies show that because goodwill impairment is highly subjective and unverifiable under the pure impairment model, managers use their discretion over the amount and timing of goodwill impairment to manipulate earnings. Beatty and Weber (2006) provide evidence that managers tend to delay recognition of impairment losses when firms have earnings-based bonus plans or debt covenants affected by accounting changes, when the CEOs have longer tenure, and when firms are listed on exchanges whose listing requirements are based on financial metrics. Ramanna and Watts (2012) also find that managers use discretion to opportunistically avoid goodwill impairment.³

Prior research has also explored how managers manipulate goodwill impairment. Filip et al. (2015) find that managers manipulate upward current cash flows to avoid recognising goodwill impairment losses, and this real earnings management seriously damages firms’ future performance. Ramanna and Watts (2012) show that managers can selectively allocate goodwill to reporting units to avoid or overstate impairment losses. Goodwill can be allocated to high-growth units masked by internally generated growth options to delay impairment or to low-growth units to accelerate impairment. In the past few years, the International Accounting Standards Board (IASB) tried to rectify this problem by proposing the use of fair value (via the ‘headroom’ method and ‘updated headroom’ method) in its effort to improve the goodwill impairment model, but it finally gave up due to the controversial theoretical bases, operational difficulty, and subjectivity involved (IASB, 2020).

2.2. Characteristics of M&A transactions

Goodwill is generated in the process of M&A under the purchase method as required by accounting standards. As a result, the characteristics of M&A transactions also affect the subsequent impairment of goodwill. Prior studies focus mainly on the impact of acquisition premiums on goodwill impairment. Hayn and Hughes (2006) find that the characteristics of the original acquisitions, such as initial overpayment, the percentage of the purchase price assigned to goodwill, and the mode of consideration given, are powerful indicators of future goodwill write-offs. Gu and Lev (2011) find that share overpricing leads to the growth of accounting goodwill and predicts goodwill write-offs and their magnitudes. Li et al. (2011) find that overpayment for targets can predict subsequent goodwill impairment.

In summary, most prior studies demonstrate that managers use their discretion to manipulate goodwill impairment in post-acquisition and that an acquirer’s overbidding may result in greater goodwill write-offs. None of these papers directly examine the role that accounting standards play in firms’ choice of M&A method or the corresponding accounting outcome of the goodwill amount initially recognised. Our research fills this gap in the accounting literature by examining the case of CMB’s acquisition of WLB. In this case study, we discuss how the two-step acquisition method reduces the amount of goodwill initially recognised, thereby reducing the likelihood of recognising future goodwill impairment.

3. M&A methods and their impacts on goodwill recognition and impairment

According to International Financial Reporting Standards (IFRS) 3 and U.S. Statement of Financial Accounting Standards (SFAS) 141 (R), different M&A methods adopted by the acquirer can result in different amounts of goodwill recognised in business combinations not under common control. Table 1 shows the different M&A methods and their corresponding accounting outcomes under different accounting bases.

Table 1. M&A methods and accounting outcomes under IFRS 3 and SFAS 141 (R).

Accounting Basis	Complete the acquisition all at once (Method 1)	Purchase the equity without gaining control in Step 1, and then purchase the equity to gain control in Step 2 (Method 2)	Purchase the equity to gain control in Step 1, and then purchase the NCIs in Step 2 (Method 3)
IFRS 3	Recognise the goodwill of purchased equity (partial goodwill) or 100% equity (full goodwill)	Recognise partial or full goodwill when gaining control in Step 2	Recognise partial or full goodwill when gaining control in Step 1, and account for the purchase premium against additional paid-in capital in Step 2
		Remeasure previously held equity interests at fair value and recognise profits or losses in Step 2	Do not remeasure previously held equity interests at fair value and do not recognise profits or losses in Step 2
SFAS  141 (R)	Recognise the goodwill of 100% equity (full goodwill) when gaining control in either step
		Remeasure previously held equity interests at fair value and recognise profits or losses in Step 2	Do not remeasure previously held equity interests at fair value and do not recognise profits or losses in Step 2

First, the acquirer can complete the acquisition all at once (Method 1). According to IFRS 3, the acquirer shall recognise goodwill measured as the excess of the fair value of considerations given and the amounts of NCIs over the net fair value of the identifiable assets acquired and the liabilities assumed. When the NCIs are measured at fair value, the acquirer recognises 100% goodwill of all the equity of the acquiree (full goodwill). When the NCIs are measured at their proportional interest in the identifiable assets acquired and liabilities assumed, the acquirer recognises the goodwill corresponding to the purchased equity (partial goodwill). SFAS 141 (R) requires the acquirer to recognise full goodwill, while IFRS 3 gives a choice and allows the acquirer to recognise full or partial goodwill.

Second, the acquirer can purchase part of the equity without gaining corporate control in the first step and then purchase the equity to gain corporate control (Method 2). The acquirer does not recognise any goodwill in step one. In step two, IFRS 3 allows the acquirer to recognise full or partial goodwill, while SFAS 141 (R) requires the acquirer to recognise full goodwill. Under both IFRS 3 and SFAS 141 (R), the acquirer shall remeasure its previously held equity interest in the acquiree at its acquisition-date fair value and recognise the resulting gain or loss, if any, in profits or losses.

Third, the acquirer can purchase part of the equity to gain corporate control in the first step and then purchase the NCIs (Method 3). IFRS 3 allows the acquirer to recognise only the goodwill corresponding to the equity purchased in the first step when gaining control (partial goodwill) or the goodwill of all the equity of the acquiree (full goodwill). When the acquirer subsequently purchases additional shares from the NCIs, the transaction shall be accounted for as an equity transaction. The carrying amount of the NCIs shall be adjusted to reflect the changes in its ownership interests in the subsidiary. Any difference between the fair value of the consideration received or paid and the amounts by which the NCIs are adjusted shall be recognised in equity attributable to the parent. However, the acquirer does not need to remeasure previously held equity interests in the acquiree. No gain or loss shall be recognised in consolidated net income or comprehensive income in the second step.

When accounting standards allow the acquirer to recognise partial goodwill, different M&A methods entail trade-offs between current and future accounting performance. Under Method 2, the acquirer can remeasure previously held equity interests in the acquiree and recognise any profits in the period of gaining control, but the acquirer should recognise a larger amount of goodwill, which will increase the likelihood of subsequent goodwill impairment. Under Method 3, the acquirer can reduce the initial amount of goodwill recognised, thereby reducing the likelihood of goodwill impairment in the future, but the acquirer gives up the opportunity to remeasure previously held equity interests and recognise any profits in the current period. Different accounting outcomes may induce the acquirer to select different M&A methods according to its motivations. When the acquirer faces earnings pressure in the period in which it gains control, it may choose Method 2 to improve current accounting performance. When the acquirer faces greater operating risks in the future, it may choose Method 3 to reduce the likelihood of recognising goodwill impairment in the future.

We use a simple example to illustrate the accounting of the three M&A methods under IFRS 3 and SFAS 141 (R). Suppose that Firm A plans to acquire 80% of Firm B’s equity. According to the preceding analysis, Firm A can choose one of three M&A methods:

Scenario 1: Firm A completes the acquisition all at once. In one step, Firm A acquires 80% of Firm B’s equity with 8 million yuan. On the acquisition date, the net fair value of identifiable assets acquired and liabilities assumed is 9 million yuan, and the fair value of NCIs is 2 million yuan.

Scenario 2: Firm A purchases part of Firm B’s equity without gaining control in Step 1; in Step 2, it purchases the additional equity required to gain control. In Step 1, Firm A acquires 20% of Firm B’s equity with 2 million yuan. The net fair value of identifiable assets acquired and liabilities assumed is 9 million yuan on that day. In Step 2, Firm A acquires 60% of Firm B’s equity with 6.6 million yuan. The revaluation of the 20% equity previously held by Firm A is 2.2 million yuan. The net fair value of identifiable assets acquired and liabilities assumed of Firm B is 9.9 million yuan, and the fair value of NCIs is 2.2 million yuan.

Scenario 3: Firm A purchases enough of the equity to gain control in Step 1 and then goes on to purchase the NCIs. In Step 1, Firm A acquires 60% of Firm B’s equity with 6 million yuan. The net fair value of identifiable assets acquired and liabilities assumed is 9 million yuan, and the fair value of NCIs is 4 million yuan. In Step 2, Firm A acquires 20% of Firm B’s equity with 2.2 million yuan.

Table 2 shows the accounting entries of the above scenarios using the three M&A methods under IFRS 3 and SFAS 141 (R). For simplicity, we show only the entries for the partial goodwill method under IFRS 3. We make four general observations. First, in all scenarios, the amount of goodwill recognised is smaller under the partial goodwill method than under the full goodwill method. Second, under the partial goodwill method, Scenario 3 yields the lowest amount of goodwill recognised. Third, under the full goodwill method, Scenario 3 yields the same amount of goodwill as Scenario 1. Fourth, Scenario 2 yields the highest amount of goodwill recognised under both the partial and the full goodwill methods (given the increase in the acquiree’s stock price). We discuss the implications of these accounting outcomes in more detail in our case study below.

Table 2. The accounting entries for the three M&A methods under IFRS 3 and SFAS 141 (R).

Accounting Basis	Scenario 1 Complete the acquisition all at once	Scenario 2 Purchase the equity without gaining control in Step 1, and then purchase the equity to gain control in Step 2	Scenario 3 Purchase the equity to gain control in Step 1, and then purchase the NCIs in Step 2
IFRS 3 Partial goodwill	Parent statement: Dr. Long-term equity investment 8 Cr. Consideration given 8 Consolidated statement: Dr. Net assets 9 Dr. Goodwill 0.8 (8–9 × 80%) Cr. Long-term equity investment 8 Cr. NCIs 1.8	Step 1 Parent statement: Dr. Long-term equity investment 2 Cr. Consideration given 2 Step 2 Remeasure the previous 20% equity Parent statement: Dr. Long-term equity investment 0.2 Cr. Profit 0.2 Purchase 60% equity Parent statement: Dr. Long-term equity investment 6.6 Cr. Consideration given 6.6 Consolidated statement: Dr. Net assets 9.9 Dr. Goodwill 0.88 (8.8–9.9 × 80%) Cr. Long-term equity investment 8.8 Cr. NCIs 1.98	Step 1 Parent statement: Dr. Long-term equity investment 6 Cr. Consideration given 6 Consolidated statement: Dr. Net assets 9 Dr. Goodwill 0.6 (6–9 × 60%） Cr. Long-term equity investment 6 Cr. NCIs 3.6 Step 2 Parent statement: Dr. Long-term equity investment 2.2 Cr. Consideration given 2.2 Consolidated statement: Dr. NCIs 1.8 Dr. Additional paid-in capital 0.4 (2.2–3.6 × 50%) Cr. Long-term equity investment 2.2
SFAS 141 (R) Full goodwill	Parent statement: Dr. Long-term equity investment 8 Cr. Consideration given 8 Consolidated statement: Dr. Net assets 9 Dr. Goodwill 1 (8 + 2–9) Cr. Long-term equity investment 8 Cr. NCIs 2	Step 1 Parent statement: Dr. Long-term equity investment 2 Cr. Consideration given 2 Step 2 Remeasure the previous 20% equity Parent statement: Dr. Long-term equity investment 0.2 Cr. Profit 0.2 Purchase 60% equity Parent statement: Dr. Long-term equity investment 6.6 Cr. Consideration given 6.6 Consolidated statement: Dr. Net assets 9.9 Dr. Goodwill 1.1 (8.8 + 2.2–9.9) Cr. Long-term equity investment 8.8 Cr. NCIs 2.2	Step 1 Parent statement: Dr. Long-term equity investment 6 Cr. Consideration given 6 Consolidated statement: Dr. Net assets 9 Dr. Goodwill 1 Cr. Long-term equity investment 6 Cr. NCIs 4 Step 2 Parent statement: Dr. Long-term equity investment 2.2 Cr. Consideration given 2.2 Consolidated statement: Dr. NCIs 2 Dr. Additional Paid-in capital 0.2 (2.2–4 × 50%) Cr. Long-term equity investment 2.2

4. Case selection

Many M&A transactions in China follow a two-step acquisition method (i.e. Method 3). For example, Kingswood Education’s acquisition of Longmen Education, Anysoft Information’s acquisition of SuperElectron, and Sunshine Laser’s acquisition of Tongyu Airline are all two-step acquisitions. In the banking sector, five out of the ten most profitable listed banks in mainland China (including CMB) have engaged in two-step acquisitions. These include Industrial and Commercial Bank of China (ICBC)’s acquisition of the Union Bank of Hong Kong, ICBC’s acquisition of Turkey’s bank Tekstilbank, China Construction Bank’s (CCB) acquisition of Brazil’s bank BIC, Industrial Bank’s acquisition of Union Trust, China International Trust and Investment Corporation (CITIC) Bank’s acquisition of CITIC International Financial Holdings Limited, and CMB’s acquisition of WLB. We take CMB’s acquisition of WLB as our case study for the following three reasons.

First, CMB’s acquisition of WLB was the largest M&A transaction between a listed bank in mainland China and a bank in Hong Kong at that time. Table 3 lists mergers between listed banks in mainland China and banks in Hong Kong. Most M&A with banks in Hong Kong took place before 2009, and CMB’s acquisition of WLB was the largest. After WLB announced its intention to sell its shares, it attracted attention from domestic and foreign banks. The acquisition price rose continuously. In the end, CMB won the bid, and the sale was the biggest M&A transaction in Hong Kong at that time.

Table 3. Mergers between a listed bank in mainland China and a bank in Hong Kong.

Acquisition year	M&A transaction details	Acquisition price (million HK dollars)
1986	CITIC acquired majority ownership stakes of Ka Wah Bank	/
1994	CCB acquired 40% ownership stakes of Industrial and Commercial Bank of Hong Kong (ICBHK)	/
1998	CCB increased its ownership stakes of ICBHK to 70%	/
2000	ICBC acquired 53% ownership stakes of Union Bank of Hong Kong	1,805
2001	BOC acquired 70% ownership stakes of Chiyu Bank	/
2001	BOC acquired 100% ownership stakes of Nanyang Commercial Bank	/
2002	CITIC Ka Wah Bank merged with Hong Kong Chinese Bank	4,200
2002	CCB increased its ownership stakes of ICBHK to 100%	105
2003	ICBC acquired 100% ownership stakes of Fortis Bank in Hong Kong	2,150
2004	ICBC acquired 100% ownership stakes of Huashang Bank	749
2006	CCB acquired 100% ownership stakes of Bank of America (Asia)	9,710
2008	CMB acquired 53% ownership stakes of WLB	19,300
2009	CMB increased its ownership stakes of WLB to 100%	17,000

(1) Data are from the official websites of the acquirers or the news media. (2) We are unable to obtain the acquisition prices and the acquired ownership stakes of some M&A transactions from public sources because they happened too early. For these transactions, we note ‘/’ in the ‘Acquisition price’ column and omit the specific acquisition stakes from the ‘M&A transaction details’ column.

Second, the effects of CMB’s two-step acquisition method (Method 3) and whether the high premium paid by CMB was reasonable triggered widespread discussions. Thus, this setting enables us to provide evidence to inform discussions on a controversial topic.

Third, it is necessary to have a long window to study the effects of M&A and whether the excess profitability represented by goodwill is realised. It has been more than 10 years since CMB acquired WLB. This long window allows us to fully observe the effects of CMB’s acquisition of WLB and evaluate whether the goodwill has been impaired.

CMB was founded in 1987. It was listed on the Shanghai Stock Exchange in 2002 and on the Hong Kong Stock Exchange in 2006. It is the first joint-stock commercial bank in mainland China to be fully owned by corporate entities. In 2021, Euromoney recognised CMB as the Best Bank in China for the third consecutive year, creating the first triple crown in the history of this award.

CMB is one of the most profitable banks in China. Figure 1 shows the operating income and net income of CMB from 2002 to 2020. The operating income and net income of CMB have increased rapidly since it was listed. While CMB suffered a temporary drop in net income when it completed the acquisition of WLB in 2009, CMB’s operating income and net income continued to grow after that. Table 4 lists the five most profitable listed banks in mainland China in 2020. They were ICBC, CCB, Agricultural Bank of China (ABC), Bank of China (BOC), and CMB. Although CMB’s earnings scale was ranked fifth, its three-year compound growth rates of operating income and net income ranked first. The results show that CMB has the strongest growth among these banks.

Figure 1. CMB’s operating income and net income from 2002 to 2020.

Table 4. Five most profitable listed banks in mainland China in 2020.

Rank	Bank	Operating income (100 million yuan)	Net income (100 million yuan)	Three-year compound growth rate of operating income	Three-year compound growth rate of net income
1	ICBC	8,827	3,177	7%	3%
2	CCB	7,559	2,736	7%	4%
3	ABC	6,580	2,164	7%	4%
4	BOC	5,655	2,051	5%	4%
5	CMB	2,905	980	10%	12%

Data sources: Annual reports of ICBC, CCB, ABC, BOC, and CMB.

CMB is less subject to government control than other Chinese banks. The Chinese government is the No. 1 shareholder of China’s four largest banks: ICBC, CCB, ABC, and BOC. Hence, they are controlled by the state. In contrast, CMB’s shareholder structure is more dispersed, and there is no de facto controller. As of 31 December 2020, CMB’s largest shareholder was Hong Kong Securities Clearing Company Ltd (HKSCC), which is an agent aggregating all of CMB’s H-shares, with stakes of about 18.04%.⁴ The second-largest shareholder was China Merchants Shipping, a state-owned enterprise with stakes of about 13.04%.

5. Case study

5.1. CMB’s acquisition of WLB

WLB was founded in 1933 as a local bank in Hong Kong controlled by the Wu family. The strategic reasons for CMB’s acquisition of WLB are as follows. First, CMB could expand its operation in the Hong Kong market and promote its global strategy. Second, CMB could optimise its business structure and adjust its business strategy in banking services by integrating with WLB. Finally, CMB could speed up the pace of comprehensive financial services with the help of WLB.

CMB took two steps to complete the acquisition of WLB. As Table 5 shows, CMB first purchased part of the equity to gain control of WLB, and then it purchased the NCIs to complete the full acquisition (Method 3). On 30 September 2008, CMB bought about 53% of WLB’s shares for about 19,300 million Hong Kong dollars and gained control. Subsequently, on 15 January 2009, CMB bought the remaining about 47% of shares for about 17,000 million Hong Kong dollars. CMB chose the partial goodwill method to account for this combination, as allowed by IFRS 3. CMB recognised about 53% of goodwill worth about 10,200 million yuan when it gained control in the first step. The premium of the remaining about 47% of shares was recognised as a decrease in additional paid-in capital.

Table 5. CMB’s acquisition of WLB.

M&A process	The first step	The second step
Completion date	September 30, 2008	January 15, 2009
Proportion of equity acquired	53%	47%
Consideration	19,300 million HK dollars	17,000 million HK dollars
Premium	10,200 million yuan	9,200 million yuan
Accounting entry for the premium	Goodwill	Additional paid-in capital

Data sources: M&A premium in the second step comes from the amount of additional paid-in capital – acquisition of noncontrolling shareholders’ equity recorded in CMB’s annual reports from 2008 and 2009.

5.2. Implications of M&A method 3

As mentioned above, different M&A methods entail trade-offs between current and future accounting performance. Method 2 helps to increase current performance (in the presence of the acquiree’s stock price increases), while Method 3 helps to reduce the likelihood of future goodwill impairment. CMB likely focused more on future accounting performance for the following reasons. First, CMB faced less short-term earnings pressure. Table 6 shows CMB’s profits before its acquisition of WLB. CMB’s net income continued to grow rapidly from its listing on the Shanghai Stock Exchange in 2002 to its acquisition of WLB in 2008. Its net income more than doubled in 2007, shortly after its listing on the Hong Kong Stock Exchange in 2006. This means that CMB had little short-term earnings pressure and had a weak motivation to choose Method 2, which would have allowed CMB to remeasure previously held equity to improve current accounting performance.

Table 6. Profits of CMB from 2002 to 2008.

Profit	2002	2003	2004	2005	2006	2007	2008
Net income (100 million yuan)	17.3	22.3	31.4	37.9	67.9	152.4	209.5
Net income growth rate	26%	29%	41%	21%	79%	124%	37%

Data sources: Annual reports of CMB.

Second, CMB faced relatively greater future operational risk arising from the acquisition of WLB, for three reasons. In terms of WLB’s profitability, WLB was a medium-sized bank in Hong Kong. Its living space was shrinking rapidly under the pressure of HSBC, Standard Chartered (Hong Kong), and other large banks as competition intensified in Hong Kong’s banking market. As Table 7 shows, WLB had a slow and fluctuating net income growth rate before being acquired by CMB. WLB suffered a net loss in 2008 when the combination started. There was great uncertainty about whether CMB could reverse WLB’s profit decline and create synergistic effects after its acquisition.

Table 7. Profits of WLB from 1998 to 2008.

Profit	1998	1999	2000	2001	2002	2003	2004	2005	2006	2007	2008
Net income (100 million HK dollars)	6.0	8.6	10.1	8.5	7.6	8.6	10.3	11.1	16.1	13.7	−8.2
Net income growth rate	-	43%	17%	−16%	−11%	13%	20%	8%	45%	−15%	−160%

Data sources: The official website of China Merchants Wing Lung Bank (the new name of WLB). The data start from 1998 because the earliest annual report on the website was from 2002, and a five-year financial overview is included in the 2002 annual report.

In terms of CMB’s profitability, the acquisition premium accounted for a large proportion of CMB’s net income. As Table 8 shows, the two acquisition premiums together exceeded half of CMB’s net income before 2012. It indicates that the amount of goodwill initially recognised would significantly increase if the two acquisition premiums were included in goodwill. If goodwill impairment happened in the future, it would seriously drag down CMB’s net income.

Table 8. Premium as a percentage of net income of CMB from 2008 to 2020.

Profit	2008	2009	2010	2011	2012	2013	2014	2015	2016	2017	2018	2019	2020
Net income (100 million yuan)	209.5	182.4	257.7	361.3	452.7	517.4	560.5	580.2	623.8	706.4	808.2	934.2	979.6
The first premium as a percentage of net income	49%	56%	40%	28%	23%	20%	18%	18%	16%	14%	13%	11%	10%
The two premiums as a percentage of net income	93%	106%	75%	54%	43%	37%	35%	33%	31%	27%	24%	21%	20%

Data sources: Annual reports of CMB.

In terms of capital market effects, some investors believed that the acquisition price CMB paid was too high. They doubted that the merger merited the high premium and would create significant synergies.

CMB’s fluctuating stock price and its negative cumulative abnormal returns further illustrate investors’ reactions to the acquisition. Figure 2 shows the stock price fluctuations of CMB in the ten trading days before and after June 3, when CMB announced that it would acquire 53% of WLB’s shares. After June 3, CMB’s share price fell sharply. CMB also experienced negative cumulative abnormal returns after the announcement date. We calculate the cumulative abnormal returns (CAR) of this M&A event as follows. We use T to denote the day. When T equals 0, it represents the event day. When T is negative, it represents days before the event. When T is positive, it represents the days after the event. We use CAR [T₁, T₂] to represent the cumulative abnormal returns for the event window from T₁ to T₂. The event day is June 3, when CMB first announced the acquisition. We use the market model to compute the expected returns, with the estimation window 200 days from T=-220 to T=-21. We use several event windows to calculate CAR. As Table 9 shows, the cumulative abnormal returns of the acquisition are all negative, suggesting that investors had a negative evaluation of the high-premium merger. The above analysis suggests that CMB faced great pressure from the capital market, which sees a large amount of goodwill as a dangerous signal. If CMB were to recognise a large amount of goodwill impairment in the future, it would significantly drag down the accounting performance of CMB, which might trigger investors’ negative reaction.

Figure 2. Stock price fluctuations in the ten trading days before and after CMB announced its acquisition of WLB.

Table 9. Cumulative abnormal returns around CMB’s acquisition of WLB.

CAR [0,1]	CAR [0,2]	CAR [0,3]	CAR [−1,1]	CAR [−2,2]	CAR [−3,3]
−0.0134	−0.0219	−0.0263	−0.0209	−0.0214	−0.0249

Data sources: China Stock Market and Accounting Research Database (CSMAR).

For the reasons explained above, CMB faced greater future operational risks after its acquisition of WLB. Hence, Method 3 was an advantageous choice because it reduced the possible impact of a huge amount of goodwill on future accounting performance. That is, purchasing part of the equity to gain corporate control in the first step and then purchasing the NCIs in the second step allowed CMB to reduce the amount of goodwill initially recognised and to reduce the risk of recognising goodwill impairment in the future.

5.3. CMB’s post-acquisition performance

Despite the concerns over CMB’s high-premium acquisition of WLB, CMB’s management believed that the acquisition was important to the transformation of CMB’s business strategy and that investors should take a long-term view of the acquisition. The vice president of CMB and the new CEO of WLB noted, ‘the acquisition will certainly make the investors of CMB feel worthy in three to five years’.⁵ In this sub-section, we analyse CMB’s post-acquisition performance to see whether the bank has realised its goal.

First, as Table 10 shows, WLB suffered a significant loss due to the fierce market competition in Hong Kong and the negative impact of the global financial crisis of 2008. WLB weathered the difficulties, and its profitability improved to a large extent after the completion of the merger in 2009. However, the growth rates of WLB’s operating income and net income began to decline significantly in 2015, and both experienced negative growth in 2020. We compare the performance of other Hong Kong banks that merged with banks in mainland China during the same period. In 2000, ICBC acquired Union Bank of Hong Kong and later renamed it ICBC (Asia). In 2002, CITIC Ka Wah Bank acquired Hong Kong Chinese Bank and later renamed it CITIC Bank (International). As Table 10 shows, the growth rates of ICBC (Asia) and CITIC Bank (International) have also declined significantly since 2015, and both had negative growth in 2020. This table shows that banks in Hong Kong have generally suffered earnings hits since 2015, and they were also greatly affected by the COVID-19 pandemic in 2020.

Table 10. Profits of WLB, ICBC (Asia), and CITIC Bank (international) from 2008 to 2020.

Bank	Profit	2008	2009	2010	2011	2012	2013	2014	2015	2016	2017	2018	2019	2020
WLB	Operating income (100 million HK dollars)	12.2	26.4	29.3	38.1	41.1	48.5	59.9	63.1	62.6	61.3	64.7	74.0	63.5
	Operating income growth rate	−56%	116%	11%	30%	8%	18%	24%	5%	−1%	−2%	6%	14%	−14%
	Net income (100 million HK dollars)	−8.2	8.8	13.5	18.7	21.2	25.9	31.6	32.7	35.1	38.6	32.2	39.9	28.7
	Net income growth rate	−160%	207%	53%	39%	13%	22%	22%	3%	7%	10%	−17%	24%	−28%
ICBC (Asia)	Operating income (100 million HK dollars)	37.5	41.9	47.1	62.3	74.5	88.2	104.5	114.8	124.1	126.3	147.4	149.8	125.7
	Operating income growth rate	18%	12%	12%	32%	20%	18%	18%	10%	8%	2%	17%	2%	−16%
	Net income (100 million HK dollars)	9.7	25.2	30.0	31.5	40.1	52.6	63.7	67.8	74.0	77.7	82.8	83.0	55.3
	Net income growth rate	−40%	160%	19%	5%	27%	31%	21%	6%	9%	5%	7%	0%	−33%
CITIC Bank (International)	Operating income (100 million HK dollars)	18.5	31.9	30.1	34.2	37.2	47.5	60.1	58.3	64.1	78.7	84.1	83.5	73.6
	Operating income growth rate	42%	72%	−6%	14%	9%	28%	27%	−3%	10%	23%	7%	−1%	−12%
	Net income (100 million HK dollars)	1.3	9.5	10.6	14.1	15.6	21.4	28.0	21.7	25.5	28.1	30.1	28.1	11.6
	Net income growth rate	18%	631%	12%	33%	11%	37%	31%	−23%	18%	10%	7%	−7%	−59%

Data sources: The official websites of China Merchants Wing Lung Bank (the new name of WLB), ICBC (Asia), and China CITIC Bank.

Second, the main goal of CMB’s acquisition of WLB was to expand its operation in the Hong Kong market and promote its global strategy. Table 11 lists CMB’s overseas branches and subsidiaries at the end of 2020. Before acquiring WLB, CMB had 1 branch and 1 subsidiary in Hong Kong and 1 branch in New York. CMB gradually entered into the overseas financial market, adding 4 overseas branches and 1 European subsidiary after acquiring WLB. At the same time, WLB had 32 branches in Hong Kong, 1 branch in Macao, 2 branches in the United States, and 21 subsidiaries. WLB’s branches also form part of CMB’s overseas footprint. Through the acquisition of WLB, CMB’s overseas expansion strategy has gradually materialised.

Table 11. Establishment of overseas branches and subsidiaries of CMB by the end of 2020.

Set-up year	Overseas branches and subsidiaries	Establishment place
1993	China Merchants International Financial Holding Co. LTD	Hong Kong
2002	Hong Kong Branch	Hong Kong
2008	New York Branch	New York
2008	China Merchants Wing Lung Group	Hong Kong
2013	Singapore Branch	Singapore
2015	Luxembourg Branch	Luxembourg
2016	London Branch	London
2017	Sydney Branch	Sydney
2019	China Merchants (Europe) Co. LTD	Luxembourg

We then further analyse the profit growth of CMB’s Hong Kong branch and overseas branches. CMB did not begin disclosing the pre-tax profit of its Hong Kong branch in its annual reports until 2012 and the operating income of its Hong Kong branch until 2013. Therefore, we only list the profits of its Hong Kong and overseas branches from 2013 to 2020. As Table 12 shows, the profits of CMB’s overseas branches came mainly from its Hong Kong branch. Since 2015, the profit growth of CMB’s Hong Kong branch and overseas branches has slowed down and even turned negative in the past several years.

Table 12. Profits of CMB’s Hong Kong and overseas branches from 2013 to 2020.

Branch	Profit	2013	2014	2015	2016	2017	2018	2019	2020
Hong Kong	Operating income (100 million HK dollars)	13.8	23.1	19.2	19.9	29.1	33.1	30.3	21.2
	Operating income growth rate	60%	67%	−17%	4%	46%	14%	−8%	−30%
	Profit before tax (100 million HK dollars)	9.9	21.7	16.6	15.9	21.5	29.2	25.5	15.4
	Profit before tax growth rate	88%	119%	−24%	−4%	35%	36%	−13%	−40%
Overseas (including Hong Kong)	Operating income (100 million yuan)	14.6	25.1	22.2	26.9	33.9	42.7	37.2	28.3
	Operating income growth rate	54%	72%	−12%	21%	26%	26%	−13%	−24%
	Profit before tax (100 million yuan)	9.3	20.8	17.9	15.0	20.7	30.4	26.7	16.5
	Profit before tax growth rate	63%	124%	−14%	−16%	38%	47%	−12%	−38%

Data sources: Annual reports of CMB.

Finally, Table 13 shows the overall performance of CMB. CMB’s profits grew rapidly, except for the temporary negative growth of operating income and net income when the merger was completed in 2009. WLB’s operating income contribution and net income contribution were relatively stable over this period.

Table 13. Profits of CMB and WLB’s profit contribution from 2008 to 2020.

Profit	2008	2009	2010	2011	2012	2013	2014	2015	2016	2017	2018	2019	2020
Operating income (100 million yuan)	553.1	514.5	713.8	961.6	1,133.7	1,326.0	1,658.6	2,014.7	2,097.2	2,209.0	2,485.6	2,697.0	2,904.8
Operating income growth rate	35%	−7%	39%	35%	18%	17%	25%	21%	4%	5%	13%	9%	8%
WLB’s operating income contribution	1.9%	4.5%	3.5%	3.2%	2.9%	2.9%	2.9%	2.6%	2.7%	2.3%	2.3%	2.5%	1.8%
Net income (100 million yuan)	209.5	182.4	257.7	361.3	452.7	517.4	560.5	580.2	623.8	706.4	808.2	934.2	979.6
Net income growth rate	37%	−13%	41%	40%	25%	14%	8%	4%	8%	13%	14%	16%	5%
WLB’s net income contribution	−3.4%	4.3%	4.5%	4.2%	3.8%	4.0%	4.5%	4.7%	5.0%	4.6%	3.5%	3.8%	2.5%

Data sources: Annual reports of CMB.

5.4. Impact of CMB’s acquisition of WLB on goodwill impairment

The above analysis shows that after CMB’s acquisition of WLB in 2009, effective integration brought strong excess profitability. However, the banking market in Hong Kong has suffered a downturn since 2015, especially in 2020 due to the COVID-19 pandemic, which greatly increased banks’ operational uncertainty. WLB’s profit growth slowed down significantly and even turned negative, indicating that CMB’s recorded goodwill may have been impaired. However, as we discussed above, under partial goodwill recognition, Method 3 recognises only the goodwill corresponding to the equity purchased in the first step when a firm gains control (i.e. 10.2 billion yuan), while Method 1 recognises the goodwill corresponding to all the equity purchased (i.e. 10.2/0.53 = 19.2 billion yuan).⁶ The book values of goodwill and net assets under Method 3 are smaller than those under Method 1. The smaller the amount of goodwill initially recognised, the less likely that the recoverable amount measured in the goodwill impairment test will be lower than the book value. As Figure 3 shows, when goodwill impairment occurs under Method 1 (the shaded part in Figure 3), it may not occur under Method 3.

Figure 3. Goodwill impairment test – case I.

As Figure 4 shows, even if the goodwill impairment occurs under both methods, the amount of goodwill impairment is smaller under Method 3 (the shaded part in Figure 4). CMB adopted Method 3 and recognised less goodwill than it would have under Method 1. As a result, Method 3 reduced the likelihood that CMB would recognise goodwill impairment. In fact, CMB has so far recognised a goodwill impairment loss of only 579 million yuan when WLB suffered a loss in 2008, which accounted for only 5.7% of its recognised goodwill.

Figure 4. Goodwill impairment test – case II.

6. Theoretical bases of accounting standards

Different M&A methods can lead to different amounts of goodwill initially recognised. This is due mainly to the different theoretical bases of accounting standards. The most important theoretical bases are (1) the nature of transactions between the parent and NCIs and (2) the choice between the partial and the full goodwill methods. We analyse the theoretical bases and their controversies in relevant accounting standards. Then, we compare the performance and goodwill impairment of CMB in 2008 simulated by the full goodwill method required by US Generally Accepted Accounting Principles (GAAP) and the partial goodwill method allowed by IFRS.

6.1. The nature of transactions between the parent and NCIs

When the parent purchases the shares of NCIs, it shall make corresponding adjustments in the financial statements to reflect the changes in the relative interests of controlling shareholders and NCIs in the subsidiary.

In this respect, the related requirements in IFRS and US GAAP converge. According to the Exposure Draft issued by the Financial Accounting Standards Board (FASB) and IASB in 2005, changes in the parent’s ownership interests while the parent retains its control of its subsidiary shall be accounted for as equity transactions (FASB, 2005; IASB, 2005). Therefore, no gains or losses shall be recognised in consolidated net income or comprehensive income, and any changes in the book amount of assets (including goodwill) and liabilities shall not be recognised. After the release of the Exposure Drafts, many respondents proposed an alternative approach, arguing that additional goodwill should be recognised if there is a change in controlling interests. The FASB and IASB rejected this alternative approach in SFAS 160, Noncontrolling Interests in Consolidated Financial Statements and IFRS 10, Consolidated Financial Statements. The Boards rejected the alternative approach because recognition of additional goodwill is inconsistent with their decision in SFAS141 (R) Business Combinations and IFRS 3 Business Combinations. Obtaining corporate control in a business combination is a significant economic event. That event requires the initial recognition and measurement of all the assets acquired and liabilities assumed in the business combination. Subsequent transactions between the parent and the NCIs should not affect the measurement of those assets and liabilities. The parent already controls the assets of the subsidiary, although it must share the income from those assets with the NCIs. By acquiring more equity interest from the NCIs, the parent is just obtaining the rights to income to which the NCIs previously had rights. However, the wealth-generating ability of those assets does not change after the parent acquires additional equity interest from the NCIs. This means that the parent is not investing in more or new assets; it is just obtaining the right to more income from the assets it already controls (IASB, 2011, Paragraphs BCZ171 to BCZ175; FASB, 2007b, Paragraphs B44 to B51). Therefore, the accounting standards stipulate that changes in the parent’s ownership interests while the parent retains its control of the subsidiary shall be accounted for as equity transactions, and any purchase premium should be recognised against additional paid-in capital or reduce the carrying value of this account. As a result, an acquirer can purchase part of the equity to obtain corporate control and then purchase additional shares from NCIs to reduce the initial amount of goodwill under the partial goodwill method.

6.2. Partial or full goodwill method

The partial goodwill method means that the acquirer recognises only the acquirer’s proportionate interests in the goodwill and does not recognise the NCIs’ share of goodwill. The full goodwill method means that the acquirer recognises goodwill corresponding to 100% equity when it gains control through an acquisition transaction. In this respect, the requirements in IFRS diverge from those in US GAAP. SFAS 141 (R) requires the full goodwill method, while IFRS 3 allows a choice between the full and partial goodwill methods. The difference in the measurement of goodwill between the two methods stems from the difference in the measurement basis of NCIs.

To achieve convergence between IFRS and US GAAP, IASB and FASB started the process to revise their standards on business combinations when the IASB was established in 2001. The revision process was divided into two phases. In the first phase, both IASB and FASB retained the fundamental requirement that the acquisition method of accounting should be used for all business combinations not under common control. The second phase of the project addressed the guidance for applying the acquisition method, and the two Boards issued the Exposure Drafts in 2005. In the end, the most significant difference between SFAS 141 (R) promulgated in Dec. 2007 and the revised IFRS 3 published in Jan. 2008 is the measurement of NCIs in an acquiree. The revised IFRS 3 permits an acquirer to choose whether to measure any NCIs in an acquiree at their fair value or as the NCIs’ proportionate share of the acquiree’s identifiable net assets. That is, IFRS 3 allows the acquirer to choose either the partial or the full goodwill method. However, SFAS 141 (R) requires the acquirer to measure NCIs in the acquiree at their fair value. That is, the acquirer must use the full goodwill method.

To achieve convergence on this matter, both IASB and FASB originally proposed, in their 2005 Exposure Drafts, that NCIs in an acquiree should be determined as the sum of the NCIs’ proportional interest in the identifiable assets acquired and liabilities assumed plus the NCIs’ share of goodwill. In re-deliberating the 2005 Exposure Drafts, the two boards noted that it would be impossible to directly measure goodwill at its fair value and that goodwill could only be measured as a residual. In contrast, an acquirer could measure the fair value of NCIs. The two boards gave three main reasons for their decision. First, the measurement of NCIs at fair value can improve decision usefulness. Second, the cost of using fair value measurement for NCIs is relatively low. Finally, NCIs are a component of equity in the acquirer’s consolidated financial statements. The measurement of NCIs at their fair value on the acquisition date will be consistent with the measurement of other equity components (IASB, 2008a, Paragraphs BC205 to BC208; FASB, 2007a, Paragraphs B205 to B208). As a result, SFAS 141 (R), eventually issued by FASB, requires that NCIs in an acquiree should be measured at fair value. That is, FASB finally chose the full goodwill method.

However, the IASB was unable to agree on a single measurement basis for NCIs because neither of the alternatives considered (fair value and proportionate share of the acquiree’s identifiable net assets) received sufficient Board support.

Some IASB members supported the use of fair value to measure NCIs. For example, Mary Barth and John Smith, IASB Board members from the US, agreed that NCIs in the acquiree should be measured at the acquisition date’s fair value rather than at the proportionate share of the acquiree’s identifiable net assets at that date. They believed that the fair value of NCIs could be measured reliably and that the benefits of consistently measuring all assets acquired and liabilities assumed outweighed the costs involved in conducting the measurement. Meanwhile, if the fair value was not adopted to measure NCIs, the initial recognition and subsequent impairment of goodwill would be underestimated (IASB, 2008a, Paragraph DO4). On the other hand, some IASB members supported measuring NCIs at their proportionate share of the acquiree’s identifiable net assets. For example, Robert Garnett, IASB Board member from South Africa, believed that measuring NCIs at fair value was equivalent to using the full goodwill method. Since goodwill cannot be separately identified or directly measured, the goodwill recognised under the full goodwill method is less accurate than the goodwill recognised under the partial goodwill method (IASB, 2008a, Paragraphs DO8 to DO10). In addition, some respondents objected to measuring NCIs at fair value because fair value measurement may be unreliable and inconsistent with the view that consolidated statements should mainly reflect the information needs of the parent’s investors (IASB, 2008b). As a result, the revised IFRS 3 permits a choice of measurement basis for NCIs and consequently allows the acquirer to choose either the partial or the full goodwill method. However, in practice, firms most adopting IFRS still adopt the partial goodwill method after the release of the revised IFRS 3.

Under the partial goodwill method, firms purchasing part of the equity to gain control and then purchasing NCIs to complete the acquisition (Method 3) recognise only the goodwill corresponding to the shares acquired when they acquired control.

6.3. Profits and goodwill impairment of CMB under the full and partial goodwill methods

CMB used the partial goodwill method. In this sub-section, we simulate goodwill and the resulting profits assuming that CMB adopted the full goodwill method instead. Table 14 shows that CMB would have recognised goodwill of 19.2 billion yuan (i.e. 10.2/53%) under the full goodwill method when it bought a 53% stake in WLB in September 2008. CMB recognised goodwill of 10.2 billion yuan under the partial goodwill method. In 2008, WLB suffered a loss, and CMB reported a goodwill impairment loss of 579 million yuan.⁷

Table 14. Profits and goodwill impairment of CMB under the full goodwill method and partial goodwill method in 2008.

	Full goodwill method (simulated)	Partial goodwill method (actual)
Goodwill (100 million yuan)	192.00	102.00
Goodwill impairment (100 million yuan)	96.24	5.79
Net income before goodwill impairment (100 million yuan)	215.25	215.25
Net income after goodwill impairment (100 million yuan)	119.01	209.46

If CMB had adopted the full goodwill method, it would have reported not only a 579 million yuan goodwill impairment loss for the 53% of shares but also the premium of the 47% of shares. Then a total goodwill impairment loss of 9,624 million yuan would have been recognised (579 + 10,200/53%×47%). As a result, the net income of CMB in 2008 would decrease from 20,946 million yuan under the partial goodwill method to 11,901 million yuan under the full goodwill method, lower than the actual net income in 2007, which is 15,243 million yuan. CMB’s acquisition of WLB was the largest bank merger in Hong Kong at that time, and it attracted widespread attention. If CMB had adopted the full goodwill method, it would have recognised a larger amount of goodwill impairment loss after the acquisition. This would have seriously dragged down the net income, which might have frustrated the stakeholders. In short, by adopting the partial goodwill method and choosing to purchase part of the equity to gain control, and then to purchase NCIs later, CMB significantly reduced the amount of goodwill initially recognised and thus reduced its likelihood of recognising goodwill impairment after the merger.

7. Conclusion

For business combinations not under common control, different M&A methods can result in different initial recognition of goodwill. From the perspective of accounting standards, we analyse how two-step acquisitions can reduce the amount of goodwill initially recognised and the likelihood of recognising goodwill impairment in the future. We use the case of CMB’s acquisition of WLB to illustrate this point. CMB acquired 53% of WLB’s shares to gain control in the first step, and then acquired the remaining 47% of shares in the second step. This two-step acquisition allowed CMB to recognise the premium as goodwill only in the first step and then to recognise the premium as a decrease in additional paid-in capital in the second step. This greatly reduced the amount of goodwill initially recognised, as well as the risk of recognising goodwill impairment in the future. The different accounting treatments for the initial recognition of goodwill under different M&A methods are driven mainly by the different theoretical bases of accounting standards: the nature of transactions between the parent and NCIs and the choice between the partial and the full goodwill methods.

Our case study of CMB’s acquisition of WLB does not imply that all two-step acquisitions qualify for the accounting treatment that CMB used to lower the amount of goodwill recognised on the financial statements. First, if a two-step or multi-step acquisition is for the same business purpose and based on the same set of conditions, these different steps should be accounted for as one package deal due to the accounting adage of substance over form. Second, in countries where accounting standards permit only the full goodwill method, a two-step or multi-step acquisition won’t affect the amount of goodwill recognised. Moreover, on 24 December 2021, the China Securities Regulatory Commission (CSRC) issued guidance on the application of the regulatory rule Accounting Class No. 2. The rule considers the goodwill impairment test after the acquirer purchases the noncontrolling shareholders’ equity. It stipulates that the amount of goodwill recognised in the consolidated statements must be the amount corresponding to the equity purchased when the acquirer gains corporate control. However, when the acquirer conducts the goodwill impairment test, the acquirer shall restore the goodwill in the consolidated statements to full goodwill (i.e. goodwill corresponding to 100% equity) and adjust the book value of goodwill-related asset groups. When goodwill is impaired, the acquirer shall recognise the losses attributable to the parent according to the equity percentage at the time of gaining corporate control. We expect this rule to resolve some of the controversies in the accounting treatment for goodwill when an acquirer adopts Method 3 to acquire a target as discussed in our case study.

Overall, our case study highlights the multifaceted and complex nature of accounting for goodwill in China. While our case analysis offers valuable insights into current accounting practices and challenges related to goodwill in China, further research is needed to fully understand this complex issue. We recommend that future researchers employ a range of approaches, such as case studies that offer detailed and nuanced analyses of specific situations, as well as empirical studies with large datasets that facilitate the discovery of broader patterns and trends. We hope that our case study inspires additional research in this important area and contributes to the development of better accounting practices in China and beyond.

Disclosure statement

No potential conflict of interest was reported by the authors.

Correction Statement

This article has been corrected with minor changes. These changes do not impact the academic content of the article.

Notes

¹ A-share firms are listed in mainland China. The data are from China Stock Market & Accounting Research Database.

² The Chinese accounting standards often specify only one accounting method when IFRS permit the choice of different methods. In the case of the partial versus full goodwill method, China’s Accounting Standards for Business Enterprises (ASBE) No. 20 – Business Combinations allows only the partial goodwill method (MOF, 2006). With this exception, ASBE 20 on business combinations not under common control substantially converges with the corresponding requirements in IFRS 3. In addition, when a firm is listed both in mainland China and in Hong Kong, which is the case for China Merchants Bank, it needs to prepare financial statements under both Chinese accounting standards and IFRS and is required to make the same accounting choice under both standards. Therefore, for simplicity, our discussion is based on the partial goodwill method under IFRS unless stated otherwise.

³ The related literature generally documents that goodwill impairment results in negative market reactions. In the Chinese setting, Han and Tang (2020) find that avoiding goodwill impairment increases a firm’s stock price crash risk.

⁴ H-shares are shares traded in the Hong Kong Stock Exchange.

⁵ The report can be found at https://finance.sina.com.cn/roll/20081111/03505490349.shtml.

⁶ As our simple example in Section 3 illustrates, Method 2 often yields an even larger amount of goodwill when the acquiree’s stock price increases over the acquisition period.

⁷ The report can be found at http://finance.sina.com.cn/roll/20090429/02536162621.shtml. However, the second step of the acquisition premium should not be called goodwill because it was recorded as a decrease in additional paid-in capital.