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 targets books prior to the merger continues to be carried on the merged firms 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. 4. 5. 6. 7. 8. 9. Single transaction (completed in one year following the initiation) Exchange of common stock (90% "substantially all" rule) No equity changes in contemplation of combination (two-year rule) Shares reacquired only for purposes other than combination No change in proportionate equity interests Voting rights immediately exercisable 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 Targets 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 Cash Accounts Receivables Notes Receivable Inventory PPE (net) Goodwill Trademark Patent Total Assets Liabilities and Equity Accounts Payable LT Notes Payable Shareholders' Equity Total Liabilities & Equity

Acquirer $185,000 $90,000 $55,000 $140,000 $250,000

Targets Balance Sheet Prior to Acquisition $6,000 $8,000 $10,000 $35,000 $12,000

Revalued Targets Balance Sheet $6,000 $8,000 $9,000 $50,000 $113,000 $15,000 $25,000

Merged Firm $191,000 $98,000 $55,000 $149,000 $300,000 $113,000 $15,000 $25,000 $946,000 $104,000 $182,000 $660,000 $946,000

$720,000 $90,000 $170,000 $460,000 $720,000

$71,000 $14,000 $15,000 $42,000 $71,000

$226,000 $14,000 $12,000 $200,000 $226,000

Example Pooling of Assets

Now the merged firm only recognizes the goodwill that existed prior to the acquisition.

Assets Cash Accounts Receivables Notes Receivable Inventory PPE (net) Goodwill Trademark Patent Total Assets Liabilities and Equity Accounts Payable LT Notes Payable Shareholders' Equity Total Liabilities & Equity

Targets Balance Sheet Prior to Acquirer Acquisition $185,000 $90,000 $55,000 $140,000 $250,000 $10,000 $35,000 $12,000 $6,000 $8,000

Revalued Targets Balance Sheet $6,000 $8,000 $9,000 $50,000 $113,000 $15,000 $25,000

Merged Firm $191,000 $98,000 $55,000 $150,000 $285,000 $12,000 $0 $0 $791,000 $104,000 $185,000 $502,000 $791,000

$720,000 $90,000 $170,000 $460,000 $720,000

$71,000 $14,000 $15,000 $42,000 $71,000

$226,000 $14,000 $12,000 $200,000 $226,000

Value from Nothing

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

Purchase Revenues COGS Gross Margin Expenses Depreciation Amortization SGAE Other Total Expenses Net Income $75,000 $6,825 $70,000 $10,000 $161,825 -$1,825 $500,000 $340,000 $160,000

Pooling $500,000 $340,000 $160,000 $75,000 $300 $70,000 $10,000 $151,550 $8,450 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 straightline method with zero residual value. Goodwill amortized over 40 years. Amortization is $300 = $12,000/40.

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 targets 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 targets 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 Value

Intrinsic value.
NPV of the future cash flows of the target irrespective of any acquisition. Conrails intrinsic value was around $71 per share when it was acquired.

Market value.
The market adds a premium that incorporates the probability that the target firm be acquired. Conrail stock price jumped to $85.13 the day the first bid by CSX was announced.

Purchase price.
A.k.a. :anticipated takeout value. How much the acquiror must pay to get the target.

Synergy value.
The NPV of the future cash flows that result from integration.

Value gap.
The difference between the intrinsic value and the purchase price.

Valuing Synergies
Types of synergies:
Cost savings Revenue enhancements Process improvements Financial engineering Tax benefits

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 firms stock price will exceed the present value of the firms 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

0.4

T otal value about 27%.

0.35

0.3

0.25

0.2

Information leakage: about 10% out of 27%.

0.15

0.1

0.05

-120

-113

-106

-99

-92

-85

-78

-71

-64

-57

-50

-43

-36

-29

-22

-15

13

20

27

34

41

48

55

62

69

76

83

90

-0.05

US TARGETS UK TARGETS

97

-8

-1