M&A deals give rise to a number of important accounting issues, including:
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:
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 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 (“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:
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:
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 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.
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:
Assuming the acquirer purchases the target’s assets:
A deferred tax liability (“DTL”) will be created on the acquirer’s balance sheet in an acquisition when:
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.
Accounting Value of Assets > Tax Value of Asset
Accounting D&A for Written-Up Assets > Tax D&A for Written-Up Assets
Taxable Income for Accounting < Taxable Income for Government
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.
When the acquirer consolidates the target in an acquisition, there are effectively three sets of adjustments that need to be made:
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.
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.
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”:
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:
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:
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).
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 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 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 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:
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.