Recapitalization ("recap") accounting refers to accounting for the repurchase, by a corporation, of its own common stock. The price paid for the common stock is booked as a decrease to shareholders' equity, and the repurchased shares are held as treasury stock. The treasury shares may be reissued at a later date or retired. There is no adjustment to the basis of the assets or liabilities of the company.
Recap LBOs are transactions that are accounted for by the target company as the sale of equity securities, the issuance of new debt, the retirement of existing debt, and the purchase and retirement of treasury stock. The practice of using recap accounting in the context of an LBO offer a potential benefit to the acquirer to the extent that reported earnings are not burdened by the potentially higher depreciation associated with the excess of the purchase price over the book value of the net assets acquired. The higher reported earnings are typically viewed as beneficial for an eventual IPO of the acquired business.
The use of recaps to effectively increase earnings was more advantageous before the FASB eliminated the amortization of goodwill (SFAS 142). Recap accounting is still somewhat relevant, since non-goodwill intangibles, which may be significant for certain service and non-industrial businesses, continue to require amortization.
To avoid push-down accounting rules (asset write-ups and the creation of a new goodwill intangible asset), a residual equity interest must be maintained by some group of original shareholders. The amount of residual equity ownership required is not explicitly identified by the SEC, but it generally ranges from a minimum of 5% to 20%, subject to the specific facts and circumstances of the transaction.
No new company structure can be used in connection with the transaction; all activities must be effected by the existing company.
Recapitalization accounting is a method of avoiding "push-down" of purchase accounting adjustments (i.e. write-up of assets) into a target company's standalone financial statements.
- Eliminates future income statement charges for higher depreciation, resulting in higher reported net income for the target company
- Given the P/E multiple focus of the IPO market, higher net income (and therefore EPS) may increase the exit valuation for the target company
- Usually results in negative book value of equity
Exhibit 5.17 – Advantages and Disadvantages of Recap Accounting