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Faculty Insights

Why Accounting and Tax Are Important Considerations in M&A Transactions

By Daniel Wangerin

September 11, 2019

Mergers and acquisitions (M&A) are among the most complex areas in accounting and taxation. I first became interested in M&A when I worked at Deloitte in their audit and assurance practice, where many of my clients were involved in M&A deals. I was fascinated not only with the complexities of the accounting issues for M&A, but also that every transaction and every business purchased was completely different. Through this experience, I was exposed to different facets of the business, the integration of business systems, transaction financing, and more.

Headshot of Daniel Wangerin
Associate Professor Daniel Wangerin

From a research perspective, many important questions remain unanswered. For example, we are continuing to learn about what makes M&A transactions successful, why sometimes they fail, how tax and accounting regulations affect companies’ decisions, and how well companies can provide investors with information helpful in assessing the valuation consequences of M&A transactions.

Over the past several years, my research within M&A has examined these questions through a number of different avenues:

1) Complex valuations and forecasting. Suppose a business is purchased by an acquiring company for $1 billion dollars. Both U.S. and international accounting standards require that $1 billion purchase price must be sliced up and allocated to each individual asset acquired, along with all of the liabilities that the buyer becomes responsible for (e.g., warranty claims, debt, pension obligations, income taxes, etc.). In most acquisitions, the biggest assets tend to be intangibles—assets such as intellectual property rights for a pharmaceutical company’s patents on patented technologies, the research and development pipeline, and brand names.

In addition, synergies are often important strategic value-drivers in M&A transactions. Accounting rules are designed to capture synergies in an asset called goodwill (frequently one of the largest intangible assets I observe in my research). An example is Disney’s 2012 acquisition of Lucasfilm—Star Wars creator George Lucas’ company—for more than $4 billion. (It goes without saying, by the way, that “The Force” is an intangible but extremely valuable asset). Disney determined that roughly half of the assets acquired were intangibles, related to things like the intellectual property rights and copyrights to existing Star Wars films and characters. But the rest of the $4 billion was recorded as goodwill—essentially representing the synergies of combining the two companies coming together. Those synergies have been realized through all of the additional Star Wars films produced since the acquisition, merchandising, and development of theme park attractions under Disney’s ownership.

2) Examining the consequences of due diligence—and due diligence failure. Much of my research looks at what happens post-acquisition, but in contrast, another area I focus on is the due diligence process—the work that occurs leading up to the acquisition. In this scenario, the target firm (the company being purchased) allows potential buyers to come in and gather private information that even its own shareholders are not privy to.

Understandably, the buyers want to know how they will profit from purchasing the target, as well as what risks they take on in the process. The target firm, meanwhile, wants to put its best foot forward, perhaps attempting to paint an overly rosy picture of the company.

Hewlitt-Packard’s 2012 acquisition of software company Autonomy for $11 billion is a good example of due diligence failure. A year after the Autonomy purchase, HP was forced to write off $8.8 billion of the assets it acquired after discovering that Autonomy had improperly inflated its historical revenues and earnings in the years leading up to the transaction. Had these issues been uncovered during the due diligence process, HP would have likely valued the company well below the $11 billion purchase price, or terminated the acquisition agreement altogether.

3) Assessing the quality of the target firm’s accounting system. In a similar vein, I also looked at the quality of the target firm’s accounting system in another study. My co-authors and I found that where indicators of low quality financial reporting existed, acquisition transactions were significantly more likely to be cancelled.

We also found that once M&A deals were terminated, the target firms involved in these failed acquisition transactions often had to issue restated financials that identified the accounting problems. This is about the worst news a CEO must deliver to angry shareholders that already have seen handsome would-be returns on their investment disappear.

4) Understanding the trade-off between tax and financial reporting benefits. WSB’s Dan Lynch and I also collaborated on research that examines the relationship between important tax and financial reporting considerations during M&A deals. Depending on how the terms of the deal are structured between the buyer and the seller, the buyer faces a trade-off between taking larger tax deductions or reporting higher earnings to Wall Street.

For example, by allocating more of the purchase price to assets that are depreciable, the firm can generate larger tax deductions earlier. Alternatively, assigning more of the purchase price to goodwill and other intangibles means reporting higher earnings to Wall Street.

So a company must decide: given this trade-off, which is more important? Our study showed that in situations where both incentives are strong, management favored financial reporting—to the tune of three cents of earnings per share for $1.8 million of foregone tax savings.

Read the papers:

Daniel Wangerin is an associate professor in the Department of Accounting and Information Systems at the Wisconsin School of Business, where he also received his PhD in 2011.