Dr. P.V. Viswanath



Economics/Finance on the Web
Student Interest


Deal Design


P.V. Viswanath, 2006


Accounting and Cashflow

It is important to keep in mind that accounting considerations affect only the reported earnings and the form in which financial statements have to be presented to the public. A merger might be required, for accounting purposes, to use the Purchase Accounting method (pooling accounting is not allowed, any more, according to FASB regulations). However, if the purchase qualifies as a tax-free merger, as it would be if it were a stock-for-stock merger, the assets of the acquired firm do not have to be written up for tax purposes (and cannot be -- hence there will not be additional depreciation for tax purposes -- although for reporting purposes, depreciation might very well be higher because purchase accounting has to be adopted and the purchase price has to be assigned to all assets based on fair value considerations. Concomitantly, the firm can use the operating loss carryforwards of the acquired firm and can employ them as an offset against its own income.

Tax implications

If the deal is a taxable one (as for example if the acquirer buys target shares for cash), then the target shareholders have to pay taxes on the capital gains. On the other hand, the acquirer gets to restate the book values of the target's values. Which is better depends on a careful comparison of the disutility of the additional tax to the target shareholders versus the benefit to the acquiring firm of having a stepped-up basis. If, for example, the target shares have dropped in value over the last two years, say, and there has been substantial turnover in the shares of the target firm, there may not be much in the way of tax liability for target shareholders; in this case, the benefit to the acquiring firm might trump the loss to the target shareholders.