Last time I discussed how P&Ls are combined in M&A transactions and the effect of synergies, changes in the mix of consideration, and balance sheet write-ups on accretion (or dilution).

Today, I’m going to turn to the balance sheets. I’ve already mentioned two of the most important balance sheet changes last time – the write-ups for PPE and Intangibles. Here, I’ll tick down the key balance sheet accounts and touch on some of the combining adjustments.

In combining the balance sheets, I must also address purchase price allocation. I’m not going to go into mind-numbing detail; that’s beyond the scope of discussion here (and actual purchase price allocation should be left to CPAs, tax experts, etc.). In broad strokes, the amount of the purchase price paid in excess of the target company’s accounting value must be recorded on the acquirer’s balance sheet. Accounting conventions require that the purchaser first allocate to tangible assets and then to intangible assets. Any amount that cannot be allocated to identifiable assets is recognized as goodwill. Goodwill therefore represents the excess of purchase price over the fair market value (FMV).

Here is my time tested “quick & dirty” method for combining and allocating purchase price to the key balance sheet accounts. Using this process should give you enough rough approximations of opening combined balance sheet figures for preliminary analysis:

Cash: The combined cash balance of buyer and target is reduced by any cash used in the purchase price.

Short Term Assets/Liabilities: No initial adjustments needed; however, future write-off of A/R or changes in accruals may be necessary.

PPE: As previously discussed, the seller’s fixed assets (PPE) are revalued at the time of the deal and are almost always worth more than the carried book value. The incremental value is added to the balance sheet. The resulting incremental depreciation will lower book earnings and may result in the creation of a deferred tax liability (DTL).

Other Intangibles: Like PPE, intangibles are examined and revalued at the time of the transaction. In most cases the intangibles will go up, resulting in incremental amortization that will lower book earnings. This additional amortization is usually not tax-deductible, so a DTL is created. Regarding purchase price allocation, the purchaser must first allocate identifiable intangibles such as trademarks, patents, and other intellectual property. Any amount that cannot be allocated to identifiable assets is recognized as goodwill.

Goodwill: In merger models, the prevailing convention is to zero out existing goodwill on the target’s balance sheet (the new transaction refreshes goodwill and old goodwill is forgotten). New goodwill is calculated by taking the allocable purchase premium less the write-ups for PPE and Intangibles (mentioned above) and also subtracting the net of the write-off of existing DTL and new DTLs created by the PPE and Intangible write-ups.  Goodwill is assumed to last forever on the balance sheet unless there’s an impairment. There is no tax impact for goodwill unless there’s a write-down.

Long Term Debt: Add any new debt issued for the acquisition.

Deferred Tax Liability (DTL): In merger models, the common convention is that existing DTL on the seller’s Balance Sheet is written off at the time of the transaction regardless of the structure of the deal (stock, asset, or 338(h)(10)). Any new DTL will be calculated from the acquirer’s perspective in the future. As discussed above, write-ups for PPE and Intangibles may create new DTLs related to the transaction. The new DTL obligation may be estimated by applying the acquirer’s tax rate to the sum of the PPE and Intangibles write-ups.

Shareholder Equity: In merger models, the common convention is to zero out seller equity and add the APIC of the buyer’s stock. The shareholder’s equity section of the target’s balance sheet is not transferred; instead, goodwill is created on the consolidated balance sheet to represent the difference between the purchase price and book value of net assets acquired.

So that completes the merger of major balance sheet items. Using this method will provide good, quick insight into the combined entity’s opening balance sheet.

Next time, I’ll go over a couple useful shortcuts and rules of thumb for telling right away whether a prospective transaction will be accretive or not.

Posted by: Mory Watkins