Mergers and acquisitions (M&As) are about more than just a change in business ownership at a hefty price tag. These transactions require intense planning and a clear strategy. And this means that they can have a significant impact on your accounting practices and tax obligations.
In this blog, we’ll help you navigate the complexities behind mergers and acquisitions, and how they affect your financial management.
Understanding the Basics of M&As
Even though the terms are often used synonymously or interchangeably, mergers and acquisitions are actually two distinct ways that companies can be combined.
Generally, a merger refers to the process in which two firms join to become a single entity. This means that they’re no longer owned and operated separately.
Acquisitions, on the other hand, occur when one business purchases and takes over another, and becomes the new owner. This doesn’t always need to be done in a friendly manner. In a hostile takeover, an acquisition is completed without the other company’s willing participation.
Both mergers and acquisitions can be done in a number of ways.
The different kinds of acquisitions
Broadly speaking, there are two ways to acquire a new company; through a stock sale or an asset sale. The former involves the buyer purchasing an entire business, along with all its assets and liabilities. In this instance, there’s a tiered legal situation. The original business still owns its assets and liabilities, but the buyer becomes the company’s new owner.
This can also take the form of a management acquisition. Here, executives from a purchasing company buy a controlling stake in another company.
In an asset sale, the buyer only purchases a specific asset from the target business, like intellectual property or even an entire business segment. It’s a pretty common occurrence when companies go bankrupt and are liquidated. However, this sale requires the approval of the target company’s shareholders.
Types of mergers
Like acquisitions, mergers can be structured differently, based on the relationship between the involved businesses.
Purchase mergers occur when one business buys another, either with cash or through a debt instrument. In consolidation mergers, an entirely new company is formed from the buyer and seller. And then there are integration mergers, which are usually based on competitive strategies. This includes:
- Horizontal mergers: Joining two companies in direct competition (sharing the same markets or products).
- Vertical mergers: Combining a supplier and business, or a customer and business.
- Congeneric mergers: Merging two companies serving the same consumer base, but in different ways.
- Market-extension merger: Here, two firms offering the same services or products to different markets join.
- Product-extension merger: The combination of two businesses offering different but related products to the same market.
- Conglomeration: A combination of firms with no common business areas.
Challenges in Mergers and Acquisitions
With so many ways to combine two businesses, it’s no surprise that there are a number of considerations and possible challenges to keep in mind. The first, and perhaps most important, is knowing how to justify the price tag.
Valuations
During mergers and acquisitions, each party will want to get the most value from the transaction. The seller wants the highest price possible, while the purchaser usually aims for the lowest. For this reason, a target company must be objectively valued. There are a few ways to do this.
By using a price-to-earnings ratio, you can make the target company an offer based on its earnings. An enterprise-value-to-sales ratio can help you make an offer based on revenue, by comparing the target business to industry standards. A discounted cash flow analysis allows you to calculate a firm’s current value based on estimated future cash flows. And finally, there’s replacement cost, when the purchase value is based on the cost of replacing the target company.
Risk management
Merging or acquiring businesses comes with a number of risks. This can be in the form of conflicting company values and cultures, souring negotiations, or delayed regulatory approval processes.
The longer it takes to close a deal, the greater the risk. As such, it’s important to have clear communication during the entire process, and set up risk management procedures.
Shareholder impact
In the lead-up to mergers and acquisitions, especially during stock sales or purchases, it’s common for the purchasing company’s share value to decrease slightly, while that of the target firm may increase slightly. This can impact shareholder voting power, especially if the pool of shareholders increases greatly. However, this usually returns to equilibrium once the deal takes effect.
Retaining employees
Many mergers and acquisitions come with changes in roles and responsibilities, which could mean layoffs. To ensure the process is as smooth as possible, you’ll need an effective change management plan.
Due diligence
Before any contracts can be signed, mergers and acquisitions must be investigated and verified. This enhances the decision-making process, as it allows you to identify liabilities, evaluate assets, and forecast future financials.
Your due diligence must be thorough, and include an overview of the target company. This encompasses everything from marketing and management structures, to financials and production capabilities, and potential legal or compliance issues.
The process consists of the following:
- A preliminary assessment is to check that the deal is a good fit.
- A financial analysis to check that there are no hidden pitfalls or liabilities.
- A legal assessment.
- An operational assessment to establish efficiency.
- An IT assessment to evaluate the infrastructure, software applications, data management, and potential cyber vulnerabilities of the target company.
Tax Considerations
Combining companies, no matter the method used, will result in changes to corporate structure, cash flow, as well as assets, and liabilities. And all that means a change in the company’s tax obligations.
For starters, did you know that the structure of the deal will dictate whether the transaction is taxable or non-taxable?
If the merger or acquisition is an asset purchase, it is considered a taxable event for the seller, who recognizes a gain or loss on the sale of individual assets. Depending on the type of asset, this is subject to ordinary income tax rates or capital gains tax rates. In addition, some assets may be subject to sales tax upon transfer. On top of this, the allocation of the purchase price will affect the tax basis and future depreciation or amortization.
Stock purchases are often non-taxable for the target company. This is because the buyer takes ownership of the target company, which therefore doesn’t recognize a gain or loss on the sale. However, shareholders will recognize a gain or loss once their stocks are sold.
Benefits and liabilities
There are a few upsides to mergers and acquisitions. In an asset purchase, it’s possible to use net operating losses (NOLs) from the purchased company for tax benefits. Basically, if the target company has NOLs, this can reduce your future taxable income.
It’s also worth noting that mergers and acquisitions don’t affect tax credits or deductions from the target company – these can be preserved and used to save money down the line.
On the downside, these transactions can be risky. You see, tax liabilities from the target company will be deferred to the purchaser, which can significantly affect your tax obligations. Also, if an S Corporation is sold within five years of being converted from a C Corporation, the buyer is liable for gains tax for any appreciated assets.
To make the most of the potential benefits and lower the risk of liabilities, you’ll need a proactive tax strategy for any mergers and acquisitions.
Tax strategies and planning
The most important part of tax planning for mergers and acquisitions is doing your due diligence. Then you’ll need to consider the best deal structure for tax purposes. As mentioned above, asset and stock purchases have different implications, and these should be considered when you’re drawing up contracts.
It’s also vital to consider integration planning, or strategies to optimize tax benefits and align tax positions after the merger or acquisition.
If in doubt, it’s best to consult a tax professional, who can help you navigate the process with ease, and save you money in the long term.
Accounting Considerations
With the right accounting practices in place, you can overcome many of the challenges associated with mergers and acquisitions, from valuation to reconciling accounts.
For starters, you’ll need to decide on the acquisition method. If you use the purchase method, the buyer recognizes the assets and liabilities of the target company at fair market values at the acquisition date. Anything above that price is recorded as goodwill on the buyer’s balance sheet. This represents the future economic benefits of assets that aren’t recognized separately. It means that the buyer’s financial statements reflect the target company’s assets and liabilities at their new fair values, which could lead to higher depreciation and amortization expenses.
On the other hand, if you decide to pool interests, the financial statements of the merging companies are combined as if they’ve always operated as a single entity. That means you have no fair market valuations, and no goodwill. Instead, assets and liabilities are carried over at their existing book values.
Note that goodwill isn’t amortized. Rather, it’s tested for impairment, which happens when the amount of goodwill exceeds its fair value. Impairment losses are recognized in your income statement, and therefore reduce your company’s net income.
The same is true for intangible assets with indefinite lives. These are non-monetary and non-physical assets like intellectual property. However, if they have a finite life, they’re amortized and affect the buyer’s income statement.
Post-merger integration
Once mergers and acquisitions take effect, several things need to happen. This includes consolidating financial statements of both companies, by combining them into a single set. Then, you need to eliminate transactions between the businesses to avoid double counting.
It also means you’ll need to implement the same accounting policies and practices in both companies. Note that these must also be compliant with regulatory standards.
If you need assistance with the tax or accounting considerations of mergers and acquisitions, schedule a Discovery Call with one of our CAs. With years of experience across industries, we’re ready to help you take your business to the next level.
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