United States: Understanding The New Accounting Standard For Business Combinations

On Dec. 4, 2007, the Financial Accounting Standards Board (FASB) issued FASB Statement of Financial Accounting Standards No. 141 (revised 2007), "Business Combinations" (FAS 141(R)),¹ a replacement of FASB Statement No. 141. The statement marked the first major product of the joint convergence agenda between the FASB and the International Accounting Standards Board (IASB) on the U.S. side. (Note that the IASB's comparable financial reporting standard, International Financial Reporting Standard 3, was issued, as revised, on Jan. 10, 2008.) FAS 141(R) will be effective to U.S. business combinations for which the acquisition date is on or after the beginning of the first annual reporting period that begins on or after Dec. 15, 2008. Consistent with other recently issued financial accounting and reporting standards, fair value is the centerpiece of FAS 141(R).

This briefing highlights certain key provisions of FAS 141(R), summarizes how the statement will change financial accounting and reporting for business combinations, and provides some perspective on the transition to the statement.

Some Key Provisions

FAS 141(R) alters much of the framework in accounting for mergers and acquisitions. The essence of the new standard is measuring the fair value of the acquired business as of the acquisition date. Fair value does not include the direct costs of acquiring the business or costs the acquirer may incur to integrate the business going forward. Additionally, any changes in fair value after the acquisition date generally are recorded in earnings.

The more significant changes mandated by the statement include the following.

• The definition of "a business" and what constitutes a business qualifying for business combination accounting has been broadened to include initial consolidation of a variableinterest entity that is a business within the scope of FASB Interpretation No. (FIN) 46(R), "Consolidation of Variable Interest Entities."²

• Fair value applies to all business combinations, whether full or partial or stage/step acquisitions. (This means the acquirer must measure and account for 100 percent, not just the acquired portion, of the fair value of the acquired business, when a change in control occurs.)

• Contingent consideration (for example, an "earnout") is recorded at fair value at the acquisition date. Subsequent adjustments are recorded through earnings.

• Acquired contingencies generally are measured and recorded at fair value at the acquisition date. Assets are recorded at their acquisition-date fair value and then, subsequently, at the lesser of their acquisition-date fair value or the amount estimated to be realized. Liabilities are recognized at their acquisition-date fair value but subsequently at the higher of their acquisition-date fair value or the amount recognizable by application of FASB Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies" (FAS 5) Subsequent changes, however, are limited to when there is new information applicable to the probable outcome.

• Contingency accounting prescribed by the statement changes acquirers' accounting for seller indemnifications. The indemnification asset is recognized as a contingent asset and generally will adjust in tandem with the related contingent liability.

• Valuation allowances for uncollectible receivables and loan losses at the acquisition date are eliminated by the statement's provisions, with receivables and loans reported at fair value. This change might affect computations of lending limits by commercial banks.

• Direct acquisition costs are no longer included as consideration and are to be expensed as incurred.

• Restructuring or exit activity costs related to the acquired business generally will be expensed in post-acquisition periods.

• In-process research and development is to be recorded as a separately identified intangible asset, but the statement prescribes capitalization and classification as indefinitely lived intangibles, subject to impairment evaluation, pursuant to FASB Statement of Financial Accounting Standards No. 142, until completion or abandonment of the associated research and development efforts. Capitalized costs for successful projects will be amortized after completion, while abandoned project costs will be expensed. FAS 141(R) does not change post-acquisition research and development expenditures, which generally will continue to be expensed when incurred.

• Changes in accounting for deferred income tax asset valuation allowances and acquired income tax uncertainties generally will be recorded in earnings rather than as an adjustment of goodwill.

• Bargain purchases result in immediate recognition of gains on the acquisition date.

The following table provides a closer look at certain FAS 141(R) provisions, as compared to currently effective U.S. generally accepted accounting principles (U.S. GAAP).

Key Provision	U.S. GAAP (as in effect)	FAS 141(R)
Definition of a business	Emerging Issues Task Force (of the FASB) (EITF) Issue 98-3, "Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business," describes a "business" as a self-sustaining integrated set of activities — inputs, processes, and outputs	A "business" is constituted by activities capable of being conducted and managed to provide a return to investors. This definition also replaces FIN 46(R)'s definition of a business.

Acquired net assets recorded at fair value`	Fair value of net assets, including goodwill, is recognized under a costaccumulation approach (that is, fair value applied to the acquired portion).	With limited exceptions, 100 percent of the acquired entity's net assets, including goodwill, are recorded at prevailing fair value.
Contingent consideration	Contingent consideration is generally recognized as additional purchase price when the contingency is resolved.	Contingent consideration is to be measured at fair value at the acquisition date. Most subsequent changes in fair value will be accounted for in accordance with the contingency's initial classification. Contingent consideration classified as equity will not be remeasured, but settlement differences will be accounted for within equity. Changes in fair value of asset or liability contingent consideration will generally be adjusted through earnings.
Contingencies	Contingent liabilities are recognized when the liability is probable and estimable. Contingent assets (gains) are generally unrecorded.	Contractual contingencies are recognized at fair value on the acquisition date. Noncontractual contingencies are recognized at fair value when meeting the "more likely than not" criteria. Liabilities are measured at the higher of the acquisition-date fair value or the amount computed under FAS 5. The adjustment is recognized through earnings. Assets are measured at the lower of acquisition-date fair value or the best estimate of its ultimate settlement with any adjustment recognized in earnings. Both assets and liabilities are adjusted only if new information about the contingency arises.
Direct acquisition costs or acquisitionrelated costs	Qualifying costs are considered part of the purchase price.	Costs are to be recognized separately from the business combination as expense when incurred pre- or post-acquisition.
Restructuring or exit activity costs	EITF Issue 95-03, "Recognition of Liabilities in Connection with a Purchase Business Combination," provides that certain costs of the acquirer's plan should be recognized as assumed liabilities in a business combination, if certain conditions, thereto, are met.	Only costs meeting the definition of a liability (as contemplated by FASB Statement of Financial Accounting Concepts No. 6, "Elements of Financial Statements") at the acquisition date are recognized in purchase accounting.
In-process research and development (R&D) activities	Fair value is immediately expensed, as a one-time charge to earnings, if of no alternative future use.	Intellectual-property and R&D intangibles are initially recognized as intangible assets at fair value, until completion or impairment. Post-acquisition R&D will generally continue to be expensed as incurred.
Subsequent "releases" of deferred tax asset valuation allowances and uncertain tax positions	Valuation allowances: First, reduce goodwill to zero and then reduce noncurrent intangibles, and, finally, recorded in earnings. Uncertainties: The resolution is reflected in purchase accounting, regardless of the timing of the resolution.	If recognized in the measurement period, the period after the acquisition date during which the acquirer may adjust provisional amounts recognized in the business combination (not to exceed one year), and based on information existing at the acquisition date, a release is to be reflected in purchase accounting; otherwise, the adjustment is recorded in earnings.
Goodwill	Only goodwill associated with the acquirer's interest is recognized.	Goodwill associated with the controlling and noncontrolling interests is recognized.
Bargain purchases	Fair value in excess of cost is first applied to reduce noncurrent assets on a pro rata basis; then any remainder is an extraordinary gain.	Excess fair value of net assets acquired is recognized as a gain attributable to the acquirer through earnings. Caution: Such a circumstance first requires revisiting identified net assets and valuation thereof.
Adjustments to purchase accounting	Adjustments made outside the allocation period (usually not to exceed one year) affect earnings in the period of change.	After the measurement period ends, the acquirer shall revise purchase accounting only to correct an error in accordance with FASB Statement of Financial Accounting Standards No. 154, "Accounting Changes and Error Corrections." Therefore, most restructuring costs related to the acquisition will no longer be included in the assumed liabilities of the purchase.

Demonstrating Certain Provisions

Several of these differences, for which the effects are significant and the occurrences seem commonplace, can be demonstrated as follows.

Less Than 100 Percent Acquisition

Facts: Assume A acquires 51 percent ownership of B. The net assets have a fair value of $100 million and the carrying amounts are $90 million.

Current U.S. GAAP: 51 percent of the acquired net assets would be subject to purchase-accounting fair value, with 49 percent reported at the pre-acquisition carrying amounts. Thus approximately $5.1 million (51 percent of fair value "step-up" computed as $100 million minus $90 million) would be recorded for goodwill, and the noncontrolling 49 percent interest would be reported based on historical carrying amounts.

FAS 141(R): $100 million (full fair value) is reported, with the noncontrolling 49 percent interest participating in the step-up. Goodwill is recognized as "the excess of consideration transferred and the fair value of the noncontrolling interest over the fair value of the net assets."

Contingent Consideration

Facts : Assume an earnout's fair value at acquisition is estimated to have a probability of 75 percent for maximum payout of $1 million over three years.

Current U.S. GAAP: Under existing guidance, the consideration is recognized upon the contingency becoming resolved, usually when paid.

FAS 141(R): The reporting entity records a contingent liability of $750,000 at acquisition.

More Facts: Assume, at the end of Year One, probability becomes 90 percent for full payout.

Current U.S. GAAP: Consistent with the accounting as of the acquisition date, no amount is recognized in the financial statements.

FAS 141(R): The increase in the estimated value of the earnout (15 percent, or $150,000) is recognized as an increased liability through a charge to earnings.

More Facts: Assume, during Year Three, the industry experiences a market downturn and only 50 percent of the maximum earn-out becomes required in full settlement/extinguishment.

Current U.S. GAAP: $500,000 now becomes contingent consideration recorded in purchase accounting.

FAS 141(R): The acquirer has settled/extinguished the previously recorded contingent liability of $900,000 for $500,000 and reverses the excess $400,000, again, through earnings.

Transaction Costs

Facts: A incurs $5 million in qualifying direct acquisition costs, which may include investment banking, legal, and other transaction costs in a cash deal paying $75 million to B.

Current U.S. GAAP: The $5 million is part of the cost of the acquisition; therefore, $80 million is allocated to the purchase via the purchase method of accounting.

FAS 141(R): A records a $5 million charge to earnings, as the costs are incurred.

Perspective

Some believe the immediate implications of FAS 141(R) do not appear as drastic as the implications experienced when changing from Accounting Principles Board Opinion No. 16, "Business Combinations," to FASB Statements of Financial Accounting Standards Nos. 141, "Business Combinations," and 142, "Goodwill and Other Intangible Assets," which, among other changes, eliminated pooling of interests and amortization of goodwill. We believe FAS 141(R) will have significant implications on the design of transactions and the financial reporting thereof, at acquisition, and in post-acquisition reported earnings. Nevertheless, the statement should not change the business purpose of completing particular transactions.

It should be noted that FAS 141(R) requires fair values to be based on marketplace assumptions. Acquirers are no longer allowed to determine fair value by making assumptions about how they will use the acquired assets. These assumptions may very well be different than the intended-use assumptions they made to arrive at the purchase price. In certain circumstances, this change may suggest that fair values could increase, as would future depreciation/amortization, and impairment charges, if recognizable. Application of marketplace assumptions in valuations will require significant modifications to traditional valuation approaches.

Earnouts, if not structured and accounted for as equity, may find their way out of more deals, in consideration of the fair value volatility they may present — in turn affecting future earnings. Earnouts have become commonplace, particularly when parties cannot agree on a purchase price, inasmuch as they allow future results and achieved operational synergies therein to settle the contingent consideration. The prescribed accounting under FAS 141(R) may appear somewhat counterintuitive, as demonstrated above. It causes better-than-expected results and greater earnout payments to be charged to earnings as an expense, while poorer-than-predicted results would result in positive earnings adjustments. In the latter case, the reduced earnout might appear to be an indicator of potential impairment of other recorded assets.

FAS 141(R) was crafted to improve financial reporting — to improve its usefulness, meaningfulness, and relevance to users of financial statements. FAS 141(R) highlights the FASB's view that an acquired business, including the underlying assets and liabilities, should be recorded at fair value, a change that provides a greater degree of transparency in reporting the business combination. The concept of full fair value and remeasurements of certain fair value items will naturally result in volatile postacquisition earnings and perhaps increased scrutiny of the financial statements, which management will need to be prepared to evaluate and explain. The substantially greater use of fair value means greater need for in-house valuation expertise or the use of outside specialists, and this need will persist long after the transaction occurs.

Most of the implications of FAS 141(R) point to enhanced due diligence, greater rigor in designing deals, complex valuation and revaluation, and a need for ongoing monitoring of estimates and postacquisition evaluation metrics, including debt compliance measurements. All of this effort appears to be necessary in order to stand ready for acquisition accounting and post-acquisition effects that will be promulgated by the provisions of the statement.

How Can You Prepare?

The effective date of FAS 141(R), and the prohibition of its early adoption, provides companies and their advisers an opportunity to assess the implications of the significant and far-reaching changes brought about by the statement. The intervening period provides a window in which implications can be incorporated into transactions, from assessment and structuring to post-acquisition financial reporting.

How can you be poised to execute and report transactions effectively, and to meet management's and investors' expectations, amid the earnings volatility that full fair value and remeasurements present? Consider the following.

• Educate your transaction leadership team and your directors about the key provisions of FAS 141(R).

• Prepare investors with analyses that include the impact of the statement, in order to settle on a mutual understanding of how transaction performance will be evaluated.

• Revisit your due-diligence process and consider expanded financial modeling.

• Review recent transactions under the guidance of FAS 141(R).

• Engage in discussions with valuation specialists.

• Understand that timing can be critical as 2009 approaches. Substantially different accounting results could occur for a deal closing in 2009, as opposed to late 2008, so consider the implications of the statement in your transaction pipeline.

It should also be noted that FASB Statement of Financial Accounting Standards No. 160, "Noncontrolling Interests in Consolidated Financial Statements" (FAS 160) was issued coincidently with FAS 141(R) and defines noncontrolling interests (formerly known as "minority interests") as "the portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent." FAS 160 provides related guidance by its provisions that embody a concept that noncontrolling interests have an equity interest in the consolidated net assets of the consolidated reporting entity. FAS 160, thus, requires recognition of noncontrolling interests within equity of the consolidating reporting entity. FAS 160 has the same effective date as FAS 141(R).

Footnotes

^{1. For the full statement, see http://www.fasb.org/pdf/fas141r.pdf}

^{2. For the full FIN 46, see http://72.3.24342/pdf/fin%2046R.pdf.}

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.