How are pro forma financial statements constructed for an M&A transaction, and what adjustments are typically needed?

Question

AcadiFi · Accepted Answer

Pro forma financial statements present the hypothetical combined results of an acquirer and target **as if the deal had closed on the first day of the reporting period**. They are required by IFRS 3 and commonly tested at CFA Level II. Here is how to build one.

**Step-by-Step Construction**

1. **Start with standalone financials** of both companies for the full period.
2. **Eliminate intercompany transactions** — if the acquirer was a customer of the target, remove those revenues and costs.
3. **Apply purchase accounting adjustments** — depreciation/amortization based on fair-value-adjusted assets (not historical book values).
4. **Add financing adjustments** — interest expense on any new debt issued to fund the deal; remove interest income on cash used.
5. **Adjust for income taxes** — recalculate the tax provision on adjusted pretax income.
6. **Exclude transaction costs** — IFRS 3 expenses these as incurred; they are not part of the ongoing combined entity's operations.
7. **Exclude synergies** — pro forma statements should reflect the combination without anticipated synergies.

**Worked Example — Landsford Corp Acquires Pinnex Ltd:**

| Line Item | Landsford | Pinnex | Adjustments | Pro Forma |
|---|---|---|---|---|
| Revenue | $580M | $210M | ($15M) interco | $775M |
| COGS | ($340M) | ($125M) | $10M interco | ($455M) |
| D&A | ($42M) | ($18M) | ($7M) FV step-up | ($67M) |
| Interest expense | ($14M) | ($6M) | ($9M) new debt | ($29M) |
| Pretax income | $184M | $61M | ($21M) | $224M |
| Tax (25%) | ($46M) | ($15.3M) | $5.3M | ($56M) |
| **Net income** | **$138M** | **$45.7M** | **($15.7M)** | **$168M** |

**Key Adjustments Explained:**

- The **$7M additional D&A** reflects the fair value step-up on Pinnex's PP&E with a 10-year remaining life ($70M step-up / 10 years).
- The **$9M new interest** represents a $150M term loan at 6% issued to finance part of the acquisition.
- **Synergy savings** (e.g., $12M expected headcount reduction) are **excluded** from the pro forma.

**Exam Tips:**

1. Always remove intercompany balances — this is a common trap.
2. Transaction costs (legal, advisory fees) are expensed separately, never included in pro forma adjustments.
3. Remember that pro forma EPS uses the acquirer's weighted-average shares **plus** any new shares issued as if they were outstanding for the entire period.

Check our CFA FRA module for more M&A accounting worked examples.

How are pro forma financial statements constructed for an M&A transaction, and what adjustments are typically needed?

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