Overpaying for acquisitions: No one cares, it seems, unless they break bad
How much is too much to pay for a strategic acquisition of a hot company, tech or trend? Almost everyone gets away with it unless they have to say they're sorry, which they often do.
I am working diligently to put together lectures for the class on financial accounting I’ll teach Wharton MBAs this fall. I am always looking for fresh examples ripped from the headlines, even better if I’ve written about them and can talk about them easily.
I was working on the lectures about accounting for tangible assets (PP&E) and long-lived intangibles — separately transferable assets such as patents, copyrights, and not separately transferable assets such as goodwill — and how these assets are amortized and/or impaired. Goodwill was always a very difficult subject to write about for a general business audience because it is an ethereal concept, maybe only slightly less difficult to explain to anyone, even accountants, than deferred tax assets and liabilities.
There has been a lot of debate, again, about whether goodwill should be amortized or impaired — the current accounting treatment is to measure it for impairment not amortize regularly — but we’ve settled on the status quo, again, for now. I’ve written about the debate, and the latest conclusion to it, and you can read those for more.
I wanted to build some detailed examples for my lectures, and so I went to the well, Berkshire Hathaway and Warren Buffett, for the best examples of overpaying for acquisitions. Buffett has an undeserved reputation as a bargain hunter. I have written about that a lot.
Goodwill represents the excess of the purchase price of the target over the fair market value of its net identifiable assets.
When an acquirer purchases a target firm, the book value of target’s individual assets and liabilities are, first, adjusted to reflect their current market values before recognizing them on the acquirer’s financial statements.
Why would the purchase price typically be greater than the net book value of the target company’s equity? Why might there a difference between the book value and the fair market value of assets and liabilities?
Historical cost was a stale reflection of current asset and liability values.
Some important assets, such as internally generated brands, patents, data, were not recognized on the target balance sheet but the buyer is recognizing their value in the purchase price.
Value of future growth opportunities or synergies between acquirer/target are not reflected on the balance sheet but are reflected in the price the buyer is willing to pay.
The acquirer is overpaying for the target because
»conditions have changed since the offer was accepted
»there are strategic or anti-competitive reasons to take out of play
» the acquirer is overoptimistic
»there were misleading or fraudulent disclosures leading to an incorrect valuation
»there is some other strategic reason to put overvalued assets on the acquirer’s balance sheet
At MarketWatch I wrote stories about another highly acquisitive company, Valeant Pharmaceuticals, now known as Bausch Health. At one point I made the case that Valeant was taking advantage of what are called “measurement period adjustments” to cushion its net income.
Valeant uses rare accounting maneuver for acquisitions that cushions income, Feb. 12, 2016, Francine McKenna
The Valeant acquisition machine often pays a substantial premium for companies. That purchase premium is booked to its goodwill account, but Valeant has not been retroactively adjusting net income and expense when it subsequently revises the balances it calculated at the time of acquisition.
That tactic is less readily available than it used to be because the time period when you can adjust the allocation of the purchase price between assets, liabilities, and goodwill is now only one year. But the tighter rules are only as good as the enforcement of them and I see very little of that.
I was reminded of this tactic asked this week about reports that newly merged together Warner Bros Discovery boss David Zaslav abandoned two films, "Batgirl" and "Scoob! Holiday Haunt," for “purchase accounting” reasons. (That was sort of the reason but not totally, so stay tuned for some media reporting on this where I will be quoted.)
From the Warner Bros Discovery 10-Q where they tell you why Discovery paid AT&T shareholders a big premium for Warner Media assets, only to write some of them off immediately.
Preliminary Purchase Price Allocation
The Company applied the acquisition method of accounting to WM, whereby the excess of the fair value of the purchase price paid over the fair value of identifiable net assets acquired and liabilities assumed was allocated to goodwill. Goodwill reflects the assembled workforce of WM as well as revenue enhancements, cost savings and operating synergies that are expected to result from the Merger. The goodwill recorded as part of the Merger has been provisionally allocated to the Studios, Networks and DTC reportable segments in the amount of $8,912 million, $7,016 million and $5,585 million, respectively, and is not deductible for tax purposes.
The purchase price allocation is preliminary and subject to change. The Company is still evaluating the fair value of film and television library, intangible assets, and income taxes, in addition to ensuring all other assets and liabilities and contingencies have been identified and recorded. The Company has estimated the preliminary fair value of assets acquired and liabilities assumed based on information currently available and will continue to adjust those estimates as additional information pertaining to events or circumstances present at the Closing Date becomes available during the measurement period. The Company will reflect measurement period adjustments, if any, in the period in which the adjustments occur, and the Company will finalize its accounting for the Merger within one year of the Closing Date.
I’ve also written quite a bit about how some companies bring back acquired deferred revenue that was written off at the time of acquisition as non-GAAP adjustments.
That work was the basis for academic research that won one young man his PhD!
When a company acquires another, the balance of the difference between the purchase price and the fair market value of net assets is recorded as goodwill. I think it’s helpful for students to see extreme cases to see how overpayment happens, how acquisitions go very wrong, and to see numbers significant enough to provide an example of how numbers can vary based on judgments and estimates of fair value. It’s also helpful to look at extreme examples to see how numbers may be massaged or manipulated based on subsequent knowledge. I immediately thought of an example from Valeant to show how all this happens.
I could have also chosen an example from Berkshire Hathaway. There are plenty of them.
The challenge when choosing examples from Berkshire Hathaway is that you have to choose a really big one like Kraft Heinz, or Precision Castparts, to have enough publicly available numbers to work with. Typically the information disclosed by Berkshire Hathaway on the progress and success or failure of its acquisitions is minimal, inconsistent, or non-existent. I complained about that once here, the SEC noticed, and Berkshire Hathaway got a comment letter.
But we likely won’t see all the cockroaches in Buffett’s conglomerate portfolio until he’s no longer in charge.
The Financial Times Opinion
Buffett’s Berkshire Hathaway needs to be broken up
Splitting the conglomerate would enable more scrutiny and allay some investors’ concerns Francine McKenna April 27, 2022
So which huge overpayment for an acquisition did I choose to dig into for my students? It’s one from Valeant, but you’ll have to wait until after the term to get the details, or enroll at Wharton! I do not want to spoil surprise for the students.
I did get a lot of suggestions on Twitter when I gave the prompt.
And finally the whale of bad acquisitions, Autonomy.
I wrote about the current state of the Autonomy litigation and lack of enforcement action aganst the auditors by US authorities.
© Francine McKenna, The Digging Company LLC, 2022