This report is one of a series on the adjustments we make to convert GAAP data to economic earnings. This report focuses on an adjustment we make to convert the reported balance sheet assets into invested capital.

Reported assets don’t tell the whole story of the capital invested in a business. Accounting rules provide numerous loopholes that companies can exploit to hide balance sheet issues and obscure the true amount of capital invested in a business.

Converting GAAP data into economic earnings should be part of every investor’s diligence process. Performing detailed analysis of footnotes and the MD&A is part of fulfilling fiduciary responsibilities.

We’ve performed unrivaled due diligence on 5,500 10-Ks every year for the past decade.

When a company makes an acquisition, the entire purchase price is added to the company’s balance sheet in the year of the acquisition along with any assumed debts or other long-term liabilities. However, the only income added to the income statement is that which occurs after the acquisition closes. In other words, the balance sheet is charged with the full price of the acquisition while the income statement only gets partially impacted.

Except for the rare event that an acquisition closes on the first day of the fiscal year, one must adjust for this accounting mismatch of income vs capital deployed when calculating return on invested capital (ROIC).

To ensure an accurate measurement of cash-on-cash returns, we adjust invested capital to reflect the time-weighted value of the acquisition. This adjustment is necessary to ensure the impact of the acquisition on NOPAT is commensurate with its impact on invested capital.

For example, Duke Energy (DUK) had over $23 billion in midyear acquisition adjustments to invested capital in 2012 for two acquisitions they made during the year. The biggest adjustment came from DUK’s acquisition of competitor Progress Energy on July 2, 2012. DUK paid $18 billion for Progress Energy and acquired an additional $27 billion in debt and other long-term liabilities. Because this acquisition occurred about mid year, we only added $22.6 billion, or the portion of the $45.3 billion that was on DUK’s books for the 182 days after the acquisition closed last year, to DUK’s invested capital for 2012.

Without this adjustment, any measures of return on assets or equity are distorted by the accounting treatment of midyear acquisitions.

Figure 1 shows the five companies with the largest midyear acquisitions adjustments to invested capital in 2012 and the five companies with the largest midyear acquisition adjustments as a percent of total assets.

Figure 1: Companies With the Largest Invested Capital Adjustment in 2012

Acquisition_Fig1Sources: New Constructs, LLC and company filings

Energy and aerospace companies make up four of the ten companies in Figure 1. However, they are far from the only companies that are affected by midyear acquisition adjustments. In 2012 alone, we found 1,139 companies with midyear acquisition adjustments totaling over $343 billion. For all years, our database contains 3,773 instances of acquisition adjustments totaling over $1 trillion.

Since our midyear acquisition adjustments decrease invested capital, companies with significant midyear acquisition adjustments will have a meaningfully higher return on invested capital (ROIC) when this adjustment is applied. For instance, Riverbed Technology, Inc (RVBD) acquired OPNET on December 18, 2012. RVBD paid roughly $1 billion. Since this acquisition occurred with only 13 days remaining in the year, we include only 13/365 of that $1 billion in RVBD’s average invested capital for the year.

If we simply used the year-end balance sheet data for invested capital, RVBD would have had an ROIC of only 5.6%. Adjusting for the amount of time that RVBD did not have access to the assets from its acquisition of OPNET, we see that it earned an ROIC of 24.1%.

Investors who ignore the impact of midyear acquisitions on invested capital are holding companies accountable for earning returns on assets to which they cannot lay claim for part of the year. By adjusting invested capital for midyear acquisitions, one can get a better picture of the value that management is creating for shareholders. Diligence pays.

Sam McBride and André Rouillard contributed to this report.

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.

    6 replies to "Midyear Acquisitions – Invested Capital Adjustment"

    • BW10


      Superb website. This website has the best writing on the internet I have seen on notes to the financial statements and how to do adjustments.

      So the idea behind this particular adjustment is to do this:

      Invested capital – Full Price of Acquisition + Time weighted value of acquisition.

      In your Duke Energy example, then, we should do this:

      Invested capital – 45 + [ (45) * (182/364) ] = Invested capital – 45 + 22.5

      This way we undo the mismatch between the I/S and B/S and include only the time weighted value of IC that is economically on par with the current NOPAT generated by the subsidiary.

      I assume this is also what you meant by we reduce invested capital (thereby inc. ROIC) because we are eliminating the entire full price of the acquisition and replacing it with only the time weighted value.

      Is this correct?

      I am new to some of these adjustments from notes to the financial statements and am trying to thoroughly understand each one.

    • BW10

      How does the adjustment decrease invested capital when you added the time adjusted total value of the acquisition to invested capital in both the Duke Energy and Riverbed Technology examples?

      Adj. = Invested capital + time adjusted value of acquisition
      Adj.= Invested capital + [Purchase price + debt + other long term liabilities]*[n/364]

      This higher invested capital should decrease ROIC, not increase it. The only way ROIC increases is if the full price of the acquisition is removed from the B/S (thru invested capital) and is then replaced with the ‘partial value’ (time adjusted value of acquisition).
      Am I understanding this right?

    • Sam McBride

      I should clarify that the midyear acquisition adjustment only impacts average invested capital, which is the number used to calculate ROIC. Year end invested capital is not impacted by this adjustment.

      In the case of Riverbed, it’s not that we’re removing the acquisition, we’re just time-weighting those assets in our calculation of average invested capital to ensure that we get an accurate picture of the impact they had on the company’s operations for the year. For companies that make a large acquisition late in the year, this adjustment significantly decreases average invested capital versus a simple average of the beginning and ending invested capital.

    • BW10

      Ok I remember now from another webpage of NC’s.

      Avg. incremental non-acquired Invested capital = [ Ending IC – Beg. IC – Acquired Invested Capital ] /2. This particular webpage describes the acquired invested capital part, thus total avg. invested capital should decrease and ROIC increases. got it.

      Thanks!!!! Deeply appreciate your fast responses.

    • BW10

      copied the wrong formula.

      Figure 1: How to Calculate Average Invested Capital

      Beginning Invested Capital + (Ending Invested Capital – Acquired Invested Capital) / 2) + Time Weighted Acquired Invested Capital.

    • BW10

      correction: meant to say this webpage describes the time weighted acquisition part.

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