In almost all private-target M&A transactions, there is a purchase price adjustment (PPA), also sometimes called an adjustment to net working capital, which is intended to reflect changes to the financial condition of an acquired company between the estimate when the price is set and the true condition when the transaction closes. This article addresses the unintended consequences of including deferred tax assets and deferred tax liabilities in the purchase price adjustment.

Net working capital, in particular, is intended to represent those assets and liabilities that are expected to have a short-term impact on cash and equity. Current assets are generally those that are expected to generate cash within twelve months. Current liabilities are generally those that are expected to use cash within the same timeframe.

Looking at the name alone, many people think that deferred tax assets and liabilities refer to expected tax refunds or taxes due. Deferred tax assets and deferred tax liabilities, however, are not the actual taxes, but simply an accounting concept. They refer to “timing differences,” an accounting term used to describe a situation in which certain revenue and expenses are recognized differently for tax purposes and book purposes, and are non-cash in nature. Even though they may be classified as short-term on the balance sheet, the calculation is derived from the classification of the underlying asset or liability that has the timing difference for tax purposes. It does not necessarily follow that the deferred tax asset or liability will have any impact on cash within twelve months, or ever.

SRS Acquiom tax experts recommend that the parties to a merger go line-by-line through the target company’s chart of accounts to determine which items actually impact the value of the business, and therefore should be included in working capital calculations, and which do not. Non-cash items, such as deferred tax assets and deferred tax liabilities, often should be specifically excluded from the definition of working capital in merger agreements.

If deferred tax assets and deferred tax liabilities are not excluded in the transaction, parties should pay special attention to their anticipated impact on determining the estimated balance sheet or any target level of net working capital. SRS Acquiom has seen large purchase price adjustments (PPA) due to inclusion of deferred tax assets and deferred tax liabilities in working capital calculations and for other reasons that don’t actually affect the combined company’s cash position or value. Purchase price adjustments are difficult to dispute and can result in an unnecessary loss of business value.

To view a related working capital video, please see below:

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