Purchase accounting
M&A / Merger ModelThe rules that rebuild an acquired business on the buyer's balance sheet at fair value, and the earnings consequences that follow from doing so.
Also written: acquisition accounting, acquisition method
Purchase accounting is what happens to the numbers on the day a deal completes. Under IFRS 3 the acquirer applies the acquisition method, and the target's own balance sheet is not carried across. Its historic cost figures, accumulated depreciation, share capital and retained earnings all disappear. Every asset and liability acquired is recognised afresh at its fair value as at completion.
Three things follow, and each shows up in a merger model. Identifiable assets are written up to fair value. Intangibles the target was never permitted to recognise, because it built them rather than bought them, are recognised for the first time. Whatever is left of the price becomes goodwill.
The earnings consequence is the part candidates miss. A bigger asset means a bigger depreciation or amortisation charge for years afterwards, so reported profit falls even though the cash left the business once, at completion. The charge sits below EBITDA, so EBITDA and every enterprise value multiple built on it are untouched while earnings per share falls.
It also creates deferred tax. In a share purchase the tax base of the assets carries over unchanged, so the write up buys no extra tax deduction, and the gap between the new book value and the unchanged tax base is recognised as a deferred tax liability at completion.
Worked example
A buyer pays 1,000 for a target reporting 250 of book equity. Diligence supports writing property up by 100 and recognising a brand at 150 and customer relationships at 200.
Deferred tax at 25% on the 450 of write ups is 112.5, so identifiable net assets are 587.5 and goodwill is the residual 412.5.
If the customer relationships amortise over ten years and the property write up over ten, the group carries 30 a year of charges it did not have before, and no cash moves at all.