- September 30, 2022
- Posted by: Ramkumar
- Category: Mergers And Acquisitions
Accounting Considerations In Mergers and Acquisitions
When an acquisition happens due to strategic reasons resulting in a business combination, the acquirer needs to factor in the accounting considerations using the Purchase method of accounting. This exercise happens after the deal closes when the buyer consolidates the target’s assets and liabilities in its balance sheet. The investors will look at the buyer’s balance sheet in the subsequent investors’ call and evaluate whether the acquisition is a success or a failure. In this post, I provide insights on how accounting standards like GAAP/IFRS look at M&A as a transaction and how it affects the combined firm’s balance sheet and income statement.
After the buyer decides the purchase price for the deal, the accountant first allocates the purchase price to the target’s tangible and intangible net assets (Target’s acquired assets – liabilities) and records them in the buyer’s balance sheet. Here the accountant does not look at the target’s book value but the fair market value, which is the price that the seller is willing to sell an asset on the date at a market price to a buyer. Any difference between the purchase price and the fair market value is Goodwill. The accountant records Goodwill as an asset because it represents future economic benefits of the target’s net assets. The acquisition date is the deal’s closing date.
Re-organizing Acquired Net Assets and Goodwill at Fair Value
The accountant will record 100% of the target’s net assets in the buyer’s balance sheet. In the case of M&A deals, where the buyer has acquired a controlling interest in the target but acquired less than 100%, the accountant recognizes the percentage of the target not acquired as a minority interest in the buyer’s liability section of the balance sheet under the equity account separately from the buyer’s equity. Then, the buyer needs to attribute Goodwill to controlling and non-controlling interest when the deal has Goodwill. Then the accountants must recognize revenues and earnings from non-controlling interest in the consolidated income statement.
For instance, if the buyer acquires 50.1% of the target, the buyer must record 100% of the target’s assets and liabilities in its balance sheet and then record the value of 49.9% as non-controlling interest in shareholder’s equity. The buyer records 100% of the target’s revenues and earnings in the income statement while deducting 49.9% of minority earnings as minority interest from the buyer’s net income.
When the buyer chooses to acquire the remaining stake from the target, it has to revalue the net acquired assets again at the fair market value. Then the buyer has to disclose gains/losses due to the earlier revaluation of the non-controlling interest in the consolidated income statement.
Re-organizing Contingent Considerations
In an M&A deal, the target can assume contingent liabilities in the form of employee litigation, competitor lawsuits or tax evasion cases filed by the IRS. When the outcome of these litigations is unknown, the buyer records the asset at a fair market value on the closing date. Still, when it gets access to the new information on the litigation, the buyer must revalue the asset and record the impact of changes in the fair values as gain/loss in its earnings that can contribute to potential earnings volatility.
In-Process R&D Assets
When the buyer acquires an IP/software from the target, it effectively acquires its R&D assets. Therefore, the buyer must record these assets separately from the Goodwill. If the outcome of future R&D investments is a success, the buyer amortizes the assets over their useful life. In contrast, when the outcome fails, the buyer expenses the investments in its consolidated income statement.
Expensing Transaction Costs
Deal-related costs, including legal, diligence and investment banking fees, must get recorded as an expense on the closing date and charged against the buyer’s earnings. If the buyer finances the acquisition through debt, the buyer can capitalize on the financing expenses.
Accounting For Goodwill
A buyer records an impairment of Goodwill when the fair market value of the target’s assets is below its carrying value. Goodwill impairment can occur when the target loses customers, its contracts or when its key employees leave the firm after the deal closing. These events have a material impact on the target’s future earnings. When the assets get impaired, the buyer must report a loss as a difference between the target’s fair market value and the carrying value. For example, when a buyer overpays for an M&A deal, it invariably writes of Goodwill.
If the buyer is a public company, it must do the Goodwill impairment exercise annually to tell the investors if the acquisition is a success or failure. Private firms do the Goodwill impairment exercise when there is a triggering event like going for an IPO/sale to another entity. When the buyer writes down Goodwill, it acknowledges that it has overpaid for the target’s assets. Thus, when the buyer does an impairment, it is its moral duty to explain why they have impaired the assets and the actions they will take to remedy the situation. If the buyer does not do, its share price will likely plummet.
In addition to Goodwill, the buyer undertakes restructuring exercises like employee layoffs, closing offices/plants and selling off their non-performing assets. The buyer takes one-time expenses and records them as a restructuring charge in the income statement. When the restructuring exercise results in an effective business strategy adding the firm’s value, the investors will welcome the restructuring with a rise in stock price. However, its share price declines when the firm restructures because it is forced to do due to its poor competence. As a result, such companies become hostile takeover targets because they have destroyed shareholder value.
When recording Purchase Price in the consolidated balance sheet, the accountant defines Purchase price as:
Purchase Price = FMV of Target Assets – FMV of Target Liabilities + FMV of Goodwill – FMV of any Non-controlling interest
The above table shows the buyer steps up the target’s book value to fair market value.
Goodwill = Equity + Liabilities – Total Assets = 100
Purchase price – 1000
FMV of Net acquired assets = 2600-1000-700 = 900
Goodwill = 1000-900 = 100
Let us take another example:
Deal closing date = 1st October 2022
Acquirer purchases 80% of Target’s stock for $50.
Shares outstanding = 1 million
Purchase price = 50180% = 40 million
The buyer steps up the target’s net acquired assets to their fair market value. The fair market value of the target’s assets = 42 million.
The buyer pays a 20% control premium at a $50 price/share and is paying 50 million for this deal.
Non-controlling interest = 50 – 40 = 10 million
Minority discount for holding non-controlling interest = 1-(1/(1+20%)) = 16.7%.
Fair market value (FMV) of Goodwill = 50 – 42 = 8 million.
FMV of Goodwill attributable to Non-controlling interest = FMV of Non-controlling interest – 20% of FMV of net acquired assets = 10 – (42*20%) = 1.6 million.
Value/share for Non-controlling interest = Purchase Price * (1-Minority discount) = $41.65.
The buyer can amortize the Goodwill for tax purposes for up to 15 years. However, when the Goodwill is negative, or the buyer acquires the target at a price below its fair value, the buyer must record a one-time gain equal to the difference between the price paid and the fair value in its income statement.
Guidelines For Valuing Net Acquired Assets
- Value cash, account receivables and accounts payable at market price.
- Value finished goods in inventory using liquidation and raw material at replacement cost.
- Value tangible and intangible assets using discounted cash flow model.
- Value short-term and long-term debt by discounting future interest payments at the target’s cost of debt.
- Value Pension fund obligations using the DCF model, and the buyer must record any excess/deficit of the present value of the projected obligations over the present value of the pension assets as asset/liability in the consolidated balance sheet.
The outcome of the above exercise must give the FMV of the target’s net acquired assets. The difference between the purchase price and FMV of net acquired assets must get recorded as Goodwill in the consolidated balance sheet.
Example Of Goodwill Impairment
In the above example, the buyer acquired a target in 2013 of 50 million and did an annual Goodwill impairment exercise.
In 2014, the target experienced a loss in its key customers, reflecting a decline in its carrying value.
Target’s carrying value is 40 million resulting in an impairment loss of 10 million.
What happens when a private equity firm does a leveraged buyout of a company?
Does the accountant record the above deal using purchase price accounting?
The answer is NO.
In an LBO, the PE firm creates a shell entity and funds it with leverage and equity. Then the PE firm merges the target with the shell and dissolves the shell. Accountants do not recognize LBO as a business combination because the buyer does not hold tangible assets. Likewise, the shell company does not have tangible assets to run business operations.
There is a change in the existing capital structure with more leverage added. However, the transaction does not impact the value of the firm’s assets and liabilities. Therefore, it does not require any change in the combined firm’s book value of the assets and liabilities. Further, the PE firm repurchases target equity, and these repurchased stocks get reflected as treasury stock. Thus there is a deduction in the shareholder equity, which is generally negative.
Thus, the PE firms do not revalue the target’s net acquired assets to their fair value in an LBO. So there is no additional depreciation, implying that there is no reduction in net income.
Thus, the accountants view the LBO as the merger of the shell firm with the target surviving as recapitalization rather than a business combination in which the survivor gained valuable assets due to the transaction.
We also apply recap accounting to reverse mergers where the public shell company merges with a private entity.
When an M&A occurs, the buyer justifies the transaction with strategic rationale and synergies. However, the investors will assess the outcome as a success or failure by studying their consolidated firm’s balance sheet and income statements. Thus, a deal maker must understand how an M&A affects the consolidated firm’s financials.