Heads and Tails

A merger accounting scenario examined from both buyer's and seller's sides. StaffJune 15, 2001

Q: Company A issues a memorandum of understanding to Company B to acquire all the assets of B, which B accepts. Since Company B is short funds, Company A agrees to advance Company B money, while negotiating the definitive agreements, on a monthly basis, to cover the salaries and related expenses of the transferring employees and to cover facility expenses in exchange for being able to direct the work effort of the transferring employees and use of the facility. The advances are funded under a secured promissory note. If the deal closes before the maturity date of the note, the amounts advanced will be forgiven. It is highly probable that the deal will close and the closing will occur before the maturity date.

What is the appropriate accounting treatment for each of the following events?

  • At the time the advances are received
  • The deal closes before maturity date and the advances are forgiven
  • If the deal “blows up” or does not close before maturity date

Name Withheld
San Diego, Calif.

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A: Good question. Here is my response from Company A’s perspective:

Since the advances were made “in conjunction with” the acquisition agreement, they cannot be divorced from the acquisition. Clearly, the advances would not have been made “but for” the acquisition. Thus, the advances are part of the whole plan of acquisition and, therefore, are part of the consideration for the acquisition. Therefore, if the deal closes before the maturity date, as expected, I would treat the advances as part of the purchase consideration to be allocated to the assets acquired. In the interim, between the date of the advance and closing, I would record the advance as an asset, descriptively labeled, perhaps as “purchase price deposit.”

If the note matures before closing and, in this case, I assume the advances are repaid, it would be improper to augment the purchase price by the amount of the advance because, in light of the repayment, there will be no “actual economic outlay.” Accordingly, I would simply reverse the “deposit” account I created at the time of the advance. If the deal “blows up”, yet the advance is repaid, I would use the same accounting. If, however, in that event (if the deal “blows up”), the advance is not repaid, a write-off (akin to a bad debt) would ensue. The amount of the write-off would be charged to operating income.

From Company B’s perspective, the answer is essentially the same: The advance constitutes additional consideration for the sale of the assets and, hence, contributes to the gain it will derive from the sale of its assets. To the extent Company B uses the advance to defray deductible expenses, those payments would be charged to expense. If the deal closes after the note matures, and, therefore, the advances are repaid, Company B would simply treat the advance as a bona-fide loan and its repayment would be treated as the repayment of a loan; no special accounting there–if, in that instance, the loan proceeds were used to pay expenses, such expenses would still be charged to operations. If the deal blows up and, in that case, the loan is not repaid, Company B would record income, in the amount of the loan–such income would be characterized as “forgiveness of indebtedness” income.

Robert Willens
Tax and Accounting Analyst, Lehman Brothers Holdings Inc.

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