This guide will assess the impact of mergers and acquisitions (M&A) on pro forma financial statements. There are several important accounting considerations to be aware of when preparing M&A pro forma financial statements.
M&A Pro Forma – Value will be harder to prove
Financial statements will vary significantly post-merger. New assets and liabilities will be recognized on the combined balance sheet while existing assets and liabilities may be measured according to different conventions. Further, balance sheet items that were recognized prior to the acquisition may be derecognized in the post-acquisition accounts.
Acquirers must identify all the assets they are acquiring, both tangible and intangible assets. As goodwill is the residual of these identifiable net assets, the goodwill amount is often lower than previously thought.
Impact of goodwill impairment calculations on EBIT, and EBITDA calculations
Instead of including an amortization charge to goodwill, the value of a goodwill asset is instead impaired, decreasing in value. Without this amortization charge, EBIT will increase while EBITDA will not change.
With impairment replacing goodwill amortization, this exhibit shows a gradual increase in earnings. However, impairments of goodwill can still arise, producing unpredictable dilutive earnings.
Tax deductibility of goodwill
Generally, goodwill is not considered tax deductible in most countries. The exception to this basic rule relates to goodwill arising on the acquisition of an entity’s net assets rather than its equity.
M&A Pro Forma – Restructuring costs and the impact on post-acquisition performance
Restructuring provisions are excluded from goodwill calculations and must be charged directly to net income, post-acquisition, unless the target entity was committed to restructuring before the acquisition. This will make it harder to demonstrate post-acquisition earnings accretion.
M&A Pro Forma – Net debt implication
Net Debt = Borrowings – (Cash + Liquid Resources)
Note that the net debt calculation contained within an annual report includes borrowings, cash, and liquid resources for the parent and its subsidiaries. Further, standard net debt calculations do not include the debt exposure included in joint ventures and associates.
With the introduction of the goodwill impairment model, there may be significant write-offs of goodwill required in respect to past deals. Consideration must be given as to how this information is communicated to the market.
*Note that the full investment banking manual contains a comprehensive example of acquisition accounting on pages 134-136.
New M&A Pro Forma accounting rules
In 2008, a revised set of rules for accounting for business combinations was published. The new rules must be applied for accounting periods beginning on or after July 1, 2009. For companies with December year ends, the first accounting period when the new rules will apply will be the year ending December 31, 2010. They may also be implemented sooner. The proceeding article highlights the most important rule changes.
Non-controlling interest and goodwill
We first focus on changes in goodwill calculation as there is now a slightly different approach to calculating goodwill:
The calculation for goodwill remains the same as with previous rules. The only difference is that goodwill is grossed up on both sides by non-controlling interest.
Under IFRS, the real change comes in the way non-controlling interest is measured. The new rules allow non-controlling interest to be measured as either the noncontrolling share of identifiable net assets (traditional approach) or at its full, acquisition date fair value. Under US GAAP, the non-controlling interest must be measured at its full, acquisition date fair value and not simply the noncontrolling share of the fair value of the separable net assets.
Many M&A transactions include a contingent consideration (future adjustment to the price, dependent on the performance of the acquiree) where, after the acquisition, there may be payments, either in cash or shares, between buyer and seller to affect any “earn out.” Existing accounting rules require annual adjustments for changes in expectations of payments, with a corresponding adjustment to goodwill. The new rules require that the adjustment be to the group income statement rather than to goodwill. The most important implication of this rules change is that the post-acquisition group income statement may be more volatile than before, as the changes to the estimates of the contingent consideration move profits rather than goodwill. Merger models will need to be adapted to be able to handle sensitivity analysis around the value of the contingent consideration.
Previous accounting rules require that any costs directly associated with the acquisition (due diligence, price negotiations, etc.) are treated as part of the cost of the acquisition, capitalized on the balance sheet as an increase in goodwill. Under the new rules, these costs are expensed through the income statement in the same period the services are received, typically around the transaction date.
Other key changes include:
Re-classification and re-designation of financial arrangements for accounting purposes on a business combination
Determination of what exactly is part of the exchange transaction as opposed to transactions that should be accounted for separately
Step acquisitions, where an existing stake is already held
Changes in ownership interest with no loss of control