A Guide to Accounting for Mergers and Acquisitions

Mergers and acquisitions (M&A) are often used by companies to achieve growth, expand market share, or gain other competitive advantages. Beyond these strategic motivations, M&A brings complex accounting challenges that companies (and analysts) need to understand and consider. This article delves into the key components of M&A accounting, as well as some of the most common challenges and best practices.

What is M&A?

Mergers and acquisitions (M&A) refer to the combination of companies or assets through various types of transactions. While the terms “mergers” and “acquisitions” are often used interchangeably, they really have different meanings. Although there is some nuance around these, in general, we will use the following definitions:

• Merger: A merger occurs when two separate companies combine to form a new entity. Both companies cease to exist separately and operate under a new corporate identity.
• Acquisition: An acquisition happens when one company (the acquirer) purchases another company (the target). The acquired company may continue to operate under its name, or it may be completely absorbed into the acquiring company.

M&A can be driven by many factors, including the desire for synergies, market expansion, diversification, and acquiring unique capabilities. M&A transactions can be extremely complex and involve significant changes to the financial statements of the different parties, making accurate accounting essential.

Key Components of M&A Accounting

Whether a company prepares its financial statements in accordance with US Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), business combinations are accounted for using the acquisition method.

The Acquisition Method

The acquisition method requires that after the transaction has been completed, the acquirer will prepare consolidated financial statements, which will include the target company’s financials and results.

Under the acquisition method, accounting rules require that the acquirer performs a purchase price allocation. This means the acquirer will need to measure the target’s identifiable tangible and intangible assets and liabilities at fair value on the acquisition date. Basically, the acquirer will actually restate the target company’s balance sheet at fair value instead of historical cost. This process usually results in write-ups, or increases, to the target company’s balance sheet.

Fair Value

In order to determine the fair value of the target company’s assets and liabilities, the acquiring company will hire specialist appraisers and valuation professionals. These specialists have a deep understanding of accounting principles and valuation methodologies.

For example, if some of the acquired assets are commercial buildings, then a real estate specialist will determine the values. The specialist might look at recent sales of comparable buildings to value the acquired buildings.

After determining the fair value of all of the target’s identifiable assets and liabilities, then the fair value of net assets is determined by deducting the liabilities from the assets. If the purchase price of the target is still greater than the fair value of net assets then the difference between the two is considered goodwill.

Goodwill

Goodwill represents the premium paid over the fair value of the target company’s net assets. Fundamentally, goodwill captures various different unidentifiable assets a company has. These are things like brand value, customer loyalty, management “know-how,” and expected synergies.

Goodwill is only created in an acquisition and cannot be recognized on a balance sheet without an acquisition. In other words, goodwill cannot be created by a company on its own… it’s only a balance sheet asset once the company is acquired.

Additionally, goodwill is considered an indefinite-lived asset so it is not amortized but it is tested annually for impairment to ensure it accurately reflects its current value.

Tax Implications

However, the purchase price allocation and calculation of the fair value of the target company’s assets and liabilities may have significant tax implications.

Companies maintain two sets of accounting records:

1. The first set is for financial reporting purposes and companies use accrual accounting guided by IFRS or GAAP rules and principles.
2. The second set of records is for tax purposes and is based on a country’s tax rules and laws.

The fair value adjustments impact the accounting records but not the tax records, although this is not always the case depending on how the transaction is structured.

Because the fair value adjustments impact the accounting records and not the tax records, then there is a mismatch between the values on the accounting balance sheet and the tax balance sheet. This mismatch can lead to deferred taxes.

The M&A Accounting Process

The M&A accounting process involves multiple stages:

1. Valuation and Deal Structuring: The acquirer evaluates the target’s value using various valuation methods like discounted cash flow (DCF), comparable company analysis, and precedent transactions. Once a value has been determined, the deal can then be structured as a cash transaction, a stock swap, or a mix of both cash and stock.
2. Due Diligence: Before finalizing a deal, analysts and other professionals conduct thorough due diligence to assess the financial results of the target company. This includes reviewing assets, liabilities, contracts, litigation risks, and calculating potential synergies.
3. Purchase Price Allocation (PPA): As mentioned above, once the deal closes, the purchase price is allocated to the acquired identifiable assets and liabilities. This step determines the amount allocated to goodwill and requires the fair value assessments by valuation specialists.
4. Consolidation and Integration: The financial statements of the acquired company are integrated with those of the acquirer. This includes consolidating balance sheets, income statements, and cash flow statements. Deferred taxes, goodwill, and fair value adjustments are also recorded during this step.
5. Post-Acquisition Accounting: Ongoing accounting tasks include impairment testing of goodwill, amortization of acquired intangible assets, and adjustments for deferred taxes. Regular financial reporting must reflect these post-acquisition changes in order to calculate accretion or dilution to earnings per share accurately.

Common Challenges with M&A Accounting

M&A accounting presents several challenges, including:

• Estimating Fair Values: Accurately determining the fair value of the acquired assets and liabilities, especially intangible assets, can be very challenging and requires expert valuation professionals.
• Goodwill Impairment: Goodwill is tested annually for impairment, or sooner if there is evidence that it is already impaired. If goodwill is impaired, then this can result in large write-downs, negatively impacting investor perception.
• Deferred Taxes: Accounting for deferred tax liabilities and deferred tax assets, which arise from differences between book and tax values, adds complexity to financial reporting and analysis.
• Integration Issues: Combining financial reporting systems and reporting standards between two companies can be difficult, especially in cross-border transactions involving different currencies and different regulatory compliance standards.

Best Practices for Successful M&A Accounting

Companies should consider the following best practices to help mitigate the challenges and ensure successful acquisition accounting:

• Early Involvement of Accounting Experts: Accounting professionals should be involved early on in the M&A process, as well as part of the due diligence team, to proactively identify and address potential issues.
• Comprehensive Due Diligence: Conduct thorough due diligence to identify financial risks and ensure that all potential liabilities are accounted for in the purchase price allocation.
• Accurate Fair Value Assessments: Utilize qualified valuation experts to determine the fair value of acquired assets and liabilities, particularly for intangible assets like intellectual property.
• Effective Integration Planning: Develop a detailed integration plan to smoothly merge the financial systems, accounting policies, and reporting practices of the buyer and target company.

Conclusion

M&A accounting is a critical component of the mergers and acquisitions process that requires careful planning, precise execution, and ongoing attention. By understanding the key elements of M&A accounting, the challenges involved, and the best practices to follow, companies can ensure accurate financial reporting, compliance with accounting standards, and the successful integration of the target company.

As M&A activity continues to be a popular strategy for growth and expansion, mastering the complexities of M&A accounting is essential for financial analysts and business leaders alike.

Additional Resources

Thank you for reading CFI’s guide on Accounting for M&A. To keep advancing your career and skills, the following CFI resources will be useful:

M&A Glossary

M&A Process

CFI’s M&A Accounting course

CFI’s Accounting for Business Combinations & Other Equity Investments course

See all accounting resources