Merger Math

Despite recent global convergence in standards, accounting for acquisitions remains tricky—in both the run-up to a deal and its aftermath. This year’s robust M&A activity is keeping finance teams busy.

The urge to merge has picked up for corporate leaders this year. The value of global acquisitions announced in the first six months was $2.49 trillion, 57% higher than in the same period last year, according to Dealogic. The global corporate community is set to break the 2015 record of $4.66 trillion in M&A transactions.

All that deal-making requires a whole lot of bookkeeping. Whether it’s a megadeal like Takeda Pharmaceutical’s proposed $62 billion merger with Shire—among the largest cross-border deals announced so far this year—or a combination of small businesses, reporting the financial implications is a major challenge.

“An acquisition always involves more work than you think it will,” says Michael Conway, director and president of Toronto-based startup SightQuest Technology. The former chief accountant for Royal Bank of Canada, that country’s largest bank, has had accounting experience for both large and small mergers. “The big acquisitions are more complicated, but the companies have a lot more resources at their disposal.”

At least the rules are fairly clear and well-established since standards for business-combination accounting were overhauled in the last 10 years­—by the Financial Accounting Standards Board (FASB) in the US and the International Accounting Standards Board (IASB) for the rest of the world.

“There have been a few minor differences, but IFRS [international financial reporting standards] and US GAAP [generally accepted accounting principles] are largely converged when it comes to accounting for business combinations,” says Dan Langlois, audit partner at KPMG. That makes certain cross-border mergers much less complicated. Still, that doesn’t mean it’s a cakewalk.

Companies that undertake acquisitions regularly, however, benefit from the experience. They often establish control models for the acquisition process and have auditors assess the controls’ effectiveness. “It certainly helps to have a process in place that you’ve done a couple of times,” says Conway. As chairman of the audit committee of Decisive Dividend Corp, he has overseen the acquisition of four small companies in the last three years. “If you have controls in place, it becomes more of a science and helps you get the ROIs you expect,” he adds.

A number of key areas, however, regularly present accounting challenges for corporate finance departments in any acquisition.

Fair Valuations

The bulk of the accounting work for acquisitions involves valuation of the assets and liabilities of the acquired company. In the past, a company simply added the historical costs of a target’s assets and liabilities to its own. If the purchase price was more than the value of the net assets, the excess was booked as goodwill and amortized over as much as 40 years.

Two accounting standards—ASC 805, issued by FASB in late 2007; and IFRS 3, issued by the IASB the following year—changed the ground rules dramatically. Both standards require companies to use fair market, rather than historical, values. Goodwill, now representing the difference between the fair value of net assets and the purchase price, is also no longer amortized to the income statement.

Measuring fair value is tricky enough with tangible assets like inventory, real estate and capital equipment. Inventory valuation, for example, involves assumptions about expected costs and profits on finished goods and work in process. Valuation of real estate depends on whether it is used for business operations or held as an investment property.

Intangible assets, however, pose a bigger challenge because they involve more uncertain and subjective assumptions. “Intangible assets tend to be harder to value, because you’re projecting cash flows, discount rates and growth rates into the future,” says Langlois.

A company’s intangible assets could include patents, brands, trademarks, software and other technologies, franchise agreements, customer relationships, noncompetition agreements and insurance contracts—even relationships with governments. Such assets are extremely tough to value.

Accountants suggest getting help with the job from valuation experts. Both the Securities and Exchange Commission and the European Union prohibit auditors from providing appraisal or valuation services for their audit clients.

“Companies can do the work themselves—and they do,” says Mark Edwards, a partner in the valuation-services practice of Grant Thornton. But Edwards, who audits fair-value positions for clients, doesn’t recommend it. “They may have very capable people, but they typically aren’t familiar with valuation techniques and best practices,” he says. Some intangible assets, like patents, have limited lives and are amortized on different schedules. Others with indefinite lives, including goodwill, must be assessed regularly for potential impairments to their value. “I prefer to see clients use third-party specialists,” Edwards says.

Contingent Complexity

Contingent considerations—commonly called earn-outs—present another significant accounting challenge. These agreements stipulate potential payments, usually from an acquiring company to a target company, based on future performance of the business. They are increasingly common—and increasingly complex.

“There are a variety of arrangements often linked to the performance of the entity after acquisition,” says Langlois. “They could be based on revenue, EBITDA or earnings; and they could kick in or be capped after reaching a threshold. They have to be recorded at fair value and marked to market every quarter.” Both the FASB and the IASB provide guidance on valuing earnouts in a variety of standards and interpretations, but again, accounting specialists suggest getting third-party help. Earnouts “can be particularly challenging to value,” Langlois says.

Along with the quarterly revaluation of contingent earnout arrangements, other regular accounting assessments and reports are mandated post-acquisition.The biggest is accounting for goodwill. Mathematically, goodwill is the excess of the price paid over the fair value of net assets. Figuratively, it represents the expected future economic benefits of acquiring a business. And it may—depending on the size and nature of the business—have to be allocated to multiple reporting units.

Accounting standards no longer allow goodwill to be simply amortized. Instead, as with other indefinite intangible assets, goodwill must be annually assessed for impairment. If it has been allocated to multiple reporting units, each unit has to be assessed. “It can be a big challenge for companies to stay on top of it,” says Langlois.

While goodwill amortization charges no longer depress earnings, impairment charges can make for bad headlines. The $6.4 billion in total impairments recognized by Toshiba for its acquisition of Westinghouse Electric’s nuclear business contributed to a more than 50% hit to its share price early last year. Similarly, in late 2015, Deutsche Bank shares fell after it took impairment charges of over $5 billion to goodwill and other intangible assets in its retail banking division and its 20% stake in Chinese bank Hua Xia.

Recently, goodwill values have held up. The latest Duff & Phelps study of goodwill impairments by US public companies, covering 2016, found the number of charges dropped from 350 to 288, and the amount fell 50% from $56.9 billion to $28.5 billion. “In a flat-to-growing economy, we wouldn’t expect to see a lot of impairments,” says Edwards.

The amount of goodwill added to US balance sheets in 2016, however, was $278 billion; and goodwill now represents roughly one-third of the net assets of publicly traded US companies. With acquisition premiums continuing to rise, those numbers will likely increase further.

If and when markets turn, impairments will be back. Per Duff & Phelps, goodwill impairments booked by US companies in 2008 totaled $260 billion. Many companies were accused of “big bath” earnings management for writing off huge amounts of goodwill during the general mayhem of the financial crisis. Notable 2008 impairments included Time Warner ($25 billion), ConocoPhillips ($39 billion) and Royal Bank of Scotland ($22 billion).

The key to making accounting for an acquisition more manageable is good research and execution at the front end, says Edwards: “Companies need to correctly identify all assets and liabilities they’re acquiring as part of the deal construction. The more planning and due diligence performed earlier, the better.”