1) Corporate development teams must understand post-transaction accounting adjustments, like purchase price allocations, which can significantly impact reported earnings per share. 2) Estimating adjustments such as intangible asset valuations early improves deal analysis and mitigates risk of dilutive transactions. 3) Key factors that affect adjustments are expected synergies, purchase price, assets acquired, and whether the deal structure is a stock or asset transaction.

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

2. One of the most common post-transaction adjustments is a In addition to the fair value of tangible assets and liabilities,
“step-up” (i.e., fair value above book value) in tangible asset SFAS 141 requires the recognition of identifiable intangible
value. Tangible assets are often stepped-up subsequent to a assets acquired in a transaction. Intangible assets have the
transaction as these assets are typically depreciated for accounting potential of being a very significant post-transaction adjustment
purposes quicker than the actual economic depreciation of the since internally-developed intangible assets (which may have
asset. The following examples illustrate where tangible asset fair substantial value) are often not reported on the balance sheet.
value may vary significantly from book value and a step-up is As such, the post-transaction adjustment process typically
likely to occur: identifies “new” assets. Since many intangible assets are
amortizing assets, the recognition of “new” assets or a step-up in
■ Acquired personal property with economic lives that existing intangible assets can have a material impact on future
exceeds book depreciation lives. EPS in the form of amortization expense. The following table
■ Acquired real property in an appreciating market. demonstrates the accretion / dilution sensitivity by varying
levels of intangible asset allocations.
■ Acquired raw material inventory is comprised of materials
whose market price has increased significantly since the The three scenarios vary based on a projected split of
raw material was originally purchased. identifiable intangible assets (which are expected to amortize
■ Acquired work-in-process and finished goods inventory over an estimated 15-year economic life) and goodwill (which
for a company with a high gross profit margin and low does not amortize for book purposes). By allocating more of the
disposal costs. purchase price to identifiable intangible assets, future reported
earnings are depressed by the additional amortization expense.
A step-up in tangible asset value could have a material impact Specifically, the proposed transaction is dilutive to EPS in
on future EPS. For example, a large step-up in personal Scenario 3 due to the increased allocation of the purchase price
property or real property will alter the expected depreciation to identifiable intangible assets. (It is important to note that for
expense of the acquired entity, which directly impacts EPS. stock transactions, the SFAS 141 analysis results in amortization
Additionally, changes in expected depreciation expense or expense, which is a non-cash item and therefore should have no
working capital requirements can impact the internal rate of impact on the ultimate investment value.) This example is
return (“IRR”) calculated for the potential transaction, which intended to demonstrate the potential impact of inaccurately
may influence the Board’s opinion on the prospective deal. forecasting the value of acquired intangible assets and their
respective remaining useful lives for the same transaction and
Liabilities may also require post-transaction adjustments.
purchase price.
Common adjustments include deferred compensation, deferred
taxes, warranty reserves, off balance-sheet environmental or
legal liabilities, and pension liabilities.
(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)
©2007

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

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

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