Cost accounting in M&A Deals
In an acquisition of a business, it is vital to audit the cost of the transaction. As with any investment, it is key for management to have a precise understanding of the financial consequences that result from making one decision versus another. One way to factor expenses into the costs of a transaction is through allocation based on relative fair market values. During this process, costs are allocated between two or more parts of an acquired company based on their respective fair market values. This enables management and investors alike to understand which assets play a larger role in determining value for shareholders during an acquisition and which assets play smaller roles.
One of the most important aspects of according to Fintalent’s cost accounting consultants is that cost allocation is not only accurate but also transparent. This is extremely important when it comes to the ultimate success of an acquisition. Investors are often concerned that changes in a company’s assets can be made without any corresponding move in their balance sheet. Therefore, investors will want to ensure that assets are properly accounted for in order to mitigate any potential discrepancies due to subjective decisions by management.
The endeavor costs incurred by acquirer (or acquiree) are generally calculated as a percentage of each party’s respective pre-transaction equity. The acquirer’s endeavor costs are typically calculated as a percentage of the acquirer’s equity before the transaction, while the acquiree’s endeavor costs are typically calculated as a percentage of the acquiree’s equity before and after the transaction. The most common formula for calculating endeavors costs utilizes a common denominator in order to ensure that both sides of an M&A deal incur an equal amount of endeavor expenditures.
Primary Function of Cost Accounting in M&A Deals
Cost accounting in M&A is primarily concerned with separating pre- and post-transaction costs into distinct categories and assigning them to each respective company based on their purchase price. This is necessary so that management and investors alike can have a clear understanding regarding the financial effects of making one decision versus another, specifically which assets play a larger role in determining value for shareholders during an acquisition. Cost accounting breaks down into two primary categories: purchase price allocation and ongoing cost allocation.
The initial purchase price allocation is allocating the total costs of acquisition among the assets purchased, or in this case, the assets of each respective company. The total consideration paid for a business is then allocated to its individual assets based on their fair market values as of the closing date. Essentially, this means that if a business was purchased for $10 million, then $10 million will be reflected as an asset on its balance sheet.
In other words, purchase price allocation represents the total cost of an acquisition. This allows management and investors alike to understand which assets play a larger role in determining value for shareholders during an acquisition and which assets play smaller roles.
The ongoing cost allocations are allocating the costs for each asset separately, each of which is separated into its own group. The ongoing allocation of each respective company’s costs becomes important when it comes to tracking how those costs change over time because they will not be reflected in any future balance sheet or when they will be reflected in future statements.
Many companies have different budgetary practices that are applied to ongoing expenses, such as variable or fixed budgets, or budget types (such as salary bands or expense centers). When it comes to cost accounting in M&A, the most common practice is applying a fixed allocation to each asset on an ongoing basis. This is because many companies will have their cost allocations based solely on their company’s size and the assets they hold.
The initial purchase price allocation will differ depending on the type of acquisition (such as asset purchase or stock purchase), the nature of consideration (cash, stock or other assets), and other key factors. However, during ongoing cost allocation, initial allocations are typically not modified.
There are various costs that should be accounted for during a merger or acquisition besides just what it takes for a company to conduct its business in normal circumstances. These costs are referred to as extraordinary (or non-ordinary) and are subtracted from the total costs after all other variable, non-variable, fixed, and extraordinary expenses (OVFEs) have been accounted for. OVFEs are estimates of items that might not be directly attributable to an acquisition, such as legal and consulting fees. Costs that cannot be directly attributed to the transaction will be subtracted from the total cost in order to avoid overstating the value that is ultimately realized through an acquisition.
The process of accounting for Unexpenses is fairly straightforward. In preparation for the transaction, management will need to estimate the amount of extraordinary expenses that might be incurred during an M&A transaction. These estimates will be made based on how similar transactions have been handled in the past. After the deal is completed, those estimates are compared to actual costs and the difference is accounted for by way of a tax credit or charge.
As of late, accounting for Unexpenses has gotten increasingly more difficult as a result of changes in tax laws and how they apply to mergers and acquisitions. The most significant change in this area came about in 2008 when two new Section 1060 regulations were issued that effectively increased corporate tax rates by 20% to 40%. These changes drastically increase the occurrence of an accounting loss.
A charge for Unexpenses is typically recognized by management when a company is purchased. The company’s tax liability associated with the acquisition should be increased, then, by 20% to 40% of the total amount to be allocated to Unexpenses on the income statement. Some companies will also choose to recognize a charge on a discrete basis as income is realized over time through amortization, depreciation or depletion. However, accounting rules require all charges to be made within 7 years after completion of a transaction in order for them to be legally recognized.
Accounting for Unexpenses is perhaps the most controversial aspect of cost accounting during a merger or acquisition because the estimates are based on past transactions, as opposed to actual events. Because of this, there will inevitably be variances between what management estimates and what is ultimately realized through an acquisition. As stated before, if the numbers are not offset by a tax credit or charge, a loss will be recognized.
In order to better manage expenses carried forward from one year to the next and other recurring costs, companies may choose to allocate them into different expense categories over time. Examples of these categories include selling and general, research and development, and advertising. This accounting practice is separate from the acquisition process discussed above; however, it is nonetheless important to understand when considering expenses during M&A.
Selling, general and administrative costs (SG&A) are generally allocating in one of two ways: fixed or variable. Both methods have their own set of benefits and limitations. Fixed allocation is often preferred because it allocates a certain percentage or dollar amount to each asset based on its size. Fixed allocation requires less adjustment than variable allocation does over time, but it also does not necessarily reflect actual spending allocations for a business that has changed as a result of an acquisition or as other factors have changed over time. Variable allocation, on the other hand, will reflect changes in the business; however, it is still more likely to be less than precise.
A fixed cost allocation is a method used when allocating costs that is based on either a percentage of an asset’s value or a dollar amount for each asset being acquired. Under both of these circumstances, it does not matter how much the asset has changed in value or size. In this case, if an M&A transaction were to occur and an asset were to increase in size by 10%, then regardless of that change its cost allocation will still be based on its original value before the merger occurred.
Accounting for costs of an acquisition is often more complex than accounting for cost allocation. These costs are unique from just about any other aspect of business, and they can have a strong impact on the company’s financial statements. They should be closely monitored in order to remain mindful of exactly how much of a company is being acquired for, as well as the projected revenue and expenses that will be associated with it in certain time periods. Because costs can vary from one acquisition to another, it is important to keep that in mind when monitoring those costs during M&A.
In some instances, tax liabilities may not be incurred at all when following an acquisition. This is because the acquiring company already has enough income tax liability from previous years’ operations to cover their taxes during the upcoming year. In these cases, it would appear that there would be no need for a deferred income tax liability. However, even though there may be no current deferral of those taxes, those companies still need to provide for income taxes in future years and likely do so by recording a liability for deferred taxes. These balances are usually paid off over time as earnings increase and other payment obligations are fulfilled.
If a company chooses to defer the payment of their income taxes until they are actually paid by another entity, such as the acquiring company or even themselves, this will result in some accounting challenges. One issue is determining if such deferred taxes should be recorded as liabilities on the balance sheet or deferred and not recorded at all. This is because financial statement footnotes are for disclosures only; they cannot be used as asset accounts on balance sheets.
Cost accounting provides transparency and insight into transactions at any level of an acquisition to ensure that agreed upon price allocations are accurate and free of fraud or manipulation. Cost accounting can be applied to both tangible assets, such as inventory and equipment, as well as intangible assets such as goodwill and purchase price allocations. Cost accounting tools are used at all times in mergers and acquisitions but become especially important when a firm is acquired by another. Its accounting systems has to be able to generate appropriate information in support of applied calculations.