Mergers and Acquisitions (“M&A”) Accounting

M&A deals give rise to a number of important accounting issues, including:

• Treatment of the target’s results on the acquirer’s financials
• Timing of the impact of acquisitions on the acquirer’s financials
• Purchase price allocation and balance sheet impact, including fair market value adjustments and goodwill
• Treatment of stock vs. asset acquisitions and related deferred tax impacts
• Income statement impact, including accretion / dilution
• Accounting for transaction fees
• Treatment of the sale of a business

Accounting for the Target’s Financial Statements in an Acquisition

The accounting treatment of the target will depend on the level of influence / control exerted by the acquirer following the acquisition. This is generally tied to the percentage of the common equity owned by the parent company. But other governance provisions or voting rights may dictate if the parent controls the subsidiary, and therefore the appropriate accounting treatment.

Generally speaking, there are three methods a parent company can use to account for a subsidiary. These methods are described below in conjunction with the related example in shown below:

1. 1. Consolidation Method: ParentCo is deemed to have control of SubsidiaryX, and therefore accounts for SubsidiaryX using the consolidation method. In this case, 100% of the subsidiary’s revenues, expenses, assets, liabilities, etc. are consolidated onto the parent’s financial statements. If <100% of the subsidiary is owned, a noncontrolling interest will also appear on ParentCo’s financial statements.
   2. Equity Method: ParentCo has significant influence over SubsidiaryY but does not control the subsidiary and therefore accounts for SubsidiaryY using the Equity Method. In this case:
      • Income Statement: the proportionate share of the subsidiary’s net income is recorded in one line on the income statement.
      • Cash Flow Statement: the proportionate share of the subsidiary’s net income recorded in the income statement is subtracted because it is non-cash, but any cash dividends received from the subsidiary are added back to cash flow.
      • Balance Sheet: the subsidiary will appear as a line item on the balance sheet, which reflects the proportionate share of the associate’s equity account.
   3. Fair Value or Cost: ParentCo does not have significant influence over SubsidiaryZ and therefore accounts for SubsidiaryZ using the fair value method or cost. If the investment is carried at fair value on the balance sheet, any changes to fair value flow through comprehensive income. In some instances, investments can be carried at cost and remain unchanged until disposal of the asset.

Timing of Including a Target on the Acquirer’s Financial Statements

From an accounting perspective, the results of the target get included on the acquirer’s financial statements beginning on the date that the acquisition closes. On the closing date, the acquirer’s balance sheet will include the acquired assets and liabilities, as well as the impact of funding used to acquire the target.

The income statement and cash flow statement will begin to include the results of the target immediately following the closing.

As a result, the income statement and cash flow statement of an acquirer will often include a partial period of results from the acquired business. It is important to read the MD&A to understand what period-over-period movements are caused by pre-existing vs. acquired businesses.

Pro Forma Financial Statements

Pro forma financial statements are often included in merger / acquisition filings purely for illustration to help investors understand a transaction.

A pro forma income statement will include the results of the acquirer and the target for a historical period, assuming the transaction took place at the beginning of that period, and will include the impact of how the transaction is being financed. A pro forma balance sheet will show the impact of the acquirer buying the target at some historical date.

This analysis is purely hypothetical to help investors understand what the two companies would have looked like on a combined basis. Typically, a pro forma cash flow statement will not be included.

Pro forma financials often involve a number of assumptions, such as the acquisition purchase price and the interest rate on new debt used in the deal. These values will only be known on or after closing, but the accountants make assumptions to illustrate the combined impact. As a result, pro forma will often be accompanied by a number of footnotes to explain the assumptions. In addition, since pro formas are hypothetical in nature, they will not be audited by the accountants.

An example of pro forma financial statements is shown below:

Purchase Price Allocation in an Acquisition

Purchase price allocation (“PPA”) is an accounting process which occurs when a target is purchased and will be consolidated into the acquirer.

Through PPA, the acquirer allocates the purchase price of the target’s equity among: (i) the fair market value (“FMV”) of the identifiable net assets of the target and (ii) goodwill. In other words, PPA assigns the purchase price of a company to the acquired company’s assets valued at fair market value (less or “net” of liabilities at fair value), and recognizes any unassigned portion of the purchase price as goodwill.

PPA can be thought of as the following process:

1. Determine the Equity Purchase Price (“EPP”), which is the price paid for the equity of the target.
2. Determine the FMV of the target’s identifiable assets and liabilities. The estimated FMV of assets and liabilities are most commonly determined by the acquirer’s accounting firm. Finance professionals must sometimes make their own rough estimates in the absence of the actual accounting figures.
3. Allocate the EPP in the following order:
   1. Net tangible assets, calculated as the FMV of the target’s tangible assets (assets with physical form) less the FMV of its liabilities.
   2. Identifiable intangible assets, calculated as the FMV of the target’s identifiable intangible assets (assets without a physical form). An intangible asset is considered identifiable if it can be separately identified, assigned a FMV, and disposed of, such as client lists, patents, trademarks, etc. These assets will often not have previously appeared on the target’s balance sheet – only because of the acquisition a value is being assigned as part of the PPA process. Note that this does not include trying to establish the FMV of any pre-existing goodwill that was already on the target’s balance sheet.
   3. Goodwill, calculated as the residual EPP not allocated in the previous two steps. Because any pre-existing target goodwill was excluded above, note that the calculation of the goodwill for the transaction in this step will therefore include any pre-existing target goodwill as part of the total goodwill calculated.

The example below illustrates an example transaction where AcquireCo is acquiring 100% of TargetCo for an enterprise value of $1.5 billion. As a result, the PPA process requires that we:

• Determine the EPP of $1,325 mm (total enterprise value less net debt of target).
• Write-up (or down) the target’s assets and liabilities to their FMV, as represented by the “FMV” column of TargetCo’s Balance Sheet. In the example, assets are being written up by $600 mm and liabilities by $20 mm, so the net increase in assets is $580 mm, from $575 mm to $1,155 mm
• Any excess purchase price over the FMV of the target’s net assets is allocated to Goodwill which will be shown on AcquireCo’s Balance Sheet. In this case, goodwill is $170 mm, or $1,325 mm less $1,155 mm. Note any pre-existing goodwill on the target’s balance sheet would be excluded from the FMV calculation – as a result the new goodwill from the acquisition will effectively include the target’s pre-existing goodwill.

Example Acquisition and Purchase Price Allocation

Fair Market Value Adjustments in an Acquisition

Companies generally do not mark-to-market their assets and liabilities on a regular basis, as it would be a difficult and time-consuming process and companies would then be obligated to keep reporting the market values of their assets on an ongoing basis. Rather, many balance sheet accounts reflect historical cost which is often very different from current market value.

In the case of an acquisition, the accountant makes the Fair Market Value (“FMV”) adjustments in an attempt to “explain” the reason for the excess purchase price over the book value of target net assets. In other words, because a buyer is establishing a value for the equity through the acquisition, the accountants of the buyer must try to allocate that value. The adjustments do not create a requirement for the company to keep presenting its financials using fair market values.

In theory, any asset or liability can be adjusted. These adjustments tend to be small, however, relative to the excess purchase price. Often a big portion of the excess purchase price is allocated to intangible assets that never previously appeared on the target’s balance sheet. For example, the accountant may allocate a value to the target’s brands or client lists. While these intangibles clearly have value to the owner, they do not get capitalized to the balance sheet during ordinary course of operations. It is only by virtue of the acquisition that value is being ascribed to them.

The example below shows the preliminary allocation of intangible assets when Loblaw (a grocery store chain) acquired Shoppers Drug Mart (a drug store chain). Significant amounts are being allocated to banners, control brands and prescription files which previously had not appeared on Shoppers Drug Marts balance sheet:

These new intangible assets will then get amortized so long as a useful life can be estimated. In the Shoppers Drug Mart example, the prescription files were given a useful life of 12 years, so the acquirer would then amortize the value for that period after closing.

This incremental amortization will have a negative impact on the acquirer’s EPS. In some M&A financial analysis, it may be necessary to calculate the impact on the acquirer’s EPS excluding the impact of additional amortization from such purchase price adjustments.

Any intangibles for which a finite life cannot be established will not be amortized, but rather subject to an annual impairment testing the same way that goodwill is tested annually.

Goodwill

Goodwill is an intangible asset created when a company acquires another company and will consolidate it for accounting purposes. Upon closing of the acquisition, goodwill appears on the acquirer’s balance sheet as a non-current asset and represents the excess of the amount paid for the target above the FMV of the target’s net identifiable assets.

Unlike other assets, goodwill is not amortized, but instead is subject to periodic valuation to determine if there has been an impairment of value. Should goodwill need to be written down as a result of a periodic impairment test, this results in a reduction of goodwill on the balance sheet and an impairment expense which flows through the income statement and reduces retained earnings on the balance sheet.

Accounting Impact of Purchasing Target Assets vs. Target Equity

An acquisition can be structured as a purchase of the target’s shares or its assets. The choice of how a transaction is structured has a number of implications.

Assuming the acquirer purchases the target’s shares:

• Assumption of Target’s Liabilities: the acquirer assumes both the target’s assets and liabilities.
• Deferred Tax Liability: since the acquirer purchased the target’s shares, the acquirer is not able to write-up the value of the purchased assets of the target company for tax purposes. If any depreciable / amortizatizable assets are written up for accounting purposes but not for tax purposes, a deferred tax liability will be created.
• Tax Losses: since the acquirer purchased the target’s shares, the acquirer assumes any outstanding tax losses the target may have had and is able to apply these tax losses against future earnings (subject to limitation according to applicable tax rules).

Assuming the acquirer purchases the target’s assets:

• Assumption of Target’s Liabilities: the acquirer assumes the target’s assets, but does not assume any related liabilities (unless agreed upon). The target’s balance sheet is therefore left with the proceeds from the acquisition (asset) and its outstanding liabilities. Typically, the target will use the proceeds to repay its liabilities, and distribute any excess proceeds to shareholders in order to wind up the company.
• Deferred Tax Liability: as part of the purchase price allocation, the acquirer is often able to write-up the purchased assets for accounting purposes. Since the acquirer purchased the target’s assets, the acquirer is also able to write-up the value of the purchased assets for tax purposes. Since the assets are written up for both accounting and tax purposes, a deferred tax liability will not be created as a result of the transaction (assuming the amount of the write-up was the same for both accounting and tax purposes).
• Tax Losses: since the acquirer is only purchasing the target’s assets, and not its shares, the acquirer does not assume any outstanding tax losses the target may have.

Creation of Deferred Tax Liabilities in an Acquisition

A deferred tax liability (“DTL”) will be created on the acquirer’s balance sheet in an acquisition when:

• The acquisition is structured as a purchase of shares;
• The acquired company’s assets have been written up to fair market value for accounting purposes, but not for tax purposes; and
• Finite life assets, either tangible or intangible, are written up for accounting purposes and therefore will cause incremental accounting depreciation or amortization (“D&A”).

The DTL gets created because of the one-time mismatch created when finite-life assets get written up for accounting purposes but not for tax purposes, and the resulting mismatch between accounting D&A and tax D&A that will occur over the remaining useful life.

In other words, over the remaining life of the written-up assets there will now be incremental D&A which will therefore lower accounting pre-tax income and accounting income tax expense. However, the acquirer will not get to deduct this incremental D&A for tax purposes. As a result, over the duration of the remaining useful life, all else being equal, the acquirer will pay more tax to the government than it recognizes on its income statement.

RESULT:

Accounting Value of Assets > Tax Value of Asset

THEREFORE:

Accounting D&A for Written-Up Assets > Tax D&A for Written-Up Assets

SO:

Taxable Income for Accounting < Taxable Income for Government

AND:

Tax Expense for Accounting < Tax Payable to Government

Every year after closing of the acquisition, Retained Earnings will go down more than cash goes down – and the balance sheet therefore would not balance. To solve this, a DTL is created on the acquirer’s balance sheet at closing, which is equal to the sum of the extra tax the company will pay to the government over the life of the written-up assets relative to what is reported for accounting purposes. Given that a new liability is created, this effectively increases the amount of goodwill from the acquisition.

In the example below, a $500 mm write up of new finite-life intangibles for accounting purposes with a life of 12 years would result in annual amortization of $41.7 mm and reduce accounting tax provisions by $10.4 mm. However, because there is no tax value to the write-up, the company will not be able to reduce cash taxes. Thus, every year for the next 12 years, income and therefore retained earnings will decline by an extra $10.4 mm while cash will not. To account for the mismatch, a DTL equal to $10.4 mm times 12 years, or $125 mm, is created. Each year for 12 years, the company’s accounting taxes will be $10.4 mm lower than what they would have been without the asset write up. This $10.4 mm annual reduction in tax also reduces the DTL by $10.4 mm until it reaches $0 by the end of year 12.

Adjustments to the Acquirer’s Balance Sheet in an Acquisition

When the acquirer consolidates the target in an acquisition, there are effectively three sets of adjustments that need to be made:

1. 1. Allocate the fair market value (“FMV”) adjustments and goodwill to the target’s assets and liabilities;
   2. Include the new financing used to acquire the target’s equity, which could include cash on hand, new debt and/or new equity; and
   3. Wipe out the target’s existing equity since that equity is being revalued and refinanced by the acquirer.

For the following example, we assume and acquisition with a purchase price allocation as follows:

We further assume the acquirer funds the $1,325 mm purchase of the target’s equity with (a) $200 mm of cash on hand, (ii) $430 mm of new debt and (iii) $695 mm of new equity (either an exchange of shares or a primary issuance of stock to raise cash). The balance sheet adjustments for the acquirer would be as follows:

The adjustment column in the figure above includes the impact of all three aforementioned adjustments. Note that the adjustment to equity of $120 mm shown in the red box includes (i) wiping out the existing target’s equity of $575 mm and the issuance of $695 mm of new acquirer equity. Every dollar of acquirer funding is allocated to a net asset of the target (including the goodwill) to make the balance sheet balance.

Accounting for Transaction Fees in an Acquisition

There can be many different kinds of fees paid by the acquirer in an acquisition, including for debt financing, equity financing (in the case of primary sale of stock), M&A advisory, consulting fees and legal advice. All of these fees would increase the funding need for the acquirer.

In general, all transaction fees other than debt financing fees will be expensed at closing and deducted from retained earnings of the acquirer – this is because there is no measurable life over which to capitalize and amortize these fees.

Debt financing fees, however, do have a measurable life equal to the term of the debt. Therefore, these fees will be capitalized and amortized. However, they are not treated as an asset such as capital expenditures. Rather, the fees are deducted from the carrying value (i.e. the number that appears on the balance sheet) as a contra-liability. The fee is then amortized over the life of the debt through financing expenses, and the carrying value of the debt increases over time toward the face value. As a result, the balance sheet figures for debt will be presented net of unamortized financing fees. Check the footnotes to the financial statements to understand the fee amount.

Defining Accretion / Dilution in M&A Transactions

Accretion simply represents growth or increase. With respect to an acquisition, accretion refers to a metric that increases for the buyer as a result of the transaction. For example, if an acquisition is accretive on an Earnings per Share (“EPS”) basis, then the post-transaction EPS of the acquirer is higher than the pre-transaction EPS would have been without making the acquisition. Conversely, dilution refers to a metric that decreases as a result of the transaction. For example, if an acquisition is dilutive on an EPS basis, then the post-transaction EPS of the acquirer is lower than the pre-transaction EPS. If a transaction is neither accretive nor dilutive, it is referred to as “break-even”.

It is worth noting that although accretion / dilution often refers to EPS, the terminology and concepts apply to other metrics. For example, financial practitioners may be interested in whether a transaction is accretive or dilutive on a cash flow per share basis.

In M&A analysis, the accretion / dilution analysis can either be on a “pro forma” basis, or on a “reported basis”:

• Pro forma analysis means the M&A transaction is assumed to have occurred at the beginning of the financial period, even if the period is a historical one. The idea is to look at the impact to the acquirer’s metric on a full-year basis. For example, one might look at the pro forma EPS for the current fiscal year even if it is halfway complete – in this case we would assume the transaction occurred at the beginning of the current year.
• Reported basis means that the metric will be calculated to include the results of the target only from the date of closing to the end of the period in question. For an acquisition expected to occur at mid-year, the EPS would include a half year of standalone acquirer EPS and a half year of combined EPS (reflecting the acquired business and related financing).

Calculating Pro Forma Earnings per Share (“EPS”) for an Acquirer

To calculate the acquirer’s EPS including the acquired business, we start with the acquirer’s stand-alone net income in total dollars. This can be pulled from the income statement or calculated based on EPS times the relevant number of stand-alone acquirer’s shares outstanding.

The following adjustments must then be made to calculate the combined acquirer net income:

• • Include the net income of the target: This can either be on a full period, pro forma basis or on a timed basis to reflect the closing date of the deal.
  • Include any anticipated synergies from the transaction: This will depend on the type of analysis being done. For example, pro forma income statements disclosed in public M&A filings will not include synergies. However, internal company analysis will often include synergies to show the related impact.
  • Make any financing adjustments in Net Income: We need to include the impact on the acquirer’s net income to common of the financing used to buy the target’s earnings. This could include using cash on hand or issuing new debt or preferred shares.
  • Amortization of any written-up assets: If the target’s assets are written up in value then this will create additional amortization on the income statement and lower net income. Only assets with definite lives will be amortized. Indefinite life intangibles will not impact net income since they are not amortized.

Once we arrive at the combined net income, we need to now divide by the weighted average number of common shares outstanding to calculate combined EPS. If any common shares were issued by the acquirer to help finance the acquisition, these incremental shares must be included in the share count since they will share in the combined net income of the company.

The example below illustrates a simple example of a pro forma EPS accretion analysis. In this case, the calculations look at the “pro forma” impact on the acquirer’s EPS, assuming the transaction occurred at the beginning of the year:

In this example, the acquirer’s EPS increases from $1.75 stand-alone to $2.23 on combined basis, an increase (i.e. accretion) of $0.48 or 27.3%. According to the three steps above, we make the following adjustments to the acquirer’s stand-alone net income of $210 mm:

1. Add the target’s $85 mm of net income (this is already after tax).
2. Add synergies of $37.5 mm (or $50 mm after tax at a rate of 25%). Note that we are including a full year worth of synergies. Sometimes only a lower amount is included to reflect a partial year or to reflect a ramp up in achieving synergies.
3. Deduct after-tax interest expense on new debt ($430 mm x 6% x (1-25%)) and after-tax foregone interest on cash on hand ($200 mm x 1% x (1-25%) used to fund part of the purchase price.

To calculate the combined EPS, we divide the adjusted net income by the new total shares outstanding of 139.9 mm, which includes the 19.9 mm of new shares issued to fund $695 mm of the equity purchase price (i.e. $695 mm divided by the acquirer’s $35.00 stock price).

Accretion / Dilution “Rules of Thumb”

When referring to Earnings per Share (“EPS”) accretion / dilution analysis, accretion simply means the pro-forma EPS of the acquirer is greater than the stand-alone EPS prior to the transaction.

There are a number of helpful “rules-of-thumb” we can refer to when assessing whether a deal will be accretive or dilutive from an EPS perspective. The following simplified examples / explanations illustrate three such rules-of-thumb (note: these examples exclude the impact of transaction fees, debt refinancing, options and incremental depreciation & amortization from potential asset write-ups).

Example 1. If the P/E ratio of the Acquirer is greater than the P/E ratio of the Target, then an all-equity acquisition will be accretive:

Example of Accretive All-Equity Acquisition

Example 2. If an all-equity acquisition is accretive, and the Acquirer’s after-tax cost of debt is lower than the Target’s earnings yield, then introducing debt will make the acquisition more accretive:

Example of Accretive Debt and Equity Acquisition

Example 3. If an all-equity acquisition is dilutive, and the Acquirer’s after-tax cost of debt is lower than the Target’s earnings yield, then introducing debt will make the acquisition less dilutive (and can in fact make the acquisition accretive::

Example of Dilutive Debt and Equity Acquisition

Example of Dilutive Debt and Equity Acquisition

Example 4. If the Acquirer’s after-tax cost of debt is less than the Target’s earnings yield, then an all-debt acquisition will be accretive:

Example of Accretive All-Debt Acquisition

Accounting for the Sale of a Business

On the date of the sale, the divested business will no longer be included in the parent’s financial results. The difference between the selling price of the business and the carrying value of the net assets will be booked as a gain or loss on the parent’s income statement and may be taxable. The sale process will show up in the investing section of the cash flow statement.