In Part I of this series we outlined the steps involved in appropriately considering the acquisition accounting and tax implications of a deal.
Acquisition Accounting is typically complex and requires considerable skills, experience and effort to ensure robust and satisfactory outcomes. Further, the requirements of three key Accounting Standards need to be to be considered together since they are interdependent: AASB 3: Business Combinations; AASB 136: Impairment of Assets; and AASB 138: Intangible Assets.
Following this, we discuss the importance and risks associated with each step of the PPA process below.
Determine if the transaction falls under the definition of a Business Combination: AASB 3 provides guidance in regards to determining if the acquisition is deemed to be a business combination, in which case a PPA will be required. Conversely, the transaction may fall under the classification of an asset acquisition.
Identify the acquirer: The identification of the acquirer is not always simple since the legal acquirer may not always be the acquirer for the purposes of accounting (i.e. “a reverse acquisition”).
- Importance: Identifying the acquirer determines the treatment to be adopted and identification of which assets to fair market value.
- Risk/impact: The accounting treatment of reverse acquisitions will change which entity requires valuation of its assets (for accounting purposes) and can lead to undesirable outcomes such as no fair market value adjustments.
Confirm the acquisition date: The date of the acquisition is the date at which control is obtained and may not necessarily be the legal date of the acquisition (i.e. when a purchase agreement is signed).
- Importance: The acquisition date determines the date at which fair market values are assessed, liabilities assumed and determination of any residual or goodwill that has been paid.
- Risk/impact: The balance sheet of many businesses can change quickly in a short period of time. Getting this date wrong can prove costly as valuations will need to be re-assessed, and practical outcomes for tax and accounting may vary.
Confirm the cost of the acquisition: The cost of the acquisition may include a number of components including the actual consideration paid; deferred cash or share consideration (which need to be appropriately discounted) and may also include contingent consideration (i.e. earn-outs, which may or may not be probable, and probability will be applied to determine their fair market value).
- Importance: It is critical that all other costs which are directly attributable to the acquisition are also captured and recorded appropriately. The acquisition costs could also include a number of expenses incurred by the acquirer which are deemed directly attributable to the acquisition. There are rules around which costs can be included and which must be excluded and treatments may be different for tax and accounting purposes.
- Risk/impact: An example relates to payments to previous owners for future services which are often treated as purchase consideration, whereas these payments are an expense of the new consolidated group. This is to the extent that expenses are included in the cost of acquisition, reducing the expenses recognised in the profit and loss for the period, and result in higher goodwill (which will be subject to regular impairment testing).
Identify all assets (both tangible and intangible) acquired and liabilities assumed (including contingent liabilities):
- Importance: Intangible assets must be recognised on acquisition if they meet the definition of an intangible asset and can be reliably measured. Asset and liability recognition relates to not just what’s on the balance sheet of the acquirer or target, but all items acquired that may have arisen as part of the transaction.
- To determine whether the acquired intangible assets should be recognised separately from goodwill, they must satisfy the recognition criteria identified under Australian Accounting Standards (and where material value is anticipated). The criteria, whilst seemingly straight-forward, are complex to apply.
- The Accounting Standards suggests that the following intangible assets should be considered:
- Trademarks, brand names, mastheads
- Customer assets (lists, contracts, relationships)
- Other contracts and relationships (distribution, supplier)
- Licence agreements
- Lease agreements
- Usage rights
- Patents, design and copyrights
- Internet domains
- Non-compete agreements
- Intellectual Property
- Risk/impact: ASIC, via its financial reporting surveillance program has heightened its scrutiny in regards to correct and adequate recognition and disclosure over recent years. In addition to the positive identification and valuation, focus areas include the economic useful life of each intangible asset (which will determine its amortisation profile and therefore have an impact on reported earnings), and any intangible asset that is not identified (as it will be consumed in goodwill and therefore not amortised, but subject to impairment testing).
Determine the fair market values of all assets and liabilities identified including Identifiable Intangible Assets and perform the PPA:
- Importance: Identifiable net assets must be measured at fair market value on acquisition, with any excess of the cost of the acquisition over the fair market value of the identifiable net assets being recognised as goodwill (or any deficit as a discount on acquisition). If the fair market value of the identifiable net assets is greater than the purchase price this discount is recognised as income in the period of the business combination, also known as a ‘bargain purchase’.
- AASB 13: Fair Value Measurement sets out the following definition of fair value:
“The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
For tax purposes: “The concept of market value relates to the price that would be negotiated in an open and unrestricted market between a knowledgeable, willing but not anxious buyer and a knowledgeable, willing but not anxious seller acting at arm’s length.”
- The PPA process will need to be undertaken in parallel with the identification of intangible assets. The effort required in this part of the process should not be underestimated. Valuations at the individual asset level of complex identifiable intangible assets require expert skills and many years of specialist experience. It is not something that can be easily performed in-house.
- In order to analyse cash flows and earnings at the asset level, one must consider the extent that a particular asset relies on the other assets of a business (such as working capital, fixed assets and the assembled workforce), and the extent to which a capital charge representing a commercial return on those should be recognised (referred to as a contributory asset charge, or CACs). CACs is a complex and technical area which is commonly dealt with poorly, or overlooked
- Tax deductible assets such as software, patents, registered designs, non-film copyrights and certain licences provide the acquirer with economic benefits in the form of future tax deductions. It stands to reason that these benefits would be factored into the price negotiated by a buyer and seller acting at arm’s length. As a result, Tax Amortisation Benefits (TABs) are often factored into the valuation of tax amortisable assets. Whilst conceptually straight-forward, the calculation of a TAB is circular in nature, since the TAB is based on the value of the asset, and the value of the asset is in turn based on the TAB. Accordingly, TABs frequently cause technical hurdles for acquirers.
- Cross-checks also need to be appropriately considered to provide additional support for the valuation outcomes. Technical valuation analysis that appears impressive can be fundamentally flawed if the resultant outputs are not adequately sense checked for reasonableness. A sense check as to the weighted average return on all assets acquired should be performed. This assists in providing comfort that the allocation of value between the assets acquired, and the required rates of return attributed to each asset, correspond with the cost of capital attributed to the target.
- As you work through the PPA process, you will need to understand the impacts on your stakeholders (i.e. impacts on future profits, earnings per share, debt covenants, tax deductibility and cash flows).
- Identification of additional, potentially amortising, intangible assets will result in lower profits (i.e. EPS impact) but also lower goodwill (which is not amortisable and subject to annual impairment testing).
- Tax deductions effectively translate to cash benefits and should be appropriately captured in the valuations.
- Further, whenever an intangible asset acquired by an acquirer is eligible for tax amortisation, the tax amortisation benefit value becomes an element of the fair market value of that intangible asset.
Consider Tax Impacts and confirm deferred tax balances:
- Importance: As a part of the Acquisition Accounting AASB 112, Income Taxes also need to be considered. Adjustments resulting from the differences between the carrying values of these assets and liabilities in the acquirer’s financial statements and their fair market values (i.e. fair market value adjustments) may also give rise to deferred tax consequences, requiring the deferred tax balances to be recalculated as at the acquisition date.
- The identification of potentially tax deductible, additional intangible assets will lead to tax benefits in the future, however, lower accounting profits due to amortisation.
- There will also be potential impacts resulting from tax consolidation where cost bases may be reset on acquisition.
- Since the tax consequences can affect the cash paid or received in the future it has a ‘real’ impact on the business. It is important that Tax Specialists work with the Valuations Specialists, as valuation outcomes will impact the tax bases.
Determine goodwill (or the discount): The implied goodwill represents a component of the payment made by the acquirer, being the excess of the consideration paid by the acquirer over the acquirer’s interest in the net fair market value of the identifiable net assets acquired.
- Importance: It is important to consider the reasonableness of the PPA outcomes and whether the amount of goodwill results in a sensible outcome (i.e. what does the goodwill relate to?). An overall cross-check in the form of a weighted average rate of return analysis (“WARA”) can be conducted, which is used to reconcile the post-tax weighted average return on all of the acquired assets with the discount rate
- Risk/impact: goodwill is subject to annual impairment testing, where any write-downs are irreversible. Testing for impairment is not straight forward and requires the expertise of a Valuation Specialist. Further, ASIC has heightened its scrutiny in regards to supportable levels of goodwill recorded in financial statements in recent years.
As discussed above, the PPA process is not straight-forward and requires a number of specialist skills to arrive at an outcome that will stand up to scrutiny and be accepted by your Auditor, the market (as applicable for listed entities), and various regulators (i.e. ASIC, the ATO). Further, the potential accounting impacts of an acquisition must be understood and clearly communicated to key stakeholders including your executive team, the Board, shareholders and your external auditor. It is critical that the accounting and tax implications are considered both prior to and following completion of a transaction.
The significance of the potential pain in getting it wrong, and the hurdles that complicate getting it right, lead to one conclusion – start planning early to avoid nasty surprises. An effective PPA process involves valuers working collaboratively with tax and accounting specialists from an early stage.
At Crowe Horwath we are here to assist you achieve the robust, reasoned and defensible PPA outcomes. Please contact us if you would like further information.
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T: +61 3 9258 6701
Partner – Sydney
T: +61 2 9619 1783