Mergers & Acquisitions

Accounting for Acquisitions

To calculate the implied fair value of goodwill, assign the fair value of the reporting
unit with which it is associated to all of the assets and liabilities of that reporting unit
(including research and development assets). The excess amount (if any) of the fair
value of the reporting unit over the amounts assigned to its assets and liabilities is
the implied fair value of the associated goodwill. The fair value of the reporting unit
is assumed to be the price that the company would receive if it were to sell the unit
in an orderly transaction (i.e., not a rushed sale) between market participants. Other
alternatives to the quoted market price for a reporting unit may be acceptable, such
as a valuation based on multiples of earnings or revenue.

The following additional issues are associated with goodwill impairment testing:
• Asset and liability assignment. Assign acquired assets and liabilities to a

reporting unit if they relate to the operations of the unit and they will be
considered in the determination of reporting unit fair value. If these criteria
can be met, even corporate-level assets and liabilities can be assigned to a
reporting unit. If some assets and liabilities could be assigned to multiple
reporting units, assign them in a reasonable manner (such as an allocation
based on the relative fair values of the reporting units), consistently applied.
• Asset recognition. It is not allowable to recognize an additional intangible
asset as part of the process of evaluating goodwill impairment.
• Goodwill assignment. All of the goodwill acquired in a business combina-
tion must be assigned to one or several reporting units as of the acquisition
date, and not shifted among the reporting units thereafter. The assignment
should be in a reasonable manner, consistently applied. If goodwill is to be
assigned to a reporting unit that has not been assigned any acquired assets or
liabilities, the assignment could be based on the difference between the fair
value of the reporting unit before and after the acquisition, which represents
the improvement in value caused by goodwill.
• Impairment estimation. If it is probable that there is goodwill impairment
and the amount can be reasonably estimated, despite the testing process not
being complete when financial statements are issued, recognize the estimat-
ed amount of the impairment. The estimate should be adjusted to the final
impairment amount in the following reporting period.
• No reversal. Once impairment of goodwill has been recorded, it cannot be
reversed, even if the condition originally causing the impairment is no long-
er present.
• Reporting structure reorganization. If a company reorganizes its reporting
units, reassign assets and liabilities to the new reporting units based on a
reasonable methodology, consistently applied. Goodwill should be reas-
signed based on the relative fair values of the portions of the old reporting
unit to be integrated into the new reporting units.
• Reporting unit disposal. If a reporting unit is disposed of, include the
goodwill associated with that unit in determining any gain or loss on the
transaction. If only a portion of a reporting unit is disposed of, you must
associate some of the goodwill linked to the reporting unit to the portion
being disposed of, based on the relative fair values of the portions being

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disposed of and retained. Then test the remaining amount of goodwill as-
signed to the residual portion of the reporting unit for impairment.

EXAMPLE

Armadillo Industries is selling off a portion of a reporting unit for $500,000. The remaining
portion of the unit, which Armadillo is retaining, has a fair value of $1,500,000. Based on
these values, 25% of the goodwill associated with the reporting unit should be included in the
carrying amount of the portion being sold.

• Reporting unit disposal, minority owner. If a company has less than
complete ownership of a reporting unit, attribute any impairment losses to
the parent entity and the noncontrolling interest in the reporting unit on a
rational basis. However, if the reporting unit includes goodwill that is at-
tributable to the parent entity, then attribute the loss entirely to the parent,
not the noncontrolling interest.

• Subsidiary goodwill impairment testing. Any goodwill recognized by a
corporate subsidiary should be dealt with in the same manner described
elsewhere in this section for the impairment of goodwill. If there is a good-
will impairment loss at the subsidiary level, also test the reporting unit of
which that subsidiary is a part for goodwill impairment, if the triggering
event is more likely than not to have also reduced the fair value of that re-
porting unit below its carrying amount.

• Taxable transaction. As part of the fair value estimation, determine whether
the reporting unit could be bought or sold in a taxable or non-taxable trans-
action, since this affects its fair value.

Tip: From a practical perspective, it is almost always easier to estimate the fair
value of the reporting unit based on a multiple of its earnings or revenues, though
this should only be done when there are comparable operations whose fair values
and related multiples are known, and which can therefore be used as the basis for a
fair value estimate of the reporting unit.

Impairment testing is to be conducted at annual intervals. You may conduct the
impairment test at any time of the year, provided that the test is conducted thereafter
at the same time of the year. If the company is comprised of different reporting
units, there is no need to test them all at the same time.

Tip: Each reporting unit is probably subject to a certain amount of seasonal activity.
If so, select a period when activity levels are at their lowest to conduct impairment
testing, so it does not conflict with other activities. Impairment testing should not
coincide with the annual audit.

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It may be necessary to conduct more frequent impairment testing if there is an event
that makes it more likely than not that the fair value of a reporting unit has been
reduced below its carrying amount. Examples of triggering events are lawsuits,
regulatory changes, the loss of key employees, and the expectation that a reporting
unit will be sold.

The information used for an impairment test can be quite detailed. To improve
the efficiency of the testing process, it is permissible to carry forward this
information to the next year, as long as the following criteria have been met:

• There has been no significant change in the assets and liabilities comprising
the reporting unit.

• There was a substantial excess of fair value over the carrying amount in the
last impairment test.

• The likelihood of the fair value being less than the carrying amount is
remote.

As an additional note for publicly-held companies that report segment information,
the asset, liability, and goodwill allocations used for goodwill impairment testing do
not have to be the same as the amounts stated in segment reports. However, aligning
the two sets of information will make it easier to conduct both impairment testing
and segment reporting.

Goodwill Amortization

The effort required to monitor the goodwill asset is considered to be excessive for
private companies, while the usefulness of goodwill information is also considered
to be limited. Consequently, a private company is allowed to amortize goodwill on a
straight-line basis over a ten-year useful life. The entity may amortize goodwill over
a shorter period if it can demonstrate that a shorter useful life is more appropriate. If
an organization chooses to amortize goodwill, it must still test the goodwill asset for
impairment at either the entity or reporting unit level. This test is triggered when
there is an event that indicates a possible decline in the entity’s or reporting unit’s
fair value to a point below its carrying amount. If an impairment loss is recognized,
then any remaining carrying amount is to be amortized over its remaining useful life.

The amortization of goodwill will eventually reduce the carrying amount of an
organization’s goodwill asset so much that goodwill impairment will be quite
unlikely, thereby reducing the need to spend time on such testing.

Variations under IFRS

The Financial Accounting Standards Board and International Accounting Standards
Board have been jointly working on reducing the differences between GAAP
accounting and International Financial Reporting Standards (IFRS). While there are
still notable differences between GAAP and IFRS in some areas of accounting,
business combinations is not one of them. The key aspects of acquisition accounting
are essentially identical under both accounting frameworks.

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Summary
Accounting for acquisitions is considered one of the more complex areas of
accounting. However, when broken down into its constituent parts, it is apparent that
the concepts are not that difficult; the accountant simply has to plow through an
established series of work steps to arrive at the proper journal entry to record an
acquisition. This does not necessarily mean that two accountants independently
compiling the accounting information for an acquisition will arrive at identical
journal entries; the valuation of assets and liabilities is a key part of acquisition
accounting, and valuation is judgmental to some degree. Thus, the risk of improperly
accounting for an acquisition is most likely to arise in the area of asset and liability
valuations. This means the accountant should pay particular attention to valuations,
and document them thoroughly for the inevitable year-end review by auditors.

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Chapter 15
Acquisition Personnel

Introduction

The acquisition process involves skills that are not usually present in a company,
because those skills are not needed in the day-to-day operations of the business.
Instead, the acquirer or seller typically employs outside experts who handle various
aspects of an acquisition. The services of specialists are absolutely necessary in
many acquisition situations, but they come at a substantial cost. In this chapter, we
discuss the types of specialists who are usually involved in acquisitions, and how a
serial acquirer can reduce their cost by bringing some acquisition functions in-house.

The Acquisitions Attorney

It is vital for both parties to retain the services of attorneys having in-depth
knowledge of acquisitions. Their assistance is required at every step of the
acquisitions process, including the development of letters of intent, non-disclosure
agreements, due diligence, and purchase agreements. They also create a number of
related agreements, such as employment agreements for the employees of the
acquiree and debt documents for any debt payable to the seller.

The acquisitions attorney is involved in a specialized field, where one must have
an in-depth knowledge of how deals are structured and understand the impact of
varying the terms of the basic agreements. Given this level of specialization, it is not
a good idea to simply retain the company’s general counsel for this work. Instead,
look for a specialist who has considerable experience in the field. The best
specialists typically work within larger law firms, so that they have access to an
ongoing stream of acquisition transactions.

The relationship between the seller and its attorney is particularly important,
since that attorney needs to know in advance if there are any current or potential
legal issues, so that he can engage in mitigation activities in advance. This may
involve a complete examination of all legal issues prior to putting a company up for
sale, including a review of board minutes, the corporate bylaws, key contracts, and
so forth for any potential problems. Otherwise, legal issues may crop up in due
diligence that could scuttle the deal, which could have been avoided if the attorney
had known about them sooner.

Attorneys are paid by the hour, typically in the range of $200 to $500 per hour.
This means that their compensation is not tied to the success of the acquisition –
they will be paid even if the acquisition transaction fails. Despite the high cost per
hour, this payment arrangement actually works quite well for both the acquirer and
seller, since the attorneys are more likely to spend time digging through due
diligence issues and the purchase agreement, looking for any items that might

Acquisition Personnel

interfere with the best interests of their principals. This pay structure makes it more
likely that attorneys will provide more conservative, protective advice to their
principals, which nicely offsets the more optimistic advice of the investment bankers
– whose compensation is mostly tied to completing the deal.

Tip: Some attorneys dig into the details too much, which results in excessive legal
fees. You can direct their attention to certain areas of concern and restrict their
activities in other areas, if you want to reduce their fees. Also, if a law firm persists
in engaging in an excessive amount of review work, switch to other firms to assist
with the next acquisition deal.

The best attorneys have the capability to not just spot every conceivable legal issue
that could arise, but also to suggest workarounds that can still complete the deal.
Too often, an inexperienced attorney will feel that he is earning his pay simply by
presenting a list of all the potential problems in a purchase agreement, which can go
a long ways toward terminating the entire deal. Thus, the ability to use his
knowledge of the legal system to craft a reasonable agreement for both parties is the
hallmark of a great attorney.

Another aspect of an excellent attorney is one who can provide advice to his
client regarding which issues are negotiable, and the impact of various legal clauses
on the acquirer and seller. In some situations, an inexperienced seller may not realize
that (for example) certain representations and warranties are totally customary
within the industry, and must be included in the purchase agreement. This is a
valuable skill that can keep an acquisition on track.

The completion of the purchase agreement is particularly burdensome for the
attorneys representing both parties, since there are usually a number of changes to
the document that are caused by information unearthed during the due diligence
process, as well as changes caused by dickering over individual clauses.
Consequently, the attorneys put in many hours at the end of the acquisition process,
and so can present some quite startling bills for their services. Nonetheless, their
work is absolutely essential, since a poorly constructed purchase agreement could be
far more expensive for the acquirer and seller than the corresponding amount of
legal fees.

There are also some legal specialists who may be brought in to investigate
certain aspects of an acquisition. For example, a patent or trademark attorney can
investigate the intellectual property filings of the acquiree to make sure that they are
valid, while a tax attorney can assist in creating a legal structure for the deal that has
the most beneficial tax effects for the parties involved.

Of all the personnel who may become involved in an acquisition, it is most
important to find an attorney with vast experience in the field, an excellent
knowledge of workarounds to acquisition problems, and the ability to act as an
advisor. This person will come at a high cost, which is insignificant when compared
to the value that he provides.

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The Investment Banker

An investment banker is particularly useful to the seller of a business. As was
mentioned in the Acquisition Process chapter, the investment banker provides the
following services to a seller:

• Provides an approximate valuation of the business
• Recommends the proper sale timing to maximize the sale price
• Preps the business for sale, based on a knowledge of which features will

bring a higher price
• Contacts those entities most likely to bid for the business
• Advises on the construction of an offering memorandum
• Manages the auction process
• Arranges for all meetings between bidders and the seller
• Assists with negotiations regarding the terms in the purchase agreement

In addition, the banker acts as a buffer between bidders and the seller. This means
that the banker can contact possible bidders while keeping the identity of the seller
secret, as well as answer the more routine bidder questions without bothering the
seller, while also handling the more difficult negotiating points without getting the
principals in a transaction angry with each other. Handling these tasks on behalf of
the seller allows the management team to continue running the business with
minimal interruptions. This buffer role is a crucial one, and can be of great
assistance to the seller.

The ideal investment banker is one who has an excellent knowledge of the
industry in which the seller’s business is located, particularly in terms of contacts
with buyers and knowing the prices at which acquisition deals have been completed
recently.

A good investment banker comes at a high price. Expect to pay a monthly
retainer of anywhere from $5,000 to $25,000, as well as a percentage of the final
sale price. If the business is not expected to sell for a large amount, then the banker
may impose a minimum fee, such as $500,000, if the business is sold. The
percentage of the sale price that a banker charges used to follow the Lehman
formula, which is:

5% Of the first million dollars price paid

4% Of the second million dollars price paid

3% Of the third million dollars price paid

2% Of the fourth million dollars price paid

1% Of all remaining dollars price paid

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This formula was originally designed in the 1960s, so subsequent inflation has made
its basic terms unprofitable for investment bankers. Instead, bankers like to propose
variations on the general concept, such as:

5% Of the first 10 million dollars price paid

4% Of the second 10 million dollars price paid

3% Of the third 10 million dollars price paid

2% Of the fourth 10 million dollars price paid

1% Of all remaining dollars price paid

It is also common for a banker not to propose the lower percentages inherent in the
Lehman formula. Instead, they may offer a descending percentage only until 3% is
reached, after which 3% applies to all remaining dollars paid to the seller. Thus, the
investment banker can earn massive fees from the sale of a business.

The investment banker has been presented here as being primarily associated
with the seller, but they may also work for acquirers, especially if they are needed to
raise funds to pay for the transaction. In this case, the banker earns a large fee based
on the amount of money raised on behalf of the acquirer. Bankers may also earn a
smaller fee when acting in an advisory role to the acquirer.

In short, the investment banker can bring value to the selling process, but this
value comes at a high price. Bankers are very highly paid, but if a seller has little
practice in selling businesses, a qualified investment banker can be of great
assistance in managing the sale process and obtaining a good price.

The Valuation Specialist

There are many valuation companies available who use a variety of techniques to
derive a valuation for an entire business or for specific assets. Valuation experts are
very useful for acquirers, particularly in regard to the recordation of a completed
acquisition. Accounting standards require that the assets and liabilities of an
acquiree be recorded on the books of the acquirer at their fair market values;
valuation firms can provide this information. In addition, valuation specialists can
provide estimates of the fair value of a reporting unit in subsequent years, when an
acquirer must test its goodwill asset for impairment. Also, auditors use valuation
reports as independent evidence that the valuations at which an acquirer records an
acquisition are reasonable.

The compensation model of the valuation specialist is typically a fixed fee,
possibly with an additional billing related to any problems encountered. They also
like to substantially increase their fees if a client wants a report within a very short
time period (as is usually the case in an acquisition). Thus, an acquirer may find that
meeting a short deadline could double its valuation-related expenditure.

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Other Consultants

It may be necessary to bring in other consultants to assist with an acquisition
transaction, depending on the circumstances. In this section, we note the situations in
which specialists may be needed for actuarial, environmental, human resources,
public relations, regulatory, and public company issues. They are:

• Actuarial. It may be useful to obtain the services of an actuarial firm to
determine the amount of any overfunding or underfunding of an acquiree’s
pension plan. This information may already have been calculated by the
actuaries working for the acquiree, but another actuary should work for the
acquirer to test the assumptions used to estimate pension funding levels. In
some cases, estimated reinvestment rates and payout levels may be unrealis-
tic, and could misstate the amount of liability that the acquirer will be taking
on.

• Environmental. An environmental testing and mitigation firm may be
needed if there is even a hint of possible environmental trouble. Given the
extremely high liability associated with environmental issues, it would be
foolish not to employ this consultant. Environmental firms typically charge
by the hour, and ratchet up their rates if an analysis must be completed in
short order (as is usually the case for an acquisition).

• Human resources. If the acquiree has been sued by its employees for various
human resources-related issues, or has had troubled relations with unions,
then the acquirer could hire a labor attorney to investigate the issues and
report back with summarizations of the issues and estimates of contingent
liabilities. This is a particularly useful consultant when a target company is
located in a foreign country, and the acquirer has little knowledge of the
labor laws of that area. For example, another country may require that a very
long notice period be given to employees before a facility can be shuttered,
as well as substantial termination payouts to employees.

• Proxy solicitation. If the acquirer is attempting to buy another publicly-held
firm and it elects to go straight to the shareholders with its offer, it should
hire a proxy solicitation firm. These businesses solicit proxies from the
shareholders, which they then use to vote the shares of those shareholders to
replace the board of directors. The proxy solicitation process involves direct
contact with the larger shareholders, which is both labor-intensive and ex-
pensive.

• Public relations. For a larger transaction, it can be useful to employ the
services of a public relations firm. This advisor can be used to craft messag-
es to the public regarding the acquirer’s intentions regarding an acquiree. A
public relations firm is particularly useful for issuing statements intended for
competitors, such as the acquirer’s commitment to buying a company, irre-
spective of the price paid. These messages may prevent competing offers
from surfacing.

• Investor relations. If the acquirer is publicly-held, the senior management
team may periodically engage in conference calls and road show meetings

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