The M&A financial follies

Acquisitions can be a fantastic driver of business value – or a career-limiting disaster. 

Three key activities increase the likelihood of a successful acquisition: 1) the deal structure; 2) planning; and 3) execution.  If all of these aren’t mastered, bring in outside help. 

Many things can go wrong when acquiring another company.  Among the top problems are lack of strategic fit, company culture, proper deal structuring, lack of communication and focus on customer needs.  However, there is another important consideration: the financial accounting implications.

The Financial Accounting Standards Board revised acquisition accounting rules by issuing SFAS 141(R), or ASC topic 805.  This newer guidance is intended to keep up with today’s rapidly changing business acquisition market.  

Software companies have the luxury of additional complexities given the intangible nature of their business.  These complexities include how to treat transactions costs, in-process research and development, earn-out arrangements and deferred revenue acquired.  Additional issues include goodwill, intangible assets and timing of the deal close. 

Let me be clear.  The accounting for acquisitions shouldn’t drive deal economics or outcomes. Leadership must be made aware, however, of key accounting implications in advance to avoid unnecessary surprises. 

Some key implications:

Transaction & Restructuring Costs – Expensed as incurred.  Transaction costs are no longer capitalized on the balance sheet.  This change in accounting may limit confidentiality and increase visibility to potential acquisitions because these expenses can appear on the income statement before acquisition announcement.

In-Process Research and Development – Software projects under development are measured at fair value on acquisition date and capitalized alongside intangible assets.  Prior treatment was to write off IPR&D at acquisition date.

Earn-outs – Also known as “contingent consideration”.  Earn-outs represent future consideration to a seller for achievement of certain goals in the future.  Examples include sales or revenue achievement over X number of months or years.  These earn-outs are considered a cost of the acquisition and are recorded at fair value on the acquisition date.  Future adjustments to actual earn-outs should be recorded in current period earnings when they are finalized.  Auditors will be particularly interested in the earn-out liability true ups because it can be viewed, by some, as earnings management.

Deferred Revenue – An often forgotten or unknown accounting impact is that of deferred revenue (cash received in advance of shipping product or providing services).  The Emerging Issues Task Force, also known as EITF 01-3, designed guidance to write down deferred revenue upon acquisition.  This write down reduces future revenue.  The theory behind this rule is the authoritative bodies want to discourage the purchase of companies primarily for their deferred revenue where there is no future “legal performance obligations”. 

Any deferred revenue that doesn’t carry a future legal performance obligation is required to be written off.  If the company does have a legal performance obligation (such as ongoing maintenance and support), the liability is written down to cost plus a reasonable markup.  This rule is a future revenue killer for software companies that don’t see this coming.

Goodwill & Intangible Assets – The purchase price that exceeds the net fair market value of the assets acquired, less liabilities assumed, is recorded as either goodwill, or intangible assets, or both.  Goodwill and intangible assets are reviewed annually for impairment.  Goodwill is not amortized as an expense (like depreciation of fixed assets), while intangible assets are amortized based upon an estimated life.  Hire a good valuation expert to help you because this process gets very complex and the valuation assumptions are largely theoretical.  Solid valuation experts I have used in the past include Valuation Research Corporation and Silicon Valley Bank.

Tax – If your company acquired another company with Net Operating Losses, or “NOL’s”, the future use of these losses may be limited.  Also known as IRC 382, the rule limits the amount of future NOL’s a company can use to “mop-up” gains in other areas of the business.  Similar to deferred revenue discussed above, this concept is similar to an anti-abuse provision so companies are discouraged from acquiring other companies solely for NOL tax benefits.

The last key operational consideration is to make sure your finance group performs a full accounting close at acquisition date.  If the deal closes mid-month without a full close then supporting documentation for auditors won’t exist.  This sends everything into an accounting tail-spin. 

The above are key financial accounting impacts to consider when purchasing a company.  If the company is in the software industry, consider the additional accounting complexities involved.  Knowing key rules in advance will help everyone involved understand and appreciate the complexities.  Make sure you have a solid financial resource to lean on to properly set expectations in advance and execute boldly.