Differences between Financial Accounting and Tax for Valuation in M&A

18 Pages Posted: 7 Aug 2019

See all articles by Mary Margaret Frank

Mary Margaret Frank

University of Virginia - Darden School of Business

Frederick Elmore

University of Virginia

Abstract

This technical note outlines the differences between financial accounting standards and tax law that affect the valuation of potential targets depending on the deal structure employed. Valuation models typically rely on financial accounting information to estimate the value of the deal; but tax laws, not financial accounting standards, affect the after-tax cash flows attributable to the deal. The note provides steps to determine a target's tax basis from information in the financial statement, which allows for a better assessment of after-tax cash flows. This technical note can be used in conjunction with several other technical notes: UVA-F-1862, UVA-F-1863, UVA-F-1875, and UVA-C-2256.

Excerpt

UVA-C-2421

Jul. 19, 2019

Differences between Financial Accounting and Tax for Valuation in M&A

Tax consequences affect the after-tax cash flows attributable to an acquisition, and thus the value of the deal. Tax laws, not financial accounting standards, affect the tax consequences. Yet valuation models of potential targets typically rely on financial accounting information to estimate the value of the deal because access to the target's (T's) tax information is typically not available before due diligence begins.

The ability to better assess the after-tax cash flows resulting from an acquisition before comprehensive due diligence begins offers strategic and financial value to potential acquirers. A key to that better assessment comes from a reliable estimate of T's basis in its assets and liabilities. “Basis” is a concept for tax purposes analogous to “book value” for financial accounting purposes. A more accurate estimate of T's basis helps the acquirer (A) forecast T's pro forma after-tax cash flows with greater accuracy and infer both parties' preferences for particular deal structures.

Generally, A uses T's financial statements to model pro forma cash flows, which are used as inputs in a discounted cash flows valuation model. To the extent the valuation model doesn't incorporate material differences between financial accounting and tax, such as future depreciation, T's future after-tax cash flows can be grossly misestimated. The differences affect more than the standalone valuation of T's after-tax cash flows. They also affect A's assessment of the benefits and costs of various deal structures and the negotiating room between A and T. In the end, the differences ultimately affect the deal price.

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Keywords: book-tax differences, tax basis, valuation, mergers, acquisitions

Suggested Citation

Frank, Mary Margaret and Elmore, Frederick, Differences between Financial Accounting and Tax for Valuation in M&A. Darden Case No. UVA-C-2421. Available at SSRN: https://ssrn.com/abstract=3431278

Mary Margaret Frank (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4432 (Phone)
434-243-5021 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/frank.htm

Frederick Elmore

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

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