During the negotiations for an acquisition, the sellers and buyer will often disagree on the value of the business. Often these disagreements will center on the future earnings potential of the new subsidiary (“the Subsidiary”). Various techniques to bridge this valuation gap exist, including the use of performance incentives for the sellers based on the future financial results of the Subsidiary. Since pushdown accounting can affect future earnings, sellers must understand when and what will happen if pushdown accounting is implemented by the buyer.
Pushdown accounting occurs when a new Subsidiary adopts the acquirer’s (“Parent”) basis for its assets and liabilities. In essence, the Subsidiary “pushes down” the consolidation entries unto its own balance sheet. Pushdown accounting is elective accounting, and is not mandatory since November, 2014. It is available for both public and private companies. Information about pushdown accounting is contained in Accounting Standards Update 2014-17 and Topic 805 of the FASB Codification. This article assumes the reader is familiar with these requirements, and presents some practical considerations the sellers of Subsidiary must deal with before selling their company to Parent.
In a business merger, assets and liabilities of Subsidiary are valued at fair market value at the acquisition date. The accounting entries to accomplish this are usually carried in the “consolidation” column of the Parent’s consolidating worksheet, or as is more common now, in a “consolidation company” in Parent’s accounting software. Since the Parent now has legal control over Subsidiary, Parent can require Subsidiary to adopt pushdown accounting.
How will this affect the future earnings of Subsidiary? Lets take a look at some common fair value entries. Assets values can be increased by fair value adjustments. Three particular types of assets are normally adjusted:
- Inventories usually increase, but not always if there are lower-of-cost or market adjustments that need to be recognized.
- Property, plant, and equipment may be adjusted up or down depending on the nature of the equipment
- Intangible assets such as goodwill may be created by the acquisition.
The sellers often receive performance incentives based on the future earnings of Subsidiary. In many cases, the sellers will be retained via employment agreements for a period of time (typically one to three years) as the management of Subsidiary. They will receive a base salary as well as additional incentive payments such as stock options and bonuses often based on the financial performance of Subsidiary. Another common technique used in acquisitions is an “earn-out” provision. Earn-out provisions require the payment of additional compensation to the previous owners of Subsidiary based on the financial performance of Subsidiary subsequent to the acquisition date. Earn-out accounting is now also governed by Topic 805, but it is primarily the cash consequences for the sellers we are concerned with here, and not the financial accounting.
Generally the increased values of the assets of Subsidiary result in lower future earnings after the acquisition date. Increased depreciation due to the fair value adjustments for property, plant, and equipment and higher cost of good sold due to increased inventory values are possible in the years after the acquisition. Any new intangible assets are divided into two groups, those with an indefinite life and those with definite lives. Intangible assets with a definite life must be amortized over their estimated lives. Goodwill is subject to impairment review or amortization ( acceptable for privately owned companies only). Amortization and impairment charges will reduce future Subsidiary income. The most catastrophic event for the sellers would be large impairment charges for long-lived assets and goodwill. These could conceivably result in completely eliminating incentive payments for a whole year.
What should sellers do? They must make pushdown accounting a subject of the acquisition negotiation. Buyers will generally benefit by pushdown accounting if fair value accounting results in greater asset value increases than liability value increases. The buyer’s negotiating position will be they will not compensate the sellers twice. After all, the buyers are already paying for the increased asset values, and believe they are entitled to reduced incentive payments when the assets subsequently turn into expense.
Let’s look at an example of this. Suppose the plan of acquisition states seller will be entitled to 10% of net income before bonus compensation for three years. Let’s also assume net income the first year after acquisition before the application of pushdown accounting is $100,000. Pushdown accounting adjustments result in a reduction of income before income taxes of $30,000. Instead of receiving $10,000 in additional compensation, the sellers will receive $7,000. The buyer will believe this is fair since he has already paid fair value for the acquired assets, and shouldn’t have to pay performance compensation based on the previous asset valuation.
What are some negotiating tips for sellers?
- The acquisition contract should clearly specify if pushdown accounting may be used, and when. Normally pushdown accounting is applied in the period of acquisition, but later implementation as a change in accounting policy may be permitted.
- If pushdown accounting is to be applied, then seller and buyer must agree to the adjustments in the contract of sale. It is always possible the entries may subsequently change (additional information can become available or an auditor may object to the valuation) but the determination of the incentive compensation may be conditioned on agreed upon accounting entries enumerated in the contract. In short, once a fair value accounting adjustment is agreed to, it will be used in any future incentive calculation.
- Asset impairments, while reflected on the Subsidiary financial statements, may be deferred for incentive compensation purposes. The seller can ask for protection in the incentive computation against any sudden impairment charges for a period of years. For instance, any impairment charge recorded in the first three years may be deferred to the fourth year of the agreement in order to protect the sellers.
- If the sellers will be required to use pushdown accounting after the acquisition, they should attempt to negotiate performance incentives based on revenues. Revenues are usually unaffected by consolidation entries.
There is no question negotiating these items can be tedious and time-consuming. Nevertheless, it is important to avoid unfortunate surprises to the seller. A small amount of time up-front could save much acrimony later on.