The many operational challenges of merging two companies push some critical accounting issues down the agenda. With so many deals ending in failure, the acquirer's C-suite tends to focus more on fundamentals than on financial reporting.
In truth, leaders buying a company can save themselves time and money by tackling the most complicated accounting issues before the deal closes. Waiting until year-end typically brings surprises for management and investors. The resulting changes to the balance sheet upend the financial projections, forecasts, and key performance indicators that management relied on since the sale. And while some other issues don't arise until years later, their consequences may extend as far as litigation.
Accounting issues may lurk beneath the surface of the target company's financials, hidden in the details of the purchase agreement or the fine print of old contracts. Let's review the top flashpoints that are often overlooked.
Debt v. equity: financing by issuing shares
Many companies finance their M&A activity by issuing shares, raising money to purchase a business or using shares as currency for the acquisition. In many cases, especially in the case of private companies, new shareholder agreements may also be entered into as part of the acquisition.
What surprises many business owners is these shares may be accounted for as liabilities. While many assume these shares are equity in the company, they should sometimes be recorded as debt for accounting purposes.
Determining the debt-versus-equity question is typically complicated. Accountants consider several factors, including related shareholder agreements.
Earnouts
Earnout arrangements can be riddled with accounting issues. These provisions are designed to create a win-win between buyer and seller on the value of the company. But earnouts are regularly tied to revenue targets—and revenue is sometimes in the eye of the beholder.
It comes down to how revenue should be recognized. In accounting terms, revenue recognition is a complicated area that involves the use of judgement. The seller and buyer may have different views on how to recognize revenue since the acquisition. Disputes of this nature sometimes lead to litigation. Make sure you understand the accounting treatment for earnouts beforehand, to help manage the expectations of all parties.
Assets acquired that rise in fair value
Assets of the target company receive a fair value increase on their acquisition. When your balance sheet reflects this increase after you purchase the company, it could have wide-ranging consequences.
As an example, consider inventory. When the fair value increases, it could impact the gross margins of your company and, in turn, key related milestones, such as earnouts and key performance indicators set by the company.
Two other examples: capital equipment and intangible equipment included on the target's balance sheet. The fair value bump in these cases can create a higher expense in the post-acquisition results. These expenses are amortized, generating an expense that gets recognized in your profit-and-loss statement going forward.
Intangible assets never recorded on a balance sheet
The idea that a balance sheet doesn't record every single asset of a business may seem odd at first glance. In theory, a balance sheet should tell the financial story of the company in numbers—and tell it in full.
Yet the rules change when your company makes an acquisition. Companies don't include intangible assets on their balance sheet when they are developed internally. But these assets were not internally developed by the buyer, so you need to now record these assets on the balance sheet.
In many cases, intangible assets add significant value to your balance sheet. Take intellectual property, for example. This asset is intangible, yet it is more valuable than the company's physical assets at many technology businesses. Another example is brand value, which doesn't appear on the seller's balance sheet but needs to be accounted for on your balance sheet.
Agreements that surprisingly fall outside the acquisition
Anyone buying a company may sign numerous agreements at the same time. While the acquisition triggered all of them, some may fall outside the acquisition for accounting purposes.
You might find this with employment contracts or those signed for managerial services, which many buyers and sellers pursue during an acquisition.
Accounting requires you to split these and similar agreements from the purchase by carefully analyzing their reasons, their timing, and who initiated them. Some could lead to expenses being recognized post-acquisition—which is hardly intuitive, since the agreements were all signed because of the acquisition.
Contingent liabilities
The due diligence conducted prior to purchase sometimes uncovers liabilities that are subject to future circumstances. However, because they may require payment, they become the responsibility of the buyer post-purchase. These contingent liabilities need particular attention.
As a result, the pre-purchase work on contingent liabilities happens in two steps: investigative and analytical. First, due diligence professionals—both accountants and lawyers—investigate all liabilities. The second step falls into the realm of complex accounting, where specialists assess whether the liability must be recognized.