Purchase Accounting - Corporate Developments Bane

Article discusses purchase accounting issues when analyzing a merger and acquisitions deal.

1. ©2007
Purchase Accounting:
Corporate Development’s Bane?
Jason M. Muraco, CFA – [email protected]
Dominic M. Brault – [email protected]
In the middle of any large M&A deal is a corporate
development team performing extensive due diligence
and analyzing the possible economic benefits of a potential
transaction. The final investment decision for a publicly
traded company is often conditioned on whether or not
the transaction is accretive to earnings per share
(“EPS”). Due to the importance a company’s Board
typically places on the accretion / dilution analysis, it is
vital that corporate development professionals fully
understand all aspects of the transaction that can affect
future earnings, including post-transaction accounting
adjustments. Estimating post-transaction adjustments
can be a complicated process, as most adjustments are
deal specific and dependent upon numerous variables
(e.g., purchase price paid, specific assets acquired,
expected synergies, asset valuation methodologies,
accounting promulgations, etc.). Obtaining an upfront
informed estimate of post-transaction adjustments can
improve the accuracy of any pre-transaction analysis
presented to the Board and may help mitigate the risk of
entering into a potentially dilutive transaction.
Typical Post-Transaction Adjustments■■ ■
Pursuant to Statement of Financial Accounting
Standards (“SFAS”) No. 141, Business Combinations
(“SFAS 141”), an acquiring entity shall allocate the cost
of an acquired entity to the assets acquired and liabilities
assumed based on their fair values as of the acquisition
date. Accordingly, any difference between the fair value
of acquired assets and liabilities (including identifiable
intangible assets) and book value represents a post-
transaction adjustment. Certain adjustments may be
material and will have a notable impact on EPS (e.g., the
fair value of amortizing intangible assets with little to no
pre-transaction book value). As demonstrated in the
following chart, a SFAS 141 purchase price allocation is
a “closed loop” process, as the fair values of the assets
and liabilities acquired must fit into the total purchase
price paid for the acquired entity. As a result, any post-
transaction adjustment to the assets and liabilities
acquired impacts the amount booked to goodwill, which is
the residual account that captures the remaining purchase
price paid above all identified assets and liabilities.
Working
Capital
Personal
Property
Real
Property
Intangible
Assets
Goodwill
Legend:
Purchase Price
Reporting
Unit 3
Reporting
Unit 1
Reporting
Unit 2

2. ©2007
One of the most common post-transaction adjustments is a
“step-up” (i.e., fair value above book value) in tangible asset
value. Tangible assets are often stepped-up subsequent to a
transaction as these assets are typically depreciated for accounting
purposes quicker than the actual economic depreciation of the
asset. The following examples illustrate where tangible asset fair
value may vary significantly from book value and a step-up is
likely to occur:
■Acquired personal property with economic lives that
exceeds book depreciation lives.
■Acquired real property in an appreciating market.
■Acquired raw material inventory is comprised of materials
whose market price has increased significantly since the
raw material was originally purchased.
■Acquired work-in-process and finished goods inventory
for a company with a high gross profit margin and low
disposal costs.
A step-up in tangible asset value could have a material impact
on future EPS. For example, a large step-up in personal
property or real property will alter the expected depreciation
expense of the acquired entity, which directly impacts EPS.
Additionally, changes in expected depreciation expense or
working capital requirements can impact the internal rate of
return (“IRR”) calculated for the potential transaction, which
may influence the Board’s opinion on the prospective deal.
Liabilities may also require post-transaction adjustments.
Common adjustments include deferred compensation, deferred
taxes, warranty reserves, off balance-sheet environmental or
legal liabilities, and pension liabilities.
In addition to the fair value of tangible assets and liabilities,
SFAS 141 requires the recognition of identifiable intangible
assets acquired in a transaction. Intangible assets have the
potential of being a very significant post-transaction adjustment
since internally-developed intangible assets (which may have
substantial value) are often not reported on the balance sheet.
As such, the post-transaction adjustment process typically
identifies “new” assets. Since many intangible assets are
amortizing assets, the recognition of “new” assets or a step-up in
existing intangible assets can have a material impact on future
EPS in the form of amortization expense. The following table
demonstrates the accretion / dilution sensitivity by varying
levels of intangible asset allocations.
The three scenarios vary based on a projected split of
identifiable intangible assets (which are expected to amortize
over an estimated 15-year economic life) and goodwill (which
does not amortize for book purposes). By allocating more of the
purchase price to identifiable intangible assets, future reported
earnings are depressed by the additional amortization expense.
Specifically, the proposed transaction is dilutive to EPS in
Scenario 3 due to the increased allocation of the purchase price
to identifiable intangible assets. (It is important to note that for
stock transactions, the SFAS 141 analysis results in amortization
expense, which is a non-cash item and therefore should have no
impact on the ultimate investment value.) This example is
intended to demonstrate the potential impact of inaccurately
forecasting the value of acquired intangible assets and their
respective remaining useful lives for the same transaction and
purchase price.
(All Dollars in Thousands) Scenario 1 Scenario 2 Scenario 3
Purchase Price $300,000 $300,000 $300,000
% of % of % of
Allocation of Purchase Price Purchase Price Purchase Price Purchase Price
Working Capital 15,000 5% 15,000 5% 15,000 5%
Fixed Assets 45,000 15% 45,000 15% 45,000 15%
Other Assets (Liabilities) 15,000 5% 15,000 5% 15,000 5%
Identified Intangibles 105,000 35% 135,000 45% 165,000 55%
Goodwill 120,000 40% 90,000 30% 60,000 20%
Income Statement (Year One)
EBITDA, Including Synergies $32,500 $32,500 $32,500
Fixed Assets Depreciation Expense (10 Years) (4,500) (4,500) (4,500)
Intangible Asset Amortization Expense (15 Years) (7,000) (9,000) (11,000)
Interest Expense ($300 million @ 6.0%) (18,000) (18,000) (18,000)
Pre-Tax Income 3,000 1,000 (1,000)
Taxes at 35% (1,050) (350) 350
Net Income 1,950 650 (650)
EPS Impact (50 million shares) $0.039 $0.013 ($0.013)

3. ©2007
The question now becomes: how should corporate development
professionals better equip themselves to account for post-
transaction adjustments? Currently, many corporate
development professionals consider prior company transactions
or Securities and Exchange Commission (SEC) filings of
competitors for guidance on post-transaction adjustments.
However, these types of methods may be misleading due to the
unique nature of each particular transaction as well as an
ongoing shift toward increased allocation of the purchase price
to intangible assets, largely driven by FASB and SEC scrutiny
of purchase accounting.
The remainder of this article provides guidance on how to
derive a more informed estimate of potential post-transaction
adjustments. To do so, corporate development professionals
need to fully understand how various variables (e.g., expected
synergies, purchase price, assets acquired, etc.) impact the
allocation process.
Expected Synergies■■ ■
Determining how the purchase price was derived and what
synergies are expected can assist in providing directional
implications on goodwill and intangible asset value. The
presence of significant buyer-specific synergies may suggest a
higher goodwill value (and thus lower intangible asset value)
relative to a situation with little to no buyer-specific synergies.
Consider the following scenario for further clarification:
A multi-national beverage company intends on acquiring a
smaller beverage company. The following synergies are
expected: a reduction in overhead, higher top-line growth
related to cross-selling opportunities, and lower input
costs due to enhanced purchasing power.
Given this scenario, a corporate development professional may
expect a sizeable amount of the purchase price to be allocated to
goodwill since current fair value standards require expected
synergies to be removed from the valuation of intangible assets,
which effectively lowers the value ascribed to intangible assets.
However, it is important to note that the Financial Accounting
Standards Board’s issuance of SFAS No. 157, Fair Value
Measurement(“SFAS 157”), which is effective for financial
statements issued for fiscal years beginning after November 15,
2007, alters the fair value definition utilized in the purchase
price allocation process to a more market-based measurement.
Specifically, SFAS 157 implies that expected synergies must be
allocated between “market participant” synergies and buyer-
specific synergies. A market participant synergy is one that
could generally be expected in an orderly transaction between
market participants.
Considering the prior scenario, under SFAS 157 the acquirer
must determine if its expected synergies are company-specific.
To do so, the multi-national beverage company must establish
who a market participant (and thus likely buyer) is for the
smaller beverage company. If another strategic (e.g., competitive
beverage company) is a likely buyer or market participant for
the target, then most of the expected synergies are probably not
buyer specific. In other words, another strategic player would also likely be able to reduce overhead, cross-sell and enhance purchasing power. As a result, the expected synergies are considered market participant and are credited to the seller (i.e., the smaller beverage company), resulting in higher identified intangible asset values as the forecasted synergistic cash flows must be used to value the intangible assets. Assuming that a market participant is a private equity firm with no established platform in the beverage industry, the synergy question may result in a materially different answer. The private equity firm would probably not be able to realize similar synergies, thereby implying that the expected synergies are specific to the buyer in the above scenario. Accordingly, the cash flows utilized in valuing the intangible assets would exclude the buyer-specific synergies, resulting in a lower value for intangible assets (and thus higher residual goodwill value).
Rationale of Deal / Assets Acquired■■ ■
Understanding the rationale of a contemplated transaction is a
key factor in anticipating post-transaction adjustments since the
motives driving a deal often suggest what types of intangible
assets may be inherent in the target entity. Once an understanding
of the types of assets of the target that may be acquired is
established, the corporate development professional can consider
the economic impact those types of assets can have on the
projected earnings of the company.
Let’s assume that Company A acquires Company B primarily
due to Company B’s reputation for market leading software
applications. Software applications generally have short economic
lives due to continual upgrades and competitive pressures.
Accordingly, this valuable software application will likely have
a substantial amortization expense impact in the near-term,
thereby increasing the risk of potential dilution.
Now let’s assume that Company C acquires Company D in
order to enter an established market based on the strength of
Company D’s existing brand name. As presented in the following
diagram, established brand names typically have relatively long
remaining useful lives (and in many cases indefinite lives),
which likely results in a minimal amortization expense impact.

4. ©2007
As presented in the diagram, intangible assets with high values
and short lives result in high dilution risk since the high value
must be amortized quickly, resulting in a large amortization
expense. Conversely, intangible assets with low values and long
lives result in lower dilution risk since the value is amortized
over a long period of time. However, it is important to note that
although assets with long lives may be better from a purchase
price allocation perspective, there is a trade-off in terms of
impairment testing. Under SFAS No. 142 and SFAS No. 144,
non-amortizing and amortizing intangible assets, respectively,
must be tested regularly for impairment. Accordingly, long-lived
intangible assets have a greater risk of eventually becoming
impaired, which may deter companies from choosing aggressively
remaining useful life estimates.
IRR Implications■■ ■
The IRR, which is the rate of return based on the purchase
price paid and projected cash flows of the acquired entity, is a
common analysis performed by corporate development
professionals in assessing the merit of a particular transaction.
The implied IRR is often compared to alternative investment
rates of return or the acquirer’s internal cost of capital in
deciding whether or not to consummate a deal. An IRR
analysis can also be utilized in assessing an appropriate
purchase price to offer. The caveat to this analysis is that a
transaction can pass the IRR hurdle (and be a value enhancing
investment), yet ultimately be dilutive to EPS in the near term.
Understanding this dynamic is important when presenting a
deal to the Board for approval.
Deal IRRs can also be impacted by acquisition structure (asset
vs. stock transaction). In an asset deal, the acquiring company
will receive the benefits of amortizing the intangible assets and
goodwill over 15 years, which should be considered in the
purchase price and IRR analysis. There is no such treatment in
a stock deal, unless the acquirer makes an election under
Internal Revenue Code 338(h)10, which allows the acquirer to
treat the transaction for tax purposes as a sale of the target’s
assets. On a related note, it is important for the corporate
development professional to understand any valuation practices
that could impact the level of post-transaction adjustments. For
example, under SFAS 141, acquired intangible asset values are
generally increased by the potential tax amortization benefit
under an assumed asset sale, regardless of whether the deal is
structured as asset or stock.
Like the expected synergy analysis discussed previously, an
analysis of the expected IRR can also provide insight into the
level of residual goodwill (and thus intangible asset value).
Considering the previous beverage company scenario, a
multi-national beverage company planning on acquiring a
smaller beverage company is utilizing its internal hurdle rate
(8%) to generate a purchase price offer. (Large corporations
typically have low hurdle rates due to lower financing costs –
equity and debt.) Based on the expected cash flows of the
acquired company (excluding buyer-specific synergies), the
company determines a purchase price of $300 million. Also
assume that a market participant in this scenario is a smaller
strategic entity with a slightly higher hurdle rate (10%).
Utilizing the same expected cash flows, the market participant
would derive a purchase price lower than $300 million. The
difference between the two purchase prices is solely attributable
to buyer-specific financing and should be considered a goodwill
item. Acquirers that do not consider market participant rates of
return run the risk of pricing a transaction too high, effectively
giving the seller the benefit of any financing synergies in the
form of a higher purchase price.
Highest Dilution Risk
Valuable In-Process R&D
Rapidly Changing Technology / Software
High-Profit Backlog
High-Turnover, High-Profit Customers
Low-Profit Backlog
Short-Term Loss Contracts
Secondary Technology / Software
Short-Term, Low-Profit Customers
Core Technology
Secondary Brands or Trademarks
Long-Term, Low-Profit Contracts
Manufacturing Processes / Know-how
Lowest Dilution Risk
Key Established Brand Names
Well Recognized Trademarks
Stable or “Sticky” Customers
Long-Term, High-Profit Contracts
High Value
Low Value
Short Life Long Life

5. Conclusion■■ ■
Despite being a post-transaction exercise, purchase price
allocation adjustments can materially impact EPS. Corporate
development professionals need to be prudent in estimating
potential post-transaction adjustments by making sure they
fully understand the various components of the deal (e.g.,
expected synergies, assets acquired, type of transaction, market
participants, etc.). Since this can be a complicated exercise, it
may be useful to engage a third-party valuation consultant prior
to the close of a deal in order to assist in the accretion / dilution
analysis and provide a more meaningful proposal for Board
approval and to avoid unexpected EPS results post-transaction.
This may be of even greater importance in today’s highly active
M&A environment, as rising market multiples increase the risk
of potential EPS dilution. Furthermore, engaging a valuation
consultant earlier in the process will likely increase the efficiency
related to the post-transaction purchase price allocation since
most of the data gathering and due diligence process will
already have been completed.
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