New merger and acquisition accounting rules under Statement of Financial Accounting Standards (FAS) No. 141(R), "Business Combinations," continue the shift of the Financial Accounting Standards Board (FASB) toward fair value accounting and introduce new complexities in determining the fair value of acquired businesses. As authors John Kurkowski and Steven Schumacher explain, the rules could have far-reaching consequences, affecting the complexity and cost of mergers and acquisitions, as well as possibly increasing the volatility of future earnings.
FAS 141(R) will be effective for U.S. business combinations for which the acquisition date is on or after the first annual reporting period that begins on or after Dec. 15, 2008. FAS 141(R) is a component of the agenda related to the convergence of the FASB and the International Accounting Standards Board (IASB).1
The essence of 141(R) is that acquired businesses must be recorded at their fair value as of the acquisition date. In contrast, the current standard allocates the cost of an acquisition to the fair value of the acquired business. The new rules mandate that acquired assets and liabilities be measured at their fair values on the acquisition date, even when partial (but controlling) ownership is obtained. Noncontrolling interests must also be measured at fair value on the acquisition date. As a result, the buyer's balance sheet on the acquisition date will reflect the fair value of the entire business rather than just the acquired portion.
As discussed in detail below, fair value excludes certain costs and liabilities that have historically been included as a cost of the acquisition and includes certain liabilities, such as earnouts, that were not considered in the cost of the acquisition until they were earned. These changes highlight the importance of determining fair values as of the acquisition date and will likely create greater volatility in future earnings periods.
The Cost Of The Deal
Acquisition expenses such as investment banking fees, due diligence costs, and attorneys' fees will no longer be included as part of the purchase price. FAS 141(R) will require these costs – except for the buyer's costs of issuing debt or equity securities, which are deducted from the proceeds – to be recorded as expenses in the periods they are incurred. CFOs will want to be sure that borrowing covenants are set with acquisition expenses in mind or exclude these costs from covenant calculations. Under previous accounting standards, such costs were generally capitalized as part of the purchase price.
The Cost Of Restructuring
Under the new standards, restructuring costs will generally be expensed in periods after the acquisition date. Charging restructuring costs to earnings could lead to increased scrutiny from stakeholders; therefore, companies should be prepared to communicate the anticipated synergies and other benefits of the deal to justify the restructuring costs and identify the expected long-term savings. Previously, the cost of a buyer's planned restructuring of the acquired company's operations was recorded as a liability and provided little visibility for the incremental costs of the acquisition.
Under FAS 141(R), contingent consideration is to be measured and recognized at its fair value as of the acquisition date. Contingent consideration will be remeasured to fair value at each reporting period until the contingency is resolved. 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 the fair value of contingent consideration settled in cash will generally be adjusted through earnings. Under current accounting requirements, a contingent consideration generally is not recorded until it is earned.
Valuing contingent consideration arrangements may be challenging and will likely require increased input from valuation specialists. After all, these arrangements often arise when a buyer and seller cannot agree on the fair value of a business at the time of the acquisition. The compromise is that the buyer will pay the seller more for the acquired business if certain future performance targets are met. In addition to the valuation challenges, companies should expect to experience greater earnings volatility, as these arrangements will need to be revalued to their then-fair value at each reporting date.
Under FAS 141(R), contingencies that might result in future assets or liabilities must be recognized at fair value on the acquisition date. The buyer must record all contractual contingencies at fair value as of the acquisition date. Noncontractual contingencies must also be recorded at fair value if they are "more likely than not" to meet the definition of an asset or liability. One caveat: The "more likely than not" threshold is a 50 percent degree of probability, which is less than the 80 percent probable threshold under FASB Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies."
If new information about the contingencies becomes available after the acquisition, assets will be remeasured at the lower of their acquisition-date fair value or the estimated amount to be realized, while liabilities will be remeasured at the higher of their acquisition-date fair value or the amount calculated under FASB Statement No. 5.
To date, contingent assets have not generally met the recognition criteria and have seldom been recorded, while contingent liabilities did not have to be recorded until the liabilities could be probable and determinable. The changes mandated by FAS 141(R) suggest that more contingent assets and liabilities will be recognized at the deal's consummation and the valuation process will be much more involved.
In-Process Research And Development
In-process research and development will be measured at fair value as an intangible asset at the acquisition date. If the projects are completed, the assets will be amortized through earnings; if the projects are abandoned, the assets will be written off. Under current accounting rules, acquired in-process research and development is recorded at fair value and expensed immediately at the date of acquisition.
In a bargain purchase, acquired assets and liabilities will be recognized at fair value and any excess over the purchase price will be calculated as a gain attributable to the buyer through earnings. As an example, assume a buyer purchases a company for $500,000 when the fair value of that business is determined to be $1 million. Under FAS 141(R), the buyer will record asset values of $1 million and have to recognize a gain of $500,000 because the company's fair value is double the purchase price. This new treatment will lead to increased depreciation and amortization expenses on the income statement subsequent to the acquisition. Under the current accounting standards, recorded asset values are limited to actual consideration or, in our example, $500,000. The $500,000 reduction to the fair value of the assets ($1 million) is determined by a pro rata allocation to the noncurrent assets.
FAS 141(R) will result in additional important changes:
- Buyers will be required to recognize goodwill associated with noncontrolling interests, as well as that associated with controlling interests, as of the acquisition date when the consideration that is transferred exceeds the fair value of the identifiable net assets acquired;
- In their income statements at the acquisition date, buyers generally will not be permitted to carry over the seller's valuation allowances related to loans and receivables;
- As they do now, companies will have a window of opportunity to adjust acquisition accounting after a purchase, but the new rules will require the revision of prior period financial statements to record material adjustments of estimated amounts in the acquisition as of the acquisition date;
- In a step acquisition, any previously held noncontrolling equity interests are to be remeasured to fair value once control is obtained, and the resulting adjustment is to be recognized in net income.
In addition to introducing new accounting concepts and adding complexity to valuations, FAS 141(R) has the potential to increase the volatility of earnings and perhaps increase the degree of scrutiny financial statements undergo from stakeholders. The changes will prompt companies to rethink how they structure transactions and communicate the results to stakeholders.
When planning future acquisitions, company management needs to understand and assess the strategic and earnings implications of the new rules. To understand the implications for contingencies and deal structures, managers should consider consulting outside valuation specialists before an acquisition occurs. They should keep in mind that, depending on how deals are structured and whether contingencies exist, the valuation process could become more extensive than expected.
Now is the time to contemplate the ramifications of future deals – particularly deals that might not close until 2009. With the early guidance of auditors and valuation specialists, acquisitive companies will be well positioned to meet the new face of business combinations.
1. For the full Statement No. 141(R), see http://www.fasb.org/pdf/fas141r.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.