Including Deferred Tax Assets and Liabilities in Working Capital Calculations for M&A Transactions? Think Twice

In almost all private-target M&A transactions, there is a purchase price adjustment (PPA)—also sometimes called an adjustment to net working capital—that 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 a PPA.

Executive Summary

• Why is net working capital important in M&A transactions?
  Net working capital is intended to represent those assets and liabilities that are expected to have a short-term impact on cash and equity. In other words, did the target company have sufficient cash to operate its business at the time of closing and if not, does that impact the purchase price resulting in a PPA?
   
• What are deferred tax assets and liabilities?
  Deferred tax assets and deferred tax liabilities are accounting concepts that represent “timing differences”—situations in which certain non-cash revenue and expenses are recognized differently for tax purposes and book purposes.
   
• Should deferred tax assets and liabilities be included in working capital calculations?
  Given that deferred tax assets or liabilities will not necessarily have any impact on cash within 12 months, or ever, deal parties often exclude them from the definition of working capital in a merger or purchase agreement.¹
   

• What if deferred tax assets and liabilities are included?
  If deferred tax assets and deferred tax liabilities are not excluded, deal parties should pay special attention to their anticipated impact on determining the estimated balance sheet or any target level of net working capital.

  ---

What is net working capital?

Net working capital is all current assets less all current liabilities, or another way to think of it is the short-term cash required to operate the target’s business on a regular basis. Current assets are generally those that are expected to generate cash within 12 months. Current liabilities are generally those that are expected to use cash within the same timeframe.

What are deferred tax assets and liabilities?

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.

Should deferred tax assets and liabilities be included in working capital calculations?

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 adjustment 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.

What if deferred tax assets and liabilities are included?

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 PPAs 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. PPAs are difficult to dispute and can result in an unnecessary loss of business value.

Footnotes 

¹82% of deals closed in 2022 with a PPA excluded tax related items from the definition of working capital for purposes of the PPA. Source: 2023 SRS Acquiom M&A Deal Terms Study.