Buying another business is one of the largest decisions a business owner can make. Most of the attention naturally goes to the commercial questions: is it a good business, is the price right, can we run it well? The accounting can seem like a detail for later.
But the accounting matters more than many buyers expect. It determines how the acquisition will appear in the buyer’s financial statements, how profit will look in the following years, whether loan covenants will be met, and what lenders and investors will see. Deal terms that seem purely commercial, such as earn-outs, deferred payments and working capital adjustments, have specific accounting consequences. And the information prepared for accounting purposes, such as fair values of assets and identifiable intangibles, can sharpen commercial thinking about what is really being bought.
This article is a practical guide for owners of small and medium businesses considering an acquisition in Australia. It draws on the concepts set out in the source course material on business combinations and the equivalent Australian standards, and connects them to the stages of a typical deal. It is part of GoCore’s series on investments, groups and acquisitions. It is not a substitute for advice from accountants, lawyers and tax advisers, which any acquisition needs.
Stage 1: deciding what you are buying
The first accounting question mirrors the first commercial one: what exactly is being bought?
Shares or assets? A buyer can acquire the shares of the company that owns the business, taking on the company with all its assets and liabilities, or acquire selected assets and liabilities directly from the seller. The choice has major legal, tax and stamp duty consequences, and it affects which liabilities, contracts and employees transfer.
A business or a group of assets? Separately, for accounting purposes, the buyer must determine whether what is acquired is a business, consisting of inputs and substantive processes that together can contribute to outputs, or simply a group of assets. The article Buying a business or buying assets? explains the test. This classification determines whether business combination accounting applies.
Control or influence? If the buyer is acquiring less than 100%, it needs to consider whether it will obtain control, significant influence or neither, as explained in Accounting for investments in other companies.
Model the reported results before you sign
Before agreeing terms, it is worth building a simple projection of how the combined business will look in the buyer’s financial statements for the first two or three years after completion: revenue and profit including the expected acquisition accounting effects, the balance sheet including goodwill and any earn-out liability, and the key covenant measures. This often reveals issues early, such as a covenant that would be breached in the first year because of expensed transaction costs, or an earn-out structure that would create volatile reported profit. Adjusting the deal terms or agreeing covenant definitions before signing is far easier than after.
Stage 2: due diligence through an accounting lens
Due diligence is the investigation of a business before buying it. Several accounting questions deserve particular attention.
Quality of earnings. Are reported profits sustainable? Look for one-off items, owner-related expenses, unusual revenue, related-party transactions and changes in accounting policies. The adjusted, sustainable profit is often the basis for the price.
Working capital. Are receivables collectable, inventory saleable and payables up to date? Many deals include a working capital target, with the price adjusted if actual working capital at completion differs.
Hidden liabilities. Employee entitlements, warranty claims, disputes, tax exposures, environmental obligations and onerous contracts can all affect value. In a business combination, some contingent liabilities are recognised at fair value even if the seller never recorded them.
Assets the accounts do not show. Customer relationships, brands, software, licences and know-how may be the most valuable things being bought, even though the seller’s balance sheet shows little or nothing for them. The article The assets the balance sheet cannot see explores this.
Fair values of tangible assets. Property, plant and equipment may be worth more or less than their book values.
Stage 3: structuring the price
Deal terms translate directly into accounting.
Cash at completion is straightforward consideration.
Deferred payments, fixed amounts payable later, are part of the consideration, measured at fair value, which may involve discounting for the time until payment.
Earn-outs and other contingent consideration, payments that depend on future performance, are measured at fair value at the acquisition date in a business combination. If classified as a liability, later changes in their fair value are generally recognised in profit. Buyers should understand that if the acquired business performs worse than expected, the reduction in the earn-out liability produces a gain, while goodwill may need to be impaired, which can make post-acquisition results confusing.
Payments to sellers who stay on. If the seller or key staff receive payments that depend on continuing employment, those payments may be treated as remuneration for future services rather than as part of the purchase price. This affects both goodwill and future expenses, and the drafting of agreements matters.
Shares as consideration. If the buyer issues its own shares, they are measured at fair value, which for a private company may require a valuation.
Stage 4: completing the deal and the acquisition date
The acquisition date is the date on which the buyer obtains control, usually the completion date. It matters because fair values are measured at that date, and the acquired business’s results are included in the buyer’s consolidated statements only from that date.
Stage 5: purchase price allocation
After completion, a business combination requires a purchase price allocation: identifying and measuring the fair value of each identifiable asset and liability acquired, and calculating goodwill as the excess.
Typical steps:
- Confirm the consideration, including the fair value of any deferred or contingent payments.
- Measure tangible assets and liabilities at fair value.
- Identify intangible assets that meet the recognition criteria, such as customer relationships, brands, technology and contracts, and value them.
- Recognise deferred tax on differences between fair values and tax values, where required.
- Calculate goodwill, or a bargain purchase gain.
Valuing intangible assets often requires specialist valuation methods. For smaller acquisitions, the effort can be proportionate, but the judgements should be reasonable and documented. The article Goodwill in acquisitions explains the calculation in detail.
The measurement period
Fair values can be finalised within a measurement period of up to one year from the acquisition date. Buyers often report provisional amounts in the first financial statements after an acquisition and refine them later.
Stage 6: the first year and beyond
The acquisition affects reported results in several ways.
Transaction costs. In a business combination, legal, due diligence and advisory fees, along with stamp duty, are expensed when incurred, reducing profit in the acquisition year.
Depreciation and amortisation. Assets recorded at higher fair values depreciate more. Identifiable intangibles with finite lives are amortised over their useful lives.
Inventory step-up. Inventory acquired at fair value, which may exceed the seller’s cost, reduces the margin on its sale after acquisition.
Goodwill impairment testing. Goodwill is tested for impairment at least annually. If the acquired business underperforms, an impairment can reduce profit sharply.
Integration costs. Restructuring and integration costs after the acquisition are generally expensed.
Taken together, these effects often mean that reported profit in the first year or two after an acquisition is lower than the combined profits of the two businesses before the deal, even when the acquisition is succeeding commercially. Explaining this to lenders, investors and staff in advance avoids misunderstandings.
Stage 7: bringing the reporting together
After completion, the acquired business’s accounting needs to be brought into line with the buyer’s. Practical tasks include:
- aligning accounting policies, for example for revenue recognition, inventory costing and depreciation, so that the group’s figures are consistent
- aligning reporting dates and charts of accounts, so that monthly results can be combined easily
- setting up intra-group arrangements, such as management fees, shared services or loans, with clear documentation, because these must be eliminated on consolidation and may have tax consequences
- establishing month-end routines for the combined group, including reconciling balances between entities
- tracking the acquired business separately for a period, so that its performance against the deal assumptions, earn-out targets and goodwill impairment testing can be monitored
Getting these basics right in the first few months saves considerable effort at the first year end and makes the acquisition’s performance visible to management.
Getting the right help
Small and medium buyers rarely have specialist acquisition accountants in-house. Useful support typically includes an external accountant experienced in business combinations, a valuation specialist for significant intangible assets, a lawyer to draft the sale agreement, and a tax adviser to advise on structure and duties. Completion accounts, prepared as at the completion date to confirm working capital and net assets, are often a useful foundation for both the price adjustment and the purchase price allocation. The level of support should be proportionate to the size and complexity of the deal, but even modest acquisitions benefit from early advice.
Lenders and covenants
Many acquisitions are financed partly with debt, and loan agreements often contain covenants based on financial measures such as earnings, interest cover, debt ratios or net tangible assets.
Acquisition accounting can affect these measures:
- transaction costs and amortisation reduce reported earnings
- goodwill and intangibles increase total assets but not tangible assets
- earn-out liabilities increase reported liabilities
Agreeing clear definitions with lenders, for example whether covenant earnings exclude acquisition costs and amortisation, avoids accidental breaches.
Tax is separate
The accounting treatment of an acquisition does not determine its tax treatment. In Australia, the tax consequences depend on whether shares or assets are bought, the nature of the assets, capital gains tax rules for the seller, the treatment of depreciating assets, the tax consolidation regime for corporate groups, and state duties. Goodwill, for example, is generally a capital gains tax asset for tax purposes, not a depreciable asset. Tax advice should be obtained early, because it often shapes the deal structure.
A worked illustration
This is an illustration, not a real transaction.
A regional electrical contractor agrees to buy a smaller competitor for $1.6 million: $1.2 million at completion and an earn-out of up to $400,000 over two years, depending on profit targets. The buyer acquires the shares of the competitor’s company.
During due diligence, the buyer adjusts the competitor’s reported profit for the owner’s personal expenses and a one-off contract, finds that some receivables are unlikely to be collected, and confirms that key staff will stay.
After completion, the purchase price allocation identifies equipment and vehicles at fair value, customer contracts and relationships, the trading name, employee entitlements and other liabilities. The earn-out is valued at $250,000, reflecting the likelihood that targets will be met. Goodwill is the remaining excess.
In the first year, the buyer’s reported profit includes the acquired business’s results from the acquisition date, less transaction costs expensed, amortisation of customer relationships and depreciation of vehicles at their fair values. Because the buyer prepared its lender for these effects and agreed covenant definitions that exclude acquisition costs, there are no surprises. When the acquired business beats its first-year target, the earn-out liability increases, and the buyer records the increase as an expense, as expected.
Common mistakes
Leaving accounting until after completion. Deal terms can produce unexpected accounting outcomes.
Overlooking intangible assets. They may be the most valuable things bought and must be valued.
Misunderstanding earn-out accounting. Changes in earn-out liabilities affect profit, not goodwill.
Ignoring covenant effects. Acquisition accounting can trip loan covenants.
Assuming accounting and tax align. They follow different rules.
Questions to ask
- Are we buying shares or assets, and is what we are buying a business?
- What identifiable intangible assets are we acquiring, and what are they worth?
- How will deferred payments, earn-outs and payments to continuing staff be accounted for?
- How will the acquisition affect reported profit and covenants in the first two years?
- For your own business: who will prepare the purchase price allocation, and when?
Bringing it together
The accounting for an acquisition begins long before completion. Deciding what is being bought, investigating earnings, working capital and hidden liabilities, structuring the price, completing the purchase price allocation and anticipating post-deal effects on profit and covenants all have accounting dimensions.
Buyers who consider the accounting early can structure deals more clearly, prepare lenders and investors for the reported results, and understand more precisely what they are paying for. Combined with sound legal and tax advice, that understanding makes an acquisition more likely to succeed on paper and in practice.
Sources: course materials from an advanced financial reporting course (Module 1, based on US GAAP), together with Australian Accounting Standards, including AASB 3, AASB 10 and AASB 136. The worked illustration is hypothetical. This article is general information, not accounting, legal, tax or financial advice; consult qualified advisers about any acquisition.
