ISSUES IN MIDDLE MARKET DEALS THAT ARE OFTEN AFTERTHOUGHTS: THE OPENING DAY BALANCE SHEET, PURCHASE ACCOUNTING ADJUSTMENTS AND INCOME TAX CONSEQUENCE

I.??? INTRODUCTION

In competitive M&A deals, consideration of accounting nuances like the opening day balance sheet, purchase accounting, and tax consequences is often deferred by buyers until after the closing.

The purchase accounting adjustments required for constructing the open day balance sheet are complex and time-consuming, often requiring input from valuation experts and accountants.

In most private equity deals, the purchase price is based on a multiple of historical or projected EBITDA rather than a detailed analysis of the fair value of specific assets and liabilities. Adjustments such as inventory write-ups or amortization of intangibles are excluded from the EBITDA multiple because they are seen as adjustments driven by accounting standards rather than operational performance.

The deal timeline typically prioritizes due diligence on strategic and operational matters (e.g., customer contracts, market position, or growth potential) over detailed accounting or post-closing financial reporting considerations.

This approach opens the door to unwarranted accounting surprises and potential adverse tax consequences for a buyer. For the non-tax M&A lead attorney (like myself) on the buyer’s deal team, the points set forth below are fundamental to understanding why the opening day balance sheet, purchase accounting adjustments, and tax consequences should not be a post-closing afterthought. This is true even if the heavy lifting required to address these issues begins only after the closing.

II.?? THE OPENING DAY BALANCE SHEET

An opening day balance sheet in the context of a business acquisition is the balance sheet prepared as of the closing date of the purchase and sale transaction. It serves as the starting point for the buyer’s financial records and reflects the acquired company’s assets, liabilities, and equity immediately after the transaction.? While the concept sounds straightforward, creating an accurate opening day balance sheet involves adjustments that go beyond what’s reflected in the target’s financial statements.

A.?? Key aspects of the Opening Day Balance Sheet

1.????? Adjusted Values:

·???????? The balance sheet incorporates purchase price adjustments agreed upon in the purchase agreement, such as for working capital, debt, and cash on hand.

·???????? ASC 805 - Business Combinations, governs the application of purchase accounting under U.S. GAAP. It requires the buyer to record all acquired assets and liabilities at their fair market value on the opening day balance sheet. This process establishes the financial foundation for post-closing reporting and compliance with GAAP.

2.????? Exclusions and Inclusions:

·???????? Only the assets and liabilities included in the transaction appear on the opening day balance sheet. Excluded assets (e.g., personal assets retained by the seller) and excluded liabilities (e.g., seller-retained obligations) are not recorded.

3.????? Goodwill and Intangibles:

·???????? If the purchase price exceeds the net fair value of the identifiable assets and liabilities, the excess is recorded as goodwill.

·???????? Other intangible assets (e.g., trademarks, patents, or customer relationships) may also be recognized if their value can be separately identified.

4.????? Post-Closing Adjustments:

·???????? The opening day balance sheet may be subject to post-closing adjustments, such as true-ups for working capital, which are often finalized within a specified period after closing (e.g., 60–90 days).

5.????? Purpose:

·???????? For the buyer, the opening day balance sheet provides the foundation for future financial reporting and compliance.

·???????? It is also critical for post-transaction integration, monitoring the performance of the acquired business, and addressing any disputes related to adjustments.

In short, the opening day balance sheet is a snapshot of the acquired business’s financial position as it transitions from seller ownership to buyer ownership, reflecting the terms and conditions of the transaction.

An opening day balance sheet is not always explicitly required by law or accounting standards, but it is a practical and common tool in M&A transactions, particularly when there is a need to reflect changes resulting from the acquisition. Whether an opening day balance sheet is required or prepared depends on the type of transaction, the terms of the purchase agreement, and the buyer’s needs.

B.?? Instances Where an Opening Day Balance Sheet is Required or is Common

1.????? Asset Purchases:

·???????? In an asset purchase, the opening day balance sheet is necessary because the buyer acquires only specific assets and liabilities. This requires a new balance sheet to reflect the acquired components rather than the entire pre-closing balance sheet of the seller.

2.????? Purchase Price Adjustments:

·???????? If the transaction includes working capital adjustments, debt adjustments, or other post-closing reconciliations, an opening day balance sheet is typically prepared to reflect the agreed-upon adjustments.

3.????? GAAP Accounting Requirements for Audited Financial Statements:

·???????? ASC 805 - Business Combinations, governs the application of purchase accounting under U.S. GAAP. It requires the buyer to record all acquired assets and liabilities at their fair market value on the opening day balance sheet.

4.????? Buyer’s Integration Needs:

·???????? If the buyer is integrating the acquired business into its own financial systems, an opening day balance sheet aligned with the buyer's accounting policies and financial reporting requirements is usually created.

C.?? Instances Where the Pre-Closing Balance Sheet May Continue Post-Closing – Only Applicable

The following apply only if the financial statements post-acquisition will be unaudited and thus ASC 805 will not be applicable:

1.????? Stock Purchases:

·???????? In a stock purchase (or equity purchase), the buyer acquires the entire entity, including its existing financial records, and the seller's pre-closing balance sheet may simply continue as the company's balance sheet post-closing.

·???????? No opening day balance sheet is required if no purchase price adjustments, fair value adjustments, or new accounting standards are applied immediately.

2.????? No Post-Closing Adjustments:

·???????? If the transaction does not involve working capital true-ups, debt adjustments, or other mechanisms requiring post-closing changes, the pre-closing balance sheet might remain unchanged.

3.????? Small or Informal Transactions:

·???????? In smaller or less formal transactions, particularly those without stringent financial or accounting requirements, parties might agree to simply carry forward the pre-closing balance sheet without preparing a formal opening day balance sheet.

D.?? Practical Considerations

1.?? Reconciliation Needs:

·???????? Even if the pre-closing balance sheet carries forward, the buyer often performs a reconciliation to ensure the financial position reflects the terms of the purchase agreement.

2.?? Seller's Practices:

·???????? If the seller's pre-closing financial practices (e.g., accounting policies or quality of records) are significantly different from the buyer’s, the buyer may prefer to create an opening day balance sheet.

3.????? Risk Mitigation:

·???????? Buyers often prepare an opening day balance sheet to protect against disputes or to document the financial condition of the acquired business at closing.

In summary, whether an opening day balance sheet is necessary depends on the transaction structure, the complexity of the deal, and the buyer’s financial statement requirements. In stock purchases or simple deals with no adjustments, the pre-closing balance sheet might suffice, but in most cases, an opening day balance sheet provides clarity and alignment for both parties.

III.? WHAT IS PURCHASE ACCOUNTING AND IT’S ROLE IN CREATING AN OPEING DAY BALANCE SHEET

As noted earlier, ASC 805 - Business Combinations, governs the application of purchase accounting under U.S. GAAP.

A.???? Key Concepts of Purchase Accounting

1.????? Acquisition Date Fair Value:

·???????? The acquired assets and assumed liabilities are recorded on the buyer’s balance sheet at their fair market value as of the acquisition date (typically the closing date).

·???????? This differs from the historical book values used by the seller.

2.????? Goodwill:

·???????? If the purchase price exceeds the net fair value of the identifiable assets and liabilities, the excess is recorded as goodwill on the buyer’s balance sheet.

·???????? Goodwill represents the premium paid for intangibles such as brand reputation, customer relationships, or synergies expected from the acquisition.

3.????? Identifiable Intangible Assets:

·???????? Specific intangible assets like trademarks, patents, and customer contracts may be separately valued and recorded.

4.????? Elimination of Seller’s Equity:

·???????? The seller’s equity accounts (e.g., common stock and retained earnings) are not carried forward. The opening balance sheet reflects the buyer’s ownership structure instead.

5.????? Contingent Liabilities and Earnouts:

·???????? Any contingent liabilities or earnout arrangements agreed upon in the transaction are recorded at their estimated fair value.

6.????? Working Capital Adjustments:

·???????? If the purchase agreement includes working capital adjustments, these are finalized post-closing and incorporated into the opening balance sheet.

Example:

A buyer acquires a company for $50 million.

The fair value of the acquired assets is $35 million.

The fair value of the assumed liabilities is $10 million.

The resulting goodwill is $50M - ($35M - $10M) = $25M.

The opening day balance sheet will reflect the revalued assets ($35M), liabilities ($10M), and goodwill ($25M).

In summary, purchase accounting is the framework for preparing the opening day balance sheet, ensuring it reflects the acquisition at fair value, aligns with financial reporting standards, and serves as the foundation for the buyer’s future financial statements.

B.?? Purchase Accounting Applies to both Stock Purchase and Asset Purchase Transactions, but the way it is applied differs based on the structure of the transaction

1. ? Stock Purchase Transactions

In a stock purchase, the buyer acquires the ownership (equity) of the target company, and the legal entity of the target remains intact. However, purchase accounting is still applied to the acquired assets and liabilities at the consolidated level for the buyer’s financial statements.

·???????? Key Points:

o?? The buyer records the acquired company’s assets and liabilities at fair value on its consolidated balance sheet, not necessarily keeping the target’s historical book values.

o?? The seller’s equity (e.g., common stock and retained earnings) is eliminated from the buyer’s consolidated financial statements.

o?? Goodwill or intangible assets are recognized if the purchase price exceeds the fair value of the net identifiable assets and liabilities.

o?? All assets and liabilities are revalued to fair value, even though the target company itself might continue using historical book values in its own records.

2. Asset Purchase Transactions

In an asset purchase, the buyer acquires specific assets and assumes certain liabilities of the target, rather than the entire legal entity. Here, purchase accounting applies more directly to the acquired components.

·???????? Key Points:

o?? The buyer only records the specific assets and liabilities acquired in the transaction.

o?? Each asset and liability are recorded at its fair market value at the acquisition date.

o?? Goodwill is recorded if the purchase price exceeds the fair value of the net assets acquired.

o?? The seller retains any unpurchased assets, liabilities, and the legal entity itself.

o?? Unlike a stock purchase, there are no retained equity balances from the seller because only selected components of the business are transferred.

C.?? When Does Purchase Accounting Not Apply?

Purchase accounting does not apply in the following situations:

1.????? Acquisition of Assets That Do Not Constitute a Business:

·???????? If the acquired assets do not qualify as a "business" (e.g., the purchase of a single property, equipment, or raw land), the transaction is treated as an asset acquisition rather than a business combination.

·???????? Accounting for asset acquisitions differs because no goodwill is recognized, and costs directly related to the acquisition (e.g., legal and due diligence fees) are capitalized rather than expensed.

2.????? Pooling of Interests (Very Rare):

·???????? Pooling-of-interests accounting was eliminated under U.S. GAAP in 2001, except for certain unique situations like common control transactions, where two entities under the same ownership are merged without recognizing goodwill or adjusting assets and liabilities to fair value.

3.????? Merger of Equals (Uncommon):

·???????? In limited circumstances, mergers of equals may use other methods (e.g., a continuation of historical accounting) if they meet the specific criteria.

4.????? Non-Business Transactions:

·???????? Transactions like the purchase of investments, financial instruments, or passive ownership stakes in an entity (e.g., buying stock in a company without acquiring control) are not subject to ASC 805.? Instead, they follow standards such as ASC 320 (Investments) or ASC 323 (Equity Method Investments).

IV.? Key Roles of the U.S. Tax Code in Purchase Accounting

A.???? IRC §1060:

1.????? Governs the allocation of purchase price in asset acquisitions (or deemed asset acquisitions under stock purchase elections). The tax code generally mandates that the purchase price be allocated among the acquired assets and liabilities based on their fair market value at the time of the transaction, following the residual method.? While the allocation should reflect FMV, practical considerations, such as buyer-seller negotiations or possible IRS challenges, may influence final allocations:

·???????? Cash and equivalents

·???????? Marketable securities

·???????? Accounts receivable

·???????? Inventory

·???????? Tangible assets (e.g., property, plant, and equipment)

·???????? Intangible assets (e.g., trademarks, patents, customer relationships)

·???????? Goodwill (the residual amount).

2.????? This allocation is also reflected in Form 8594 (Asset Acquisition Statement), which both the buyer and seller must file with the IRS, ensuring consistency in reporting.

B.????? Goodwill and Intangible Asset Amortization:

1.????? Under IRC §197, goodwill and certain other intangible assets are amortized over 15 years for tax purposes. This differs from U.S. GAAP (ASC 805), where goodwill is not amortized but instead subjected to annual impairment testing.? This creates differences between book and tax treatments.

C.?? Stock vs. Asset Purchase Tax Implications:

1.?? In stock purchases, the acquired company’s tax basis in its assets remains unchanged unless the buyer and seller make a 338(h)(10) or 336(e) election, which allows the transaction to be treated as an asset purchase for tax purposes.

2.?? Without such elections, purchase accounting may reflect revalued assets for book purposes, but tax basis stays at historical values, leading to book-tax differences.

D.?? ASC 740 - Deferred Taxes

1.?? Ensures that temporary differences between book value (fair value under ASC 805) and tax basis are properly accounted for in the opening day balance sheet. These differences create deferred tax assets (DTAs) or deferred tax liabilities (DTLs) that impact future financial and tax reporting.

For example:

·???????? If an asset is written up to fair value for financial reporting but its tax basis remains unchanged, a DTL is created.

·???????? Conversely, if a liability is recorded for tax but not for book purposes, a DTA is created.

These adjustments are a critical part of the opening day balance sheet under purchase accounting.

E.?? Transaction Costs

1.?? The tax treatment of transaction costs differs:

·???????? Many costs (e.g., legal, advisory, and due diligence fees) are capitalized for tax purposes if directly related to the acquisition.

·???????? Under GAAP, such costs are expensed immediately and do not affect the opening day balance sheet.

F.?? Working Capital Adjustments

1.?? Post-closing working capital adjustments affect both financial and tax reporting:

·???????? For tax purposes, these adjustments may result in additional purchase price allocation.

·???????? Under GAAP, these are reflected as changes to the acquisition date balances.

G.?? Debt and Liabilities Assumed

1.?? The tax code may treat certain assumed liabilities differently than GAAP does. For example:

·???????? If liabilities are assumed as part of the transaction, they may affect the buyer’s taxable purchase price.

H.?? Reconciling Tax and GAAP in Purchase Accounting

1.?? ASC 740 - Deferred Taxes, ensures that temporary differences between book value (fair value under ASC 805) and tax basis are properly accounted for in the opening day balance sheet. These differences create deferred tax assets (DTAs) or deferred tax liabilities (DTLs) that impact future financial and tax reporting.

·???????? Tax Basis Retention or Adjustment: Whether the tax basis of assets is adjusted (e.g., via a 338 election) determines the degree of alignment between tax and book values.

·???????? Form 8594 Consistency: Both the buyer and seller must report the same purchase price allocation for tax purposes, ensuring alignment between tax filings and book reporting.

V.?? SURPRISE TAXABLE GAIN

A.?? How Does It Happen?

A surprise taxable gain for the buyer can occur when the financial and tax implications of the acquisition are not fully understood or accounted for during the deal structuring and the creation of the opening day balance sheet. Here are the scenarios where such surprises might arise:

1. ? Bargain Purchase Gain:

·???????? A bargain purchase gain occurs when the purchase price is less than the fair value of the net assets acquired.? Under ASC 805, the buyer must recognize the difference as an immediate gain on its income statement.

o?? Example: The target is barely making a profit and, on a purchase price determined by a multiple of EBITDA, the purchase price is less than the fair value of the net assets acquired.?

2. ? Working Capital Adjustments

·???????? Post-closing working capital true-ups can result in adjustments to the purchase price. If the adjustment increases the buyer’s cash or receivables, it might inadvertently trigger taxable income.

·???????? The IRS may view these adjustments as taxable income rather than adjustments to the purchase price if the transaction terms are not clear. For instance:

3.????? Assumed Liabilities Treated as Income

·???????? In some cases, if the buyer assumes the seller’s liabilities and those liabilities are forgiven or resolved for less than their recorded amount, the IRS may treat the difference as cancellation of debt income or other taxable gain.

·???????? Buyers might not expect that resolving assumed liabilities (e.g., negotiated settlements on trade payables or tax liabilities) could generate immediate taxable income, especially if the liability fair value adjustments were misunderstood.

4.????? Tax Basis Step-Up in Certain Transactions

·???????? In an asset purchase or a stock purchase with a 338(h)(10) election, the tax basis of the acquired assets is stepped up to fair market value. While this higher basis typically reduces taxable gains upon sale, it can affect post-acquisition tax treatment in certain situations:?

o?? Inventory: The step-up to fair market value at closing may reduce the cost of goods sold (COGS) deduction relative to the sales price, leading to higher taxable income from inventory sales.?

o?? Receivables: If accounts receivable are collected above their original tax basis (pre-step-up), the excess may be recognized as taxable income, even after the step-up.

5. ? Contingent Consideration Revaluations

·???????? If the transaction includes contingent consideration (earnouts), the buyer must record the fair value of the liability on the opening day balance sheet. Future revaluations of this liability can result in gains or losses for book purposes.

·???????? If the IRS interprets any reduction in contingent consideration as taxable income (e.g., the buyer ultimately pays less than anticipated), the buyer may face unexpected taxable gains.

6.?? Unplanned Taxable Events from Integration

·???????? During post-closing integration, certain actions taken by the buyer may trigger taxable events. Examples include:

o?? Selling off or liquidating assets acquired in the transaction.

o?? Revaluing acquired liabilities (e.g., contingent liabilities).

o?? These actions might inadvertently trigger recognition of taxable gains, especially if the assets' stepped-up tax basis is lower than the fair market value recorded for book purposes.

7. Poor Documentation of Purchase Price Allocation

·???????? IRC §1060 governs the allocation of purchase price in asset acquisitions (or deemed asset acquisitions under stock purchase elections). The tax code mandates that the purchase price be allocated among the acquired assets and liabilities based on their fair market value, following the residual method.

·???????? The IRS might reallocate purchase price amounts, increasing the value assigned to short-lived or immediately taxable assets (e.g., inventory or receivables), which can increase taxable income for the buyer.

7.????? Gain on Pre-Acquisition Net Operating Loss (NOL) Utilization

·???????? If the buyer acquires a company with significant net operating losses (NOLs), they might anticipate using these to offset future taxable income.

·???????? However, IRC §382 imposes limitations on the buyer’s ability to use the seller’s net operating losses (NOLs) post-acquisition. These limitations are triggered by changes in ownership resulting from the transaction and must be carefully considered during tax diligence.

·???????? Buyers may inadvertently trigger taxable income if they cannot fully utilize the NOLs as expected or if they violate the limitations imposed under §382.

VI.? opening day balance sheet adjustments THAT can flow through to the income statement

A.?? Fair Value Adjustments to Assets

1.?? Tangible Assets:

·???????? Inventory: If inventory is written up to fair value, the buyer's cost of goods sold (COGS) will increase when that inventory is sold, reducing gross profit.

·???????? PP&E: If PP&E is written up, future depreciation expense will increase, reducing net income over time.

·???????? Impact on Income Statement:? These fair value adjustments create non-cash expenses that impact profitability in the post-closing period.

2.?? Intangible Assets and Amortization:

·???????? Purchase accounting requires the recognition of intangible assets like trademarks, customer relationships, or proprietary technology, which might not have been on the seller’s pre-acquisition balance sheet.

·???????? These assets are amortized over their useful lives.

·???????? Impact on Income Statement:? The amortization of these newly recognized intangibles creates a non-cash expense that reduces net income in post-closing periods.

3. ? Goodwill and Impairment:

·???????? If the purchase price exceeds the fair value of the net identifiable assets, the difference is recorded as goodwill on the opening day balance sheet.

·???????? While goodwill is not amortized under U.S. GAAP, it is subject to annual impairment testing.

·???????? Impact on Income Statement: If goodwill becomes impaired in the future, the impairment charge will reduce net income significantly in that period.

4. ? Deferred Revenue Adjustments:

·???????? Deferred revenue (e.g., prepayments for services not yet delivered) must be adjusted to fair value at acquisition. This often results in a reduction of the deferred revenue balance compared to the seller’s books because the fair value reflects only the cost to fulfill the obligation, not the full revenue amount.

·???????? Impact on Income Statement:? The reduced deferred revenue means the buyer will recognize less revenue post-closing, impacting profitability until the deferred revenue is fully amortized.

5. ? Deferred Taxes Assets (DTAs) and Liabilities (DTLs):

·???????? The revaluation of assets and liabilities for purchase accounting purposes creates differences between the book basis (fair value) and the tax basis (historical cost). These differences result in the recognition of DTAs or DTLs.

·???????? Impact on Income Statement:? Changes in deferred taxes flow through the income statement as adjustments to income tax expense in the post-closing period.

6. Contingent Consideration (Earnouts):

·???????? If the transaction includes contingent consideration (e.g., earnouts), the buyer must record the fair value of the liability on the opening balance sheet.

·???????? Changes in the estimated fair value of the earnout liability are recorded as gains or losses.

·???????? Impact on Income Statement:? Any subsequent revaluation of the contingent consideration impacts net income in the periods when the revaluation occurs.

7. ? Interest Expense from Debt Assumed:

·???????? If the buyer assumes debt as part of the acquisition, the debt is remeasured at fair value. This revaluation may alter the effective interest rate.

·???????? Impact on Income Statement:? Future interest expense could be higher or lower, depending on the revaluation of the debt.

8. ? Buyer’s Transaction Costs:

·???????? Costs incurred by the buyer for legal fees, advisory services, or due diligence are expensed immediately under GAAP, even though they do not appear on the opening balance sheet.

·???????? Impact on Income Statement:? These transaction costs reduce income in the period they are incurred.

9. ? Stock-Based Compensation:

·???????? If the buyer assumes the seller's outstanding stock-based compensation awards, these are remeasured at fair value and recognized as expense over the remaining vesting period.

·???????? Impact on Income Statement:? The fair value of these awards results in additional compensation expense in post-closing periods.

10. When No Immediate Income Statement Impact Might Occur:

·???????? If no fair value adjustments, intangible assets, or deferred taxes are recognized (which is rare), and the acquired entity's operations remain consistent post-closing, there may be no immediate impact on the income statement. However, this is uncommon in most acquisitions where purchase accounting is applied.

11. Adjustments That Can Impact EBITDA:

These adjustments affect the operating performance and thus flow through EBITDA:

·???????? Inventory Fair Value Adjustments (COGS Impact)

o?? Impact: EBITDA takes a hit in the short term until the inventory adjustment is fully recognized in the income statement.

·???????? Deferred Revenue Adjustments (Revenue Impact):

o?? Impact: EBITDA can be negatively affected in the periods during which the adjusted deferred revenue is recognized.

·???????? Contingent Consideration Revaluations (If Directly Related to Operations):

o?? Some remeasurements of contingent consideration (e.g., earnouts tied to operational metrics like revenue or profit) can be included in operating expenses if classified as such under GAAP.

o?? Impact: These adjustments can directly affect EBITDA in the reporting periods when they are recognized.

12. Adjustments That Do Not Impact EBITDA

These adjustments are excluded from EBITDA because they are non-operational, non-cash, or below the line:

·???????? Amortization of Intangible Assets

·???????? Depreciation of Fair Value Adjustments to Tangible Assets

·???????? Goodwill Impairment

·???????? Deferred Tax Adjustments

·???????? Transaction Costs:? Legal, advisory, and other transaction costs are expensed immediately under GAAP but are normally excluded from EBITDA because they are considered non-recurring and non-operational.

VII. CONCLUSION

Understanding the opening day balance sheet is not just an exercise in technical compliance—it’s a critical aspect of safeguarding the buyer’s interests and ensuring the long-term success of the transaction. While M&A attorneys may not be tax lawyers or accountants, having a solid grasp of the fundamental concepts allows them to confidently lead the deal, coordinate effectively with other advisors, and anticipate challenges before they arise.

One critical aspect of purchase accounting under ASC 805 is the determination of fair value, which requires buyers to adhere to specific standards and methodologies to ensure compliance and objectivity.? This nuanced process, including the challenges of self-performing valuations and the importance of engaging valuation experts, will be explored in an upcoming article.?

By addressing fair value adjustments, working capital considerations, and tax implications with foresight, M&A attorneys can help buyers avoid costly surprises, align expectations, and set the foundation for a smooth post-closing transition.

THIS ARTICLE IS FOR INFORMATION PURPOSES ONLY AND DOES NOT CONSTITUTE LEGAL ADVICE

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