Accounting, taxes,and m AV

Purchase Method Accounting• Purchase accounting requires the acquirer to record in its financial statements the fair market value of all assets acquired.. – The fair value of an asset i

Accounting, Taxes, and M&A

Valuation

What Every Investment Banker

Needs to Know

M&A Accounting

• Depending on the characteristics of a merger or acquisition transaction will be accounted for as a:

– purchase combination or a

– pooling-of-interest (pooling) combination.

Purchase Method Accounting

• Purchase accounting requires the acquirer to

record in its financial statements the fair market value of all assets acquired.

– Both tangible and intangible, and liabilities assumed – The fair value of an asset is generally its market or

appraised value, and liabilities are generally valued

on a present value basis.

• Any excess or residual purchase price over the fair value of the net identifiable assets is

considered goodwill that must be recorded as an asset and amortized over its useful life or a

maximum of 40 years.

Pooling Method Accounting

• The pooling method accounts for a combination of two firms as a union of the ownership interests of the two

previously separated groups of stockholders.

• No sale or purchase is considered to have occurred.

• The assets and liabilities of the combining firms continue

to be carried at their book values, that is, on the basis of their historical costs.

• Any goodwill carried on the target’s books prior to the

merger continues to be carried on the merged firm’s

books at its historical cost, but no new goodwill is

recognized as a result of the pooling.

• The stockholders’ equity of the merged firm is recorded

at the sum of the book values of the two firms.

Pooling-of-Interest Treatment

• Twelve Criteria For A Pooling of Interests Merger

– Attributes of the Combining Companies

1 Autonomous (two-year rule)

2 Independent (10% rule)

– Manner of Combining Interests

3 Single transaction (completed in one year following the initiation)

4 Exchange of common stock (90% "substantially all" rule)

5 No equity changes in contemplation of combination (two-year rule)

6 Shares reacquired only for purposes other than combination

7 No change in proportionate equity interests

8 Voting rights immediately exercisable

9 Combination resolved at consummation (no pending provisions)

– Absence of Planned Transactions

10.Issuing company does not agree to reacquire shares 11.Issuing company does not make deals to benefit former stockholders 12.Issuing company does not plan to dispose of assets within two years

(Source: http://acct.tamu.edu/smith/purpool/apb16_17.htm)

Controversy Over Pooling

• On September 7, 1999, the FASB issued a draft with

four significant changes to existing accounting practice:

1 Use of the pooling-of-interest method would be prohibited.

2 The current 40 year maximum amortization period for goodwill would be reduced to 20 years.

3 Companies would be required to present separate line items in the income statement for income before taxes and goodwill

amortization , and for goodwill amortization net-of-tax basis.

4 The current 40-year maximum amortization period for acquired intangible assets (other than goodwill) would be replaced with a presumption that their useful lives are 20 years or less.

Example: Purchase of Assets

• Assume that Acquiror Co buys Target Co for

$200,000 in stock

• Acquiror Co must then revalue the assets and liabilities of Target Co to their fair values at the date of the acquisition and record any

identifiable intangible assets that were not

carried on Target’s books.

• Any difference between the purchase price and the fair value of the net assets would be shown

as goodwill arising from the acquisition.

Assets Acquirer

Target’s Balance Sheet

Prior to Acquisition

Revalued Target’s Balance Sheet Merged Firm

Accounts Payable $90,000 $14,000 $14,000 $104,000

LT Notes Payable $170,000 $15,000 $12,000 $182,000 Shareholders' Equity $460,000 $42,000 $200,000 $660,000 Total Liabilities & Equity $720,000 $71,000 $226,000 $946,000

Example Pooling of Assets

• Now the merged firm only recognizes the goodwill that existed prior to the

acquisition.

Assets Acquirer

Target’s Balance Sheet

Prior to Acquisition

Revalued Target’s Balance Sheet Merged Firm

Accounts Payable $90,000 $14,000 $14,000 $104,000

LT Notes Payable $170,000 $15,000 $12,000 $185,000 Shareholders' Equity $460,000 $42,000 $200,000 $502,000 Total Liabilities & Equity $720,000 $71,000 $226,000 $791,000

Value from Nothing

• Under pooling, the earnings of the merged firm “look better” than under purchase!

Amortization is $300

= $12,000/40

Straight-Line method of depreciation with zero residual value and a useful life of 4

years Depreciation: $75,000 =

$300,000/4

Total Amortization uses the straight-line

method with zero residual value and a

10-year useful life for patents and

trademarks, and goodwill amortized over

40 years Amortization: $6,825 =

($250,000+$15,000)/10 + $113,000/40

Tax Considerations

• In general, the target’s shareholders pay taxes

on the gains or losses immediately when the

transaction is concluded, while the acquirer

restates the acquired assets at fair market value.

• The asset write-up increases the amount of

depreciation which is valuable for an acquirer in

a tax paying status.

• M&As can be tax-free, whereby the target’s

shareholders recognize a loss or gain only if

they sell the assets they receive in payment from the acquirer.

Qualifying for Tax Free Treatment:

Mergers

1 The shareholders of the target have to

retain a continuing equity interest in the acquirer.

2 The interest must be substantial in

relation to the net assets of the target.

• These two rules have been interpreted to

mean that the target shareholders have

to receive at least 50 percent of their

payment in stock of the acquirer.

Qualifying for Tax Free Treatment:

Acquisitions

1 All payment to the shareholders of the

target has to be in the form of voting

stock.

2 The acquirer must obtain at least 80

percent of the voting stock of the target.

Valuing Acquisitions

• Despite 30 years of evidence

demonstrating that most acquisitions do not create value for the acquiring

company, both the number and the

volume of deals have been increasing from year to year.

• You need to understand however the

several meanings of the word “value.”

It Depends on What You Mean by

Valuation Assumptions

• Capital structure assumption

– The capital structure assumption should not

be reflective of the financing used to buy the target per se, but should reflect the degree to which owning the target incrementally affects your debt capacity.

Valuation Assumptions Continued

• Pre-Tender Offer Strategy

– The target firm’s stock price will exceed the present value of the firm’s future cash flows if

it reflects the possibility that the firm may

eventually be taken over at a premium.

– Toeholds: Bidder buys shares in the open

market prior to making the tender offer.

• Can buy up to 5% and then have a window in which to notify the markets that a tender offer will

be forthcoming At that point open market purchases must cease.

Target Firm Stock Prices Around a

Tender Offer

Information leakage: about 10% out of 27%

Total value about 27%