M&A options’ taxation, accounting items, and rights and obligations arrangements

M&A options

In Buffett’s 1999 shareholder letter (the content in italics in this article), he spent a lot of space explaining to investors the taxation, accounting items, and rights and obligations of many corporate M&A options.

How are accounting items arranged in M&A options?

When a company is acquired, generally accepted accounting principles (“GAAP”) currently condone two very different ways of recording the transaction: “purchase” and “pooling.” In a pooling, stock must be the currency; in a purchase, payment can be made in either cash or stock. Whatever the currency, managements usually detest purchase accounting because it almost always requires that a “goodwill” account be established and subsequently written off — a process that saddles earnings with a large annual charge that normally persists for decades. In contrast, pooling avoids a goodwill account, which is why managements love it.

Goodwill amortization

For accounting rules to mandate amortization that will, in the usual case, conflict with reality is deeply troublesome: Most accounting charges relate to what’s going on, even if they don’t precisely measure it. As an example, depreciation charges can’t with precision calibrate the decline in value that physical assets suffer, but these charges do at least describe something that is truly occurring: Physical assets invariably deteriorate. Correspondingly, obsolescence charges for inventories, bad debt charges for receivables and accruals for warranties are among the charges that reflect true costs. The annual charges for these expenses can’t be exactly measured, but the necessity for estimating them is obvious.

In contrast, economic goodwill does not, in many cases, diminish. Indeed, in a great many instances — perhaps most — it actually grows in value over time. In character, economic goodwill is much like land: The value of both assets is sure to fluctuate, but the direction in which value is going to go is in no way ordained.

Most companies want to avoid the amortization of goodwill

To escape from the fiction of goodwill charges, managers embrace the fiction of pooling. This accounting convention is grounded in the poetic notion that when two rivers merge their streams become indistinguishable. Under this concept, a company that has been merged into a larger enterprise has not been “purchased” (even though it will often have received a large “sell-out” premium). Consequently, no goodwill is created, and those pesky subsequent charges to earnings are eliminated. Instead, the accounting for the ongoing entity is handled as if the businesses had forever been one unit.

So much for poetry. The reality of merging is usually far different: There is indisputably an acquirer and an acquiree, and the latter has been “purchased,” no matter how the deal has been structured. If you think otherwise, just ask employees severed from their jobs which company was the conqueror and which was the conquered. You will find no confusion. So on this point the FASB is correct: In most mergers, a purchase has been made. Yes, there are some true “mergers of equals,” but they are few and far between.

Charlie and I believe there’s a reality-based approach that should both satisfy the FASB, which correctly wishes to record a purchase, and meet the objections of managements to nonsensical charges for diminution of goodwill. We would first have the acquiring company record its purchase price — whether paid in stock or cash — at fair value. In most cases, this procedure would create a large asset representing economic goodwill. We would then leave this asset on the books, not requiring its amortization. Later, if the economic goodwill became impaired, as it sometimes would, it would be written down just as would any other asset judged to be impaired.

Cash M&A can increase cash flow

In our purchase of Jordan’s, we followed a procedure that will maximize the cash produced for our shareholders but minimize the earnings we report to you. Berkshire purchased assets for cash, an approach that on our tax returns permits us to amortize the resulting goodwill over a 15-year period. Obviously, this tax deduction materially increases the amount of cash delivered by the business. In contrast, when stock, rather than assets, is purchased for cash, the resulting writeoffs of goodwill are not tax-deductible. The economic difference between these two approaches is substantial.

Stock-for-stock M&A is the worst way

From the economic standpoint of the acquiring company, the worst deal of all is a stock-for-stock acquisition. Here, a huge price is often paid without there being any step-up in the tax basis of either the stock of the acquiree or its assets. If the acquired entity is subsequently sold, its owner may owe a large capital gains tax (at a 35% or greater rate), even though the sale may truly be producing a major economic loss.

Note: In the 2016 shareholder letter, Buffett complained: “Unfortunately, I followed the GEICO purchase by foolishly using Berkshire stock – a boatload of
stock – to buy General Reinsurance in late 1998. After some early problems, General Re has become a fine insurance operation that we prize. It was, nevertheless, a terrible mistake on my part to issue 272,200 shares of
Berkshire in buying General Re, an act that increased our outstanding shares by a whopping 21.8%. My error caused Berkshire shareholders to give far more than they received (a practice that – despite the Biblical endorsement – is far from blessed when you are buying businesses).”

Conclusion

Pros and cons of cash M&A

If buying in cash, the biggest disadvantages are: double taxation and more complicated tax and legal procedures. Goodwill and amortization over several decades need to be recorded. However, goodwill losses are tax-deductible and ultimately generate more cash flow. But the general listed companies do not like this approach. On the other hand, the acquired company’s rights, responsibilities and liabilities need not all be transferred to the acquirer, nor does the acquirer need to accept all of the acquired party’s employees.

Pros and cons of equity consolidation M&A

If the merger is done in the form of a stock exchange, the tax is only paid once when the stock is sold. However, all rights, liabilities and liabilities of the acquired party are transferred to the acquiring party. Moreover, in this transaction method, the loss of goodwill is not tax-deductible.

M&A options
credit: esofund.com

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